PennyMac Financial Services, Inc. (PFSI) Earnings Call Transcript & Summary

Good afternoon, everyone. Welcome. Thank you for joining us. My name is Terry Ma. I'm the consumer finance [Audio Gap] Spector, the CEO, and Dan Perotti, the CFO. So welcome...

Thank you.

Thank you for hosting us, Terry.

Yes. So I think we'll just get right into it. Let's start with a mark-to-market in the third quarter. I think you guys put out the August update today. Can you maybe just touch on what you're seeing across each channel and then also just the competitive environment?

Sure, sure. Well, we -- as you pointed out, we released some August updates this morning. And we're seeing a very good opportunity for us. The market in of itself is running at a rather anemic pace of $1.2 trillion to $1.3 trillion in originations. On the correspondent side, we're starting to see some -- I think, some perceived share growth. We'll find out when the numbers finally come out in October but we're seeing some good activity there, both on the government and conventional side. We had some issues in the second quarter with guarantee fee volatility of the GSEs and some irrational pricing on certain executions on the government side. But on the correspondent side, we have -- at the end of the second quarter, we were reporting share of about 18%, 19%. I expect it to be above 20% at the end of this quarter. Having said that, we're seeing some good margin opportunities. And while they remain flat, I think given the size of the market, that in of itself is a really good sign. On the broker side, there we're seeing margins remaining steady. We're the #3 broker originator, but #1 is 50%, #2, [indiscernible]. And so there's really good opportunity for us to continue to grow share. We have increased production in August, both locks and fundings in broker and I'm hopeful that, that will continue. On the consumer direct side, there, it's -- we're really seeing depths of the low volume of refinance activity in the marketplace. The one that I'll say the real bright light are consumer direct channels are closed-end second. We're doing about -- we're doing over $100 million a month in locks there. And that's a product that we introduced for our portfolio before -- 3% mortgages, who want to take equity out of the properties, whether it's existing debt or to do all the modeling. There, we're seeing very strong activity and all of this speaks to really supporting what we've built in PFSI and that is a large servicing portfolio or consumer direct channel serves as an integral part of the flywheel that we've created in itself. In correspondent right now, we're buying a lot of 6% mortgages that ultimately rates will decline and we'll have our consumer direct channel available to refinance those loans, and that's another value of our closed-end second product and that will keep the capacity in place to be able to pivot to cash out refinances or rate and term refinances when rates would decline.

Got it. So helpful color there. You touched on it a little bit, the origination market is running at a $1.2 trillion to $1.3 trillion run rate this year so far. I think MBA and Fannie are closer to $1.7 trillion in our estimates. And I think for 2024, they're $1.9 trillion and $2 trillion. So just a million dollar question is what's your view on originations for '24?

Well, personally, I think we're going to be higher for longer. So my [ guess ] would be the low $2 trillion. Th., important thing to remember is the managing both PFSI and PMT. We really think about managing these vehicles -- these companies to a range of accounts. And then what we've built in PFSI is really unique in that we have an extensive business model. So in many cases, take higher for longer for us gives the opportunity to buy more loans and to correspond and build the servicing portfolio with [indiscernible] mortgages. But when rates do decline, and we see production increase where you will be able to participate in the refinance opportunity that comes about as a result of that. In the case of PMT, there, we've kind of very -- have a [ tricky ] balance sheet from our CRT investments, combined with the lower note-rate mortgages that whether it's higher for longer I think by and large, it's going to have as much over the past. But I would say that it's going to be tough [indiscernible] for the next 12 months, at least, I suspect.

Got it. That's helpful. And what did you say was the ideal operating environment if you have to tentative higher for longer or the rates come down to [indiscernible] maybe end of next year?

I think I'm going to higher for longer [indiscernible] product. We have the ability to continue to operate efficiently in terms [indiscernible] weren't a real position at both companies. But when you think about what we've gone through in the last year. There's been a lot of volatility and a lot of unknown. And the scenario we're now where the consumer is very healthy in making their payments, housing is starting to appreciate again, delinquencies to remain lower and I talked about with the consumer. We still have ongoing mortgage [indiscernible] spot to but the servicing portfolio remains strong and have the ability to add to that servicing portfolio I think, is very valuable to us. And obviously, as we [indiscernible] now when rates do decline, we'll have more of a universe of refinance the mortgages to be...

I think the other piece, too, is that given that the position we're in, where we have this balanced business model being higher for longer allows for some more consolidation of the industry, some reduction of capacity and again some renormalization of some of the margins and so forth so that when we do -- having a sharp interest rate rally in the near term would be a feel good and sort of the short term, right, everyone likes to see the production numbers go up but we're probably in a better competitive position in the higher for longer scenario as we look out further and what the ultimate best case for long time as we look at the franchises.

That's helpful. Can you talk about what the current rate environment means for servicing profitability? Are there any opportunities to add additional operating leverage to your businesses?

So in terms of servicing profitability, having higher rates is beneficial. Obviously, we have lower prepayment speeds, which benefits us from an operational point of view and also from the point of view of visibility of cash flows, generally speaking, scenario should be a lower cost of service because you don't have as much sensitivity -- lower cost to hedge rather because you don't have as much sensitivity of the portfolio from a prepayment fee perspective. The other benefit that we see in the current [Technical Difficulty] environment is -- are earnings on escrow balances that we manage for the borrowers or for the investors in the mortgage loans or mortgage-backed securities. Both principal and interest and taxes and insurance funds that come into us before we have to remit that we hold in custody for those borrowers or the agencies [indiscernible] placement fees for placing those deposits at different banks. And our general earnings rate there is Fed funds plus a bit of a spread. So you can see in our servicing profitability, that lien item has increased from being pretty minimal just 2 quarters ago when interest rates -- short-term interest rates were so low to approaching $100 million a quarter in the most recent quarter. And so that's been a really big benefit for us on the servicing side. In terms of getting leverage on business, we have continued to focus on the expenses or the operational costs in our servicing division continue to drive those down to get additional ridge out of our servicing business. You've also been taking on through our corresponded business at PFSI, taking on an additional portion of the correspondent loans over the past few quarters. So I think PMT and PFSI, the correspondent business has traditionally been split where PMT has retained the conventional correspondent loans. PFSI has retained the government correspondent loans. As PMT's portfolio has been in terms of MSRs they've been selling through -- actually a significant portion of the conventional correspondent loans that's allowed us to grow our mortgage servicing rights portfolio at a more rapid pace in PFSI that gives us also some additional [indiscernible] from a servicing profitability point of view in PFSI and allows us to deploy our capital [indiscernible] in a quicker fashion.

Got it. So you talked a bit earlier by adding current note rate loans to your portfolio via correspondent channel. Maybe just talk about why that's the preference versus going to the bulk MSR market?

Sure. So if you look at the bulk MSR market, a significant portion of the loans in the bulk MSR market, especially the larger packages that have come out are generally 2020, 2021 vintage lower note rate not likely to be refinanceable in the near future. As opposed to the loans that we bring into our portfolio via correspondent are all recently originated high note rate and have a decent amount of likelihood as interest rates bounce up and down over the next few years of having some ability to be refinanced through our consumer direct channel and thus add additional sort of profitability or additional avenues of generating revenue from that customer that we're bringing on. Additionally, we prefer originated mortgage servicing rights of which corresponded classification we're selling the loan and generating mortgage servicing rights as opposed to acquiring because it provides a tax benefit for us. We assume a deferred tax liability when we do that, hence that gain from recognizing the originated mortgage servicing rights is again for a gap we are bringing an asset onto our balance sheet, but it's not recognized for the tax. And so we're effectively deferring that income out into the future that allows us better sort of leverage in the business from being able to recognize that deferred tax liability, and that is not an advantage that would [indiscernible] put us if we were to just purchase the servicing rights out in the market. And so that's really the aspects. I'd say the final advantage there is that in terms of the correspondent loans versus a package, we do diligence on all of the loans that come through our correspondent channel, we're able to sort of pick and choose on a loan level basis. What type of characteristics we want to bring into our portfolio. And you have a more limited ability to do that when you're looking at whole packages. It's generally potentially, there are some ways to carve out certain pieces but generally speaking, you're sort of taking the package as it comes.

Got it. Can you just touch on the bulk market itself? What are you seeing there in terms of potential returns or pricing?

Bulk MSR?

Yes, bulk MSR.

Bulk MSR. Overall, our view in terms of the way that we analyze the bulk MSR packages on an ROE we're seeing returns in the double digits -- potentially mid-double digits within for PMT1, one package is a little over $1 billion of unpaid principal balance that hit our target returns. But overall, we've been very judicious about sticking to our target return levels [indiscernible] pulls straight away generally that we're looking at in that regard.

Got it. So let's maybe switch gears and talk about overall ROE. I think ROE last quarter was 7%. And you talked about getting back to pre-COVID ranges over the near term. So can you maybe just provide some color on how you bridge from 7% to double digit?

So if you look at the balance of our business currently, given the overall mortgage origination environment, as David mentioned in terms of the piece that we're seeing in the most recent month or 2 been at a [ $1 trillion to $1.3 trillion ] pace. Overall, that's constrained the production side of our business somewhat there's only so much mortgage volume to do in specialty consumer direct side, where there's a very limited number of our general -- they're general for us. As we look forward in time with overall mortgage volumes, pushing back toward a $2 trillion market moving in that direction, gives us a little bit more sort of leverage, if you will, on the production side of the business. We have the ability to expand in broker direct where we're the #3 originator in that channel. There's additional opportunities in terms of consumer direct, both on the second lien side and if there's additional interest rate volatility being able to capitalize on that we brought in for the correspondent sale at these higher rate and refinance those loans gives us some additional upside [indiscernible] in terms of that channel. There's probably some [indiscernible] to expand, certainly as the market expands in correspondent and we really like the competitive dynamics there. But overall, those 3 channels continuing to grow really almost historic -- historically low levels of activity that we're seeing today leaves us back towards our pre-COVID ROEs, double-digit ROEs and ultimately normalizes up toward our [indiscernible] in a normalized environment of 20% of...

Yes. So the longer-term goal was 20 plus. Is that just what you need to get from double digits to 20% plus just a more normalized market? Or is there -- are there any other levers or things.

Similarly to when we went through this in our Investor Day back in '21, a normalized environment where that probably is the market evolve a little bit of [ $3 trillion ] with overall market volumes is probably a sort of underlying condition that we would expect if we were to get to the 20% plus. But as the market is moving that way, that gives us the firepower, if you will, our ROEs at double digit.

Got it. And then just on the expense side of the equation, how do you think about that as you match back toward double digits?

On the expense side of the equation, we really normalized pretty significantly over the past year in 2022. We are very early in terms of bringing down our expenses went from headcount over 7,000 to about 4,000 dip today, obviously reduced our expense base. At this point, we are mostly at what we think of as core functionality. And so from a base expense perspective, aren't -- we're expecting to continue to reduce significantly there. That being said, there are efficiencies that we can continue to gain, I would say, especially I mentioned on the servicing side. There's continued improvement in sort of the [Technical Difficulty] there -- some ability to additional efficiencies in certain areas. And then certainly, as production continues to grow from these low levels at on a unit basis. So we see greater economies of scale and efficiencies as we get to greater levels of production.

That's helpful. So maybe switching gears again, maybe just business on technology that have been made in recent years.

Yes. So we have invested a lot in technology going back to the last 7 years. As Dan talks about efficiencies, clearly, that investment [indiscernible] has just allowed us to be [indiscernible] that's [indiscernible] our investment in service -- servicing system that proves to be [indiscernible] and allowed us to do things from a technology standpoint that we otherwise would not have been able to do. And that technology continues to grow and evolve, and we continue to drive down through the cost as a result of the technology. In our production channels, we have varying degrees of investment in technology in all 3 channels. In the correspondent channel, we introduced a new system back in [ 2020 ] allows us to deal with different market sizes and different scale issues that allows us to be able to [indiscernible] granular pricing and different margin components of [indiscernible] seller is. On the broker side, we introduced new technologies earlier this year. This has been very well received by all of our broker customers, and we're getting a lot of good feedback and this is again something really [indiscernible] originate there. And then in Consumer Direct, we have [indiscernible] facing technology, it's not that new anymore. We introduced it about a year ago. Again, it's allowing borrowers to [indiscernible] serve more if they want to. I think all [indiscernible] the fulfillment [indiscernible] benefit, what's really important, if we think about technology [indiscernible] actions, we've gone to these periods of rate declines, we want to be able to [indiscernible] opportunity [indiscernible] the most efficiently possible. Historically, these have been brought down by either [indiscernible] people. And that's how we think about technology is there a way to leverage the people that we have in the organization to be able to bring on more [indiscernible] fire power and more origination capabilities. Similarly, on the fulfillment side, we're uniquely structured in that we have 1 performance group for all of our production channels. And a lot of the lion's share of our investment in technology has been on the fulfillment side. And that includes [indiscernible] things like our technology, the ability to alter parties and really there, we have a little bit more technology investment that we'll be making in the consumer direct channel [indiscernible]. But I am very confident that when we go to [indiscernible], our technology [indiscernible] our investment in technology will allow us to become more efficient than we were kind of on the end of the last [indiscernible].

Got it. That's helpful. And you mentioned the broker channel. Can you maybe just dig in a little bit deeper, talk about, I guess, your share in the brokerage channel now where you maybe hope to get to longer term and maybe how technology helps you get there.

So the broker channel is an interesting channel that we have. The # 1 book originator is a 50% market share, and the #2, a 20% market share. And they try to tell their customers not to sell to the other person. And that allowed us to be able -- to be kind of a third option. I think, as I said, the technology has been table stakes. And we have technology that still allows the broker to do a lot of what the broker needs to do very quickly and very efficiently. We've built this technology in coordination with brokers to meet their demands and their needs. And from -- as we sit here today, our market share is at 3%. I don't think getting to 5% or 10% necessarily is a huge spread. I think it's a function of [indiscernible] to continue to bring up more brokers. We have to continue to evolve our pricing methodologies and evolve how we operate with those brokers. But I'm really confident and really happy to see what I'm seeing with the new technology, and we're making good inroads. And I think as I often say to investors, if you and I, we're delivering all of our loans to one counterparty, we would look to one another and say, we need to find a #2. Number one, until you get to number two. Well, that I think it's clearly getting into the large broker originators, and it's something that we're hearing from them, and we want to continue to institute a lot of the discipline that we've instituted in our correspondent channel and bring it over to our broker channel.

That's helpful. So I think I'm going to pause here and go to the 2 audience response questions that I have. I can just queue the first question you want to participate. So relative to Fannie and MBA's forecast in total market originations of $1.6 trillion to $1.8 billion -- trillion in 2023, to $1.9 trillion to $2.1 trillion in 2024, you expect 2024 originations of [indiscernible]. Any comments there?

I probably would have leaned in to #1. But I think it's going to be -- I don't want to be a prognosticator, but I think it's going to be a little bit tougher in 2024 to see rates decline. And so I think somewhere between #1 and #2, [indiscernible].

Yes. I'm probably with the crowd. I'm a little -- I think there's going to be some volatility. We've got more higher rate mortgages that we hit #2.

And you can see why we managed to arrange about that [indiscernible].

Yes. So let's go on to the second -- over the next year, would you expect your position in PFSI Tier 1 increase [indiscernible]?

So pretty bullish.

Bullish. So before we move on to PMT topics, I'll just open the floor to Q&A if anyone has any questions.

Just a couple of questions. On the second mortgage product that you're rolling out, who carries the credit risk of that? Or how is it sold off? Or how does it [indiscernible]?

So as we treated today, in the [indiscernible], taking place. the financing of it is a lot of our existing warehouse lines it's a tangible asset for the warehouse in [indiscernible]. We originated only through our consumer direct channel and it's offered only to our existing portfolio. That's not to say we wouldn't think about bringing it into broker or corresponders that made economic sense for those channels. Today, it's just in the consumer direct channel. We're selling that product as whole loans. All the credit risk as we travel to the new investor, and we're servicing those mortgages. As I said, these are second lien and only offered to customers where we have existing first [indiscernible]. So it's something that I think is an advantage to those who are buying whole loans. We're getting very good distribution of the whole loans. We're getting it. We've sold some to insurance companies, to private equities as well as to Wall Street. So there's a pretty good demand for it as well. So it's not -- there's -- the only risk we have is the servicing risk, which we already have [indiscernible] as we're servicing the first [indiscernible]. So I think that, that's the alignment of interest for a particular product is strong.

Any other questions? Another one up here.

Just talk about all these regional banks, potentially being foresellers of MSR assets as they try to rightsize, the new kind of new regulatory regime that creates a material opportunity for you guys. Is that something that you actually see happening yet? Or can you quantify that?

So we haven't seen foreselling, and I generally think that regardless of what happens with the new capital revenue that came out. I don't think you'll see foresell. We're seeing certain banks slow down, their pace of activity in Correspondent, which is a servicing acquisition business. And so generally -- I generally believe you'll continue to see that kind of slowing down process. Maybe [indiscernible] as far as Wells did when they got out entirely, but I'm generally seeing the trend in terms of slowing down on the on the new MSRs. In terms of the [indiscernible] service, it's not happening at the pace that we thought it would at the beginning of the year. We've seen some large packages come out of some banks. We're seeing some conventional MSRs come out of very small originators, but not as much as we thought would take place. And on the Ginnie servicing side, we're seeing real [indiscernible] on. I think that speaks a lot to where the industry -- the mortgage banking industry is. Many of these mortgage banks made a lot of money in '20 and '21. So the industry is very well capitalized. And many of them created their own version of the balanced business model that they retain some MSRs. And so in a way that those MSRs are allowing them to stay and to wait for rates in the [indiscernible] take origination income. We'll see what happens. If you say [indiscernible] there may be a capitulation of source of the small mortgage banks. The larger banks, I think, is going to be it's going to be a very slow process. I don't see -- unless there's a real kind of unique issue, I don't see them being proposed sellers.

Any other [indiscernible] PFSI. Okay, so we'll move on to PMT. So can you just remind everyone about PMT's significance in the overall PennyMac complex? Just maybe tell us a little bit more about its current investment portfolio.

So the PMT, PFSI relationship has been an incredibly a unique, successful and synergistic relationship that I think that both have benefited from. As we sit here today, PMT has operates under 3 different investment channels. One is it's interest rate-sensitive channel, which is investing in mortgage services, right. It's really -- we -- our correspondent business, which was the second channel, is really run-through PMT, and that's a legacy issue. All the loans are sold to PMT, who then sells the government loans to PFSI and many of now the conventional loans that Dan was referring to earlier. But I mean on the sensitive side, it's MSRs and the Correspondent side, it's being [indiscernible] Correspondent activity on conventional loans and the gain on sale on those loans. And the third channel is its credit-sensitive strategy, which historically was investing in its own lender risk share securities, but since that program has been suspended by the [ DFCs ], it now engages in buying securities off of the agencies [indiscernible] as well as buying [indiscernible] securitization. It's primarily jumbo securitization. So it's [indiscernible] it's operated and it's operated. And it's allowed the -- PMT is the beneficiary having PFSI's operating capability in terms of fulfillment activities of Correspondent business and providing subservicing and we capture opportunities, off of the servicing portfolio that [indiscernible] PFSI has been a beneficiary, just having this investment vehicle that it could use its scale for and help just work under a larger universe of loans. And I think as we sit here today, I think PMT has had a terrific track record really managing its credit risk and interest rate risk in a way that has allowed us to be able to term out our CRT debt. We hedge our MSRs in PMT like we do in PFSI and it's really run, I think, of a best-in-class risk management focused REIT.

So what's the overall investment environment look like an [indiscernible] what's the opportunities set look like for new investments?

So PMT always has the opportunity to investing in the [indiscernible] and that could be through the conventional correspondent. Given the capital constraints [indiscernible] difficult [indiscernible] to raise capital, focusing a little bit more on investing in credit [indiscernible] strategy. We're very much focused on looking at CRT loans, on looking at the [indiscernible] bonds [indiscernible] ratio. I think with the new capital that are coming up, you're going to see new jumbo loan securitizations. PMT was created back in 2009. It really was with a vision that you'd see securitization come back and there would be a need for an investment vehicle to invest in subordinate bonds. And I think given what we're seeing in the jumbo loan market, we're seeing some of that product running its way into non-banks. And so I'm hopeful that over time we'll see a return to [indiscernible] and continue to participate in buying jumbo loans and whether it's through the brokerage channel, our PFSI or whether it's through Correspondent channel that we can see an ongoing program of securitization of jumbo loans.

Got it. You touched on new credit portfolio. Are you -- anything you're seeing with respect to delinquency? Is there anything of the concern?

So in terms of delinquencies, we've really seen delinquencies decline pretty significantly at the height of the pandemic, down to [indiscernible] low level now hovering around [indiscernible] seeing any stress in PMT's portfolio. In terms of the bulk of the investment in our PMT exposure from a credit point of view, meaning where the credit risk transfer, where [indiscernible] those loans. Those loans are currently sitting on very low [indiscernible] as well, generally in the 50% to 60% mark-to-market [indiscernible] range. So even if we do have a handful of borrowers that [indiscernible] also kind of [indiscernible] some other way. We'll be able to sell their home and get out with the losses to the credit risk transfer. So overall, that investment and the delinquencies that we're seeing there are really very low levels and we expect that [indiscernible] the price appreciation over the past year [indiscernible] those loans be really well supported as we move forward.

That's helpful. So just to switch gears and touch on the dividend. PMT's dividend's $0.40 a quarter. Your earnings run rate has been closer to $0.30. So how should investors think about that gap and coverage?

So the $0.40 dividend, we are down at $0.47 to $0.48 a few quarters ago. Generally speaking [indiscernible] dividend in place and expect it to remain there for a period of time. You mentioned in the last quarter, when we look at our GAAP run rate earnings in the current environment brought down to a [indiscernible] level in terms of what we are seeing, our expectation for GAAP earnings over -- that's really over the next year in the current environment. The primary place where we were seeing sort of a reduction or compression of earnings is really in our interest rate-sensitive strategies, which was largely -- which is largely driven by the inversion of the yield curve looking at the financing versus the yields, the fair value yields on those investments, MSRs and MBS and sort of the utilization of carry there. As -- we do expect over time for the yield curve to normalize, we've seen some of that in the current quarter. That's beneficial to those -- our expectations for those strategies. And so to the extent that we've seen a little bit of a reversal there in terms of our expectations and the ability to have greater earnings, greater earnings profile from the interest rate-sensitive strategies. You could see that projection improve. Absent that, if we do see -- so we're not very quick to reduce the dividend there. We still see that there's potential upside. And certainly, we just announced relatively recently $0.40 dividend for the third quarter. If we do see our run rate maintained at that $0.30 level, eventually, those 2 things need to converge, and we would bring down the dividend, but we still think that there's a potential for that to [indiscernible] over the next couple of years that we do see a normalization of the yield curve.

Got it. Helpful. So pause here and just go to the last ARS question. Can you -- operators, can you queue that up? Over the next year, would you expect to position in PMT to [indiscernible] increase [indiscernible]. Okay, so pretty bullish. So we have a couple of minutes left. I'll just open the floor up to Q&A for any PMT questions. If there are no more questions, I think. I will just ended there.

Thank you, Terry.

Thank you all for taking the time. We appreciate it.

Thank you.