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PennyMac Mortgage Investment Trust (NYSE:PMT)
Q3 2019 Earnings Call
Oct 31, 2019, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Isaac Garden

Good afternoon and welcome to the third-quarter earnings discussion for PennyMac Mortgage Investment Trust. The slides that accompany this discussion are available from PennyMac Mortgage Investment Trust 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.

Stan Kurland -- Executive Chairman

Thank you, Isaac. Let's begin with Slide 3. PMT reported net income attributable to common shareholders of $63.8 million or $0.71 per share, representing an annualized return on average common equity of 14%. Book value per common share increased to $21.14 at quarter end from $20.79 at June 30.

And PMT paid a dividend of $0.47 per share for the quarter. PMT reports results through four segments: credit sensitive strategies, which contributed $51.9 million in pre-tax income; interest rate sensitive strategies, with a pre-tax loss of $10.1 million, correspondent production, which contributed $21.8 million in pre-tax income; and corporate, with a pre-tax loss of $15.4 million. Lastly, we recorded a $21.9 million income tax benefit, driven by fair value losses on MSRs held in PMT's taxable REIT subsidiary. Our results this quarter reflect continued strong performance from our GSE credit-risk transfer investments.

The performance of our agency mortgage-backed securities and interest rate hedges were to substantially offset fair value losses on mortgage servicing rights and excess servicing spread investments during the quarter, resulting from declining interest rates and market volatility. Results in our interest rate sensitive strategy were more than offset by strong correspondent production results. PMT continued its strong pace of capital investment, driven by record quarterly conventional acquisition volumes of $18.5 billion in UPB. For the quarter, we delivered to Fannie Mae CRT-eligible loans of $14.2 billion in UPB, which resulted in a firm commitment to purchase $523 million of CRT securities.

New MSR investments for the quarter totaled $250 million. Let's turn to Slide 4 and continue our discussion of third-quarter results. During the quarter, we completed the previously announced sale of loans from the distressed portfolio totaling $94 million in UPB. PMT's strong investment opportunities and excellent performance drove successful capital raising activities in the quarter totaling $253 million in net proceeds.

In August, through an underwritten equity offering, we raised approximately $198 million in net proceeds from the issuance of $9.2 million common shares. And through our at-the-market equity offering program, we sold an additional 2.5 million shares for $55 million in net proceeds. Finally, I am pleased to note that after the quarter end, we issued $375 million of three-year-term notes related to our fifth CRT investment, which David will expand upon later. Now let's turn to Slide 5 and discuss the current market environment.

Looking ahead, the outlook for the direction of the U.S. economy continues to reflect uncertainty, driven by the lack of clarity around the impact of tariffs on international trade and slowing rate of global growth. In response, the yield on the 10-year treasury bond declined during most of the third quarter, driving mortgage rates lower. The 30-year fixed-rate mortgage in the third quarter averaged 3.66% and remained at comparable levels through October, driving substantial increase in refinance activity.

As a measure of increase in activity, the average monthly MBA Refinance Index in the third quarter was 42% higher than it was in the prior quarter. Forecasts for total loan originations in 2019 now total over $2 trillion, up 19% from the average forecast in June. Similarly, originations in 2020 are now forecasted to total $1.9 trillion, largely driven by the continuation of elevated refinance volumes in a low-rate environment. Purchase originations are still expected to grow by low single-digit percentages into 2021, aided by low rates and home price appreciation that has moderated to levels more consistent with wage growth, while tight levels of supply continue to support home prices.

Credit markets remain strong as spreads on GSE credit risk transfer securities tightened relative to the prior quarter and delinquencies remained low. The total U.S. mortgage delinquency rate was 3.53% as of September 30, 2019 down from 3.73% at June 30 and 3.97% a year ago. Now let's turn to Slide 6 to discuss potential changes in housing finance and the implications for PMT.

In September, the treasury released plans for housing finance reform, which seeks to end conservatorship of the GSEs and minimize taxpayer risk. The plan seeks to facilitate competition in the mortgage finance market and outlines legislative and administrative actions required to enact reforms. Furthermore, in July, the CFPB announced a proposed rule to eliminate the QM patch, which has exempted GSE loans from having to follow the ability to repay qualified mortgage rule to its full extent. We believe that any significant reduction in the roles of Fannie Mae and Freddie Mac in the U.S.

mortgage market would take place over time. Even with the changes in the structure of GSEs, we expect PMT will continue to provide meaningful private capital to invest in agency credit risk. We also believe PMT is well positioned to expand its investments in prime, nonagency loan and securitization interests. Building on our previous activities and expertise, we expect to remain active with products such as prime, non-QM and HELOC securitizations as the market evolves.

Let's turn to Slide 7 and discuss the quarter's investment activities. On Slide 7, we detailed investment activity for each of PMT's investment strategies during the third quarter. The primary driver behind PMT's capital raising activity this year has been its compelling outlook for investment growth. Supporting this perspective is our investment activity in the third quarter, which was driven by strong capital deployment to CRT and MSR investments, resulting from robust growth in production volume.

As I noted earlier, loans eligible for CRT deliveries led to a firm commitment to purchase $523 million in new CRT investments. Net of runoff, new CRT investments for the quarter totaled $507 million. Continuing our liquidation efforts in our distressed loan and REO portfolio, the previously mentioned sale of distressed loans reduced our investments in this asset class to $95 million as of September 30, down significantly from $172 million at the end of the prior quarter. New MSR investments added during the quarter were $250 million and net of runoff totaled $187 million sourced from the securitization of $18.5 billion in UPB of conventional production.

Agency MBS are held by PMT as part of a comprehensive strategy designed to mitigate the interest rate sensitivity of the MSR and ESS assets. This quarter, we rebalanced the MBS portfolio, reducing our net agency MBS position by $287 million. In total, new investments in the third quarter were $331 million, and long-term mortgage assets as of September 30 grew to $6.9 billion. Now let's turn to Slide 8 and review the run rate quarterly return potential of PMT's investment strategies.

Our expectation for PMT's investment strategies is a run rate diluted EPS of $0.53 per quarter, which would result in an annualized return on common equity of 10.4%. PMT's run rate potential reflects our expectation for returns over the next several quarters. Our income potential results from continued growth of CRT and MSRs organically driven by our correspondent production activities. PMT's equity allocation related to credit sensitive strategies is expected to average 44% with a run rate annualized return on equity potential of 19%.

Our credit sensitive strategies primarily consist of our investments in CRT with a return potential that reflects credit spreads that have tightened. Equity allocated to interest rate sensitive strategies is expected to average 26% with an annualized return on equity of 10%. We consider the results of this segment in aggregate, as MBS and hedge positions are primarily used to moderate the impact of interest rate volatility on MSRs and ESS returns. Our expectations are primarily driven by our outlook for the earnings contributions from the growing MSR asset and increased hedge costs, which Andy will expand upon later.

Equity allocated to the correspondent production segment is expected to average 15% and deliver an annualized return on equity of approximately 14%, which reflects a normalization over time from the elevated results we have seen recently. And lastly, the ongoing impact of distressed loans and REO has diminished substantially given the recent sales. This concludes my presentation. And I'd now 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 -- President and Chief Executive Officer

Thank you, Stan. Let's begin with Slide 10 for a look at our correspondent production highlights. Correspondent acquisitions by PMT from nonaffiliated sellers in the third quarter totaled $31.5 billion in UPB, up 45% from the prior quarter and 90% year over year. The mix of our acquisition activity was 54% conventional loans and 46% government loans.

Conventional correspondent acquisitions totaled $16.6 billion in UPB, up 55% from the prior quarter and 122% from the third quarter of 2018. Government loan acquisitions in the quarter, for which PMT earns a sourcing fee from PennyMac Financial, totaled $14.3 billion in UPB, up 36% from the prior quarter and 60% from the third quarter of 2018. As part of its correspondent loan acquisitions, PMT also acquired conventional loans originated by PFSI totaling $1.4 billion in UPB, up from $1.1 billion in the prior quarter. These loans were originated through PFSI's consumer- and broker-direct channels and with their growth, PennyMac Financial remains PMT's largest single correspondent client.

Combined, conventional lock volume totaled $19.5 billion in UPB, up 54% from the prior quarter and 132% for the third quarter of 2018. Given our growth in acquisition volumes, I am proud to mention that according to Inside Mortgage Finance, PennyMac was the largest correspondent aggregator in the United States in the third quarter. We believe our commitment to consistently high service levels and fast turn times is a key to the success of our correspondent seller network. And we expect this to continue to drive further growth in our market share over time.

As a whole, the conventional correspondent market remains highly competitive, and margins were stable in comparison to the prior quarter. The weighted average fulfillment fee paid to PFSI to facilitate correspondent loan production was 27 basis points, down slightly from 28 basis points in the previous quarter. We also continue to increase the number of approved correspondent sellers in our network, with 770 at quarter end, up from 752 at the end of the prior quarter. This quarter, we also launched an e-note pilot with a correspondent seller and have funded and financed our first notes with the bank warehouse lines of credit and delivered those notes to Fannie Mae.

But we do not expect this to drive meaningful volume in the near term. It is a testament to our industry leadership and commitment to be on the forefront of technology. Further, we believe that having the liquidity source for delivery of e-notes will be an important enhancement for our correspondent customers and drive future growth as the industry continues to adopt e-note closings. Looking forward, monthly production volumes have remained strong in October with estimated correspondent loan acquisitions and interest rate lock commitments to be both approximately $14.2 billion in unpaid principal balance, both up significantly from October 2018.

Now let's turn to Slide 11 and discuss PMT's investments in GSE credit risk transfer. Last quarter, we began loan deliveries into our sixth CRT transaction, expected to be our largest one yet. This quarter, we delivered to Fannie Mae, a total of $14.2 billion in UPB of eligible loans pursuant to this transaction, which resulted in a firm commitment to purchase $523 million in CRT securities. On a pro forma basis, at September 30, 2019, PMT's outstanding CRT investments totaled $3.1 billion, with the UPB of the loans underlying the CRT agreements totaling $69 billion.

Credit performance and characteristics of the loans underlying these investments remain strong. The 60-plus day delinquency rate was 0.31%, up modestly from 0.27% in the prior quarter, reflecting normal seasoning in the underlying loans. Losses recognized on CRT investments in the third quarter totaled $1.7 million, bringing lifetime cumulative losses on our CRT investments to $7.1 million, in line with expectations for credit performance. Now let's turn to Slide 12 and talk about the financing arrangements associated with our CRT investments.

This slide details the outstanding financing arrangements underlying our CRT investments. As Stan mentioned earlier, after the quarter end, we issued $375 million of three-year secured term notes related to our fifth CRT investment. We have now financed the majority of our funded CRT transactions with over $1.3 billion of outstanding term notes on October 31, 2019. As we have mentioned in the past, the term note financing structure strengthens PMT's liquidity profile by reducing the potential margin call risk and the need for associated internal cash reserves.

Now let's turn to Slide 13 and discuss MSR and ESS investments. PMT's organic MSR investments resulting from its corresponding conventional production activity totaled $1.2 billion at quarter end, up slightly from June 30, 2019, driven by growth from increased levels of conventional production. PMT's MSR portfolio totaled $116.3 billion in unpaid principal balance at September 30, 2019, up from $106.2 billion at June 30, 2019. PMT's ESS investments resulting from bulk, mini-bulk and flow MSR acquisitions by PennyMac Financial from 2013 to 2015, decreased slightly to $183 million at September 30 from $194 million at the end of the second quarter.

The decline resulted from repayments of the underlying loans in addition to interest rate-driven fair value losses in the investment. The unpaid principal balance associated with ESS investments totaled $20.7 billion at September 30 down from $21.8 billion at June 30, 2019. Now I'd like to turn the discussion over to Andy Chang, PMT's chief financial officer, to review the third-quarter's financial results.

Andy Chang -- Chief Financial Officer

Thank you, David. Let's turn to Slide 15 and discuss the third-quarter's income and return contributions by strategy. PMT's activities in the third quarter generated an annualized return on common equity of 14%, net of all expenses. In total, credit sensitive strategies contributed $51.9 million to pre-tax income or a 31% annualized return on equity for the quarter.

Within this segment, CRT investments contributed pre-tax income of $55.2 million, which I will expand upon later. Distressed loan and REO investments contributed a $3.6 million pre-tax loss, primarily driven by expenses related to the bulk sale completed in the quarter and holding cost on the remaining loans and REO. Interest rate sensitive strategies, which include the performance of our MSRs, ESS and agency and non-agency senior MBS positions and related interest rate hedges, together contributed a pre-tax loss of $10.1 million or a negative 5% annualized return on equity for the quarter. These results were primarily driven by fair value losses on our MSR investments, which resulted from the continued decline in mortgage rates and market volatility, offset by gains in the fair value of our interest rate hedges and Agency MBS.

While we show the income contribution for each of these interest rate sensitive strategies separately, they are managed together as the interest rate sensitivity of MSRs and ESS, is inversely correlated to that of MBS and our other interest rate hedges. I will discuss this in more detail on the following slide. Correspondent production contributed $21.8 million to pre-tax income or a 15% annualized return on equity for the quarter, driven by the increase in production volumes. The corporate segment contributed a pre-tax loss of $15.4 million.

And lastly, we recorded a $21.9 million income tax benefit, driven by the fair value losses on our MSR investments, which are held in PMT's taxable REIT subsidiary. Now let's turn to Slide 16 to further discuss the impact of interest rate movements on our third-quarter results. PMT seeks to manage its interest rate exposure on a global basis, recognizing interest rate sensitivities that exist across its investment strategies. In the third quarter, MSR and ESS investments recorded fair value losses totaling $161.8 million, driven by expectations for higher prepayment activity in the future due to lower interest rates.

PMT's MSR portfolio is concentrated in recently originated vintages, loans that were originated from 2016 to 2018, that are highly sensitive to prepayments at the current level of interest rates, and as a result, the MSR is costly to hedge. For the quarter, Agency MBS produced fair value gains of $11.3 million, and interest rate hedges produced fair value gains of $118.4 million, offsetting approximately 80% of the fair value losses on MSRs and ESS. The gains on our interest rate hedges are reported net of hedge costs, which have been elevated, driven by market volatility. And lastly, as Stan and David discussed, the decline in mortgage rates during the quarter drove a substantial increase in production volume and the related income contribution from our correspondent production segment.

Now let's turn to Slide 17 and talk about the performance of our CRT investments. Our CRT investments contributed $55.2 million of pre-tax income in the third quarter, consisting of $19.2 million in gains from market-driven value changes and $36 million of income, excluding market-driven value changes. Gains on our existing CRT investments from market-driven value changes included $8.7 million, driven by credit spread tightening. The remaining market-driven value changes were $10.5 million included in net gains on loans acquired for sale.

These gains relate to the fair value recognition upon loan delivery under firm commitments to purchase CRT securities pursuant to our current transaction with Fannie Mae. $15.4 million of such gains were attributed to the correspondent production segment. Income, excluding market-driven value changes, consists of net realized gains and net interest expense related to our CRT investments. For the quarter, realized gains and carry on CRT investments totaled $45.6 million and losses recognized were $1.7 million.

Interest income earned on cash deposits securing CRT investments was $11.2 million, while interest expense relating to the financing of these investments was $19.2 million. And with that, I'll turn the discussion back over to Stan for some closing remarks.

Stan Kurland -- Executive Chairman

Thank you, Andy. Our results reflect continued strong performance from PMT's unique investment strategies. The third quarter also represents the third consecutive quarter we have prudently raised capital in the equity markets. As we continue to source attractive organic investment opportunities in CRT and interest rate sensitive investments from our leadership position in the conventional correspondent market.

We continue to see compelling opportunities for new investments in CRT and MSRs, and expect to benefit from greater economies of scale as we leverage our larger capital base. As a result, we remain optimistic about our ability to continue to provide strong shareholder returns. Lastly, we encourage investors with any questions to reach out to our investor relations team by email or phone. Thank you.

Isaac Garden

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.

Duration: 29 minutes

Call participants:

Isaac Garden

Stan Kurland -- Executive Chairman

David Spector -- President and Chief Executive Officer

Andy Chang -- Chief Financial Officer

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