Earnings Call Transcript - PFSI Q2 2020

Operator, Operator

Good afternoon, and welcome to the Second Quarter 2020 Earnings Discussion for PennyMac Financial Services, Inc. The slides that accompany this discussion are available on PennyMac Financial's website. Before we begin, let me remind you that our discussion contains forward-looking statements that are subject to risks that could cause our actual results to differ materially. 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 second quarter 2020 results.

David Spector, President and CEO

Thank you, Isaac. PennyMac Financial reported record earnings in the second quarter, driven by core Production and Servicing results, partially offset by fair value losses on mortgage servicing rights and associated hedging and other losses. Net income was $352.7 million or diluted earnings per share of $4.39. Book value per share increased 15% to $34.26 from $29.85 at the end of the prior quarter. In June, we purchased approximately 7 million shares of our common stock or approximately 9% of our total shares outstanding. The shares were purchased at a price of $34 each. Finally, I'm pleased to note that our Board of Directors increased the quarterly cash dividend to $0.15 per share, a 25% increase from the prior quarter. Production segment pretax income was a record $538.1 million, up 124% from the prior quarter and up 448% from the second quarter of 2019, driven by record volumes in the direct lending channels and record margins across all of our channels. Direct lending locks were a record $13 billion in unpaid principal balance, up 31% from the prior quarter and 177% from the second quarter of 2019. Of these, $8.9 billion were in the Consumer Direct channel, while $4.1 billion were in the Broker Direct channel. Government correspondent lock volume was $12.9 billion in UPB, down 13% from the prior quarter, reflecting a temporary slowdown in the origination market for government loans early in the quarter due to the impact of COVID-19. However, government correspondent lock volume was up 7% from the second quarter of 2019. Total production volume for the quarter was $37.6 billion in UPB, up 6% from the prior quarter and up 56% from the second quarter of 2019. Correspondent acquisitions of conventional loans fulfilled for PMT totaled $18.9 billion in UPB, up 17% from the prior quarter and up 76% from the second quarter of 2019. Continuing on to discuss our Servicing segment, we reported a pretax loss of $62.4 million versus pretax income of $170.8 million in the prior quarter and a pretax loss of $2.7 million in the second quarter of 2019. The segment results this quarter were primarily driven by valuation-related items. These included $108.4 million in mortgage servicing rights fair value losses and $15.1 million in hedging and other losses, driven by elevated hedge costs and fair value losses due to a decrease in volatility. The net impact of these items was a pretax loss of $123.5 million and a $1.13 decrease in diluted earnings per share. Pretax income, excluding valuation related changes for the Servicing segment, was a record $86.9 million, up 105% from the prior quarter and 84% from the second quarter of 2019, primarily driven by a large contribution from early buyout activities and a lower realization of MSR cash flows. As of June 30, our Servicing portfolio totaled $388.3 billion in UPB, an increase of 1% from the end of the prior quarter and 16% from June 30, 2019. Our Investment Management segment delivered pretax income of $4.7 million, up from $3.8 million in the prior quarter and up from $4 million in the second quarter of 2019. Segment revenue was $10.5 million, up 7% from the prior quarter and 2% from the second quarter of 2019. Net assets under management totaled $2.2 billion as of June 30, up 23% from March 31, driven by an increase in PMT's book value. Now let's look at PFSI's unique business model. The success we enjoy today is a direct result of the unique business model we organically built, our unwavering focus on risk management, and a track record of successful capital management. PennyMac Financial is recognized as an established leader in the mortgage industry, with scale in both loan production and servicing, which continues to drive profitability across different market environments. Additionally, 42% of our production year-to-date has been purchase money loans, significantly higher than the industry average. Our expertise in managing risk since the company's founding in 2008 has enabled PennyMac Financial to remain a consistent and constructive source of new capital for consumers seeking to purchase a home or refinance their existing home. This commitment is demonstrated by our strong balance sheet with low levels of leverage versus competitors, and the well-developed and sophisticated enterprise risk management systems we have built. PennyMac Financial continues to be recognized as a leader in capital markets operations and interest rate risk management, which includes our successful history of hedging mortgage servicing rights. These foundational disciplines have been critical to our success, including during the COVID-19 crisis. The management team has a track record of successful capital management, with retained earnings driving book value growth. In fact, since our initial public offering more than seven years ago, we have grown book value at a compounded annual growth rate of 25%. Additionally, we have repurchased over 8 million common shares since 2017 and introduced a quarterly dividend last year as an important component in the structure of providing long-term sustainable stockholder returns. Now let's review PFSI's earnings growth. Our consumer and Broker Direct lending channels are significant contributors to PFSI's increased earnings power. The growth in production pretax income has been driven by the profitable growth of the direct lending channels. PFSI is capturing this growth due to significant investments in technology and infrastructure to further scale our end-to-end mortgage fulfillment process, coupled with increased hiring to grow the operating platform and the growth of our servicing portfolio. Notably, Production segment pretax income for the first half of 2020 was $778.2 million, up significantly from $527.8 million for the full year of 2019. As you can see in the chart, operating earnings for the Servicing segment provide a core earnings contribution driven by the growth of our servicing portfolio and increased scale. Our operational results in 2020 are tracking towards a record year, with pretax income excluding valuation-related changes of $129.2 million for the first half of 2020 compared to $146.8 million for the full year of 2019. Investment Management is the smallest contributor to our pretax income, but has grown in recent years alongside the growth in PMT's equity. While prospects for the U.S. economy remain uncertain, we expect PFSI's exceptional financial performance to persist into 2021. Now let's discuss economic developments affecting our businesses. Challenges in the U.S. economy reflect the impact of COVID-19 as a recent resurgence of the virus weighs on states' plans to reopen. Reopening plans, including a return to physical work locations, are now on pause in over 80% of the country, and the economic recovery is expected to be more gradual than previously forecasted. According to the Bureau of Labor Statistics, the unemployment rate reached a recent high of 14.7% on April 30, while leading economists forecast a gradual recovery to 6.9% by the end of 2021. New requests for mortgage forbearance have decreased substantially, and borrowers are beginning to exit forbearance plans as they continue or resume making payments or obtain assistance through government-supported loan modification programs. Despite tight levels of supply, economists have forecast home price decreases in areas heavily affected by the economy. Fiscal stimulus benefits from the federal government have begun to roll off, with an extension or further stimulus remaining uncertain as Congress has yet to resolve differences on several issues, including the jobless benefit and other forms of aid. Liquidity in the financial markets has largely rebounded since March and April; however, markets continue to reflect uncertainty related to the long-term impacts of COVID-19. The improved liquidity during May and June resulted in a significant recovery in the fair value of credit-related assets, particularly in government-sponsored enterprise credit risk transfer investments. Now let's discuss PennyMac's opportunity in the mortgage origination market. Economic forecasts for total originations in 2020 have increased to nearly $3 trillion, the highest level since 2003, and forecasts for total originations in 2021 have recently increased to $2.3 trillion, similar to the strong market we saw in 2019. These forecasts are supported by all-time low mortgage rates, which continue to drive robust refinance and purchase mortgage demand. Additionally, sales of previously owned homes posted their largest-ever monthly increase in June, and sales of new homes have been above consensus expectations. Gain on sale margins remain elevated, particularly in direct lending channels driven by capacity constraints. PennyMac was able to successfully capitalize on the market opportunity and continue to originate, fund, and settle loans throughout the crisis. On the next slide, we will discuss some of the investments we've made to drive our continued growth, including a new milestone in production technology. I am excited to announce the completion of the development of P3, a new portal for our correspondent sellers that leverages our proprietary technology and integrates with Ellie Mae's next-generation Encompass Digital Lending Platform for a best-in-class experience. Through July 31st, approximately 80% of our correspondent clients have been migrated onto P3, and almost $9 billion in lock volume has been processed. Additionally, MAC, our consumer direct portal, is a state-of-the-art system that transforms the old mortgage process into a more efficient, customer-centric, and transparent experience. Borrowers are able to interact with their loan applications online from end-to-end through a portal backed by superior service. POWER, our Broker Direct portal, provides brokers with an efficient self-service delivery platform, enabling the exchange of data and information for loan originations with a focus on zero defects. Our investment in production technology will continue across all channels as we scale our business, with plans to eventually consolidate all channels onto a single cloud-based system. In servicing technology, we announced the completion of SSE, our proprietary workflow-driven servicing system, last year.

Doug Jones, Chief Mortgage Banking Officer

Thank you, David. Our correspondent acquisition volumes increased slightly during the quarter, and we estimate our market share in the channel was 16.7%, essentially unchanged from 16.6% in the prior quarter and up from 13.2% a year ago. We also estimate that our market share in Consumer Direct was 1%, essentially unchanged from the prior quarter and up from 0.61% a year ago. This year-over-year increase reflects our success in growing the Consumer Direct channel, and we are confident in our ability to continue this growth. Our Broker Direct channel market position grew quarter-over-quarter, reaching 1.8% market share, up from 1.5% in the first quarter and 1% in the second quarter of 2019. Since entering the broker channel early in 2018, we are already among the top 10 in this channel. As David mentioned, our Servicing portfolio grew slightly in the second quarter, and we estimate that we service over 3.4% of all mortgage debt outstanding in the U.S., unchanged from March 31, and up from 3.1% at June 30, 2019. Correspondent acquisitions totaled $29.9 billion in UPB in the second quarter, up slightly from the prior quarter and up 40% from the second quarter of 2019. 37% of our acquisitions were government loans and 63% were conventional loans. Government loan acquisitions totaled $11 billion in UPB, down 19% from the prior quarter due to a temporary slowdown in the origination market, which has since recovered. Conventional correspondent acquisitions totaled $18.9 billion in UPB, up 17% from the prior quarter and 76% from the second quarter of 2019. Fulfillment fees for loan production increased due to strong conventional loan acquisition volumes and a slightly higher fulfillment fee. Our weighted average fulfillment fee as a percentage of conventional correspondent UPB was 28 basis points, up from 26 basis points in the prior quarter. Government correspondent locks were $12.9 billion in UPB, down 13% from the prior quarter and up 7% from the second quarter of 2019. Higher-margin commitments increased to 38% of lock volume, enabled by our capital and expertise to hedge production pipelines efficiently. Meanwhile, revenue per fallout-adjusted government lock was 163 basis points, significantly up from 76 basis points in the first quarter. While purchase-money loans in our correspondent channel accounted for 40% of the total acquisition volume, down from 58% in the prior quarter, July 2020 volumes remained elevated with total correspondent loan acquisitions of $12.7 billion in UPB and interest rate lock commitments for the month set a record at $16 billion in UPB. Turning now to our Consumer Direct channel, we originated $5.1 billion in UPB of loans, which is up 27% from the prior quarter and up 161% from the second quarter of 2019. Interest rate lock commitments for this quarter totaled $8.9 billion in UPB, which is up 25% from the prior quarter and 167% from the second quarter of 2019. This strong growth can be attributed to the investments made to scale the platform and our efficient low-cost structure in the channel. Non-portfolio interest rate lock commitments totaled $568 million, up 120% quarter-over-quarter, as we implement strategic initiatives to focus on increasing the share of originations sourced outside of our loan servicing portfolio. Revenue per fallout-adjusted consumer direct lock was 575 basis points, up from 464 basis points in the previous quarter. Our strong performance continued in July, with $2 billion in UPB of originations, $3.5 billion of locks and a committed pipeline of $5.1 billion at month end. Now, let's move to our Broker Direct production highlights. We originated $2.6 billion in UPB in the Broker Direct channel in the second quarter, which is a significant 67% increase from the prior quarter and up 210% from the second quarter of 2019. Interest rate lock volume was $4.1 billion in UPB, up 48% from the first quarter and 204% from the second quarter of 2019. The competitive landscape in this channel has been fundamentally altered due to the COVID-19 crisis, which has resulted in an increase in margins and PennyMac's market share. Our operational performance through market volatility attracted new brokers to our platform and established a greater level of brand loyalty. The number of brokers approved to offer our products increased to 1,255 at the end of June 30th, up 17% from March 31st. Our brokers can expect the highest levels of service from PennyMac as we continue to invest in fulfillment capacity and technology to meet increased demand and support market share growth. In July, our Broker Direct originations totaled $1.1 billion in UPB, and locks totaled $1.6 billion, with a committed pipeline at July 31st of $1.9 billion. Regarding our Servicing segment, our portfolio grew to $388.3 billion in UPB at the end of the second quarter, up 1% from March 31st and up 16% from June 30, 2019, despite elevated prepayment speeds and disruptions in the correspondent origination market. Our owned portfolio reported a prepayment speed of 24.4% in the second quarter, up from 19.2% in the prior quarter. Similarly, our sub-serviced portfolio reported an increase of prepayment speeds to 34.8% from 20.6% in the prior quarter. The loans in our total servicing portfolio that are over 60 days delinquent increased significantly from March 31st due to COVID-19 hardships and forbearance. Our owned portfolio had a 60-day plus delinquency rate of 11.7%, up from 3.3% at the end of the prior quarter, while our sub-serviced portfolio reported a 60-day delinquency rate of 5.1%, up from 0.4% at March 31st. The UPB of EBO loan volume totaled $293 million in the second quarter, a significant reduction from $1.6 billion in the first quarter due to a temporary pause in EBO activities driven by market and regulatory uncertainties. 69% of forbearance plans in effect as of April 30th have been extended. The percentage of loans in forbearance within our MSR portfolio decreased to 11.7% at July 31st from 13.2% at April 30th. A 21% increase in new forbearance plans since April 30th was more than offset by 31% of borrowers in forbearance plans as of April 30th exiting those plans. This provides a significant opportunity for us in the second half of 2020 and into 2021 as we expand our financing facilities and expect to utilize excess liquidity to support the anticipated EBO opportunities.

Andy Chang, CFO

Thank you, Doug. Now let's discuss our investment management segment and highlight key trends and factors in PFSI's financial results. Net assets under management totaled $2.2 billion at June 30th, up 23% from March 31st due to the increase in PMT's book value. PMT's earnings in the second quarter were primarily driven by record results in its correspondent production segment and a significant recovery in the fair value of its CRT investments. Investment Management revenues were $10.5 million, up 7% from the prior quarter and 2% from the second quarter of 2019. PFSI did not recognize incentive fees in the second quarter and does not expect to for some time. PMT's current investment focus is on conventional correspondent production and resulting MSRs. Our comprehensive hedging strategy is designed to moderate the impact of interest rate changes on the fair value of our MSR asset and also includes production-related income, which totaled $538.1 million in the second quarter. In the second quarter, the fair value of our MSR decreased, resulting from expectations for increased future prepayment activity related to lower interest rates and higher-than-modeled prepayments. We maintained our hedge discipline throughout the market turmoil; however, elevated volatility early in the second quarter drove option costs to near record highs, while the subsequent decrease in volatility by June 30th resulted in fair value losses. Year-to-date, through June 30th, our MSR fair value losses have totaled $1.03 billion, offset by hedging and other gains totaling $1.04 billion, reflecting PennyMac's disciplined focus on capital preservation and risk management. As we look at the drivers of profitability in PFSI's Production segment, Consumer and Broker Direct have a significant impact on production earnings. Currently, we have less than 2% market share in these channels, with substantial potential for growth ahead. As Doug discussed, PMT's position as the largest correspondent aggregator in the U.S. drives servicing portfolio growth and, in turn, opportunities in our Consumer Direct lending channel. Production expenses remain contained quarter-over-quarter as the channels benefited from increased economies of scale driven by our centralized end-to-end fulfillment process. Turning now to the profitability of our Servicing segment, pretax income excluding valuation-related changes was a record $86.9 million, up from $42.3 million in the prior quarter and $47.1 million in the second quarter of 2019. Operating revenue decreased quarter-over-quarter driven by decreased income from custodial deposits due to lower earnings rates. Early buyout loan revenue increased quarter-over-quarter, while related expenses decreased. Interest shortfall expenses from prepayments remain elevated and increased quarter-over-quarter. Valuation-related changes included provisions for credit losses on active loans as a result of higher delinquencies related to COVID-19. Now let’s discuss servicing trends for PFSI's MSR portfolio. The percentage of loans in our MSR portfolio that were 30 days or more delinquent was 14.6% at July 31st, down from 15.1% at June 30th and up from 13% at April 30th. Servicing advances outstanding were approximately $285 million, up from $260 million at April 30th. PFSI has approximately $1.5 billion in available liquidity, less $220 million in minimum liquidity required by Ginnie Mae as of July 31st. Importantly, our financing structure allows for expansion via adding other lenders or issuing term notes if needed.

David Spector, President and CEO

Thank you, Andy. During this period of historically low interest rates and disruptions in the economy, PennyMac Financial was, and remains, a consistent and constructive source of new capital for consumers seeking to purchase a home or refinance their existing home throughout the COVID-19 crisis. I'm proud of the hard work and investments we have made in our platform leading up to this period, which have established PennyMac as an industry leader with strong capabilities to best serve our customers while delivering record financial performance to our shareholders. We reported record Production segment results and strong operating earnings in our loan servicing segment, driving 15% book value growth from the prior quarter. We continue to invest in our platform and are pleased to note a new milestone in the development of our production technology, specifically the launch of P3 for our correspondent customers. This new portal is designed to drive operational efficiencies and improve customer experience across all channels, enhancing the speed of system improvements. Additionally, we continue to be a positive force in the economy as we hired over 1,000 new team members in the quarter to support planned growth in our direct lending platforms and assist borrowers facing hardships. Our substantial investments in people, systems, and infrastructure throughout our history have positioned us uniquely to address the significant opportunities in the mortgage markets. I am proud of the role this company continues to play in the economic recovery.

Operator, Operator

This concludes PennyMac Financial Services, Inc.'s second quarter earnings discussion. For any questions, please visit our website or call our Investor Relations department. Thank you.