PennyMac Mortgage Investment Trust Q2 FY2024 Earnings Call

Good afternoon, and welcome to PennyMac Mortgage Investment Trust Second Quarter Earnings Call. Additional materials, including the presentation slides that will be referred to in the call, are available on PennyMac Mortgage Investment Trust's 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 Trust, Chief Financial Officer.

Thank you, operator. PMT's second quarter financial results reflect increased levels of income, excluding market-driven value changes and contributions from all three investment strategies, partially offset by fair value changes in the interest rate-sensitive strategies due to elevated volatility. Net income to common shareholders was $15 million or diluted earnings per share of $0.17. PMT's annualized return on common equity was 4% and book value per share was $15.89 at June 30, down slightly from the end of the prior quarter. Turning to the origination market. Current third-party estimates for total originations averaged $1.7 trillion in 2024 and $2.1 trillion in 2025, reflecting projections for lower rates from current levels and increased refinance volumes. PMT's financial performance in recent periods highlights the strength of the fundamentals underlying its long-term mortgage assets and our expertise in managing mortgage-related investments in a challenging environment. I am pleased to note that in the second quarter, we successfully issued $217 million of exchangeable senior notes and $355 million of term notes secured by Fannie Mae MSRs, both at attractive terms and both with consideration for similar notes with upcoming maturities. Given its increased investable capital in the current market, PMT is expected to retain an increased percentage of total conventional correspondent loan production in the third quarter. Dan will provide additional detail later on in the discussion. More than two-thirds of PMT shareholders' equity is currently invested in the seasoned portfolio of MSRs and the unique GSE lender risk share transactions that 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 over 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 a 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 to produce stable cash flows over an extended period of time. MSR values also benefit from the current interest rate environment as the placement fee income PMT receives on custodial deposits is closely tied to short-term interest rates. Similarly, mortgages underlying PMT's large investment in GSE lender risk share have low delinquencies and a low weighted average current loan-to-value ratio of 48.5%. 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 potential expected from PMT's investment strategies over the next four quarters. PMT's current run rate reflects a quarterly average of $0.33 per share, down slightly from $0.35 per share last quarter, driven primarily by lower 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 second quarter financial performance.

Thank you, David. PMT earned $15 million in net income to common shareholders in the second quarter or $0.17 per diluted common share. PMT's credit-sensitive strategies contributed $16 million in pretax income, including $11 million from PMT's organically created CRT investments. Credit spreads were relatively unchanged during the quarter, with only minor impacts on the fair value of our investments. 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 below 50% and a 60-day delinquency rate of 1.11%, both as of June 30. Income from opportunistic investments in CAS and STACR bonds issued by the GSEs totaled $6 million in the quarter. As mortgage credit spreads tightened over the last several quarters, the go-forward returns on some of the investments that we had previously made fell below our thresholds. In this quarter, we sold $8 million in subordinate tranches of investor loan securitizations we participated in during 2021. The interest rate-sensitive strategies contributed $17 million of pretax income. The fair value of PMT's MSR investment increased by $46 million due to slightly higher mortgage rates at the quarter end. These fair value gains were more than offset by changes in the fair value of MBS, interest rate hedges, and related income tax effects during the quarter. MBS fair value decreased by $39 million, and interest rate hedges decreased by $18 million. Income on assets held in PMT's taxable REIT subsidiary drove a tax expense of $3 million. The fair value of PMT's MSR asset at the end of the quarter was $3.9 million, essentially unchanged from March 31. Delinquency rates for borrowers underlying PMT's MSR portfolio remain low, while servicing advances outstanding decreased to $83 million from $110 million at March 31. No principal and interest advances are currently outstanding. Turning to the Correspondent Production segment. Pretax income was down slightly from last quarter as lower margins offset the impact of higher volumes. Profitability in the segment in recent periods has benefited from the release of reserves related to representations and warranties provided at the time of securitization, as the high volumes of loans produced from 2020 to 2022 passed the three-year window for violations with minimal repurchase-related losses. We expect a contribution from the release of these reserves to decline to more normalized levels over the next several quarters. Total correspondent loan acquisition volume was $23 billion in the second quarter, up 24% from the prior quarter, driven by an increase in the size of the mortgage origination market. Conventional loans acquired for PMT's accounts totaled $2.2 billion, up 26% from the prior quarter. As David noted, in the third quarter, we expect PMT to retain a higher percentage of total conventional correspondent production from 30% to 50% versus 18% in the second quarter. The weighted average fulfillment fee rate was 20 basis points, down from 23 basis points in the prior quarter. PMT reported $35 million of net income across its strategies, excluding market-driven value changes and the related tax impacts, up from $28 million last quarter, primarily due to higher average yields on interest-sensitive assets during the quarter. Turning to capital. We are fully reserved in our liquidity management for repayment in full of the $210 million in exchangeable senior notes due in October 2024. In May, we issued $217 million of new 5-year exchangeable senior notes with a coupon of 8.5%. In June, we issued $355 million in 5.5-year Fannie Mae MSR term notes at SOFR plus 275 basis points. After quarter end, we redeemed $305 million of similar term notes due in 2027 with a coupon of SOFR plus 419 basis points. These successful financing activities further solidify PMT's capital position, illustrating our deep access to capital and liquidity across various types of transactions and investors. We'll now open it up for questions.

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 Jason Weaver with Jones Trading. Please go ahead.

Hi. Good afternoon, everyone. Thanks for taking my question. I fully agree with you on where credit spreads are and your decision to retain more correspondent production. It makes a ton of sense. But ultimately, can you talk about what form that will take? Is this as simple as just keeping more whole loans on the balance sheet? Or will you be looking to term fund that via securitization eventually?

For the loans that we are maintaining this quarter through the correspondent channel, we will primarily retain Fannie Mae and Freddie Mac eligible loans, which we have kept historically. Typically, we either sell these loans or securitize them with the agencies, and occasionally we sell some as whole loans to third parties. Generally, the investment we generate from this is in mortgage servicing, alongside the gain from correspondent securitization. Currently, we do not have plans to retain loans on the balance sheet specifically, aside from the possibility of securitizing certain groups of loans, which we might consider retaining subordinate tranches on. We have done this in the past, and it seems like there might be an opportunity for this in the current market.

Okay. Got it. That's clear. And just my follow-up is really on the macro level. Sort of at what level or range of benchmark 30-year mortgage rates do you see as really the inflection point for refinancing activity and prepayment? And I really asked as it pertains to correspond to production levels.

I believe we are experiencing a gradual decline. If we examine originations post-COVID, we saw a significant increase with loans at around a 5% rate. I see a lot of potential in the 6% to 7% range, and even above 7%. The way I view it is that this will be a slow descent. Once rates hit 6.5%, I expect to see significant momentum. At 6%, I consider it to be a very active refinancing market because not only are existing first-lien loans benefiting, but loans at 4% and 5% can also look to refinance for debt consolidation, cash-out refinancing, or to pay off existing HELOCs or second mortgages. The ability to refinance largely depends on the types of debts behind the first lien. I still hold the view that when the 10-year yield is around 3.75% and mortgage rates have decreased by 50 basis points, that will signal a real shift into a new phase of refinancing opportunities.

Great. I really appreciate that color. Thank you.

Your next question comes from the line of Doug Harter with UBS. Please go ahead.

Thanks. I know you guys take a long-term approach to the dividend. But I guess, how are you thinking about the dividend given kind of the run rate earnings that you laid out and that took a slight tick down in this quarter?

Yes, we approach the dividend with a long-term perspective, aiming for it to reflect the company's earnings capacity over time. However, we don’t plan to adjust it with every market fluctuation. We did notice a slight decrease in our run rates, going from $0.35 to $0.33, while maintaining a dividend of $0.40. This change was mainly influenced by some additional inversion of the yield curve in recent weeks. What this indicates is an anticipated decline in short-term rates, which would lead to lower financing rates for us. Looking ahead beyond our current forecast into next year, we expect our EPS to potentially rise above the $0.40 mark again. Therefore, we do not intend to modify the dividend in the short term and aim to keep it stable as the market readjusts, with expectations of decreasing short rates in the upcoming periods.

I guess just a follow-up to that. In addition to the direction of short rates of the yield curve, what other factors could be a positive towards getting run rate earnings back to the dividend?

The deployment of capital is important, and so that's part of why we are looking to adjust and deploy more capital in PMT through the correspondent channel, which we view at the current moment as the best option for PMT to deploy the capital that it raised in the second quarter through its convertible debt issuance. As I had talked about earlier, in addition to investments in MSRs, we are looking at potential securitizations of certain subsets of the loans, notably investor and second-home loans where we do think that those securitizations have become viable again, and we do have sufficient amounts of those types of loans coming through the correspondent channel to be able to form a securitization. Further investment into those areas, I think, could help drive the earnings back towards the dividend level. But in addition to that, the other driver with the de-inversion of the yield curve, having our long-term assets, the yields on our long-term assets, which are marked-to-market according to where the current market is. Given that longer-term rates are currently lower than shorter rates, having short rates come down some and normalize would drive the sort of earnings potential, the run rate earnings potential up given the balance of the longer-term yields and the shorter-term yields. We think that's probably the biggest driver.

Doug, PMT has a distinctive synergistic relationship with PFSI. As we observe the market where more loans are being delivered outside of the GSEs and securitized, we are optimistic about our ability to aggregate quickly and develop credit-related investments for PMT in a sustainable manner. One of the advantages of CRT is that, alongside credit risk investments, we established a sustainable asset creation mechanism, enabling PMT to invest in credit-related assets. I notice various subsectors of the market. Regarding the point Dan made about investors and second homes, we are identifying opportunities to generate investments that align with our return targets, whether slightly above or below. What may not be fully appreciated is that if we can consistently demonstrate our capability to raise and deploy capital, it will be significantly beneficial for PMT. Furthermore, PFSI is experiencing substantial growth in our jumbo business, which we can provide to PMT, allowing PMT to acquire more jumbos through the correspondent channel for additional investments. Lastly, while closed-in seconds currently do not yield the returns we seek for PMT, this asset class is still accessible to us. The creation of PMT was based on this investment thesis. We believe we are well positioned to capitalize on opportunities in the capital markets, influenced by election outcomes and the regulatory landscape.

I guess just to that last point, do you foresee that opportunity being more durable than it's been since PMT was created since that opportunity has kind of been completing in its life?

I don't like predicting the future, but I can tell you it's the most traction I've seen in private label securitization since we started PMT. I think the capital runs deep, but we have a real advantage in the fact that we have this flywheel of sorts where we can buy the loans and raise the securities, sponsor the securitization, sell the senior bonds, and retain the sub bonds. I don't know who else has that ability.

All right. Appreciate the answers. Thank you.

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

Thanks. In the interest rate-sensitive strategies segment, can you just speak to the investment opportunities you're seeing and which you view as the best risk-adjusted returns, whether it's on the MSR or the Agency and non-Agency side as you look forward? And how about those opportunities compare to the credit side?

Sure. In the current environment, and this goes along with some of the commentary and some of the activities that we've had in the portfolio recently. On the credit side, we've seen credit spreads tighten over the last several quarters. We had been opportunistically purchasing credit investments primarily STACR and CAS securities. We've generally been divesting of those and certain other credit investments in the recent quarters as spreads have tightened significantly and brought some of those investments below our return hurdles. Where we see the most attractive places to invest currently is in the interest rate-sensitive strategies primarily in mortgage servicing rights. We have access through the correspondent channel to those mortgage servicing rights, which is why we're shifting a portion of PMT retaining in Q3, a greater portion of those conventional correspondent loans given the capital that it raised through its convertible issuance. That's what we see as the most attractive and present opportunity. We also are looking at MSR portfolios that come to market in the secondary market or bulk MSR portfolios. We've participated in a few of those purchases or bought a few of those portfolios over the past few quarters. In recent periods, we've seen those portfolios be bid up to a significant degree to where the acquisition of MSRs through the correspondent channel appears more attractive at this point in time. But we still, from a collateral point of view and from a PMT positioning point of view, generally see the low coupon MSR portfolios as attractive pricing. The bulk market has not been what we are looking for most recently. As David mentioned, the other opportunities are really around the securitization of some of the production that comes through the correspondent channel, potentially also in terms of loans that are originated from the direct channels at PFSI and potential generation of securitizations and retention of the subs, the subordinate bonds there. That's another avenue we view as attractive currently, especially to the extent that we can create a program that allows us to consistently invest in those types of assets.

Great. Thank you. That's helpful. And then just on the third-party estimates that you mentioned early on in the prepared remarks on mortgage originations. I think it was $1.7 trillion in '24, and $2.1 trillion in '25. In the current environment, do you believe those estimates are about right with the forward curve and your rate expectations? Or do you think those could be a little bit too aggressive with what you're seeing right now?

Look, I think they are personally, I will tell you they are back-loaded to Q3 and Q4. In that back-loading, there is a perception that rates are going to decline. You have to ask yourself, if you just look at the current run rate and annualize it or look at the first two quarters and annualize it, you don't get to $1.7 trillion. The question is, what is the general direction of rates as you go through those quarters.

Thank you. I appreciate you taking my questions.

Thank you.

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

Yes, good afternoon. I wanted to try and quantify just the benefit from retaining more of the conventional production at PMT. So I was just looking at the difference between the gain on sale and the fulfillment fee, it's 0.35% versus 0.20%. So can we just look at sort of 15 basis points on the incremental loans that have been retained with PMT?

I think that the primary benefit is really around the capital deployment. So if we look at the gain on sale or the gain in PMT, a portion of that is driven by the gain of the loans that flow through to PFSI, which is a portion that is also driven by what I've mentioned earlier in the call: some of the rep and warrant relief, which is really related to loans that we sold historically and not necessarily loans that are being sold and securitized in the current period. The additional correspondent benefit on those loans is a smaller spread; a few basis points, really the primary benefit overall is in terms of the retention of additional investment and additional MSR that will grow that MSR asset a bit and drive additional earnings for a growing MSR portfolio, rather than the MSR portfolio which has been pretty static over the past few quarters.

Okay. Okay. Great. That's helpful. And then on Slide 7, where you have the run rate earnings, does that just incorporate the forward curve? Or like if the curve steepens, is there any benefit? How should we think about that?

Yes, it incorporates the forward curve. If the curve steepens, it would generally be due to either long rates increasing or short-term rates rising, possibly due to a Federal Reserve cut. When considering steepening, if we think about it in terms of two 10s, the current decline in three-year rates doesn’t provide much benefit to us. We only see advantages when actual short rates decrease, which would help with financing. If yields on our longer-term assets go up, we adjust those to market value and typically hedge against that, which would enhance the ongoing returns of the assets compared to financing. Additionally, if long rates stay the same while short rates drop, the widening spread between short rates and longer-term yields would generate more earnings from interest rate-sensitive strategies.

Okay, great. Thanks.

Your next question comes from the line of Matthew Howlett with B. Riley Financial. Please go ahead.

Hi David, thanks for taking my question.

Hi Matt, how are you?

Good thanks. Look, on the subject of the balance sheet and the capital constraints, I know you want to put more money to work out there. If rates start coming down in September, does that change your opinion and maybe trying to refinance the '24 maturity? I mean, what's the appetite? I'm assuming the preferred markets probably aren't open quite yet, but you probably don't want to issue equity below book. So just thoughts on environment starts going down, the rates are heading downward.

Yes, regarding our financing, we may consider additional issuance. As for the 2024 maturity, we have accounted for that in our liquidity forecasting. We have limited investment to ensure we have enough liquidity reserved to cover the upcoming convertible debt maturity later this year. Raising additional convertible debt in the second quarter has increased our investment capacity. This is enabling us to pursue further investments in conventional correspondent loans and MSR, as well as enhance our correspondent activities and income. If interest rates decline and we see more opportunities to issue additional financing, we would consider taking advantage of those, which could further enhance our investment potential.

Well, I say because, David, I mean, you've been in the business a long time and I hear you talk about the securitization market like you just did. It's really eye-opening. My question is, I mean, non-Agency securitization, where is PFSI selling all that production today? That's one. And then two, if PMT was to start acquiring investor seconds, I mean, what type of returns are we talking about here?

I wish.

Those were great days.

There's been a shift of loans with high loan-level price adjustments or higher delivery costs moving away from the GSEs to those with cheaper capital. We've particularly noticed this with insurance companies and other entities that are aggregating and securitizing these loans, as they have a lower capital cost than PMT. At the same time, I'm observing a specific opportunity with investors in second homes to pursue a securitization. Our dividend yield is around 10%, which reflects our view of the returns we want to achieve net of expenses. I believe this is feasible, whether the return is 9.75% or 10.25%. We approach returns cautiously, factoring in the investment burdens from margin call reserves required for financing. We stress test against 2x losses or faster speeds. We have a solid history of doing this, especially with CRT. This presents an exciting and significant opportunity for us to possibly enhance credit-sensitive investments in PMT by leveraging our synergistic relationship with PFSI.

Yes, look, we'd love to see you grow in the next part of the cycle, get more capital into the company. Best of luck. Thanks a lot.

Thanks.

Your next question comes from the line of Doug Harter with UBS. Please go ahead.

Thanks. Just wanted to follow up, how you're thinking about the different risk profile of kind of the current coupon MSR from correspondent versus the lower coupon that's currently in the portfolio? And if you could just remind us kind of the recapture agreement that PMT has with PFSI?

Sure. To your point, PMT's preferred investment in MSR in terms of collateral characteristics would be in the lower coupon that comprises the vast majority of its current investment in MSR. We expect that investments in MSR to have lower prepayment speeds, and more stable prepayment speeds as interest rates fluctuate because generally, those loans are at 3% to 4% note rates, and we don't expect them to become refinanceable except in a very, very significant interest rate decline. However, those portfolios are priced in the current market when they come through bulk pretty fairly aggressively as far as we've seen recently. Through the correspondent market, PMT is able to acquire more recently originated current note rate loans, so in loans with note rates generally in the 6s today. Those loans are obviously more sensitive to refinances. PMT does have a recapture arrangement with PFSI to the extent that PFSI recaptures loans that are part of PMT's MSR; it can recapture around generally 35% of the MSR value of the new MSR, which varies a little bit depending on the recapture rate that PFSI achieves. That's the protection that PMT has and the benefit that PMT has as interest rates fluctuate and prepayment speeds might pick up.

Great. Appreciate it. Thank you.

Next question comes from the line of Michael Kaye with Wells Fargo. Please go ahead.

Hi. I know you just said you don't like predicting the future, but do you think there's potentially a better chance of reviving the lender CRT that you did in the past, given what could happen potentially with the election?

Well, I think that we've been in discussion with the GSEs about lender CRT. It's really doubtful for the foreseeable future. The GSEs are creating CRT; they're not even selling all the CRT. I think that a few things need to happen. One is you need a much bigger origination market. But more importantly, you need a change in thought in terms of what do you do with the CRT, and the GSEs would have to be put in a position where they feel compelled to sell more of the bonds. They need the additional liquidity from PMT. A few things need to take place, but I don't, at this point, believe that it's really in the cards. To your point, Michael, you could have a change of administration; you could have a change of leadership at FHFA. We try to remain very close to the people in FHFA. I've been spending time in D.C. once a quarter meeting people in and out of government. We're trying to make ourselves available to leaders to give our point of view. But I think it's not something that we're really planning on, which is what makes the opportunity to do private label securitization, so exciting for me.

Okay. And second quarter is, I mean, does PMT have any interest in issuing equity below book value? I saw that $200 million distribution agreement recently filed.

Yes. So, no, consistent with how we've operated through our entire history, we're not looking to issue equity below book value. We did renew our equity shelf which we had not used since the last renewal of note as we've been below book value, but we did renew that. With that renewed equity shelf agreement at the money agreements with our underwriters, we would really only look to utilize that to the extent we saw PMT's price move above book value to potentially end and had opportunities to deploy the capital then we would potentially look to issue through that shelf. We don't have any plans to issue equity below book value.

Okay. Thank you.

We have no further questions in our queue at this time. I will now turn the call back over to Mr. Spector for closing remarks.

Well, I'd like to thank everyone for joining our call today, and thank you very much for your great questions. If you have any additional questions, please feel free to reach out to our Investor Relations department, and they will be responsive as always. So thank you all very much, and have a good day.

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