PennyMac Mortgage Investment Trust (NYSE:PMT)
Q3 2017 Results Earnings Conference Call
November 2, 2017, 04:30 PM ET
Stanford Kurland – Executive Chairman
David Spector – President and Chief Executive Officer
Andy Chang – Senior Managing Director and Chief Financial Officer
Good afternoon, and welcome to the third quarter 2017 earnings discussion for PennyMac Mortgage Investment Trust. The slides that accompany this discussion are available from PennyMac Mortgage Investment Trust’s website at www.PennyMac-REIT.com. Before we begin, please take a few moments to read the disclaimer on slide two of the presentation. Thank you. Now I’d like to turn the discussion over to Stan Kurland, PMT’s Executive Chairman
Thank you, Chris. Let’s begin with Slide 3. For the third quarter, PMT reported net income attributable to common shareholders of $13.3 million on net investment income of $75.8 million, or $0.20 per diluted share, representing an annualized return on average common equity of 4%. PMT paid a dividend of $0.47 per share for the quarter, and book value per common share decreased to $19.74 at quarter end, from $20.04 cents at June 30.
PMT’s results reflect distressed loan investment losses and a lower than expected contribution from GSE credit risk transfer investments due to credit spread widening, which we believe is partially attributable to the recent natural disasters.
PMT reports results through four segments: Credit Sensitive Strategies, which generated $13.1 million in pretax income; Interest Rate Sensitive Strategies, which earned $13.3 million in pretax income; Correspondent Production, which earned $8.3 million in pretax income; and Corporate, with a pretax loss of $10.5 million.
During the third quarter, we continued to grow our investments in CRT and mortgage servicing rights resulting from PMT’s correspondent production activities. Conventional correspondent loan production totaled $6.5 billion in unpaid principal balance, up 10% from the prior quarter. CRT eligible deliveries totaled $4.1 billion in UPB, which will result in approximately $144 million of new CRT investments once the aggregation period is complete. We also added $83 million in new MSR investments resulting from our correspondent activities. Also, we repurchased approximately $1 million PMT common shares from August 29 to October 4 at a cost of $16.9 million.
Turning to Slide 4, let’s continue our review of the highlights. We continued to reduce equity allocated to distressed mortgage loans to 29% of total equity, down from 42% a year ago. We completed the previously announced sale of $145 million in UPB of performing loans from the distressed portfolio during the third quarter. After quarter end, we agreed to sell a portfolio of nonperforming and performing loans totaling $324 million in UPB to a third-party. Upon completion, this will mark the first bulk sale of nonperforming loans by PMT and will further accelerate the reduction of equity allocated to distressed loans. The liquidation and paydown of distressed mortgage loans and REO during the quarter generated cash proceeds of $65 million.
Now let’s turn to Slide 5 and discuss our perspective on the current mortgage market. Mortgage rates as reported by Freddie Mac’s Primary Mortgage Market Survey declined to their lowest levels of 2017 in early September. Since then they have steadily increased, closely tracking the increase in the 10 year Treasury bond yield, and reversing all of the third quarter declines. The 30 year fixed rate mortgage is currently hovering around 4%, consistent with its average level thus far for 2017.
Application activity as tracked by the MBA’s refinance application index increased in response to lower rates, reaching the second-highest level of the year in early September, but about 40% below levels at the same time last year. As a result of the subsequent increase in interest rates, the refinance activity index has slowed about 7% since the recent September peak.
Both new and existing home sales slowed during the third quarter from their recent high levels last spring. The slowdown appears to have been temporary, as recent sales data has shown renewed strength, and macroeconomic fundamentals remain supportive of long-term home sales growth.
The credit performance of residential mortgages remains strong, with delinquency rates remaining at multi-year low levels despite recent delinquency increases in other consumer credit products, such as auto loans and credit cards. According to Black Knight Financial Services, the total U.S. loan delinquency rate was 4.4% at the end of September. Recent natural disasters led to what is expected to be a temporary increase in delinquencies, with the uptick concentrated in areas affected by the recent hurricanes. September 2017 was the first month since July 2010 during, which mortgage delinquencies increased.
Now, let’s turn to Slide 6 to discuss PMT’s continuing transition to correspondent generated investments such as CRT and MSRs. The chart on slide 6 shows the ongoing progress we have made toward reducing the equity allocated to distressed mortgage loans, redeploying capital into MSRs and GSE credit risk transfer assets generated from PMT’s own correspondent production.
On September 30th, approximately 29% of PMT’s equity was allocated to distressed loan investments compared with 58% two years ago, while CRT, MSR and ESS investments now make up 59% of PMT’s equity allocation. PMT has consistently grown the capital allocated to CRT, MSRs and ESS, using its market position as a top conventional mortgage producer to organically generate new investments with attractive returns.
Now let’s turn to Slide 7 and discuss our progress in reducing PMT’s distressed loan investments through liquidations and sales. Our activities continue to be focused on resolving the nonperforming loan portfolio, which supports the transition of PMT’s capital into correspondent generated opportunities.
Total performing loans in our distressed portfolio stood at $668 million in UPB at the end of the third quarter, down from $803 million at the end of the prior quarter. The quarter-over-quarter decrease was driven by a bulk loan sale of $145 million in UPB.
The chart on the bottom left portion of the slide shows the components that drove changes in our performing portfolio balance from the end of the prior quarter. The performing loan portfolio decreases with payoffs, recidivism of loans back to nonperforming status and bulk loan sales, and increases as nonperforming loans transition into performing status.
Loan modifications are the primary strategy for bringing nonperforming loans back to performing status which, once seasoned, can be sold into well established markets for these loans. The success of our resolution activities, including modifications, has reduced PMT’s portfolio of nonperforming loans by 38% from a year ago.
As I mentioned earlier, PMT agreed to sell $324 million in UPB of distressed loans, or almost a quarter of the distressed loan portfolio at September 30. The loans in this sale comprise approximately 60% nonperforming loans and 40% performing loans.
Now, let’s turn to slide 8 and discuss the third quarter’s income and return contributions by strategy. PMT’s investments in the third quarter generated an annualized return on common equity of 4%, net of expenses and overhead. In total, credit sensitive strategies contributed $13.1 million to pretax income and a 6.7% annualized return on equity during the third quarter. Within the segment, distressed loan investments posted a loss of $1.4 million in the quarter, which equates to an annualized return on equity of negative 1.2%.
Distressed loan investments continued to underperform, primarily driven by home price indications that were below prior forecasts. CRT investments contributed pretax income of $14.2 million. As I mentioned, the fair value of these investments was adversely impacted this quarter by the widening of credit spreads for such securities during the quarter, which we believe is partially attributable to Hurricanes Harvey and Irma.
Interest rate sensitive strategies, which include the performance of our MSRs, excess servicing spread and Agency and non-Agency senior MBS positions and related interest rate hedges, together contributed $13.3 million of pretax income and a 7.9% annualized return on equity in the third quarter.
While we show the income contribution for each of these interest rate sensitive strategies separately, they are managed in aggregate as the interest rate sensitivity of MSRs and ESS is inversely correlated to MBS positions and many of our interest rate hedges. Returns on MSRs and ESS were adversely impacted this quarter by fair value losses resulting from lower interest rates and higher projected prepayment activity. Agency MBS benefitted from spread tightening during the quarter.
Correspondent production contributed $8.3 million in the third quarter and an annualized return on equity of 35.4%, consistent with the prior quarter. The contributions from PMT’s investment strategies were partially offset by a negative $10.5 million impact from Corporate activities and $4.8 million of income tax expense.
Now let’s turn to Slide 9 and discuss the run-rate quarterly income potential for PMT’s strategies. The run rate potential from PMT’s investment strategies is approximately $0.47 per quarter, which would equate to an annualized return on common equity of 9.9%, in-line with the current dividend level of $0.47.
Correspondent segment results are expected to benefit from improvements to loan acquisition strategies and opportunities to optimize our secondary market execution and financing arrangements. Together, these items are expected to drive improvement in the ROEs for correspondent production.
The run-rate also contemplates the continued deployment of proceeds from the preferred capital raises into CRT and MSR investments. The contribution from the distressed loan portfolio has been reduced, driven by expectations for higher liquidation expenses. The income potential depicted here for PMT does not reflect any gain or losses related to future bulk asset sales.
Our continuing objective at PMT is to distribute a dividend consistent with earnings per share over time. In our evaluation of the earnings potential for PMT and the appropriate dividend, we also consider the income required to be distributed for the year to maintain our tax advantaged status as a REIT, which effectively forms a floor for dividend payments. This concludes my overview of PMT’s third quarter performance.
Now I’d like to turn the discussion over to David Spector, PMT’s President and Chief Executive Officer, who will review our Mortgage Investment Activities.
Thank you, Stan. Let’s turn to Slide 11 and discuss the resolution activity on PMT’s distressed whole loan investments in the third quarter. Here we show the five quarter trend for distressed loan resolutions, including liquidation and modification activities, which totaled $185 million in UPB during the quarter. As a percentage of the average nonperforming loan and REO balances, quarterly resolution activity represented 18% in the third quarter, unchanged from the prior quarter and up from 14% in the third quarter of 2016.
Modifications totaled $89 million in UPB and comprised 48% of total resolution activity, compared with 50% in the prior quarter. Of these, streamlined modifications totaled $77 million in UPB, down from $88 million in the prior quarter.
Liquidation activities comprised 49% of total resolutions, or $90 million in UPB, down from 48% of total resolutions, or $98 million in UPB, in the prior quarter. Liquidation activities include payoffs, foreclosure sales to third-parties, short sales and sales of REO properties to third-parties.
REO sales comprised 34% of total resolution activity, up from 30% in the prior quarter. We continued to make progress in resolving the foreclosure pipeline, with the carrying value of REO inventory declining to $185 million at September 30, down from $207 million at June 30. New REO rentals were$ 6 million for the quarter, down from $7 million in the prior quarter.
Now, let’s turn to slide 12 for a look at our correspondent production highlights. Correspondent acquisitions by PMT in the third quarter totaled $17.4 billion in UPB, up 7% from the second quarter and down 8% year-over-year. Conventional conforming acquisitions, for which PennyMac Financial performed fulfillment services for PMT, totaled $6.5 billion in UPB in the third quarter, up 10% from the prior quarter, while down 10% from the third quarter of 2016. Total lock volume was $17.4 billion in UPB, down 5% from the prior quarter and 19% year-over-year.
The increase in PMT’s correspondent production volumes this quarter reflects the purchase money orientation of our correspondent production, which continues to be an important differentiating factor for PMT.
We continued to grow our seller relationships, with a total of 604 at the end of the third quarter, versus 589 seller relationships in the previous quarter. Looking at October volumes, total correspondent loan acquisitions were $5.4 billion in UPB, while interest rate lock commitments totaled $5.2 billion in UPB.
Now let’s turn to Slide 13 and discuss PMT’s unique investments in GSE credit risk transfer. At the end of the third quarter, PMT’s investments totaled $546 million, which after leverage resulted in an equity allocation of $244 million.
During the quarter, we completed $4.1 billion in UPB of CRT deliveries to Fannie Mae, which resulted in commitments to fund approximately $144 million of new CRT investments once the aggregation period is complete, $45 million of which had been invested at quarter end.
The income contribution from CRT was $8 million lower than our expectations for the third quarter, reflecting the widening of credit spreads during the quarter. Excluding the impact of fair value changes, the income contribution was $12.7 million, an increase from $10.2 million in the prior quarter, and the return on average CRT equity was 18.7%.
The fair value of PMT’s CRT investments reflects market expectations for higher potential credit losses that could result from the recent natural disasters. However, we expect to mitigate actual disaster related credit losses by a number of targeted servicing initiatives we have launched. In addition, the underlying loans are of high credit quality with the average loan to value at origination of 81%.
For our CRT investments, losses are recognized when a borrower reaches 180 days in delinquency, while severity is calculated on a fixed percentage of the loan’s UPB. Our servicer, a subsidiary of PennyMac Financial, has implemented modification and other servicing initiatives that are designed to address cash flow disruptions that may be experienced by affected customers. If our servicer is successful in preventing serious delinquencies, we would benefit from improvements in returns on our CRT investments.
Now let’s turn to Slide 14 and discuss our MSR and ESS investments, which continue to grow. PMT’s organic MSR investments, resulting primarily from correspondent production activity, increased to $790 million at quarter end, up from $735 million at June 30. To help facilitate the continued growth of our MSR investments, we are in the process of pursuing new financing structures that will provide term financing and while improving the return on equity for PMT’s MSR investments. PMT’s ESS investment resulting from bulk, mini-bulk and flow MSR acquisitions by PFSI decreased to $249 million at September 30, from $262 million at June 30.
Now I’d like to turn the discussion over to Andy Chang, PMT’s Chief Financial Officer, to review the third quarter’s results.
Thank you, David. On Slide 16, we show the pretax income contributions from each of PMT’s operating segments over the last five quarters. As Stan noted earlier, we report results in four segments which reflect the evolution of PMT’s activities and the strategies that drive its financial results. PMT’s pretax income in the third quarter totaled $24.2 million, with the breakdown by segment as noted on the slide.
Now let’s turn to Slide 17 and review the results of the Credit Sensitive Strategies segment. The Credit Sensitive Strategies segment includes results from PMT’s distressed mortgage loans, CRT, non-Agency subordinate bonds and commercial real estate investments. Segment revenues totaled $20.5 million, a decrease of 49% from the prior quarter. Lower revenue was primarily driven by a significant decrease in net gain on investments. Net gain on investments in the third quarter was $18.6 million, down 46% from the prior quarter, primarily driven by a 54% decline in gains on CRT due to spread widening during the quarter.
Net interest income for Credit Sensitive Strategies was $2.9 million, down 59% from the prior quarter. Interest income was $16 million, a 23% decrease from the prior quarter, due primarily to the sale of performing loans and a decrease in capitalized interest from loan modifications. Interest income included $7 million of capitalized interest from loan modifications, down from $10.8 million in the prior quarter.
Capitalized interest increases interest income and reduces loan valuation gains. Interest expense decreased 5% from the prior quarter to $13.1 million, driven by ongoing reductions in the distressed mortgage loan and REO portfolios. Other investment losses were $935,000, compared with losses of $1.1 million in the prior quarter. Segment expenses were $7.5 million in the third quarter, a 23% decrease from the prior quarter, resulting from a reduction in professional services fees and advance losses from the distressed portfolio.
Now let’s turn to Slide 18 and discuss the revenue and cash flows related to PMT’s distressed loan portfolio. PMT’s distressed mortgage loan portfolio generated realized and unrealized gains on mortgage loans totaling $3.2 million versus $1 million in the prior quarter. Combining the net gains with net interest income, revenue from distressed loans was $8.2 million, compared with $10.3 million in the prior quarter. Valuation gains on distressed loans totaled $2.8 million compared with losses of $284,000 in the prior quarter.
Positive valuation changes in the performing loan portfolio were partially offset by negative valuation changes in the nonperforming loan portfolio. Valuation of the performing loan portfolio benefitted from a strong market for portfolios with similar attributes, as well as the continued payment performance of loans in the portfolio. Valuation changes for the nonperforming loan portfolio were adversely affected by home price indications that were below prior forecasts, as well as increased litigation risk and liquidation expense forecast for certain remaining NPLs.
Gains from the payoff of distressed loans totaled $224,000, compared with $1.3 million in the prior quarter. Liquidation and paydown activity on distressed loans decreased from the prior quarter, consistent with the reduced size of the distressed portfolio. Gross cash proceeds from the liquidation of mortgage loans and REO – before debt repayment and payment of related expenses – totaled $65 million, down $from 71 million in the prior quarter.
With respect to the distressed loans and REO liquidated during the quarter, $287,000 in net valuation losses were recognized over the holding period of the assets, while $3.5 million of gains were realized at liquidation.
PMT also completed a previously announced bulk sale of performing loans during the third quarter, which generated $132 million in gross cash proceeds and approximately $47 million in net cash proceeds after debt repayment and related expenses.
Now let’s turn to Slide 19 and review the income statement and balance sheet treatment for the GSE credit risk transfer transactions. Our investments in CRT are evidenced by M-1 bonds, which we own and pledge as collateral in financing transactions. However, in our financial statements, our investments in CRT are reported as the components of the M-1 bonds – cash deposits securing credit risk transfer agreements and a derivative asset representing the expected future cash inflows related to our assumption of the credit risk and expected future losses of the credit guarantee, which is included in derivative assets.
From inception of the CRT investment program through September 30, a total of $25.5 billion in UPB of residential mortgage loans has been delivered to Fannie Mae through the CRT special purpose vehicles or SPVs. We have deposited cash into the SPVs to secure our obligations under the CRT Agreements, and it is recorded as a separate line item on our balance sheet.
Realized gains and losses recognized on the CRT investment represent cash income or loss to PMT from the SPVs. Valuation related gains and losses, which in the third quarter were gains resulting from fair value recognition upon loan delivery under CRT agreements, are non-cash. Payments made to Fannie Mae to settle our contractual losses are made in cash from the SPVs. To date, PMT’s CRT investments have paid $1 million for credit losses, including payments to settle credit losses totaling $539,000 this quarter. These credit losses reflect the seasoning of the CRT loans and are in-line with our expectations.
The bottom table provides information related to the outstanding balance of our CRT investments by delinquency status. Detail on the performance of the loans underlying the CRT investments is presented on slide 32 of this presentation.
Deposits securing CRT Agreements on the balance sheet were $546 million on September 30, and the derivative asset was valued at $57 million at quarter end. Our latest CRT transaction with Fannie Mae contained a structural change, which adjusts the timing of cash due to the cash collateral account, allowing PMT to more efficiently deploy capital during the aggregation period. As a result, the schedule includes a line item titled “Commitments to fund Deposits securing CRT agreements” which represents the amount that is presently due to the cash collateral account upon completion of the loan aggregation period. That amount was $356 million at September 30, and we expect to fund it largely through repurchase financing upon settlement of this CRT transaction.
Now let’s turn to Slide 20 and discuss the results of the Interest Rate Sensitive Strategies segment. The Interest Rate Sensitive Strategies segment includes results from investments that have offsetting exposures to interest rates, including MSRs, ESS, Agency MBS, non-Agency senior MBS, and interest rate hedges.
Segment revenues totaled $20.7 million, an increase of 71% from the prior quarter, primarily resulting from a 39% quarter-over-quarter increase in net mortgage loan servicing fees, resulting from a growing servicing portfolio and a reduced impact from valuation related changes. Segment investments produced a net loss of $4.7 million, consisting of $4.9 million of gains on MBS; $5.9 million losses on hedging derivatives; and $3.7 million of net losses on ESS.
Net interest income for the segment was $3.6 million compared to $3 million in the prior quarter. Interest income in the third quarter was $19.4 million, a 4% increase from the prior quarter, driven by higher placement fees on MSR related escrow deposits. Interest expense totaled $15.8 million, a 1% increase from the prior quarter due to higher short-term borrowing costs.
Net mortgage loan servicing fees for the segment were $21.8 million, up from $15.7 million in the prior quarter. Net mortgage loan servicing fees included $44.3 million in servicing fees, reduced by $21.6 million of amortization and realization of MSR cash flows. Net mortgage loan servicing fees also included a $1.7 million impairment provision for MSRs carried at the lower of amortized cost or fair value, a $4 million valuation loss on MSRs carried at fair value and $4.6 million of related hedging gains. Net mortgage loan servicing fees also included $333,000 of MSR recapture income.
MSR and ESS valuation losses primarily resulted from a combination of yield curve flattening, tighter mortgage spreads, and higher than expected prepayment activity during the quarter. ESS fair value losses are net of recapture income totaling $1.2 million receivable from PFSI for prepayment activity during the quarter. Segment expenses were $7.4 million in the third quarter, a 10% increase from the prior quarter, driven by servicing portfolio growth.
Now let’s turn to Slide 21 and discuss the value of PMT’s mortgage servicing rights and excess servicing spread assets. PMT’s mortgage servicing rights portfolio, which is subserviced by a subsidiary of PennyMac Financial, grew to $67.9 billion in UPB. PMT also owns investments in ESS purchased from PennyMac Financial with a UPB on the underlying loans of $28.4 billion.
The chart on slide 21 shows some of the key metrics for PMT’s MSR and ESS portfolio including pool characteristics such as the average coupon of the underlying loans and average servicing fee or spread of the investment; the lifetime prepayment speed assumption; and valuation metrics such as the multiple of the servicing fee.
We account for most of PMT’s MSRs at the lower of amortized cost or fair value, or LOCOM. For MSRs accounted for at LOCOM, the slide also highlights the difference between the carrying value of PMT’s MSRs and their fair value. At the end of the quarter, the fair value of PMT’s LOCOM MSRs was $20.8 million greater than their carrying value on the balance sheet.
Now let’s move to Slide 22 and review the results of the Correspondent Production segment. As we mentioned previously, Correspondent Production pretax income was $8.3 million, compared with $8.1 million in the prior quarter.
Segment revenues totaled $34.4 million, compared with $31.5 million in the prior quarter. Net gain on mortgage loans acquired for sale totaled $18 million, a 5% increase from the prior quarter driven by continued strong conventional lock volumes and stable margins.
Net interest income for the segment was $4.7 million, up 21% from the prior quarter driven by higher average inventory balances versus the prior quarter. Other income, which is primarily comprised of loan origination fees, was $11.8 million, a 1% increase from the prior quarter resulting from higher loan production volumes.
Expenses in the Correspondent Production segment increased 11% from the prior quarter to $26.1 million, driven by an increase in fulfillment fee expense resulting from higher funding volumes. The weighted average fulfillment fee paid for the quarter was 36 basis points, unchanged from the prior quarter.
Now let’s move to Slide 23 and review the results of the Corporate segment. The Corporate segment includes interest income from certain cash and short-term investments, management fees, and corporate expenses. Segment revenues were $182,000 compared with $155,000 in the prior quarter.
Segment expenses were $10.7 million, a 13% decrease from the prior quarter. Management fees, including incentive fees, $were 6 million, up 7% compared with $5.6 million in the prior quarter, resulting from PMT’s higher equity capital base. No incentive fee was paid in the third quarter, versus $304,000 in incentive fees paid in the second quarter. Other segment expenses totaled $4.7 million compared with $6.6 million in the prior quarter, driven by a reduction in share based compensation. The prior quarter’s expenses also included professional services fees related to the Series-B preferred equity raise.
And with that, I’ll turn the discussion back over to Stan for some closing remarks.
Thank you, Andy. PMT continues to make solid progress transitioning from distressed loans and into correspondent related investments such as credit risk transfer and mortgage servicing rights. We are focused on specific initiatives in our correspondent business that we expect to deliver higher production volumes, as well as optimized financing that should improve earnings from our correspondent production. We also are deploying more capital into the higher returning CRT and MSR strategies.
In addition, we have raised capital that is not yet earning its full potential. Taking all of these initiatives together, we believe PMT’s strategies will generate improved earnings that are more consistent with our current quarterly dividend on common stock. Lastly, we encourage investors with any questions to reach out to our Investor Relations team by email or phone. Thank you.
End of Q&A
This concludes PennyMac Mortgage Investment Trust’s third quarter earnings discussion. For any questions, please visit our website at www.pennymac-reit.com, or call our Investor Relations department at 818-224-7028. Thank you.
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