PennyMac Mortgage Investment Trust Q1 FY2024 Earnings Call

Good afternoon, and welcome to PennyMac Mortgage Investment Trust First Quarter Earnings Call. Additional earnings materials, including the presentation slides that will be referred into 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 earnings materials. 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.

Thank you, operator. PMT produced solid results in the first quarter with strong contributions from the credit-sensitive strategy in its correspondent production business. These results were partially offset by net fair value declines in the interest rate-sensitive strategies. Net income to common shareholders was $37 million or diluted earnings per share of $0.39. PMT's annualized return on common equity was 10% and book value per share was $16.11 at March 31, essentially unchanged from the end of the prior quarter. While many of the mortgage REITs have been negatively impacted by increased levels of interest rate volatility in recent periods, PMT's book value per share has remained relatively stable due to its diversified portfolio and disciplined approach to hedging. Turning to the origination market. Current third-party estimates for total originations in 2024 averaged $1.8 trillion, reflecting growth from an estimated $1.5 trillion in 2023. However, we believe these estimates to be optimistic and dependent upon multiple interest rate cuts from the Federal Reserve in the second half of the year. With current expectations for market interest rates to remain higher for longer and mortgage rates back up into the 7% range, we expect these third-party estimates will decline further from their current levels. PMT's strong financial performance in recent periods highlights the strength of the fundamentals underlying its long-term mortgage assets and our expertise managing mortgage-related investments in a challenging environment. We remain focused on leveraging PMT's unique relationship with PFSI to actively manage PMT's portfolio. And in the first quarter, we took advantage of tighter credit spreads, selling $111 million of previously purchased floating rate GSE CRT bonds. Importantly, we realized significant gains on these investments with the sales driven by our belief that these investments no longer met our long-term return requirements. Additionally, credit spread tightening drove our ability to issue more than $550 million in CRT term notes at attractive terms during and after the quarter end, effectively refinancing similar notes with extended maturities and reduced spreads. More than two-thirds of PMT shareholders' equity is currently invested in the seasoned portfolio because MSRs and the unique GSE lender risk share transactions we invested in from 2015 to 2020. As the majority of mortgages underlying these assets were originated during periods of very low interest rates, we continue to believe these investments will perform well in the foreseeable future as low expected prepayments extend the expected asset lives. Additionally, delinquencies remain low due to the overall strength of the consumer as well as the substantial accumulation of home equity in recent years due to continued home price appreciation. MSR investments account for more than half of PMT's deployed equity. The majority of the underlying mortgages remain far out of the money, and we expect the MSR asset to continue producing stable cash flows over an extended period. MSR values also benefit from the current interest rate environment as the placement fee income PMT received from custodial deposits is closely tied to short-term interest rates. Similarly, mortgages underlying PMT's large investment in lender risk share have low delinquencies and a low weighted average current loan-to-value ratio of 50%. These characteristics are expected to support the performance of these assets over the long term, and we continue to expect that realized losses will be limited. Slide 7 outlines the run rate return potential expected from PMT's investment strategies over the next four quarters. PMT's current run rate reflects a quarterly average of $0.35 per share. This is up from the prior quarter, driven primarily by higher expected asset yields in the interest-rate-sensitive strategies. Now I'll turn it over to Dan, who will review the drivers of PMT's first quarter financial performance.

Thank you, David. PMT earned $37 million in net income to common shareholders in the first quarter or $0.39 per diluted common share. PMT's credit-sensitive strategies contributed $61 million in pretax income, including $48 million from PMT's organically created CRT investments. This amount included $36 million in market-driven fair value gains, reflecting the impact of tighter credit spreads. The fair value of these investments was up slightly from the prior quarter as fair value gains more than offset the decline from runoff. As David mentioned, the outlook for our current investments in organically created CRT remains favorable, with a low underlying current weighted average loan-to-value ratio of 50% and a 60-day delinquency rate of 1.11%, both as of March 31. Income from opportunistic investments in CAS and STACR bonds issued by the GSEs totaled $8.9 million in the quarter. As mortgage credit spreads continued to tighten during the quarter, the go-forward returns on some of the opportunistic investments that we had previously made fell below our thresholds, so we sold $111 million of these CAS and STACR investments during the quarter. The interest rate-sensitive strategies contributed a pretax loss of $27 million. The fair value of PMT's MSR investment increased by $72 million as the increase in mortgage rates drove a decline in future prepayment projections and an increase in projections of future earnings on custodial balances. These fair value gains were more than offset by changes in the fair value of MBS, interest rate hedges, and the related tax effects during the quarter. MBS fair value decreased by $44 million and interest rate hedges decreased by $70 million. Net fair value declines on assets held in PMT's taxable REIT subsidiary drove a tax benefit of $15 million. The fair value of PMT's MSR asset at the end of the quarter was $4 billion, up slightly from $3.9 billion at December 31, as growth in the MSR portfolio from fair value gains, loan production, and MSR acquisitions more than offset runoff from prepayments. Delinquency rates for borrowers underlying PMT's MSR portfolio remain low while servicing advances outstanding decreased to $110 million from $191 million at December 31. No principal and interest advances are currently outstanding. Income from PMT's correspondent production segment was up slightly from last quarter as higher margins offset the impact of lower volumes. Total correspondent loan acquisition volume was $18 billion in the first quarter, down 23% from the prior quarter, driven by our focus on profitability over volume. Conventional loans acquired for PMT's accounts totaled $1.8 billion, down 29% from the prior quarter. The weighted average fulfillment fee rate was 23 basis points, up from 20 basis points in the prior quarter. PMT reported $28 million of net income across its strategies, excluding market-driven value changes and the related tax impacts, down from $41 million last quarter, primarily due to lower average yields on its interest rate-sensitive assets during the quarter. Turning to capital. We issued $306 million of new three-year CRT term notes during the quarter, effectively refinancing recently matured term notes. And in April, we issued $247 million of new three-year CRT term notes which refinanced $213 million of notes that were due to mature in 2025, extending the maturities and reducing the spreads for the financing for our CRT assets.

I would like to remind everyone that we will only take questions related to PennyMac Mortgage Investment Trust or PMT. Your first question comes from the line of Jason Weaver of Jones Trading.

So I was curious about how you view the sustainability of the dividend looking forward. I thought I heard in David's prepared remarks something about a $0.35 earnings run rate. Excuse me if I'm misconstruing that.

Sure. Similar to previous quarters, our run rate is slightly below our current dividend level. However, we did see an increase in the run rate during the quarter, driven by the inversion of the yield curve and the upward movement in the longer-term portion of the yield curve, which boosts asset yields on our MSRs and MBS portfolio and enhances returns in our interest rate-sensitive strategies. As we anticipate the yield curve to normalize or de-invert in the coming periods, we expect to see additional benefits in our interest rate-sensitive strategies, possibly reaching or exceeding the $0.40 target. Regarding the $0.40 dividend, a key aspect of our dividend philosophy is stability. We do not aim to adjust the dividend to exactly align with our projections every quarter, as these fluctuate with the market, but we foresee the run rate potentially moving closer to the $0.40 dividend level. Therefore, we plan to maintain the $0.40 dividend level for now, unless market conditions change in a way that leads us to believe the run rate will not continue to progress towards that level. Given the current trajectory and the normalization of the yield curve, we expect to sustain the $0.40 dividend for this period and likely the next few periods as well.

All right. That's helpful. And then just noting the CRT sales, I was curious about your priorities for new capital deployment given the rate outlook today, whether that is maybe tilted more towards interest rate strategies still and less into CRT.

I think that's fair to say. We've identified more opportunities and have invested some into low rate MSR portfolios over the past few periods. As we discussed earlier, we've noticed credit spreads tightening significantly in the CRT area or in mortgage credit, with some of those investments falling below our return thresholds. If we continue to see a normalization of the yield curve, we believe that opportunities will likely be more in interest rate-sensitive strategies rather than in credit-sensitive strategies, unless there is a change in the overall environment. In previous periods, we've mentioned our preference for a more balanced approach between credit-sensitive and interest rate-sensitive strategies, but we currently have a greater allocation towards the latter. Our primary focus is on investing in assets that we believe offer the highest risk-adjusted returns and meet our criteria, which currently appear to be more in the interest rate-sensitive strategies.

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

This is Bose. I wanted to follow up on the overall return expectation. A significant part of the increase appeared to be linked to a higher return expectation on the MSR. Is that due to a slower prepayment expectation with higher rates, or what factors influenced that aspect?

Not necessarily a higher or lower prepayment expectation, but our valuation method as interest rates rise affects the expected prepayment speeds of the MSR and the projected custodial income. We also value our MSRs at a spread over the risk-free rate. As risk-free rates increase, our overall yield or discount rate on the MSR rises, leading us to expect a greater yield moving forward, even if cash flows remain the same or similar, because we are discounting those cash flows at a higher rate to determine today's value. Similarly, for the MBS, as we mark the MBS to market, the yield increases as interest rates rise, so we also expect a higher return on MBS moving forward.

Okay. Great. And then you talked about the benefit from the yield curve or de-inverting, but does that have to happen with the yield curve with long rates remaining relatively elevated? Like if there's a shift down kind of a parallel shift down in the curve? And then the curve de-inverts, does that sort of hurt you to some degree? So is kind of higher for longer with the yield steeper curve better?

I think, overall, for PMT, we would prefer a scenario where asset returns are higher, specifically if we have a flatter and higher yield curve rather than a flatter and lower one. Either way, this situation would help our interest rate-sensitive strategies since most of our financing is floating rate and tied to short rates. If short rates decrease compared to longer-term asset yields, that would also be a positive outcome. Maintaining the shape of the yield curve while having higher overall yields on assets would be more advantageous in a higher rate environment with the same steepness of the yield curve than in a lower rate environment. However, either option would still be better than facing an inverted curve.

Your next question comes from the line of Matt Howlett from B. Riley Securities.

The first question is about the frustration with the stability you've shown in book value and earnings while trading at a discount to book. You're in a group of mortgage REITs that are trading significantly below book value, which I know must be frustrating. My question for you, David, is regarding the buyback. How willing would you be to start buying back shares when they are over 20 percent discounted to book? Additionally, when do you expect to enter the market to refinance in November '24?

There are aspects we can control and aspects we cannot. I can't control the share price; my focus is on influencing the company's results. We've achieved strong performance, especially over the past five to six quarters. I firmly believe that as long as we keep delivering good results, the share price will take care of itself. We remind our team of this regularly. We have a limited amount of capital, which we will deploy carefully. If we identify opportunities in the marketplace that align with our required return, we will take action. We have a history of buying back stock when it is undervalued. The percentage of that discount varies over time. However, we believe in being patient, and we have always maintained that patience, which will continue.

And then with respect to the 2024 maturity, we continue to look for opportunities to raise additional capital, but we have fully reserved for the retirement of that maturity in our liquidity forecasting. So we have sufficient secured financing assets to be able to retire that maturity even if we do not raise additional capital. That being said, we are looking for opportunities to raise capital that would replace some of that convertible debt that matures in 2024. We've not found what we view to be the right opportunity, yet that supports our basically financing cost goals, but we'll continue to look at the different avenues, whether that be baby bond, which we issued last year, convertible debt potentially or depending on the market dynamics. To your point, if we eventually move to book value, potential equity raise, but we're not looking to do a dilutive equity raise in order to refinance that maturity. And we've, as I mentioned, fully reserved for that in terms of being able to use secured debt to refinance it if we don't find another opportunity that attracts us between the maturity and now.

Great. And just one last question. How long will the current dynamic between PFSI, the selling of conventional loans to PFSI, and your purchasing of bulk packages continue? Is there a specific interest rate at which you would stop selling loans? I assume you're buying lower coupon bulk loans while selling the higher coupon current production to PFSI. Is there a rate level that would change this dynamic or revert it to historical practices?

I believe this primarily depends on capital and the decisions around capital allocation. If we were to raise more capital and have additional resources to deploy, that would influence our choices. I don't expect any changes in Q2, and I don't foresee significant shifts in Q3 either. However, if we were to raise substantial capital, we would consider addressing that situation. This situation highlights the strong collaborative relationship between PMT and PFSI, where PMT has the chance to invest in mortgage servicing rights when current period mortgage servicing rights have both capital and the inclination to act, while PFSI is interested in expanding their servicing portfolio.

And your next question comes from the line of Eric Hagen from BTIG.

Eric Hagen. Has PMT ever sold any MSRs? And do you ever look at that as a viable option to generate liquidity? Or is it maybe not really a reasonable option just given the market and the assets kind of higher than what we see in the rest of the market?

Well, I think we're primarily an investment vehicle, and it's not something we've focused on historically. That said, it's possible for us to consider it in the future. Currently, we view PMT as an investment platform. The reason we sold the CRT is that it was acquired during a time when spreads were wide, and our strategy over the past year has been to strategically invest in credit-sensitive assets. Given that the return on those assets fell below our required return, we saw it as an opportunity to sell. At this point, PMT can't continuously issue capital, so we need to be careful about having funds available for strategic investments. When returns dip below what's required, we decided to sell. However, there’s nothing stopping PMT from selling servicing; it's just not something we're actively pursuing right now.

Yes. I believe that when we examine PMT's core investments, particularly the Mortgage Servicing Rights (MSR) and our historical credit risk transfer, which account for about 70% of our total equity deployed, we see these as the main investments of the company. Considering the characteristics of these investments, including the low interest rates and their gradual runoff, along with positive credit traits and the synergy with PFSI's operations, we think it’s prudent to maintain both assets. We demonstrated this during COVID by implementing innovative programs to minimize losses on our credit risk transfer. However, as David mentioned, if circumstances arise where selling a portion of the MSRs would benefit PMT, we would consider that option. Overall, we view these two assets as essential for the company, and given our current situation—far out of the money with stable cash flows and low credit exposure—it seems advisable to retain them.

Yes. That's a helpful answer. On the secured leverage side, how much of the funding is fixed versus floating rate at this point?

On the secured side, all of our debt is floating rate.

Okay. And should we think of any hedges that kind of potentially into service there?

Our hedging is generally aligned with our asset base, which we mark to market. The discount rate on our assets includes short-term rates, and we consider our hedges as providing protection against both short-term and long-term rate sensitivity over time. However, we do not have specific hedges against our debt that would neutralize the effects of short rate changes from a GAAP perspective. Additionally, our earnings from the escrow balances related to mortgage servicing rights are typically linked to short rates, which also serves as an offset to the floating rate nature of much of our secured debt. On the credit risk transfer side, the assets are floating rate, so it is logical to match them with floating rate debt.

And your next question comes from the line of Douglas Harter of UBS.

As you guys are thinking about investment opportunities, how are you thinking about sort of a credit investment in closed-end seconds or the second liens that PennyMac is originating?

We're exploring execution opportunities and looking into the investment potential of securitizations involving close-end second mortgages and jumbo loans. I believe that PFSI is increasing its origination activity for these assets, which aligns with the investment opportunities that can meet PMT's required returns. It's clear that as spreads have widened, there is a chance to invest. PFSI has enough activity for PMT to engage with securitization. Essentially, PFSI is focused on achieving the best execution for PMT while aiming for their required return.

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

Thank you. Thank you all for joining us today. If you have any additional questions, please don't hesitate to reach out to our IR department. We appreciate your time, and looking forward to speaking to all of you in the near future. Take care.