PennyMac Mortgage Investment Trust Q3 FY2023 Earnings Call

Good afternoon, and welcome to PennyMac Mortgage Investment Trust Third Quarter 2023 Earnings Call. Additional earning material including the presentation slides that will be referred to in the call are available on PennyMac Mortgage Investment Trust website at pmt.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 earning material. I would like to remind everyone we will only take questions related to PennyMac Mortgage Investment Trust or PMT. We also ask that you please keep your questions limited to one preliminary question and one follow-up question as we'd like to ensure we can answer as many questions as possible. Now I'd like to introduce David Spector, PennyMac Mortgage Investment Trust Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Mortgage Investment Trust, Chief Financial Officer. You may begin.

Thank you, operator. PMT had an outstanding third quarter. Annualized ROE was 14%, reflecting very strong financial results and growth in book value per share from the prior quarter due to meaningful income contributions from all three of its investment strategies. As a result, book value per share net of the $0.40 dividend increased to $16.01. As you can see on Slide 4 of the presentation, mortgage rates have continued to increase from record lows in recent years and are now near 8%. As a result, many borrowers who locked in a low fixed-rate mortgage in recent years have been incentivized to stay in their homes given their low mortgage payments. This has resulted in an extremely low inventory of homes for sale, driving expectations for the lowest unit origination volume since 1990. Additionally, we believe quarterly run-rate origination volumes are trending lower than the average estimate from third parties for this year of $1.6 trillion. Turning to Slide 5. Though the current origination market remains constrained, I am very enthusiastic about PMT's opportunities in this environment. Approximately two-thirds of PMT's shareholders' equity is currently invested in a seasoned portfolio of MSRs and the unique GSE lender risk share transactions that we invested in from 2015 to 2020. Given the majority of mortgages underlying these assets were originated during periods of very low interest rates, we believe these investments will perform well over the foreseeable future as low expected prepayments extend the expected asset life. Additionally, delinquencies remain low due to the overall strength of the consumer and the substantial accumulation of home equity in recent years due to continued home price appreciation. Mortgage servicing rights investments account for about half of PMT's deployed equity. The underlying mortgages are far out of the money given current mortgage rates, reducing the sensitivity for MSR fair values. As a result, we expect the MSR asset to produce stable cash flows over an extended period. MSR value should also find additional support in a higher-for-longer environment as the placement fee income PMT receives on custodial deposits is closely tied to short-term interest rates. Similarly, low delinquencies and very low current loan-to-value ratios on the mortgages underlying PMT's large investment in lender risk share are expected to support the performance of these assets over the long term, and we ultimately expect the realized losses over the life of these investments to be limited. PMT's current capital deployment is focused on opportunistic investments that we believe have the potential for strong, long-term risk-adjusted returns. This quarter, we invested nearly $65 million in such investments, and we'll continue to monitor the markets for similar opportunities. Looking at our run rate potential on Slide 7, with expectations for interest rates to remain higher for longer and a de-inversion of the yield curve during the third quarter, potential returns from the interest rate-sensitive strategies have improved, driven by higher projected yields relative to financing costs for MSRs and MBS. As such, the run rate return potential expected from PMT's investment strategies over the next four quarters increased from $0.30 in the prior quarter to $0.35 per share or 9% annualized return on equity. I will now turn it over to Dan, who will review the drivers of PMT's third-quarter financial performance.

Thank you, David. Turning to Slide 11. PMT earned $51 million in net income to common shareholders in the third quarter or $0.51 per share. PMT's credit-sensitive strategies contributed $41 million in pretax income. Income from PMT's organically created CRT investments this quarter totaled $27 million. This amount included $14.6 million in market-driven fair value gains, reflecting the impact of tighter credit spreads. The fair value of these investments decreased slightly from the prior quarter to $1.1 billion as runoff from prepayments more than offset fair value gains. As David mentioned, the outlook for our current investments in organically created CRT remains favorable with an underlying current weighted average loan-to-value ratio of approximately 50% and a 60-day delinquency rate of 1.18%, both at September 30. Income from opportunistic investments in CAS and STACR bonds issued by the GSEs totaled $16.3 million in the quarter. The interest rate-sensitive strategies contributed $82 million to pretax income. MSR fair values increased due to the higher interest rates, which drove expectations for lower prepayment activity and higher earnings from placement fees on custodial balances. Before recognition of realization of cash flows, PMT's MSR fair value increased by $263 million. These fair value gains on MSRs held in PMT's taxable REIT subsidiary also drove the large provision for income tax expense in the quarter. Net fair value losses on Agency MBS, interest rate hedges and the related tax impacts were $254 million, driven by higher interest rates. The fair value of PMT's MSR asset at the end of the quarter was $4.1 billion from June 30 as fair value increases and newly originated MSR investments more than offset runoff from prepayments. Delinquency rates for borrowers underlying PMT's MSR portfolio remain low, and servicing advances outstanding decreased to $80 million from $94 million at June 30. No principal and interest advances are currently outstanding as prepayment activity continues to sufficiently cover remittance obligations. Income from PMT's correspondent production segment was up from last quarter, primarily due to higher margins. The prior quarter also included a negative impact of $4.5 million due to changes in GSE pricing. Total correspondent loan acquisition volume was $22 billion in the third quarter, up 2% from the prior quarter. Conventional loans acquired for PMT's account totaled $2.8 billion, down 9% from the prior quarter due to the ongoing sales of certain conventional loans to PFSI. The weighted average fulfillment fee rate was 20 basis points, up from 18 basis points in the prior quarter. PMT reported $32 million of net income across its strategies, excluding market-driven value changes and the related tax impacts, up from $25 million last quarter. As you can see on Slide 13, in the third quarter, we also took several steps to further strengthen PMT's balance sheet. These included the upsizing of a previously issued Fannie Mae term loan from $155 million to $370 million, the redemption of $450 million in Fannie Mae MSR term notes due in 2025, and the opportunistic issuance of $54 million in unsecured senior debt at very attractive terms. Finally, while there has been significant interest rate volatility since quarter-end, PMT's book value per share is little changed as a result of our hedge discipline. We'll now open it up for questions.

Your first question comes from the line of Bose George from KBW. Please go ahead.

Hey, everyone. Good afternoon. Actually, going to Slide 7. If the yield curve continues to de-invert or whatever normalizes, would that continue to push up the return? And is that a way that you potentially get back to your ROE that could cover the dividend?

Hey, Bose. This is Dan. Yes, that's exactly right. During the quarter, the primary factor that drove up what we see as the run rate potential was that the inversion of the yield curve. We've seen some additional de-inversion here as we move further into Q4, and we would expect that to have the same impact as we saw during last quarter, which could get us back to the $0.40 type of run rate to the extent that we see further de-inversion continuing to happen.

Okay. Great. Thanks. And then on the mortgage banking return this quarter, would you characterize this quarter as somewhat more normal than last quarter as being impaired by the GSE pricing change? Or how would you characterize this quarter?

Yes, this quarter, I think we would characterize as somewhat more normalized. To your point, last quarter, we had the negative impact of the GSE pricing change that did not recur this quarter. I think we're seeing something fairly similar going into Q4 here, so I'd say your characterization is right that it's a more normalized result than we saw in the prior quarter.

Okay. Great. Thank you.

Your next question comes from the line of Kevin Barker from Piper Sandler. Please go ahead.

Great. Thanks for taking my questions. I noticed that the MSR has marked up fairly high relative to some of the peers. Now, obviously, you hedge it to protect that value. But is there anything that's really driving some of that value, and is there anything there that could create slight risk despite the hedging that you put in place?

I don't think there's anything in there that would necessarily constitute a more significant risk than what we've seen in the past. In fact, given how far out of the money the borrowers are underlying the MSR, the prepayment sensitivity is lower than what we've seen historically. And so the hedging risk there is lower. Really what's driving a lot of the value or potential additional value at this point has to do with the escrow, the earnings on the escrow balances, which are a part of the cash flows projected as part of the MSR value. As these market and yield curve adjust to this higher for longer scenario, that increases the expected value of those escrow balances and those cash flows associated with that. But that is all incorporated into our sensitivity of the MSR asset and what we're hedging against to the extent that we see interest rate changes or volatility.

That's great. Helpful color. And then also, obviously, CRT was a major investment for you for a long period of time. Are you seeing any other avenues for investment in credit out there that might be attractive, whether it's other GSE products or potentially even non-GSE or non-Agency products?

Hey, Kevin, it's David. Look, I think that we've brought a little bit of CAS and STACR in the third quarter. And we bought $58 million in sub bonds, albeit it's not really credit because we're buying more at the top of the credit stack. But suffice it to say, I think that given what we're seeing with the capital regulations that have come up for banks, I expect there will be more securitization. Out of that, I'm hopeful that we'll see opportunities for PMT. PMT is really positioned well. We do see an increased amount of securitization, and I think there's going to be potential for jumbo securitization. Right now, for all the closed-end second production being done in PFSI, that product is being sold, but others are securitizing that, albeit at returns that don't meet PMT's minimum return. Ultimately, I can see there being an opportunity for securitization of closed-end seconds where there is a retained investment for PMT.

Another factor that's important to note that we called out this quarter, is just—if you look at our current investments in the mortgage servicing rights and the GSE credit risk transfer, which are 50% and 15% of our shareholders' equity together 65%. Those are all based on very low note rate borrowers underlying those investments. They are running off very slowly for that reason and both have very strong credit characteristics of the underlying borrowers to drive them. So as we are waiting for some of these other trends to develop or we're seeing some of these other trends develop, we have this really strong base of assets that is running off at a slow rate that we expect to perform really well over time.

So ideally, over the long-term, how would you want PMT's balance sheet structured from an equity investment standpoint, credit-sensitive strategies versus interest rate sensitive strategies?

I think that we always optimize for is return on equity. So I always start there. The 50% mortgage servicing rights is higher than we'd like. A lot of that is because of the write-up of the asset. I think if you saw a rate decline, you would see it get much more in line or closer to where the credit risk is. All things being equal, if returns are identical, then you could say, okay, maybe a 50-50 split—but I think the ROE is always going to be the driving factor. If we can find investments that are creating franchise value for PMT as well as we saw going back to NPLs or then followed on by the CRT we did from 2015 to 2020, that's something we would definitely support. Right now, I think the 50%, 15% split between mortgage servicing rights and CRT is one we'd like to get a little bit more in balance.

Okay, great. Thank you.

Your next question comes from the line of Eric Hagen from BTIG. Please go ahead.

Hey, again, how are you doing? Just a question around risk management and managing just rate risk and leverage and such. How much more MBS do you think you need to add to the portfolio given an increase in the MSR portfolio from here? Are there levels of spreads on the MBS side where you can get more aggressive there and even raise leverage? And how much room do you have to raise leverage in that portfolio?

Hey, Eric. It's Dan. Yes, given the increase in the MSR portfolio, we may add incrementally to the agency MBS portfolio. We've added incrementally in terms of some of the non-agency MBS, as David mentioned. It's not necessary to add substantially due to the change in the MSR to balance out from a REIT test perspective. If we see spreads widen and that investment appears attractive, we could add additional agency MBS. Our overall leverage ratio is around 5x currently, so we do have some ability to continue to increase that, but we aren't necessarily looking to substantially increase our agency MBS portfolio unless we saw that as a significant opportunity.

Yes, totally understood. Second question, I mean, looking at the liquidity requirement, on Slide 18, you have a cushion of around $200 million of liquidity. Do you feel like that's a comfortable cushion just given the size of the balance sheet? How sensitive would you say that kind of liquidity, that regulatory liquidity is to higher interest rates and wider spreads? Thanks, guys.

Yes. When we look at our hedging position, we look at both our liquidity as well as the balance sheet value and hedge for both of those. Yes, we do think that cushion is very sufficient to manage our liquidity for the balance sheet size that we have. It would take a substantial increase in spreads to put a meaningful dent into that liquidity that we're holding here. We do have a little bit of additional overall liquidity that we can tap that isn't on the balance sheet today, so this doesn't represent the maximum size of the liquidity where we have a bit more that we could tap as well if we saw a spread widening or something of that nature.

Did you guys give an update for your book value through October? And if I missed it, I apologize. Thank you.

Yes, we did. It's a little changed from what we saw at the end of the quarter.

Your next question comes from the line of Matthew Erdner from JonesTrading. Please go ahead.

Hey guys. Thanks for taking the question. I believe you didn't repurchase any shares during the quarter. If that's true, let me know. And then how are you guys weighing share repurchases versus deployment of capital, given where the stock has traded over the past couple of quarters?

Yes, this is Dan. Yes, we did not repurchase any shares over the quarter. That is something we look at as a potential deployment of our capital. Certainly, the shares were trading during most of Q3 higher than they have been over the recent couple of weeks. I would say that we find share repurchase to be more attractive, meaningfully more attractive at the levels we're seeing today than we did at some of the levels that we saw during Q3. So that could result in some activity versus to your point, we did not repurchase any shares during Q3.

Got it. Thank you.

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

Again, I want to thank everyone for joining us here today for our Q3 earnings. If you have any questions or comments, please don't hesitate to reach out to our Investor Relations team, and I look forward to speaking with all of you in the near future. Take care.

This concludes today's conference call. Thank you for your participation. And you may now disconnect.