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

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Second Quarter 2026 Earnings Call. [Operator Instructions] Additional earnings materials, including presentation slides that will be referred to in this call as well as an Excel file with supplemental information are available on PennyMac Financial's website at pfsi.pennymac.com. Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials. I'd now like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer. Please go ahead.

Thank you, operator. Good afternoon, and thank you to everyone for participating in our second quarter 2026 earnings call. As shown on Slide 3, PennyMac Financial generated net income of $22 million in the second quarter or $0.41 in earnings per diluted share, representing a 2% annualized return on equity. While interest rate volatility during the quarter created noncash MSR valuation headwinds that impacted our GAAP results, our underlying adjusted earnings per share came in at $1.39 or 7% annualized adjusted return on equity. Although our operational execution remains solid, these results fell short of our expectations as interest rates increased and origination demand declined. To address these rate headwinds, we have already taken proactive steps to align our cost structure with current market conditions and the operational capabilities provided by recent enhancements to our technology platform. Our results were also impacted by our current funding of major technology initiatives in AI and automation that will structurally lower our cost to produce and cost to service while enhancing the customer experience and expanding our origination servicing capacity. At the same time, I'm particularly encouraged by the strong underlying operational momentum across our platform, highlighted by the meaningful increase in our recapture rates. Turning to Slide 4. Let's review several key business updates. First, the transition to our new consumer direct loan origination system has helped to facilitate our rapid deployment and development of process automating AI agents. Another example of our technology transformation is the recent launch of our proprietary Natural Language Virtual Agent or NLVA, which handles 24/7 conversational voice interactions across both inbound and outbound customer calls. This technology deployment is already directly benefiting customer engagement and retention. Conventional first lien refinance recapture rates increased 7 percentage points from the prior quarter to 29%, while government first-lien refinance recapture rates increased 9 percentage points to 59%. Third, we continue to make excellent progress toward onboarding Cenlar's subservicing portfolio with the transaction on track to close in the fourth quarter. And finally, we expanded our strategic partnership with Amazon Web Services to further bolster our transformation as an AI-driven mortgage technology leader. Turning to Slide 5, I want to address our financial outlook and the steps we are taking to rightsize our cost structure. With a smaller projected origination market due to higher interest rates, we expect adjusted ROEs to remain in the high single digits through 2026 as we reduce our expense base. Earlier this month, we took targeted actions to reduce our production footprint and adjust staffing levels to better align with the smaller market. And because of our investments in technology, we are able to execute these expense reductions while preserving operational capacity when mortgage demand increases. With exciting new technology fully deployed in our consumer direct channel and our AI agents expanding rapidly, we are laying the foundation for unprecedented operational capacity and long-term ROE expansion. Turning to Slide 6. While our near-term outlook reflects high single-digit adjusted ROEs in the back half of this year, we see a well-defined and visible path back to mid-teens ROEs. The cost realignments we executed this month are expected to generate approximately $60 million of annualized cost savings, which will begin to be realized in the third quarter. We believe expansion in our ROEs will be driven by the structural operating leverage we are creating across the enterprise. Our proprietary AI agents and workflow automation are permanently lowering both our cost to produce and cost to service, expanding our operating margins without adding fixed overhead. Our trajectory towards higher returns is also based on the operational momentum we are building today with continued growth in broker direct and in consumer direct, where the meaningful increase in our recapture rates positions us to capture upside as the origination market normalizes. And while we are currently running at a higher expense base to fund our tech transformation, these technology expenses have begun to decline, and we expect they will continue trending lower. As we pair this technology foundation with the capital-light scale of Cenlar's subservicing portfolio in the coming months, we expect to realize significant operating leverage. Slide 7 highlights the opportunity in our consumer direct channel if interest rates decline as well as our first lien refinance recapture rates over the 5 most recent quarters. As of June 30, we serviced a combined $343 billion in UPB of loans with note rates above 5%, of which more than half had note rates above 6%. As you can see on the charts in the middle of the page, government refinance originations from our portfolio in the consumer direct channel have more than doubled from the second quarter of 2025 as our refinance recapture rates have grown to 59% from 44%. We are seeing even more success in conventional loans, where volumes are up nearly threefold from levels reported in the second quarter of 2025, driven by a significant improvement in recapture rates to 29% from 17%. Given the size of our servicing portfolio, our technology foundation and our accelerating recapture trends, we feel a high level of conviction in our ability to execute on this opportunity as refinance demand grows. Turning to Slide 8. Our servicing segment continues to demonstrate the power of scale combined with our advanced technology, otherwise known as Place. According to the latest MBA study, PennyMac's direct servicing expense per loan was $89 in 2025, down 8% from 2024 and far below both the large IMB average of $133 and the overall industry average of $185. And we've achieved these low costs despite our higher concentration of government loans, which are inherently more complex and costly to service. As you can see, our operating expenses remain extremely low at 4.5 basis points of average servicing UPB. The combination of our proven low cost to service and AI capabilities gives me confidence that we will continue to drive down unit costs and expand platform efficiencies as we prepare to onboard Cenlar's subservicing portfolio. Slide 9 details the transformative operational gains we are realizing in production. Consumer Direct has facilitated a rapid implementation of process automated and AI agents, and we are now beginning the transition of Vesta into our broker direct channel to deliver these same structural efficiencies and automation gains to our broker partners. Across our production workflows, we have mapped and standardized 150 discrete origination tasks. Today, approximately 25% of these tasks are being completed by automated logic or AI agents, and we are targeting 80% by year-end 2027. This technology is delivering immediate measurable benefits. We have already seen a significant reduction in our processing cost to produce a loan, and we are targeting an additional 20% or more by the end of the third quarter. Similarly, we've seen dramatic cycle time reductions of 40% to 80% across major loan programs, specifically from application to conditional approval on files where our autonomous AI agents are deployed. Speed is a direct cost saver and closing loans faster allows us to price more profitably through shorter lock windows, drastically reduces fallout while delivering a best-in-class experience for our borrowers. And I believe we are still in the early stages of this transformation. As we scale AI automation, onboard Cenlar's capital-light subservicing portfolio and capitalize on our consumer direct recapture momentum, we are establishing a permanent structural advantage that will compound across our platform for years to come. We have the right strategy, the scale and the technology to navigate current market headwinds while driving a clear return to mid-teens ROEs and delivering compelling long-term value for our stockholders. I will now turn it over to Dan, who will review the drivers of PFSI's second quarter financial performance.

Thank you, David. PFSI reported net income of $22 million in the second quarter or $0.41 in earnings per share for an annualized ROE of 2%. Adjusted net income was $74 million or $1.39 in adjusted earnings per share for an annualized adjusted ROE of 7%. The $0.98 difference between our GAAP and adjusted EPS was driven by $77 million of fair value declines on MSRs net of hedges and costs, a $9 million valuation gain related to our minority interest in Vesta and $1 million of expenses related to our acquisition of Cenlar's subservicing business. PFSI's Board of Directors declared a second quarter common share dividend of $0.30 per share. On Slides 11 and 12, beginning with our Production segment, pretax income was $38 million, down from $134 million in the prior quarter and $58 million in the second quarter of 2025. Total acquisition and origination volumes were $35 billion in unpaid principal balance, down 6% from the prior quarter and 8% from the second quarter of last year. Of this, $32 billion was for PFSI's own account and $3 billion was fee-based fulfillment activity for PMT. PennyMac maintained its leading position in correspondent lending. The revenue contribution from the channel was down $9 million from the prior quarter. Fallout adjusted lock volumes were down compared to previous periods due to higher rates in a highly competitive environment, which includes the GSEs. Correspondent margins were 29 basis points, up from 28 basis points in the prior quarter due to a shift in mix towards higher-margin government loans. Under its fulfillment agreement, PMT retains the right to purchase all nongovernment correspondent loan production from PFSI. However, in June, PMT elected to stop acquiring agency-eligible conventional loans through correspondent production, but will continue acquiring 100% of all non-agency loans. In July, correspondent volumes were down versus the second quarter versus second quarter levels, reflecting our pricing discipline in a competitive environment and our continued focus on allocating capital to drive optimal returns. In Broker Direct, we continue to see strong momentum despite increasing levels of competition, and the number of brokers approved to do business with us continues to grow, reflecting brokers who are increasingly leveraging our distinct value proposition. Broker Direct's revenue contribution was down $3 million from the prior quarter. Fallout adjusted lock volumes were down 8%, but were up 21% from the second quarter of 2025, driven by market share gains in a larger origination market. Margins increased to 104 basis points from 99 basis points in the prior quarter. Non-QM locks in our broker channel more than tripled from the prior quarter to $515 million in UPB, underscoring the positive reception and rapid market adoption of our expanding product menu. The revenue contribution from our consumer direct channel declined $36 million from the prior quarter as higher interest rates resulted in lower refinance demand. Fallout adjusted lock volumes were down 32% from the prior quarter. And margins were up to 317 basis points from 267 basis points in the prior quarter, reflecting an increase in closed-end second lien production as refinance volumes declined. Post-lock impacts across the channels resulted in a $23 million pretax loss compared to $13 million of pretax income in the prior quarter. This $36 million shift was driven by adverse market price changes on specialized pools and other cross-channel impacts. Production expenses net of loan origination expense increased 6% from the prior quarter due to increased capacity and funded unit volume in the consumer direct lending channel. As David mentioned, the cost realignments we executed in July are expected to be reflected in our third quarter results. Turning to the Servicing segment on Slides 13 and 14. Our total servicing portfolio UPB ended the quarter at $731 billion, up 1% from the end of the prior quarter and 4% from June 30, 2025, as production volumes more than offset runoff due to prepayments. The Servicing segment recorded pretax income of $22 million. Excluding valuation-related changes, pretax income was $99 million or 5.5 basis points of average servicing portfolio UPB, up from $57 million or 3.1 basis points in the prior quarter. Average custodial deposit balances increased 7% from seasonal lows in the prior quarter, driving a $14 million increase in earnings on custodial balances and deposits. Realized prepayment speeds were 11.6%, down from 13.7% in the prior quarter. Realization of cash flows declined 9% as prepayment speeds declined. Operating expenses in the quarter were 4.2 basis points of average servicing portfolio UPB or $76 million, both lower than prior quarters. Income from EBO activities was higher as buyout and redelivery volumes increased from the prior quarter. Including the provision for losses on active loans, the fair value of PFSI's MSR increased by $110 million. An increase of $96 million was due to changes in market interest rates and another $13 million was due to other model and performance-related impacts. Hedge fair value losses, including principal-only bond accretion changes were $135 million. Hedge costs were $52 million, up from $14 million last quarter, reflecting elevated option pricing due to heightened interest rate volatility. While rate movements created some adverse impacts in May, our hedging strategy was highly effective for the remainder of the quarter. Our hedge ratio remains near 100% to proactively manage prepayment risk. Coming out of the quarter, hedge costs have moderated significantly, trending in the mid-single-digit millions of dollars. Maintaining a disciplined continuous hedge is central to how we manage risk. Rather than leaving our balance sheet exposed to directional rate impacts, we prioritize book value preservation to protect stockholder capital across all market environments. Corporate and other items recorded a pretax loss of $29 million, down from $42 million in the prior quarter as the prior quarter's expenses included elevated marketing expense related to the Olympic and Paralympic winter games. PFSI recorded a provision for tax expense of $10 million, resulting in an effective tax rate of 31%. Total debt to equity at quarter end was 3.6x, down from 4x at the end of the prior quarter and nonfunding debt to equity was 1.8x, up slightly from the end of the prior quarter. The decrease in total leverage from the prior quarter was driven by a decline in funded debt, reflecting lower overall production. The increase in nonfunding leverage from the prior quarter was driven by higher interest rates, which drove increased utilization of our MSR credit facilities. We expect these leverage ratios to remain near these levels as interest rates remain high. Finally, we ended the quarter with $4 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledge. We'll now open it up for questions. Operator?

[Operator Instructions] Your first question comes from the line of Doug Harter with BTIG.

Can you just talk about how you're balancing kind of trying to take costs out that you mentioned with also kind of being prepared if we ultimately do get a reversal in rates to not kind of be caught short in capacity like you were late last year?

Yes. Doug, thanks so much for the question. So look, as you know, we've always been disciplined in how we think about expenses and capacity. And look, I think that one of the things that we did at the end of last year, and we talked about was adding capacity in the event that the market did decline. What's really exciting for me is that in the technology work that we've been doing on the new loan origination platform, we're creating that excess capacity. And so there's -- it's going to lead to really a meaningful reduction in costs. And really what the cost reduction that we're talking about is $60 million annually. And it's really coming about as a result of, one, rates being higher, but also as we've gotten more and more confident with the technology, we feel very comfortable and convicted that the excess capacity that we brought on at the end of last year is no longer needed. And the -- as we sit here today, that as we talked about, there's a lot of work that we're doing to continue to chip away at that. But I think where also, I think we've really shined these last few quarters is just the continued growth of recapture. And so when you look at the recapture rates that we're getting on both the government and the conventional servicing portfolios, they're very, very good. And so I think -- I believe that as we get a normalized market, this work that we're doing, that we've done is going to allow us to maintain the recapture levels as we get into a bigger market.

Great. Appreciate that, David. And then just quickly, the ROE, as you kind of laid out the path back to mid-teens, does that require lower rates? Or do you think you can get there with the current rate environment?

Look, I think the path that we've laid out at this level, and we're at very high levels of rates. Today, I saw the 10 years at -- I'm sorry, the 30 years at a 20-year high. And so at this level of rates, I would say that the path we've laid out is more weighted to an exit of 2027. Obviously, if rates were to decline, that would accelerate getting there -- just getting there faster.

Your next question from the line of Mark DeVries with Deutsche Bank.

David, when you think about kind of getting to your objective of the drive to $55, can you just talk about how much of that is coming from added operating efficiency versus just scale? And how much does Cenlar kind of help get you there?

As we look at the drive to $55, we're really focused on cutting actual expenses without really leaning into growing the denominator as you would talk about in terms of adding Cenlar. There is a lot of AI agents being developed to be put into place for us to be able to drive down the costs. Obviously, with the scale in place, not just from Cenlar, but from our own activity, that will accelerate to get down to $55. But my feeling is that there's a lot of deeper servicing integrations that need to take place. There's a lot of additional agents that need to be built. And I think from the team standpoint, when we look at it, we look at it just in terms of the current -- the effect of the activity vis-a-vis the current expense structure, not focusing necessarily on the scale itself. because I said the scale always helps.

Okay. That's helpful. And then, Dan, I think you indicated that hedge costs have actually come down a lot since the end of the quarter, although we've had another obviously, big spike in rates and a lot of volatility. Can you just talk about how the hedge is performing so far quarter-to-date?

So fourth quarter-to-date, the hedge overall has been more stable than what we saw in the second quarter and especially with the emphasis on hedge costs given what we saw in the second quarter. We've adjusted -- some of our practices in terms of readjusting our hedges, that was part of what contributed to our overall -- the overall cost during the quarter was given the volatility and the overall realized volatility during the quarter and the impact that, that has on the MSR adjusting fairly frequently. We've sort of calibrated our practices to minimize that the amount of impact that has. And that has been despite the fact that we've had a little bit of uptick of volatility here in the last couple of days has been beneficial, and we've been able to maintain a lower run rate of hedge costs going here into the third quarter. So overall, tracking much better, especially on the hedge cost side than what we saw in the second quarter.

Your next question comes from the line of Crispin Love with Piper Sandler.

Just on the ROE outlook, how would you frame 2027 based on what you know today? Previously, you were expecting getting back to that low to mid-teens by the end of '26, but that's pushed out now. So would you expect ROE to grind higher from the end of the year into 2027, so looking at a low to mid-double digits in '27? Or could there be a step function higher just based on the environment? Just curious on how you're thinking about this.

Yes. Look, I think, Crispin, you have it identified correctly. I think as we look at where we are in rates today, combined with the fact that we're going to be reducing expenses throughout the year, I view us leaving 2026 kind of in the lower part of that range, call it, high single digits to low double digits. I generally think that throughout the year, '27, that's when you'll see the step up to the mid-teens level that we spoke about. I think there's going to be real benefit to some of the key initiatives we're working on in 2027, including things like getting our broker direct channel on to Vesta. That's going to be a key component that we should have them on by the middle of 2027. I think we'll begin the work in terms of transitioning Cenlar onto the servicing portfolio and achieving some of the efficiencies there. And I think that we're going to continue to focus on driving down the cost to originate in our consumer direct channel. But I think that, obviously, as you on the call is aware of, the path to how quickly we get that, there is an interest rate component to that. But even without interest rates moving, I feel good about exiting '27 at these levels at the mid-teens levels that we talk about.

All right. Great, David. I appreciate the color there. And then just on the broker channel, you discussed elevated competition. Looking in your deck, your market share over the past year or so is about 6%. Can you remind us of your targets here? Was it getting to 10% by the end of '26. First, is that still attainable? Is there investment needed there that may be now on hold just given the plans? And what would you need to do to get there?

Yes. So look, I think that our view in terms of share growth in broker direct or TPO is number one, we want to do it profitably. And we're being disciplined in how we approach that. Obviously, that part of the market, there's -- it's been a little bit more volatile with some of the market participants. I will tell you that given the work we're doing in terms of getting broker on to Vesta, I don't see us getting to that 10% market share by the end of '26. But I can tell you that the brokers, I think are going to be really enthusiastic about what they're going to see when we get broker on there in mid-'27. So we don't want to do anything irrational or do anything that's not disciplined. And so that's how we're thinking about the broker channel.

Your next question from the line of Terry Ma with Barclays.

I guess maybe just on the ROE guide. Is it still a target that high teens to low 20s is the kind of right normalized ROE for the business going forward? And then as we kind of think about it, any reason why it can't be higher than that with all the enhanced efficiencies from tech investments that you're making?

Yes. So look, the mid -- the high teens to low 20s is a guiding principle of this company, and it will be -- continue to be a guiding principle of this company. I think that what we're in the midst of now is, one, we're at the higher rates. Two, we're investing a lot in technology. And that's an investment for the long term to create a consistent high teens to low 20 operating company. And so I think that it's going to continue to grind up there. And I see that we are going to be one of a few winners because we can afford to make the investment in the technology and to build something clearly unique in the market. And when you combine what we're doing on the production side to what we're doing on the servicing side, that's something to me that is truly, truly unique. Our servicing technology is something that has, I think, served us really well. As you can -- as we talked about, we are the low-cost servicer by a meaningful, meaningful amount. Industry parties see the low cost, they see the scale benefits. It doesn't go unnoticed. And I think as we think about continuing to drive down costs, I think we are really the only ones who can get down to $55 a loan. And that's, by the way, with a heavy government portfolio. And so what we're in the midst of right now is a perfect storm of negatively of where the fact that we are investing a lot in the future and in technology, combined with the fact that we see rates at high levels as it pertains to this cycle. And so I think that you're going to see a company coming out of this. I truly believe that we are going to live by the high teens to low 20 North Star that we've run this company on for the last 18 years.

Got it. That's helpful. And then on the recapture rates you guys show on Slide 7, it's good to see the consistent improvement as you embark on this tech journey. I guess, is there a target or a goal in mind that you have like after you kind of run rate all these improvements? Just trying to figure out what the upside is.

Yes. So look, the target for us is we want to recapture every possible loan that we can. And the work that the team is doing, both operationally and analytically using AI is allowing us to meaningfully grow our recapture levels. And I think that as we deploy the work in Vesta to close loans faster, to close loans cheaper, those recapture rates are going to be growing even more. The idea that you can close a VA IRRRL in 14 days when the rest of the market is taking 34 days is a meaningful competitive advantage. And that's something that we're guiding towards. And so I think it's more -- we're looking at it as ways to drive down the cost to originate, drive down the days to close. And then the investment in the technology and the consumer experience, I believe we'll continue to see those recapture rates grow.

Your next question comes from the line of Bose George with KBW.

Your volume in the correspondent channel looks like it declined again or at least the share probably declined a little bit again. Can you just talk about the competitive dynamics there? Is it still the cash window? Are there other factors? And then when we just think about the share, do you think it kind of stays at this level for the foreseeable future until something changes?

Look, I think that in correspondent, we have a combination of factors taking place. As you point out, we're seeing the GSEs continue to be aggressive and on some days, they are even more aggressive through the cash window. And so that's a meaningful change from even Q4 of last year. We are maintaining our pricing discipline. We have a very large servicing portfolio with a lot of loans that would become refinanceable in the event of an interest rate decline. And I think we want to maintain our dry powder should perhaps rates move higher and we need more leads or we want to do more activity. And likewise, I think that we want to do so at adhering to our margin discipline. I do think that there are market participants at the time to time that perhaps are being a bit irrational. But I wouldn't read too much into the correspondent decline. I think it's more, again, a combination of the GSEs and from time to time other participants. But we're still the leaders in this space, and we'll continue to be the leaders in the space.