Earnings Call Transcript - PFSI Q4 2023

Operator, Operator

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Fourth Quarter and Full Year 2023 Earnings Call. Additional earnings materials, including presentation slides that will be referred to in this call 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's Financial's Chief Financial Officer. Gentlemen, I'll turn the call over to you.

David Spector, CEO

Thank you, operator. Good afternoon, and thank you to everyone for participating in our fourth quarter earnings call. PFSI reported a net loss of $37 million and an annualized return on equity of negative 4% in the fourth quarter. These results included a nonrecurring accrual of $158 million relating to our long-standing arbitration with Black Knight, and $76 million of net fair value declines on MSRs and hedges, given significant interest rate volatility during the quarter. Excluding the impact of these items, performance was very strong with an annualized operating return on equity of 15%, marking the culmination of another outstanding year for the company and highlighting the strength of our balanced business model. 2023 was one of the more challenging origination markets in recent history, with industry volumes down approximately 40% from 2022, and unit originations at their lowest level since 1990. However, PennyMac, through its multichannel production platform, generated $69 million of production pretax income and produced nearly $100 billion in UPB of mortgage loans, down only 9% from 2022. This demonstrates both our strong access to the purchase market and our ability to profitably support our customers and business partners. These production volumes continue to drive the organic growth of our servicing portfolio, which ended the year with more than 2.4 million customers and over $600 billion in UPB, up 10% from the end of last year. Our servicing business generated $268 million in pretax income, excluding the Black Knight accrual. As the second largest producer of mortgage loans in the country and the fifth largest servicer, we have achieved significant scale in our mortgage banking platform with the capacity for continued growth and profitability in the years to come. This management team's ability to effectively manage capital has always been a competitive advantage for PFSI, and I am extraordinarily proud of the work we accomplished in 2023. Not only did we return more than $110 million to stockholders through share repurchases and dividends, we took meaningful steps to further strengthen the balance sheet, issuing more than $1.5 billion in new long-term debt at attractive terms and redeeming $875 million in debt with upcoming maturities. I would like to provide a brief update on our long-standing litigation with Black Knight as outlined on Slide 5 of our earnings presentation. In January, the arbitrator issued a final award of $150 million plus interest to Black Knight, down from the interim award determined in November. PFSI recorded the related expense accrual in the fourth quarter, as previously noted. While we disagree with the ruling, we are very pleased with the arbitrator's affirmation that SSC remains our proprietary technology and provides PennyMac the ability to utilize it as we see fit to benefit our customers and stakeholders. Since launching the system in 2019, it has performed extremely well, meaningfully enhancing our capabilities while helping to drive down costs. With this technology now free and clear of any restrictions on use or development, we believe there is potential for additional opportunities for the company and stakeholders over time. Turning now to the origination market, we believe the overall market troughed in 2023 as mortgage rates have declined from their recent highs, and anticipated future rate cuts have increased third-party estimates for industry originations in 2024 to approximately $2 trillion. Much of this anticipated growth is based on expectations for interest rate reductions later in the year, and we expect volume in the loan origination market to remain seasonally low in the first quarter of 2024 before moving into the spring and summer home-buying season. With a balanced business model and scale in both production and servicing, we remain very well positioned if interest rates remain high or decline further. As you can see on Slide 7 of the earnings presentation, operating returns on equity have increased throughout 2023, returning to the double digits and consistent with our goals at the beginning of the year. The Servicing segment continues to drive earnings and operating pretax income has improved in recent quarters due to the growth in the size of PFSI's portfolio and increased earnings from placement fees on custodial balances due to higher short-term rates. Operating expenses remain low given our growing operational scale and continued low delinquencies. In production, while the market is expected to remain competitive, margins have improved over the course of 2023, and we estimate we have gained a considerable amount of market share, especially in the core spanner and Broker Direct channels, which provides strong access to the purchase market. As we add these higher note rate mortgages to our portfolio, we are creating additional opportunities for our consumer direct business to offer our customers a new lower rate mortgage when interest rates decline. At year-end, 22% of our servicing portfolio consisted of mortgages with note rates in excess of 5%. In the fourth quarter, production pretax income was $39 million. And while we expect some seasonality in the first quarter, we expect to build on this profitability in future quarters as the origination market improves. As I said earlier, I am extraordinarily proud of what we accomplished in 2023, and I am even more excited about PennyMac Financial's future. Our long track record of strong operational and financial performance is unique in the mortgage industry and has been driven by the resilience of our balanced business model with industry-leading positions in both production and servicing as well as our strong capital and risk management disciplines. I believe we are the best positioned company in the industry with a fully scaled balanced business model, proprietary industry-leading technology, a strong balance sheet, and a growing number of servicing customers that stand to benefit from the products and services we offer to fulfill their home ownership needs. I will now turn it over to Dan, who will review the drivers of PFSI's fourth quarter financial performance.

Dan Perotti, CFO

Thank you, David. PFSI reported a net loss of $37 million in the fourth quarter or negative $0.74 in earnings per share for an annualized ROE of negative 4%. As David mentioned, these results include a nonrecurring expense accrual of $158 million before income taxes, or $2.20 per diluted share after income taxes, related to the final award of our long-standing arbitration with Black Knight. PFSI's Board of Directors also declared a fourth quarter cash dividend of $0.20 per share. Book value per share was $70.52, down from the end of the prior quarter, primarily due to the net loss. Turning to our production segment. Pretax income was $39 million, up from $25 million in the prior quarter. Total acquisition and origination volume were $26.7 billion in unpaid principal balance, up 6% from the prior quarter despite a decrease of more than 20% in the size of the origination market from the prior quarter. $24.2 billion was for PFSI's own account, and $2.5 billion was fee-based fulfillment activity for PMT. PennyMac maintained its dominant position in correspondent lending, with total acquisitions of $23.6 billion in the fourth quarter and margins similar to levels reported last quarter. We estimate that in 2023, PennyMac represented more than 22% market share in correspondent lending, up from 15% in 2022. We attribute this market share growth not only to the retreat of certain market participants, but also to our consistency in execution and industry-leading technology. Acquisitions in January are expected to total approximately $6.6 billion, and locks are expected to total $6.9 billion. In Broker Direct, we see strong trends and continued growth in market share as we position PennyMac as a strong alternative to the channel leaders. Both locks and fundings for the quarter were down in the single-digit percentages from last quarter, less than the overall market, and margins were down due to higher levels of fallout as mortgage interest rates declined. The number of approved brokers at year-end was over 3,800, up 42% from the end of the prior year, and we estimate that we represented approximately 3.6% of originations in the channel in 2023. In January, broker direct originations were $600 million and locks were $1 billion. In Consumer Direct, volumes remain low, but as David talked about, we remain well positioned given the number of customers we have added to the portfolio with higher mortgage rates. Production expenses net of loan origination expense were 8% lower than the prior quarter, primarily due to lower compensation accruals related to financial performance. Turning to servicing. The Servicing segment recorded a pretax loss of $96 million, primarily driven by the nonrecurring expense accrual mentioned earlier. Excluding this accrual, servicing contributed $63 million to pretax income, down from $101 million in the prior quarter, primarily due to higher net MSR valuation-related declines. Excluding valuation-related changes and nonrecurring items, servicing had very strong results with pretax contribution of $144 million or 9.6 basis points of average servicing portfolio UPB, up from $120 million or 8.6 basis points in the prior quarter. Loan servicing fees were up from the prior quarter, primarily due to growth in PFSI's owned portfolio, as PFSI has been acquiring a larger portion of the conventional correspondent production in recent periods. Operating expenses declined also due to lower compensation accruals related to PFSI's financial performance. As expected, earnings on custodial balances and deposits and other income decreased by $10 million from the prior quarter as balances declined due to seasonal property tax payments. Realization of MSR cash flows decreased by $14 million from the prior quarter due to higher average interest rates for the majority of the quarter. EBO income remained relatively unchanged, and we continue to expect its contribution will remain low for the next few quarters, while interest expense increased from the prior quarter due to higher average balances of debt outstanding. The fair value of PFSI's MSR decreased by $371 million during the quarter, driven by a decline in mortgage rates, which drove expectations for increased prepayment activity in the future. Hedging gains were $295 million, offsetting 80% of the decline in the MSR fair values. The net impact of MSR and hedge fair value changes on PFSI's pretax income was negative $76 million, and the impact on earnings per share was negative $1.05. The Investment Management segment contributed $1.9 million to pretax income during the quarter, and assets under management were unchanged from the end of the prior quarter. Finally, on capital. Last quarter, we noted the October issuance of a 5-year $125 million term loan secured by Ginnie Mae MSRs and servicing advances. In December, we successfully raised $750 million in 6-year unsecured senior notes and subsequently retired $875 million of secured term notes due in 2025. We'll now open it up for questions.

Operator, Operator

We'll take our first question today from Kevin Barker with Piper Sandler.

Kevin Barker, Analyst

I just wanted to follow up on your comments about SSE and with the technology being free and clear from any restrictions. You also made the quote I believe there's a potential for additional opportunities and benefits for the company. Could you maybe expound upon what you can do with this technology, whether it's utilized within PennyMac or maybe expand upon the use of that technology within PennyMac or outside of PennyMac? Thank you.

David Spector, CEO

Sure, Kevin. First of all, SSE has been a great system for us as a servicer. We adopted it at the end of 2019. We put it to use during COVID in 2020, and it performed very, very well in terms of being able to meet the needs of our borrowers and offering forbearances and modifications. It's a system that we believe gives us a tremendous competitive advantage. It's cloud-based, with full integration from front end, back end, and middleware components. Customers can access our advanced web, mobile, and IVR solutions easily, with high satisfaction rates. It has unique workflow attached to it with state-of-the-art technology. I think it gives us a competitive advantage in the marketplace. Since we adopted it, we have continually seen our servicing expenses driven down, which has been meaningful in our evolution as a top 5 servicer. Regarding litigation, we're very happy to have that behind us. While I disagree with the final ruling, we are pleased to retain ownership of our servicing system. We own SSE free and clear to use as we see fit. In terms of other opportunities, it's been 60 days since the ruling, and we've been exploring and evaluating new possibilities. We don't feel any rush to make a decision; we want to do what's best for all stakeholders. This technology is unique in the industry and gives us a real advantage.

Kevin Barker, Analyst

And then you produced a 15% operating return on equity this quarter. It seems like you have quite a bit of momentum going into 2024, not only within the origination channel but also on the servicing side. Do you feel that the 15% ROE is the run rate now, and there is potential for significant upside in '24, particularly if we were to see a bigger origination market?

David Spector, CEO

Look, I think that, as you pointed out, the operating ROE was 15% in the fourth quarter, which was up 13% from the third quarter. I'm expecting us to continue to build on the core Q4 results. There's going to be some seasonality in the first quarter, but the servicing has just been unbelievable for us. Profitability continues to remain strong in this high interest rate environment. Consumers are continuing to perform and stay current. We have continuing higher servicing fees and the growth in our own portfolio. On the production side, we were very profitable in '23. We were more profitable in '23 than we were in '22 on the production side. Given the trends I'm seeing in margins, and the trends we’re seeing in correspond and broker direct, I'm really encouraged that if we do see rate declines, especially in the back half of the year as the markets are projecting, we can see our production business grow profitability.

Dan Perotti, CFO

Just to add on to that a little bit to echo what David said, we saw operating ROEs increase through 2023, consistent with what we had hoped for, put forth at the beginning of the year where we really viewed Q1 of last year as a sort of trough. It's not necessarily going to be in a totally straight line. There is some seasonality to this business if we look at Q1. However, we do think there is upside potential from that 15% ROE in 2024 overall, especially if the mortgage market expands.

Operator, Operator

Our next question comes from the line of Michael Kaye with Wells Fargo.

Michael Kaye, Analyst

At the 2021 Investor Day, you said a 20% ROE in a more normalized environment? Just wondering what's been some of the pluses and minuses since that analysis back then. I know you bought back a lot of stock during the pandemic period. It was like 20% of your share count. Correspondent broker direct are likely ahead of plan servicing doing great to consumer direct probably has pushed out the opportunity a little bit. What I'm trying to figure out is 20% is that still the right goalpost considering you just did 15% in a very challenging mortgage market?

Dan Perotti, CFO

I think that still is the goalpost that we have. Obviously, we're generally striving to do 20% plus. That's part of David's mantra, and that's what we focus on. We do think that 20% is achievable in a more normalized market. Looking at 2024 specifically, it's probably still under what we would consider a totally normalized market. If we look at what changed since that projection, we've probably outperformed even what we expected in correspondent growth, especially given the market size. However, the growth of the servicing portfolio over that period of time is probably a little bit lighter than what we had expected just because the market has been smaller. On the growth of the direct lending channels, it's been constrained due to the overall size of the market and especially the refi market in terms of consumer direct. We still believe 20% is a reasonable and achievable goal.

Michael Kaye, Analyst

Okay. I wanted to talk about the competitive landscape in correspondent, looks like things slowed down a little bit in January. I've been hearing some other large nonbanks like Freedom talking about getting more competitive after raising a large amount of corporate debt. I was just looking for an update on what's happening correspond so far this year?

David Spector, CEO

We have a dominant position in correspondent. We have very deep relationships. The market in January is going to be smaller than even in December. We're seeing good activity in correspondent, specifically with builders. A lot of our share growth in the latter part of the year is due to activity coming from builders where we have solid relationships. We're also witnessing a flight to quality, and many sellers are delivering a disproportionate amount of their loans to us. Interestingly enough, in correspondent, we saw a decrease in the number of sellers, down to 812 from 830. We are seeing a bit of consolidation. I believe our value proposition is tried and true. We operate in the market every day and are confident that we'll continue to provide value. Margin growth continues to be strong.

Michael Kaye, Analyst

Okay. Thank you.

Operator, Operator

Our next question comes from the line of Eric Hagen with BTIG.

Eric Hagen, Analyst

I hope you guys are well. Yes, I thought the hedging results were good, but what do you feel like maybe prevented you from hedging even more of the fair value mark during the quarter? Is there a sense maybe for how much sensitivity you feel like there is to, call it, the next 50 basis points lower in mortgage rates with respect to the fair value mark?

David Spector, CEO

We're pleased with our hedging performance in the fourth quarter. As you know, interest rates were volatile. We were able to cover 80% of the move, which included the costs associated with hedging. We have targeted a tighter hedge ratio than we have historically. Given the volatility of interest rates, we are pleased with the performance. If interest rates move down further, the asset has increased sensitivity, partly because we've been adding a fair amount of loans with higher interest rates. That strategy enables a greater number of loans to become refinanceable if interest rates decline. In January, we’ve seen an uptick in refinances compared to the previous quarter.

Eric Hagen, Analyst

Yes, that's helpful. How are you thinking about the secured financing for MSRs versus replacing some of that balance with unsecured debt? Do you see any risk that banks could pull back from supporting the market for MSR funding? And does that influence your appetite for unsecured debt in any way?

Dan Perotti, CFO

We've discussed in the past our strategy to move toward unsecured financing. Our issuance in Q4 included $750 million of unsecured debt that was used to pay off some of our secured financing. We expect to continue toward unsecured financing to bolster our credit position with rating agencies. The unsecured debt is generally more stable and not subject to margin calls. We have not seen a pullback in MSR financing from banks; in fact, more banks are willing to lend on MSRs. We're adding banks to our MSR facilities for risk management purposes. We don't see that as a concern that pressures our move toward unsecured debt.

Operator, Operator

Our next question is from the line of Bose George with KBW.

Bose George, Analyst

Can you give us just your updated thought on share buybacks just given the current valuation?

Dan Perotti, CFO

We didn't have any share repurchases in the fourth quarter. The share price has moved up significantly from a few quarters ago. When considering our capital deployment, we look at the relative returns between deploying it into shares or reinvesting it back into the business and acquiring MSRs. The optimal path currently is back into the business. Additionally, we manage our leverage ratio closely, maintaining it a bit above 1x in terms of non-funding debt to equity. Share buybacks apply pressure on that metric.

Bose George, Analyst

Okay. Great. Makes sense. And then actually just switching over a follow-up on the MSR hedging question from earlier, you noted that you're going to run a tighter hedge ratio, I think you said 100% last quarter. If volatility abates, I mean, should we have a more matched hedge result, assuming we don't see a big pickup in prepayments?

Dan Perotti, CFO

So in the first quarter, we’re still aiming for a tighter hedge ratio. Thus far in the first quarter, we've faced considerable volatility and an inverted yield curve, which negatively impacts our hedge costs. As we proceed to lower interest rates, the percentage of our portfolio aligned with higher mortgage rates might not lead us to hedge right at 100% but will still be higher than we've been historically. Expect a little variability between the MSR and hedge in the first quarter.

Operator, Operator

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

Mark DeVries, Analyst

First, a question for Dan on the margin. I heard you comment on the quarter-over-quarter decline in margin in broker direct being attributable to the fallout effect. Didn't hear whether you commented on the decline in consumer direct. Was it the same fallout effect? Or is there something else that pushed the gain sale level in consumer direct?

Dan Perotti, CFO

In consumer direct, the margin decline was influenced by a shift towards more refinances as opposed to second lien origination. Second lien originations have smaller balances, which ultimately impacts the per unit margin since the revenue per loan for a refinance is higher, but the basis points are lower due to the balance size. On a unit basis, we're actually experiencing an increase in revenue per unit. However, we see those declines on a basis points basis.

Mark DeVries, Analyst

Okay. Got it. And then a follow-up for David on the new opportunities around your servicing platform. How do you think about the trade-offs between potentially sharing a source of competitive advantage with competitors versus the incremental revenue that you might be able to generate off of that?

David Spector, CEO

These are questions we're considering as we come out of litigation. There is demand for more competition in the marketplace. It’s not healthy for the industry to have reliance on any one participant. From our perspective, we must evaluate the decision from an economic value standpoint. Are we better served by maintaining our competitive advantage in servicing versus what we could gain from other means? As I mentioned earlier, this is early on in the process, and we will continue to work on finding the right balance.

Operator, Operator

Our next question comes from the line of Kyle Joseph with Jefferies.

Kyle Joseph, Analyst

Yes. Just want to pick your brain a little bit more on the correspondent channel. So the number of sellers obviously went down, but what do you see that doing to margins over time? Obviously, that impacts supply, not necessarily demand. But we're just curious to get your thoughts on how that impacts your margins in that segment?

David Spector, CEO

I don't think there's any significant impact on margins. It's mostly sellers who weren't selling us a considerable amount of loans, and we weren't active in the marketplace. The margins have been stable over recent quarters. Even in January, with volumes down, we're maintaining those margins. We still desire higher margins. Our team does an excellent job providing value to our correspondent sellers. We're positioned well in the market, especially where other banks are retreating.

Kyle Joseph, Analyst

Got it. Very helpful. And then on just expenses, the outlook for '24. Obviously, you guys have been doing a good job of getting more efficient in a tough market, but would you expect those to kind of stay in parallel with volumes? Or how much variability is there in that line item, particularly on the production segment?

Dan Perotti, CFO

On the production segment, we worked hard in '22 to bring down our expense base which served us well in '23. As David noted, we had higher pretax income in production in '23 than we did in '22 due to right-sizing our expense base. We expect most of our other businesses to be stable as the servicing portfolio grows. There may be slight growth in expenses based on the marketing dynamics, especially if we see interest rates decline leading to an uptick in refinances as we expand.

Operator, Operator

Our next question comes from the line of Trevor Cranston with JMP Securities.

Trevor Cranston, Analyst

One more question on the hedging of the servicing side of things. The earnings on the custodial balances have obviously become pretty significant over the last several quarters. Can you talk about any hedges you guys have put in place to protect that earnings stream as that fund potentially starts to move lower? And also just talk in general about how we should think about the impact of lower Fed funds on the economics of the servicing business.

Dan Perotti, CFO

Our earnings on custodial balances are projected to follow the forward curve. As rates project a decline in short-term interest rates, our cash flows are embedded in our MSR value reflecting lower earnings as we move forward. Those earnings changes are incorporated into our hedging strategies. So if we see a drop in interest rates, we will also see a decline in custodial earnings. Additionally, we expect some of our financing costs to decrease with a floating rate on secured MSR financing, representing an offset. However, that revenue stream is part of what we're hedging against as we expect changes in MSRs across varying rates.

Operator, Operator

Our next question comes from the line of Shana Chao with Bank of America.

Unidentified Analyst, Analyst

Previously on the call, you mentioned the margin calls under secured debt. Like, how should we think about how much rates need to decline before you see any impact of margin calls on your secured facilities?

Dan Perotti, CFO

We're over-collateralized at the moment. At the end of Q4, we had a little under $1 billion of cash and the ability to draw against our secured facilities for around $2 billion of additional value. We paid down some of our secured facilities during the quarter with our unsecured debt issuance. We're in a strong position to mitigate any margin calls; moreover, our hedges generate cash, which can help cover margin calls, making us significantly covered against that risk.

Unidentified Analyst, Analyst

Okay. Great. That's helpful. And then I think we've heard from some third parties that even first season books, there are some delinquencies for certain pools of Ginnie Mae over 10%. It looks like the 60-day delinquency increased 40 bps sequentially for the USDA, but still is relatively low at 5.2%. Can you just comment on what you're seeing and then generate delinquencies and expectations going forward?

Dan Perotti, CFO

Overall, we've seen our Ginnie Mae delinquency remain fairly stable. There’s always some seasonality during the fourth quarter, particularly in December, followed by a meaningful drop in February and March as borrowers receive income tax refunds. While we've observed slight upticks in certain areas, overall delinquencies have remained contained and manageable. In terms of cash impacts, these are not significant issues. Our servicing advances increased slightly, but this was mainly seasonal due to property tax payments rather than a substantial issue with delinquencies. Year-over-year, servicing advances are down slightly.

Operator, Operator

We have a final question today from the line of Kevin Barker with Piper Sandler.

Kevin Barker, Analyst

I just wanted to follow up on the realization of cash flows line that came down pretty meaningfully. We also saw prepay speeds drop significantly this quarter. Now, obviously, seasonality played a big part in that. But do you feel that the realization of cash flows remains fairly low as we go through the first half of 2024 given the portfolio is producing very low prepay speeds at this time?

Dan Perotti, CFO

The realization of cash flows declined a bit from Q3 to Q4 as interest rates were high for most of the fourth quarter. However, we've seen decent interest rate declines entering Q1 and an uptick in refinances that will lead to higher prepayment speeds. We expect some uptick in cash flow realization as we move into the first quarter given these dynamics. Nonetheless, our servicing profitability will remain significant and meaningful throughout the next year.

Kevin Barker, Analyst

Great. And then could you just provide maybe a little bit more depth on the demand for refinances versus closed-end seconds? Now I realize the demand is very low relative to the overall market and what it has been in the past, but just given your customer base and servicing portfolio, are you seeing your customers start to lean in more towards refinances in the last month or two? Or are you seeing the closed-end seconds still starting to garner more retention?

David Spector, CEO

As rates decline, we do see more customers leaning into closed-end seconds, primarily on the servicing we added in 2023. As for cash outs, I believe more borrowers will turn towards cash-outs versus closed-in seconds as rates decline. Conversely, in a high-rate environment, they may lean more toward closed-end seconds. We have a strong product mix that benefits borrowers by allowing them to cash out of their property typically to pay down lower-cost debt. As interest rates decline, you will see an increase in refinances as mentioned. We've also invested in technology to support the brokers. I'm encouraged by our growth and share in the broker direct channel, which continues to perform well.

Dan Perotti, CFO

To add to what David said, the refinances we've observed indicate a shift towards rate and term refinances in Q4 and Q1 as opposed to second liens since refis generally yield better profitability. We're prepared for both scenarios and will optimize our operations accordingly.

Operator, Operator

We have no further questions at this time. I'll now turn it back over to Mr. Spector for closing remarks.

David Spector, CEO

Thank you. I want to thank everyone for joining us this afternoon. We covered a lot of good information, and I believe we had an outstanding quarter. Thank you for your thoughtful questions. If anyone has additional inquiries, feel free to reach out to our Investor Relations team by e-mail or phone. Again, thank you all for joining the call.