PennyMac Mortgage Investment Trust (PMT) CEO David Spector on Q4 2018 Results - Earnings Call Transcript

PennyMac Mortgage Investment Trust (NYSE:PMT) Q4 2018 Earnings Conference Call February 7, 2019 5:00 PM ET

Company Participants

Chris Oltmann - SVP, IR

Stan Kurland - Executive Chairman

David Spector - CEO

Andrew Chang - CFO

Chris Oltmann

Good afternoon, and welcome to the Fourth Quarter Earnings Discussion for PennyMac Mortgage Investment Trust. The slides that accompany this discussion are available from PennyMac Mortgage Investment Trust's website at www.pennymac-reit.com. Before we begin, please take a few moments to read the disclaimer on Slide 2 of the presentation. Thank you.

Now I'd like to turn the discussion over to Stan Kurland, PMT's Executive Chairman.

Stan Kurland

Thank you, Chris. Let's begin with Slide 3. For the fourth quarter, PMT reported net income attributable to common shareholders of $35.4 million or $0.55 per share. Annualized return on average common equity for the quarter was 11%, down from 13% in the prior quarter. PMT paid a dividend of $0.47 per share for the quarter, and book value per common share increased to $20.61 at quarter-end from $20.48 at September 30, 2018.

Our operating results reflect solid contributions from our GSE credit risk transfer or CRT investments and Interest Rate Sensitive Strategies. Fair value declines in CRT and mortgage servicing rights investments held in PMT's taxable subsidiary drove $15.4 million in income tax benefits.

PMT reports results through 4 segments: Credit Sensitive Strategies, which contributed $17.9 million in pretax income; Interest Rate Sensitive Strategies, which contributed $20.1 million in pretax income; Correspondent Production, with a pretax loss of $600,000; and Corporate, with a pretax loss of $11.2 million.

During the fourth quarter, PMT continued to deliver growth in its core investments in CRT and MSRs resulting from its own Correspondent Production activities. Conventional Correspondent Production totaled $9 billion in unpaid principal balance or UPB, up 21% from the prior quarter, and conventional loan acquisitions from PennyMac Financial totaled $879 million in UPB, down slightly from the prior quarter. Loans eligible for CRT deliveries totaled $8.1 billion in UPB, resulting in firm commitments to purchase $310 million of CRT securities. New MSR investments added during the quarter totaled $128 million, up from $96 million added in the third quarter. Lastly, we completed $267 million in UPB of sales of performing and non-performing loans from our distressed portfolio.

Now let's turn to Slide 4 and discuss the current market environment. The fourth quarter saw increased market volatility as a result of global growth concerns and uncertainty regarding the trajectory of the Federal Reserve monetary policy. However, the Federal Reserve recently signaled it will be patient in regards to any future rate hikes, which has helped reduce volatility. During the fourth quarter, the average 30-year fixed mortgage rate was 22 basis points higher on average than in the prior quarter. However, at quarter-end, mortgage rates retreated about 50 basis points from their mid-quarter high of nearly 5% in mid-November and have remained at those levels after year-end, driving expectations for a modest increase in refinance activity.

Credit spreads widened and finished the year 40 to 80 basis points wider than they were at September 30 as the increase in volatility during the quarter contributed to a higher premium for risk assets. This year, so far, however, spreads have substantially recovered.

A healthy overall economy, low unemployment and favorable trends among home-buying demographics, in addition to slowing home price appreciation growth, are driving a purchase market outlook that is expected to grow by mid-single-digit percentages over the next couple of years.

Mortgage delinquencies improved further quarter-over-quarter, with the total U.S. loan delinquency rate falling to 3.9% at year-end, down from 4% at September 30 and 4.7% a year ago, driven by a favorable U.S. economy, high-quality mortgage underwriting standards and strong home prices.

Now let's turn to Slide 5 and discuss PMT's unique business model. PMT is focused on U.S. residential mortgage-related investments that leverage the operational capabilities of its manager and service provider, PennyMac Financial. PMT's partnership with PennyMac Financial provides it access to specialized mortgage capabilities, including industry-leading production and servicing operations. Our model has delivered a track record of stable book value and attractive dividends as well as an annualized total return to shareholders of 10% since our IPO.

PMT sources organically generated investments from its own conventional conforming mortgage production, including MSRs and investments in CRT, where we retain a portion of the credit risk associated with the loans we produce. Our MSR investments are part of a comprehensive set of Interest Rate Sensitive Strategies that also include Agency MBS and hedging instruments designed to minimize the impact of interest rate volatility on PMT's earnings. PMT was the second largest correspondent producer in 2018 according to Inside Mortgage Finance and the fifth largest producer of conventional conforming loans.

Another key differentiating factor for PMT is the diversity of its financing, which includes strong bank partnerships and debt held by institutional investors and relatively modest leverage versus peers. We have over $4 billion of warehouse line financing capacity sized to support growth in our production volumes. Last year, we put in place a Fannie Mae MSR financing structure that provides long-term financing for one of PMT's largest assets through issuance of secured term notes that are more effectively matched with the life of the MSR asset and diversify our financing counterparties to include institutional investors. In addition to existing financing for our CRT investments from multiple banks, we are pursuing alternative structures to provide longer-term and more advantageous financing.

Underpinning all of PMT's strategies and growth initiatives is a robust governance and risk management infrastructure overseen by an executive management team with substantial industry experience. We have sophisticated programs to identify and manage risk across the enterprise, including comprehensive interest rate risk management activities. Overall, we believe PMT is in a strong position to support growth in both our core CRT and MSR investment strategies as well as new investment opportunities with attractive long-term return profiles.

Now let's turn to Slide 6 and discuss the strong performance of PMT's unique mortgage-related investments. A key element of PMT's strong performance is its high-quality balance sheet, which is comprised of long-lived mortgage investments focused on core strategies of organic investments in CRT and MSRs, in addition to mortgage-backed securities utilized as a hedge for interest rate sensitivity. We also hold newly originated mortgage loans acquired in our Correspondent Production activities on our balance sheet pending sale or securitization.

PMT has delivered strong returns as our CRT and MSR investments have grown and the impact on earnings from our distressed loan portfolio has been reduced through bulk sales and resolution activities. The success of our strategies is evidenced by the 25% year-over-year increase in net income attributable to common shareholders and the corresponding improvement in PMT's return on equity. Further, we are confident in our ability to deliver our shareholders strong risk-adjusted returns given the opportunities afforded to PMT to invest in new products in the mortgage market, such as HELOCs and prime non-QM securitization interests.

Now let's turn to Slide 7 and review the run rate quarterly return potential of PMT's strategies. Our expectation for PMT's activities is a run rate diluted EPS of $0.52 per quarter, which would result in an annualized return on common equity of approximately 11%. PMT's run rate potential reflects our expectation for returns over the next several quarters. Our income potential results from continued growth of CRT and MSRs, organically driven by our Correspondent Production activities.

PMT's run rate equity allocation related to Credit Sensitive Strategies is 42%, with an expected annualized return on equity of 20.4%, driven by continued strong performance from and growth in CRT investments. Our outlook also reflects expectations for a reduced impact from the significantly smaller distressed loan portfolio.

Equity allocated to Interest Rate Sensitive Strategies is also 42%, with annualized return on equity expectations of 11.3%. We consider the results of this segment in aggregate as MBS and hedge positions are primarily used to moderate the impact of interest rate volatility on MSRs and ESS returns. Our expectations are primarily driven by our outlook for the earnings contributions from the growing MSR asset.

The Correspondent Production segment is expected to deliver an annualized return on equity of 9.2%, which reflects our outlook that the competitive production environment that prevailed throughout 2018 will continue for the foreseeable future.

This concludes my presentation. I'd now like to turn the discussion over to David Spector, PMT's President and Chief Executive Officer, who will review our mortgage investment activities.

David Spector

Thank you, Stan. Let's start with Slide 9 for a look at our Correspondent Production highlights. Correspondent acquisitions by PMT in the third quarter totaled $18.1 billion in UPB, up 9% quarter-over-quarter and up 17% year-over-year.

Conventional conforming acquisitions for which PennyMac Financial performed fulfillment services for PMT totaled $9 billion in UPB in the fourth quarter, up 21% from the prior quarter and up 54% year-over-year. Government acquisitions were down 1% quarter-over-quarter while down 7% year-over-year. Total lock volume was $19.1 billion in UPB, up 7% from the prior quarter and 20% year-over-year. Additionally, PMT acquired $879 million in UPB of conventional conforming loans originated by PennyMac Financial during the fourth quarter, down slightly from the $897 million in the prior quarter.

Correspondent Production recorded a small pretax loss in the fourth quarter compared to pretax income as a percentage of locks of 7 basis points in the prior quarter. While the market for conventional conforming loans remains competitive, our Correspondent Production segment results reflect PMT's ability to create attractive long-term investments in CRT and MSRs from its production. The weighted average fulfillment fee in the third quarter was 32 basis points, down from 35 basis points in the previous quarter, reflecting discretionary reductions made by PennyMac Financial to help facilitate successful loan acquisitions.

We experienced substantial growth in our correspondent seller relationships during the fourth quarter, reaching 710 correspondent clients at quarter-end, up from 655 at September 30. This growth reflects our ongoing strategic initiatives to attract community banks and credit unions and our continued focus on growing the non-delegated business. In the fourth quarter, we originated $120 million in UPB of non-delegated correspondent loans, up 61% from $75 million in the prior quarter.

Purchase-money loans comprised 88% of total fourth quarter acquisitions, up from 87% in the prior quarter and 76% in the fourth quarter of 2017. We also remain focused on developing new products to address consumers' evolving mortgage financing needs, and in January, we launched a prime non-QM loan product that utilizes a technology-based underwriting solution. Monthly production and interest rate lock commitment volumes in January totaled $5.2 billion in UPB.

Finally, through 2018, we have benefited by receiving incentives under one of our master repurchase agreements to finance mortgage loans that satisfy certain consumer relief characteristics. We expect to cease accruing the incentives beginning in the second quarter of 2019. While the impact is uncertain, we expect that the decrease in our interest income resulting from this change will be offset by an improvement in pricing margins.

Now let's turn to Slide 10 and discuss PMT's investments in GSE credit risk transfer. Eligible CRT loan deliveries in the fourth quarter represented 81% of PMT's total loan production, unchanged in the prior quarter but up significantly from the same period a year ago, with the increase enabled by our new REMIC CRT transaction structure with Fannie Mae.

On a pro forma basis at December 31, PMT's outstanding CRT investments totaled $1.9 billion, with the UPB of the loans underlying the CRT agreements totaling $46 billion. The credit performance underlying our CRT loans remains strong, with lower delinquency levels at December 31 than at the end of the prior quarter. Losses recognized during the quarter were $700,000, bringing the cumulative lifetime losses on our CRT investments to $3.6 million, in line with expectations and normal portfolio seasoning.

Now let's turn to Slide 11 and discuss MSR and ESS investments. PMT's organic MSR investments resulting from its Correspondent Production activity as well as conventional conforming loans acquired from PennyMac Financial increased to $1.2 billion at year-end, up from $1.1 billion at September 30. This increase was driven by additions from our loan production activities net of runoff, slightly offset by the decrease in fair value from lower mortgage rates at year-end.

PMT's legacy ESS investments resulting from bulk, mini-bulk and flow MSR acquisitions by PennyMac Financial from 2013 to 2015 decreased slightly from $223 million at the end of the third quarter to $216 million at the end of the fourth quarter, with the ongoing reduction resulting from prepayments and amortization of the underlying loans. The UPB associated with ESS investments totaled $23.2 billion at December 31, down from $24.1 billion at the prior quarter-end. PMT's MSR portfolio totaled $92.4 billion in UPB at December 31, up from $84.4 billion at September 30.

Now let's turn to Slide 12 and talk about the transition out of PMT's distressed loan investments through liquidations and sales. During the fourth quarter, we completed $267 million in UPB of previously announced distressed loan sales. At quarter-end, the distressed loan portfolio totaled $201 million in UPB, down from $488 million in UPB at the end of September. Performing loans in our distressed loan portfolio stood at $43 million in UPB, down substantially from $262 million at the end of the third quarter, driven by bulk sales. The non-performing loan portfolio ended the quarter at $158 million in UPB, a 30% decrease from the end of the prior quarter and down 70% from a year ago.

Now I'd like to turn the discussion over to Andy Chang, PMT's Chief Financial Officer, to break down the fourth quarter's financial results.

Andrew Chang

Thank you, David. Let's turn to Slide 14 and discuss the fourth quarter's income and return contributions by strategy.

PMT's activities in the fourth quarter generated an annualized return on common equity of 11%, net of all expenses. In total, Credit Sensitive Strategies contributed $17.9 million to pretax income or an 11% annualized return on equity for the quarter. Within the segment, CRT investments contributed pretax income of $21.8 million, which I will expand upon in the next slide. Distressed loan investments contributed a $4.1 million pretax loss, down from a $9 million loss in the third quarter, primarily resulting from improved performing loan valuations and lower expenses as a result of a smaller portfolio.

Interest Rate Sensitive Strategies, which include the performance of our MSRs, ESS and Agency and non-Agency senior MBS positions and related interest rate hedges, together contributed $20.1 million of pretax income or a 10% annualized return on equity for the quarter. The fair value of our MSR investments declined due to the decrease in mortgage rates at the end of the quarter and was largely offset by the increase in the fair value of our Agency MBS positions. While we show the income contribution for each of these Interest Rate Sensitive Strategies separately, they are managed together as the interest rate sensitivity of MSRs and ESS is inversely correlated to that of MBS and our other interest rate hedges. Correspondent Production contributed a pretax loss of $600,000, driven by the market factors David discussed earlier. The Corporate segment contributed an $11.2 million pretax loss. Lastly, as Stan mentioned, fair value declines in PMT's taxable REIT subsidiary drove a $15.4 million benefit for income tax expense.

Now let's turn to Slide 15 and break down the performance of our GSE credit risk transfer investments. Our CRT investments contributed $21.8 million of pretax income in the quarter, consisting of $5.7 million of losses from market-driven value changes, more than offset by $27.6 million of income from net realized gains and net interest income. Losses from market-driven value changes consisted of $19.6 million driven by credit spread widening on existing CRT investments, partially offset by $13.9 million of net gain on mortgage loans acquired for sale relating to the fair value recognition upon loan delivery under firm commitment to purchase CRT securities under the new REMIC structure. Excluding market-driven value changes, income related to our CRT investments totaled $27.6 million. Realized gains on existing CRT investments totaled $30.1 million, while losses recognized during the quarter totaled $0.7 million. Interest income, which we earn on cash deposits securing CRT investments, was $6.7 million, while interest expense, which relates to the financing of these investments, was $8.5 million.

And with that, I'll turn the discussion back over to Stan for some closing remarks.

Stan Kurland

Thank you, Andy. PMT's partnership with PennyMac Financial and exclusive access to unique investments in GSE CRT and MSR from its own conventional Correspondent Production have delivered strong results, placing PMT among the top performing residential mortgage REIT stocks in 2018. We remain focused on prudently growing PMT's core investments in CRT and MSRs while continuing to seek attractive new opportunities in the dynamic U.S. mortgage market.

The recent launch of HELOC and prime non-QM products by our manager and service provider, PennyMac Financial, is expected to leverage PMT's ability to securitize and retain credit risk investments from securitizations while further diversifying its investment portfolio.

Lastly, we encourage investors with any questions to reach out to our Investor Relations team by e-mail or phone. Thank you.

Chris Oltmann

This concludes PennyMac Mortgage Investment Trust's fourth quarter earnings discussion. For any questions, please visit our website at www.pennymac-reit.com or call our Investor Relations department at 818-224-7028. Thank you.

Question-and-Answer Session

End of Q&A