PennyMac Financial Services, Inc. (NYSE:PFSI) Q3 2020 Earnings Conference Call November 5, 2020 5:00 PM ET
Isaac Garden – Vice President Investor Relations
David Spector – President and Chief Executive Officer
Doug Jones – Chief Mortgage Banking Officer
Andy Chang – Chief Financial Officer
Good afternoon, and welcome to the third-quarter 2020 earnings discussion for PennyMac Financial Services, Inc. The slides that accompany this discussion are available on PennyMac Financial’s website at ir.pennymacfinancial.com. Before we begin, let me remind you that our discussion contains forward-looking statements that are subject to risks identified on Slide 2 that could cause our actual results to differ materially as well as certain non-GAAP measures. Thank you.
Now I’d like to begin by introducing David Spector, PennyMac Financial’s President and Chief Executive Officer who will review the company’s third-quarter 2020 results.
Thank you, Isaac. PennyMac Financial reported an increase in earnings from a record second quarter driven by higher income in both production and servicing. Net income was $535.2 million or diluted earnings per share of $7.03.
During the quarter, we issued $500 million of 5.375% Senior Unsecured Notes followed by an additional $150 million after quarter end, which I will explain upon later in my presentation. We also repurchased approximately 118,000 shares of PFSI’s common stock for an approximate cost of $6.9 million. Book value per share increased 22% to $41.67 from $34.26 at the end of the prior quarter. I’m pleased to note that PFSI’s Board of Directors declared a third quarter cash dividend of $0.15 per share.
Production segment pre-tax income was $613.3 million, up 14% from the prior quarter and up 242% from the third quarter of 2019, driven by continued growth in direct lending and strong performance across all channels. Direct lending locks were $16.4 billion in unpaid principal balance, up 26% from the prior quarter and up 153% from the third quarter of 2019. Of these, $10.9 billion were in the consumer direct channel, while $5.5 billion were in the broker direct channel. Government correspondent lock volume was $20.2 billion in UPB, up 56% from the prior quarter and up 27% from the third quarter of 2019.
Total production volume for the quarter was $54.2 billion in UPB, up 44% from the prior quarter and up 55% from the third quarter of 2019. And finally, correspondent acquisitions of conventional loans fulfilled for PMT totaled $27.4 billion in UPB, up 45% from the prior quarter and up 64% from the third quarter of 2019.
Moving on to Slide 4. The Servicing segment recorded pre-tax income of $111.7 million, up from a pre-tax loss of $62.4 million in the prior quarter and a pre-tax loss of $18.1 million in the third quarter of 2019.
Pre-tax income, excluding valuation-related items for the Servicing segment, was $179.5 million, up 107% from the prior quarter and 612% from the third quarter of 2019. These increases were primarily driven by loss mitigation activities related to COVID-19.
Valuation-related items included $37 million in MSR fair value losses, partially offset by $9.7 million in hedging and other gains. The net impact of these items was a pre-tax loss of $27.4 million and a $0.26 decrease in diluted earnings per share.
As of September 30, our Servicing portfolio totaled almost $402 billion in UPB, an increase of 4% from the end of the prior quarter and 15% from September 30, 2019. This increase was driven by high production volumes offsetting elevated prepayment activities.
Our Investment Management segment delivered pre-tax income of $3.3 million, down from $4.7 million in the prior quarter and down from $5 million in the third quarter of 2019. Net assets under management totaled $2.3 billion as of September 30, up 2% from June 30. Segment revenue was $9.8 million, down from $10.5 million in the prior quarter, which included gains related to PMT shares owned by PFSI.
Now let’s turn to Slide 5 and discuss why PennyMac Financial is unique among mortgage specialists. PFSI’s industry-leading platform was built organically and not through acquisitions with a disciplined approach to growth over its more than 12-year history. This development includes scalable processes and systems built for sustainable long-term growth.
We have maintained a strong governance and compliance culture led by a highly qualified and distinguished Board that includes eight independent directors. Our governance structure includes nine committees that oversee key risks and controls. Additionally, we have external oversight from regulators, business partners and other third parties. Our synergistic relationship with PMT, the REIT that we manage, has proven to be a competitive advantage for PFSI with tax-efficient access to long-term permanent capital.
The distinctive expertise we have today with a full range of capabilities across mortgage banking and investment management is core to the success and growth we have achieved. I am proud to tell you that we now have over 6,000 dedicated PennyMac-ers led by a deep and highly experienced management team. In fact, the 156 senior-most executives that PennyMac have, on average, 25 years of relevant industry experience.
Now let’s turn to Slide 6 and talk about the platform we have built. PFSI’s industry-leading mortgage banking franchise has substantial long-term value. According to Inside Mortgage Finance, over the last 12 months, we were the third largest producer of mortgage loans in the country with approximately $170 billion in UPB production.
We are one of the largest producers of loans delivered into Fannie Mae, Freddie Mac and Ginnie Mae-guaranteed securitizations, and we have a diversified model with production source from all three channels: correspondent, consumer direct and broker direct. As I will detail later on in the presentation, our leadership position in correspondent lending and our rapidly growing broker direct business position us well for growth in the more sustainable and growing purchase market.
Importantly, PFSI retains the mortgage servicing rights on all of its high-quality loan production, which, in turn, creates servicing portfolio growth and a flywheel effect. Our servicing portfolio growth has been primarily driven by the growth in our production volumes and has been supplemented with opportunistic bulk MSR acquisitions from time to time.
As I mentioned earlier, our servicing portfolio is now over $400 billion in UPB. And at June 30, we were the eighth largest servicer of residential mortgages in the United States, according to Inside Mortgage Finance.
Our servicing business provides recurring fee revenue captured over the life of the loans we service. And in the event of higher interest rates, the expected life of the loan would increase, which would result in a more valuable MSR asset. These dynamics create a natural hedge to production income. Importantly, our servicing portfolio drives leads for new originations in consumer direct, our higher-margin channel.
Mortgage banking requires both scale and efficiency for continued success, and we have built an industry-leading platform with a presence nationwide. Our servicing portfolio has almost 1.9 million valuable ongoing consumer relationships, and the proprietary technology we have built across our mortgage banking platform is world-class, with systems and capabilities well beyond leading industry vendors.
Now let’s turn to Slide 7 and discuss PFSI’s consistent track record of profitability and value creation. As you can see from the charts on the slide, over our more than seven years as a public company, PFSI has delivered strong results and returns to shareholders through varying mortgage market cycles with an average return on equity of 24%.
This consistent performance is attributed to the disciplined management we have maintained since our founding, combined with our diversified business model, including industry-leading businesses in loan production and servicing.
The substantial increase in earnings this year is due to not only COVID-related tailwinds but also significant advances in PFSI’s business. In contrast to our record financial results this year, in 2018, when mortgage rates increased and many lenders became unprofitable, PFSI reported net income of $244 million or a 13% return on average common stockholders’ equity.
The investments we have made over the years in our people, infrastructure and technology to drive operational scale and excellence have positioned us to perform well through the COVID crisis in the current historic low rate environment. This is evidenced by PFSI’s net income of $1.2 billion through the first nine months of 2020 or an annualized return on average common stockholders’ equity of 64%.
Net income and retained earnings have now driven our equity base to over $3 billion. And since our IPO in 2013, we’ve grown our book value per share at a compounded annual growth rate of 27%.
Now let’s turn to Slide 8 and discuss PennyMac Financial’s earnings growth. The faster growth of our consumer and broker direct lending channels is a significant contributor to PFSI’s increased earnings power. As you can see in the upper left chart on this page, the growth in production pre-tax income has been driven by the profitable growth of the direct lending channels.
PFSI is capturing this growth as a result of the significant investments we’ve made to scale our end-to-end mortgage fulfillment process. In addition, we continue to hire at a meaningful pace as a result of current refinance demand as well as our planned growth in these channels. Production segment pre-tax income for the first nine months of 2020 was nearly $1.4 billion, up significantly from $528 million for the full-year 2019.
In addition to providing PFSI with recurring earnings contribution, the Servicing segment earnings have been increasingly driven by the growth of our servicing portfolio and increased scale, along with loss mitigation activities. As you can see on the chart on the upper right, our operational results thus far in 2020 have more than doubled from full-year 2019 results with pre-tax income, excluding valuation-related changes, of $309 million.
And finally, Investment Management has grown in recent years, along with the growth in PMT’s equity. So while the macroeconomic outlook remains uncertain, we expect PFSI’s exceptional financial performance to persist through 2021.
Now let’s turn to Slide 9 to discuss PFSI’s orientation toward purchase money mortgages. PFSI’s most developed production business is our correspondent channel, which we entered into at a time when large banks, which had historically dominated this channel, reduced their participation.
As we grew this business, we focused our customer growth on those correspondents with a strong orientation towards the more sustainable purchase market. As a result, our purchase mix has consistently exceeded the industry average, and we were the second largest purchase money lender in the country over the last 12 months, according to Inside Mortgage Finance.
As we expanded our broker direct channel, we expect this strong orientation toward purchase money loans to continue. Our purchase money lending orientation has enabled PFSI to gain market share during years of declining mortgage origination markets as evidenced by our production volumes in 2017 and 2018, which remains essentially unchanged from 2016 despite higher rates in the smaller origination market.
The U.S. origination market for purchased loans has grown every single year since 2009 and, as I will talk about on the next slide, is expected to grow further in 2021, positioning PFSI for continued strong performance.
Now let’s turn to Slide 10 to discuss PennyMac’s opportunity in the mortgage origination market. Economic forecast for 2020 total originations have now increased to over $3.6 trillion, and forecast for 2021 total originations range from $2.5 trillion to $2.7 trillion. These forecasts indicate a continuation of the robust market supported by all-time low mortgage rates and expectations that the Federal Reserve will hold interest rates near 0 through 2023.
Purchase originations in 2021 are forecasted to increase 5% year-over-year, while refinance originations are expected to return to 2019 levels. PennyMac is well positioned to successfully grow all three channels, driving an increase in its overall market position. We’ve been able to capitalize on this current market environment as a result of our capital structure, risk management disciplines and significant infrastructure and technology investments.
Now let’s turn to Slide 11 to discuss market share across PennyMac businesses. As can be seen on this slide, PennyMac has a strong track record of market share growth across its mortgage production channels and servicing over the last several years. With over $125 billion in UPB of correspondent production for the first nine months of the year, we estimate our market share in this channel is 16.9%, up from 15.5% in 2019.
We also estimate that year-to-date, PennyMac’s market share in consumer direct is nearly 1%, up from 0.7% last year. The nearly 25% increase reflects our success growing the consumer direct channel. And with a servicing portfolio of over $400 billion in UPB and initiatives in place to grow non-portfolio originations, we are confident in the continued growth of this channel.
Our broker direct channel market position has grown substantially as well. As we have been able to apply our business-to-business expertise in the correspondent channel to our broker relationships. Currently, we estimate PennyMac represents a channel market share of 2%, nearly double from 1.1% in 2019.
Finally, our servicing portfolios continue to grow this year. And we estimate that we now service approximately 3.6% of all mortgage debt outstanding in the United States, up from 3.3% at December 31, 2019.
Next, let’s turn to Slide 12 and discuss the infrastructure we have built to enable PFSI’s rapid growth in mortgage banking. Crucial to the scalable architecture we’ve built is our centralized mortgage fulfillment organization, which performs loan processing and underwriting for all production channels.
We have developed an end-to-end fulfillment process for our direct lending channels, which enables our mortgage fulfillment division to remain flexible when market conditions change and allows for greater scalability than a traditional processing and underwriting model.
Our loan origination process is broken down into over 30 specific functions, which are then assigned to task specialists with a focus and expertise on that specific process. Furthermore, we have a growing platform with operations distributed in significant locations across the country and offshore, allowing us to operate more efficiently, drive down cost and attract talent for more labor markets.
Looking at the chart on the right. We have increased our employee base by over 1,800 PennyMac-ers for the nine months ended September 30, primarily to address the increased demand for mortgage production and servicing requirements. In fact, 89% of our employee growth this year has been in mortgage production and servicing roles. Additionally, production cost per loan is down, and loans per employer are up significantly from a year ago as we continue to realize the benefits of the investments we’ve made in infrastructure, technology and workflows.
Now let’s turn to Slide 13 and talk about our current focus for technology investments. With the expected growth in our direct lending businesses, ongoing technology investment is critical to our continued success.
Within our consumer direct lending channel, initiatives include enhancing our lead generation capabilities and use of data analytics, in addition to increasing the use of digital marketing to drive non-portfolio originations. And we continue to enhance our MAC consumer portal, thus improving the ability for borrowers to self-service throughout the entire origination process.
In our broker direct channel, we are focused on further reducing the length of our loan origination cycle via workflow enhancements and upgrades to our broker portal, POWER. We are also extending our best-in-class tools and solutions to our brokers to further enhance their self-service capabilities.
Finally, our mortgage fulfillment division is making enhancements to further automate and improve the production and distribution of loan documents. We are also increasing the use of online closings and fulfillment automation. All of these workflow and technology investments will improve the experience for the consumer and broker, improve productivity, specifically in sales and operations, which will enable higher volumes at a reduced cost to originate. Combined with P3, our new correspondent portal, and SSE, our proprietary servicing technology, these systems will provide a robust platform to drive operational scale and support future growth.
Now let’s turn to Slide 14 for an update on liquidity and capital. PFSI further strengthened its balance sheet with the issuance of $650 million of 5-year senior unsecured corporate debt in September and October. Net new liquidity raise was $500 million after retiring a $150 million revolving credit facility. This inaugural issuance was well received among institutional investors and represents a milestone in our long-term strategic initiative to diversify our liability structure, add unsecured term debt and improve PFSI’s corporate issuer ratings over time.
The use of proceeds in the near-term is to pay down short-term secured debt, resulting in no increase to overall leverage. PFSI’s available liquidity has now increased to approximately $1.6 billion as of October 31, consisting of approximately $500 million in cash and short-term investments and $1.1 billion that may be immediately drawn on secured facilities with excess pledged collateral.
We view our capital and liquidity position as an important competitive advantage. As I mentioned earlier, we have significant ongoing investments in our operations to ensure long-term success, specifically across our direct lending platform and mortgage fulfillment divisions. We also have significant capital requirements to support increased volumes of low production and EBO activity.
Furthermore, given current economic uncertainty, we believe it is prudent to maintain excess liquidity, which is also viewed favorably by regulators and the counterparties we work with on a daily basis. And finally, we will continue to evaluate other uses of excess liquidity including common share repurchases on an ongoing basis.
Now I’d like to turn it over to Doug Jones, PennyMac Financial’s Chief Mortgage Banking Officer for an update on volumes and trends in our production and servicing businesses.
Thank you, David. Let’s turn to Slide 15. Correspondent acquisition volumes totaled $44.3 billion in UPB in the third quarter, up 48% from the prior quarter and 43% from the third quarter of 2019. 38% of correspondent acquisitions were government loans, and 62% were conventional loans. Government loan acquisitions in the quarter totaled $17 billion in UPB, up 54% from the prior quarter.
Conventional correspondent acquisitions, for which PFSI earns a fulfillment fee from PMT, totaled $27.4 billion in UPB, up 45% from the prior quarter and 64% from the third quarter of 2019. Government correspondent locks were $20.2 billion in UPB, up 56% from the prior quarter and up 27% from the third-quarter 2019. In October, our correspondent acquisitions totaled $18.7 billion and locks totaled $21.7 billion.
Looking at the consumer direct channel in the center column, we originated $6.3 billion in UPB of loans, up 24% from the prior quarter and 138% from the third quarter 2019. Interest rate lock commitments in the third quarter totaled $10.9 billion in UPB, up 22% from the prior quarter and 136% from the third quarter of 2019. In October, our consumer direct originations totaled $2.4 billion in UPB and locks totaled $4.3 billion. The committed pipeline at October 31 was $7.3 billion.
Finally, broker direct originations totaled $3.5 billion in UPB in the third quarter, up 34% from the prior quarter and 190% from the third quarter of 2019. Interest rate lock volume was $5.5 billion in UPB, up 34% from the second quarter and 195% from the third quarter of 2019. In October, our broker direct originations totaled $1.4 billion in UPB and locks totaled $2 billion. The committed pipe at October 31 was $2.1 billion. PFSI’s production margins remained elevated, especially given the mix shift to consumer and broker direct.
Now let’s turn to Slide 16 and discuss additional Production segment highlights and trends in the channels. PennyMac remained the largest correspondent aggregator in the U.S. in the third quarter as overall correspondent channel volumes return from low levels in the second quarter.
Margins in the channel continue to benefit from the increased volume of higher-margin, best efforts commitments, which increased to 40% of lock volume or $21.8 billion in UPB, up from $14.3 billion in the second quarter and $6.9 billion in the third quarter of 2019. Government correspondent margins were down from record levels in the second quarter but remain high on a historical basis. I am proud to report that all of our correspondent clients have now migrated to P3, PennyMac’s new correspondent lending portal.
Moving on to consumer direct, we achieved record quarterly volumes as a result of advanced modeling and analytics, combined with the recent growth in sales and fulfillment capacity. Additionally, we continue to see benefits from our low-cost infrastructure and end-to-end fulfillment process that David had talked about.
As a result of the initiatives launched at the beginning of the year, non-portfolio interest rate lock commitments totaled $906 million in the third quarter, up from $568 million in the prior quarter and $90 million in the third quarter of 2019. Margins decreased modestly but also remained elevated relative to historical levels.
Lastly, we saw record funded and lock volumes in our broker direct channel driven by the increase in approved brokers and our larger presence in the channel. Our approved brokers totaled 1,422 at September 30, up 13% from June 30, and we believe we can continue to garner share from the estimated 12,000 brokers and non-delegated sellers active in the market. Margins have decreased from the peak levels seen in the second quarter but remain high on a historical basis.
Now let’s turn to Slide 17, and I will highlight results in our Servicing segment. Our servicing portfolio grew to $401.9 billion in UPB at the end of the third quarter, up 4% from June 30 and 15% from September 30, 2019, driven by record production volumes that drove portfolio growth despite elevated prepayment activity. PennyMac Financial’s own portfolio reported a prepayment speed of 29.7% in the third quarter, up from 24.4% in the prior quarter.
Similarly, the prepayment speeds of PennyMac Financial’s sub-serviced portfolio, which includes mostly Fannie Mae and Freddie Mac mortgage servicing rights owned by PMT, increased to 39.2% from 34.8% in the prior quarter. Our owned portfolio had a 60-plus day delinquency rate of 11.4%, down slightly from 11.7% at the end of the prior quarter, while our sub-serviced portfolio reported a 60-plus day delinquency rate of 3.7%, down from 5.1% at June 30 as borrowers begin to emerge from forbearance plans.
The UPB of completed modifications was $4 billion, up significantly from $595 million last quarter and the UPB of EBO loan volume totaled $2.7 billion, also up significantly from last quarter, as a result of substantial increase in loss mitigation activities.
That concludes my presentation, and now I’d like to turn it over to Andy Chang, PennyMac Financial’s Chief Financial Officer.
Thank you, Doug. On Slide 18, I will discuss our Investment Management segment, then highlight some of the key trends and factors in PFSI’s financial results. We encourage you to read our press release for more detailed information. Net assets under management totaled $2.3 billion at September 30, up 2% from June 30, primarily due to the increase in PMT’s book value.
Investment Management revenues were $9.8 million, down from $10.5 million in the prior quarter, which included gains related to PMT shares owned by PFSI. In the third quarter, PFSI did not recognize incentive fees, which we do not expect to resume for some time.
Slide 19 summarizes the impact of our hedging results on PFSI’s earnings. Our comprehensive hedging strategy is designed to moderate the impact of interest rate changes on the fair value of our MSR asset and also considers production-related income.
The fair value of our MSR decreased modestly in the third quarter driven by increased estimates of foreclosure costs impacted by COVID-19. The decrease was partially offset by $9.7 million in hedging and other gains and was more than offset by PFSI’s record production income in the quarter.
Let’s turn to Slide 20 to look at the drivers of profitability and PFSI’s Production segment. This slide breaks down the revenue contribution from each of PFSI’s loan production channels, net of loan origination expenses, including the fulfillment fees received from PMT for conventional correspondent loans.
The direct lending channels have an outsized impact on PFSI’s production earnings. Consumer and broker direct represented 21% of fallout-adjusted lock volume in the third quarter but accounted for over 70% of segment pre-tax income. Production revenue margins remain elevated, especially with PFSI’s mix shift to consumer and broker direct. Revenue per fallout-adjusted lock for PFSI’s own account was 236 basis points in the third quarter, up from 118 basis points a year earlier.
Our costs vary by channel, ranging from approximately 15 basis points in correspondent to 150 basis points in consumer direct. As our production mix continues to shift toward direct lending, production expenses as a percentage of fallout-adjusted locks are expected to trend higher.
Now let’s turn to Slide 21 to discuss the profitability of our Servicing segment. Pretax income for the Servicing segment, excluding valuation-related changes, was a record $179.5 million, up from $86.9 million in the prior quarter and $25.2 million in the third quarter of 2019. Operating revenue increased $4.2 million quarter-over-quarter driven by higher fees from our growing servicing portfolio.
EBO loan-related revenue increased significantly to $170.2 million as a result of loss mitigation activity on loans emerging from forbearance, while related expenses were modest as most of the loans bought out returned to performing status immediately.
Payoff-related expense, which includes interest shortfall and recording and release fees related to prepayments, remains elevated and increased by $6.1 million quarter-over-quarter. Valuation-related changes in the third quarter included $40.5 million in provision for credit losses on active loans driven by higher delinquencies related to COVID-19.
Now let’s turn to Slide 22 and discuss trends in delinquencies, forbearance and loss mitigation for PFSI’s MSR portfolio. As you can see on the slide, the 30-plus day delinquency rate of PFSI’s MSR portfolio at September 30 was 14.1%, down from 15.1% at June 30. The percentage of loans in forbearance decreased to 10.1% at September 30 from 12.4% at June 30 as new forbearance plans since June 30 were more than offset by the 34% of borrowers in forbearance plans at June 30 who have since exited.
Of our borrowers who were in forbearance at June 30, 16% exited related to reperformance. Of those, 9% were or became current and 7% were FHA partial claims or completed modifications. Servicing advances outstanding were approximately $346 million at September 30, up from $237 million at June 30 and are expected to continue increasing over the next six to 12 months.
No P&I advances have been made in 2020 as prepayment activity continues to sufficiently cover Ginnie Mae’s requirement. As Doug mentioned, $2.7 billion in UPB of loans were bought out in conjunction with loss mitigation efforts in the third quarter. 79% was related to FHA partial claims, which must remain current for a minimum of six months to be eligible for resecuritization. 21% was modifications, which may be resecuritized immediately.
At September 30, 9% of the loans in PFSI’s predominantly government loan portfolio were delinquent and in forbearance. We expect elevated levels of reperformance and resecuritization to continue into 2021.
And with that, I would like to turn it back over to David for some closing remarks.
Thank you, Andy. PennyMac Financial again delivered record earnings in the third quarter driven by increases in income from both our Production and Servicing segments. Record Production income resulted from outstanding performance across all channels and continued growth in our higher-margin consumer and broker direct lending channels. We continue to add capacity for further growth and now have more than 6,000 PennyMac employees throughout our operations across the country.
Our servicing portfolio grew over $400 billion in UPB, thanks to our record production volumes, which more than offset elevated prepayment speeds, and servicing made a significant contribution to the company’s earnings driven by COVID-related loss mitigation activities. PennyMac Financial has a long track record of consistent profitability and value creation throughout its history, including more than seven years as a public company.
Our leading Loan Production business, historically oriented to the purchase market, and our servicing portfolio of nearly 1.9 million customers position the company to succeed across different market environments. The expected growth in direct lending and continued loss mitigation activities in our servicing business are positive trends driving PFSI’s success.
So while the macroeconomic outlook remains uncertain, we expect PennyMac Financial’s exceptional financial performance to persist through 2021.
Lastly, we encourage investors with any questions to reach out to our Investor Relations team by email or phone. If any such questions are received, we will post these questions and our answers to our website. Thank you.
This concludes PennyMac Financial Services, Inc.’s third quarter earnings discussion. For any questions, please visit our website at ir.pennymacfinancial.com or call our investor relations department at 818-264-4907. Thank you