Q2 2017 PennyMac Mortgage Investment Trust Pre-Recorded Earnings Call
CALABASAS Aug 12, 2017 (Thomson StreetEvents) -- Edited Transcript of PennyMac Mortgage Investment Trust earnings conference call or presentation Thursday, August 3, 2017 at 10:59:00am GMT
TEXT version of Transcript
* Andrew S. Chang
PennyMac Mortgage Investment Trust - CFO and Senior MD
* David Spector
* Stanford L. Kurland
PennyMac Mortgage Investment Trust - Executive Chairman
Good afternoon, and welcome to the second 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 2 of the presentation. Thank you.
Now I'd like to turn the discussion over to Stan Kurland, PMT’s Executive Chairman.
Stanford L. Kurland, PennyMac Mortgage Investment Trust - Executive Chairman 
Thank you, Chris. Let's begin with Slide 3. PMT’s second quarter results were driven by strong contributions from our uniquely generated GSE credit risk transfer investments and results from the Correspondent Production segment activities.
During the quarter, we also continued to make steady progress liquidating our distressed loan portfolio. PMT reported net income attributable to common shareholders of $26.4 million on investment income of $84 million or $0.38 per diluted share, representing an annualized return on common equity of 8%. PMT paid a dividend of $0.47 per share for the quarter, and book value per share decreased to $20.04 at quarter end from $20.14 at March 31.
PMT reports results through 4 segments: Credit Sensitive Strategies, which generated $30.4 million in pretax income; Interest Rate Sensitive Strategies, which earned $5.4 million in pretax income; Correspondent Production, which earned $8.1 million in pretax income; and Corporate with a pretax loss of $12.1 million.
During the second quarter, we made significant progress growing our investment activities in CRT and mortgage servicing rights resulting from PMT’s Correspondent Production activities. CRT eligible deliveries totaled $3.8 billion in UPB, which will result in approximately $132 million of new CRT investments once the aggregation period is complete. We also added $66 million in new MSRs resulting from our correspondent activities.
Conventional Correspondent Production totaled $5.9 billion in unpaid principal balance, up 28% from the prior quarter.
Turning to Slide 4, let's continue our review of the highlights. We also continued to successfully reduce equity allocated to distressed mortgage loans to 31% of total equity, down from 50% a year ago.
Cash proceeds from the liquidation and paydown of distressed mortgage loans and REO totaled $71 million, down from $89 million in the second quarter, and we entered into an agreement to sell $149 million in UPB of performing loans from the distressed portfolio during the quarter. We expect this sale to close in the third quarter. We are also assessing opportunities to access the market for additional bulk sales of performing and nonperforming loans from the distressed portfolio.
After quarter end, we issued $7.8 million preferred shares, for gross proceeds of $195 million. This transaction marks PMT’s second capital raise this year, and we expect the proceeds to be primarily deployed in growing PMT’s investments in credit risk transfer and MSRs generated from its conventional correspondent loan production. When combined with the issuance of preferred stock in the second quarter, PMT has now raised over $300 million in capital this year.
Now let's turn to Slide 5 and discuss our perspective on the current mortgage market. The interest rate volatility experienced in the first quarter continued into the second quarter, with mortgage rates as reported by Freddie Mac's primary mortgage market survey moving up and down within a relatively narrow range through May, but ultimately ending the quarter down 26 basis points from the end of March. The 30-year fixed mortgage rate ended the quarter at 3.88%, down from 4.14% at March 30. Volatility continued into the third quarter, with the PMMS rate increasing to 3.92% at the end of July.
For the second quarter, the decline in yields on the 10-year U.S. Treasury bond and Agency MBS were smaller, at just 9 basis points and 10 basis points respectively. Despite the decline in rates and the fact that they remain relatively low from a historical perspective, mortgage refinance activity hovered near multi-year lows in the second quarter, as measured by the Mortgage Bankers Association refinance index. In June, the MBA’s index reached 1,391, up from 1,271 in March, but well below the index average of approximately 2,000 over the last 5 years.
Both new and existing home sales have steadily increased over the past several years, but they have only recovered to levels seen in the early 2000s. Over the same time period, the number of households in the United States has grown by 15%. Given this trend, we would expect to see further expansion in home sale activity.
Credit performance of residential mortgages has improved modestly. According to the most recent data available, the Mortgage Bankers Association's delinquency survey showed that total residential mortgage delinquencies fell to 4.71% at March 31 from 4.77% for the same period a year ago.
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 progress we have made towards 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 June 30, approximately 31% of PMT’s equity was allocated to distressed loan investments compared with 57% 2 years ago, while CRT, MSR and ESS investments now make up 53% of PMT’s equity allocation.
PMT’s success in growing the capital allocated to CRT, MSRs and ESS highlights its unique strategy of generating investments from its own Correspondent Production. The ability to generate investments directly from PMT’s market position as a top conventional mortgage producer affords it a distinct opportunity to generate new investments with attractive returns going forward.
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 driving the resolution of the nonperforming loan portfolio, which supports the transition of PMT’s capital into correspondent-generated opportunities.
As I mentioned earlier, we entered into an agreement to sell $149 million in UPB of performing loans from the distressed portfolio. Once completed, it will bring total performing loan sales completed in the past 12 months to nearly $400 million in UPB.
The chart on the bottom left portion of the slide shows the components that drive changes in our performing portfolio balance. 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 39% from the same period a year ago. We are also assessing opportunities to access the market for bulk sales of performing and nonperforming loans from the distressed portfolio.
Now let's turn to Slide 8 and discuss the second quarter's income and return contributions by strategy. PMT’s investments in the second quarter generated an annualized return on common equity of 7.9% net of expenses and overhead.
In total, Credit Sensitive Strategies contributed $30.4 million in pretax income and a 17.6% annualized return on equity during the second quarter. Within the segment, distressed loan investments posted a loss of $1.7 million in the quarter, which equates to an annualized return on equity of negative 1.5%. While distressed loan investments continued to underperform as a result of a portfolio that is increasingly concentrated in slower-to-resolve judicial states, CRT investments contribute pretax income of $31.5 million and have grown to a size where they are now a significant driver of PMT’s earnings.
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 $5.4 million in pretax income and a 3.7% annualized return on equity in the second 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. Interest rate volatility during the quarter and the relatively modest decline in MBS and U.S. Treasury rates resulted in a loss from hedge activities.
Correspondent Production contributed $8.1 million in the second quarter, driven by strong production growth, partially offset by tighter margins. The annualized return on equity was 34.3%. The contributions from PMT’s investment strategies were partially offset by a negative $12.1 million impact from corporate activities and $3 million of income tax expense.
Now let's turn to Slide 9 and discuss the run rate quarterly income potential for PMT’s strategies. We believe that the run rate potential from PMT’s investment strategies is approximately $0.48 per quarter, which would equate to an annualized return on equity of 10.5% and similar to the current dividend level of $0.47. Returns on credit sensitive strategies are expected to remain a significant earnings contributor, driven by our continuing capital allocation to CRT investments and strong performance of the underlying loans. We also anticipate improvement in the performance of the distressed loan portfolio. Returns on Interest Rate Sensitive Strategies are expected to increase from recent levels with an improvement of MSR and ESS performance.
Correspondent Production results are expected to be generally consistent with the second quarter. The income potential depicted here does not reflect any share repurchases, gain or losses related to fair value changes, or bulk asset sales such as distressed loans. 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 taxed advantage (sic) [tax-advantaged] status as a REIT, which effectively forms a floor for dividend payments. This concludes my overview of PMT’s second 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.
David Spector, 
Thank you, Stan. Let's turn to Slide 11 and discuss the resolution activity on PMT’s distressed whole loan investments. Here we show the 5-quarter trend for distressed loan resolutions, including liquidation and modification activities, which totaled $209 million in UPB during the second quarter. As a percentage of the average nonperforming loan and REO balances, quarterly resolution activity represented 18% in the second quarter, up from 14% in the second quarter of 2016.
Modifications totaled $105 million in UPB and comprised 50% of total resolution activity compared with 42% in the prior quarter and 36% in the second quarter of 2016. Streamlined modifications totaled $88 million in UPB, up from $76 million in the prior quarter. With streamlined modifications, once a homeowner makes its first modified payment, the homeowner is moved directly into a trial modification. This quarter, 59% of total streamlined modifications were done through PennyMac's own proprietary program.
Liquidation activities totaled $98 million in UPB, down from $120 million 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 were $64 million, down from $96 million in the prior quarter. The decrease in REO property sales reflects a lower volume of high value properties sold in the second quarter versus the previous quarter. However, we continue to make progress in resolving the foreclosure pipeline, with REO inventory declining to $207 million at June 30 from $225 million at March 31. New REO rentals were $7 million for the quarter, down from $10 million in the first quarter.
Now let's turn to Slide 12 for a look at Correspondent Production highlights. Correspondent acquisitions by PMT in the second quarter totaled $16.3 billion in UPB, up 17% from the first quarter and up 12% year-over-year. Government loan acquisitions accounted for 64% of total correspondent acquisitions or $10.4 billion in the second quarter, up 12% from the prior quarter and up 10% from the second quarter of 2016.
Conventional conforming acquisitions, for which PennyMac Financial performed fulfillment services for PMT, totaled $5.9 billion in the second quarter, up 28% from the prior quarter. Total lock volume was $18.2 billion, up 26% from the prior quarter. The increase in PMT’s acquisition volumes this quarter was driven by a strong purchase market, with purchase money loans making up 82% of PMT’s second quarter acquisition volume, up from 73% in the prior quarter. The purchase money orientation of our Correspondent Production volume continues to be an important differentiating factor for PMT. We also continue to grow our seller relationships. At the end of the second quarter, we had 589 seller relationships, up from 557 in the first quarter.
Looking at July volumes, correspondent loan acquisitions totaled $6.1 billion in UPB, while interest rate lock commitments totaled $6.3 billion in UPB.
Now let's turn to Slide 13 and discuss our activities in GSE credit risk transfer. At the end of the second quarter, PMT’s CRT investments totaled $503 million, which after leverage results in an equity allocation of $196 million in CRT. During the quarter, we completed $3.8 billion in UPB of CRT deliveries to Fannie Mae, which will result in approximately $132 million of new CRT investments once the aggregation period is complete, $33 million of which had been invested at quarter end.
The income contribution from CRT was $31.5 million in the second quarter, reflecting strong underlying investment income and market-driven fair value changes due to credit spread tightening. Excluding the impact of fair value changes, the income contribution was $10.2 million and the return on average assets was 9.5%. Payments made to settle losses in the second quarter totaled $262,000, bringing credit losses to date for our CRT program to $501,000 on a total outstanding unpaid principal balance of $19.3 billion. These credit losses have been consistent with our modeled expectations. We have included additional performance and credit metrics for CRT on Slides 19 and 32.
Fannie Mae and Freddie Mac recently announced structural changes to their credit risk transfer programs. We believe these are positive developments for this asset class and will be beneficial for PMT’s future CRT investments.
Now let's turn to Slide 14 and discuss our MSR and ESS investments. PMT’s investment in MSRs and ESS was $997 million, up 2% compared with $974 million as of March 31. Investments in MSRs, which result from PMT’s Correspondent Production activities, increased to $735 million, up from $697 million at March 31, reflecting strong Correspondent Production volumes, partially offset by fair value changes resulting from interest rate declines. Our ESS investments decreased to $262 million, down 5% from $277 million at March 31, resulting from prepayment of the underlying loans as well as fair value losses due to lower mortgage rates.
Now I'd like to turn the discussion over to Andy Chang, PMT’s Chief Financial Officer, to review the second quarter's results.
Andrew S. Chang, PennyMac Mortgage Investment Trust - CFO and Senior MD 
Thank you, David. On Slide 16, we show the pretax income contributions from each of PMT’s operating segments over the last 5 quarters.
As Stan noted earlier, we report results in 4 segments, which reflect the evolution of PMT’s activities and the strategies that drive its financial results. PMT’s pretax income in the second quarter totaled $31.8 million, comprised of $30.4 million from Credit Sensitive Strategies, $5.4 million from Interest Rate Sensitive Strategies, $8.1 million from Correspondent Production and a pretax loss of $12.1 million from Corporate.
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 $40.2 million, an increase of 56% from the prior quarter. The increase in revenues was driven by a significant increase in net gain on investments and a reduction in other losses. Net gain on investments in the second quarter was $34.1 million, up 55% from $22 million in the prior quarter. The increase in net gain on investments was primarily due to strong gains on CRT, which totaled $32.9 million. Net interest income for Credit Sensitive Strategies was $6.9 million, up 15% from the prior quarter.
Interest income was $20.7 million, a 2% increase from the prior quarter and included $10.8 million of capitalized interest from loan modifications, up from $9.9 million in the prior quarter. Capitalized interest increases interest income and reduces loan valuation gains. Interest expense decreased 3% from the prior quarter to $13.8 million due to a smaller distressed mortgage loan portfolio. Other investment losses were $1.1 million compared with losses of $2.3 million in the prior quarter. Segment expenses were $9.7 million in the second quarter, a 52% increase from $6.4 million in the prior quarter. Other expenses in the first quarter benefited from gains realized on previously sold REO.
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 $1 million versus $3.2 million in the first quarter. Combining the net gains with net interest income, revenue from distressed loans was $10.3 million compared with $12.3 million in the first quarter. Valuation losses on distressed loans totaled $284,000 compared with gains of $2.8 million in the first quarter. Positive valuation changes in the performing loan portfolio were offset by negative valuation changes in the nonperforming loan portfolio. Valuation changes for the nonperforming loan portfolio were adversely affected by home price indications that were below prior forecasts as well as increased uncertainty regarding the realization of cash flows on the remaining population of loans.
Valuation of the performing loan portfolio, on the other hand, benefited from a strong market for portfolios with similar attributes. Gains from the pay-off of distressed loans totaled $1.3 million compared with $415,000 in the prior quarter.
Liquidation and paydown activity on distressed loans decreased from the prior quarter. Gross cash proceeds from the liquidation of mortgage loans and REO, before debt repayment and payment of related expenses, totaled $71 million, down from $89 million in the prior quarter.
With respect to the distressed loans and REO liquidated during the quarter, $397,000 in net valuation losses were recognized over the holding period of the assets, while $4 million of gains were realized at liquidation.
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 M1 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 M1 bonds, deposits included in other assets 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. From inception of the CRT investment program through June 30, a total of $21.4 billion in UPB of residential mortgage loans has been delivered to Fannie Mae through the CRT special-purpose vehicles. 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 second quarter were gains resulting from tight credit spreads, are noncash. Valuation related changes include fair value recognition upon loan delivery into the CRT agreements as well as market value changes. 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 $501,000 for credit losses, including payments to settle credit losses totaling $262,000 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. The current UPB of the underlying loans totaled $19.3 billion at June 30. The delinquency summary is divided into 3 categories: loans that, as of June 30, are current to 89 days delinquent; loans that are 90 days or more delinquent; and loans in foreclosure. More 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 $503 million on June 30, and the derivative position was an asset of $52.7 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 due to the cash collateral account upon completion of the loan aggregation period.
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 $12.1 million, an increase of 61% from the prior quarter, primarily resulting from a 33% quarter-over-quarter increase in net mortgage loan servicing fees. Net gain on investments included $3.8 million of gains on mortgage-backed securities and $456,000 of gains on mortgage loans held by a variable interest entity, net of the related asset-backed secured funding. These gains were offset by net losses of $4.9 million on hedging derivatives and $5.9 million of losses on ESS.
Net interest income for the segment was $3 million compared to $1.1 million in the prior quarter. Interest income in the second quarter was $18.7 million, a 16% increase from the prior quarter, driven by higher placement fees on MSR-related escrow deposits. Interest expense totaled $15.7 million, a 4% increase from the prior quarter due to higher short-term borrowing costs.
Net mortgage loan servicing fees were $15.7 million, up from $11.7 million in the prior quarter. Net loan servicing fees included $41.1 million in servicing fees, reduced by $19.5 million of amortization and realization of MSR cash flows. Net loan servicing fees also included a $4.1 million impairment provision for MSRs carried at the lower of amortized cost or fair value, a $4.4 million valuation loss on MSRs carried at fair value and $2.4 million of related hedging gains. Net loan servicing fees also included $0.2 million of MSR recapture income.
MSR and ESS valuation losses primarily resulted from higher projected prepayment activity due to a decline in mortgage rates during the quarter. ESS fair value losses are net of recapture income totaling $1.4 million receivable from PFSI for prepayment activity during the quarter. Segment expenses were $6.7 million in the second quarter, a 1% decrease from the prior quarter.
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 $63.3 billion in UPB. PMT also owns investments in ESS purchased from PennyMac Financial with a UPB on the underlying loans of $29.7 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 $25.7 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 $8.1 million compared with $12.5 million in the prior quarter. Segment revenues totaled $31.5 million compared with $30.8 million in the prior quarter. Net gain on mortgage loans acquired for sale totaled $17.1 million, a 10% decline from the prior quarter. The prior quarter included a $4.6 million benefit from a reduction in the estimate of the liability for representations and warranties.
Net gain on mortgage loans in the second quarter were driven by a 35% increase in conventional lock volume, partially offset by lower margins that reflect a highly competitive mortgage market. Net interest income for the segment was $3.9 million, up 12% from the prior quarter. Other income, which is primarily comprised of loan origination fees, was $10.5 million, a 26% increase from the prior quarter resulting from higher loan production volumes. Expenses in the Correspondent Production segment increased 28% from the prior quarter to $23.4 million, driven by an increase in volume-based fulfillment fee expense. 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 $155,000 compared with $326,000 in the prior quarter. Segment expenses were $12.3 million, up 19% from the prior quarter. Management fees, including incentive fees, were $5.6 million, up 13% compared with $5 million in the prior quarter. Incentive fees were $304,000 compared to no incentive fee paid in the first quarter. Other segment expenses were $6.6 million compared with $5.4 million in the prior quarter, primarily related to financing and distressed asset transaction activities.
And with that, I'll turn the discussion back over to Stan for some closing remarks.
Stanford L. Kurland, PennyMac Mortgage Investment Trust - Executive Chairman 
Thank you, Andy. PMT continues to focus on CRT and MSR investments that result from our Correspondent Production business. As mentioned earlier, Fannie Mae and Freddie Mac recently announced structural improvements to their credit risk transfer programs, which we expect will benefit PMT’s future CRT investments. We are pleased with our capital progress, highlighted by our successful raise of new preferred equity after quarter end. The ability to finance mortgage servicing rights has also improved markedly with attractive transactions recently in the market. These are exciting developments that we believe will enhance the attractiveness of PMT’s core strategies and earnings potential going forward.
Lastly, we encourage investors with any questions to reach out to our Investor Relations team by email or phone. Thank you.
This concludes PennyMac Mortgage Investment Trust's second 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.