Last week was tumultuous for mortgage originators as the 10-year bond yield fell from 1.16% to 0.77%. This drop in yields was directly attributable to fears about the novel coronavirus pandemic and the Fed's drastic half-point cut in the federal funds rate. For mortgage originators like PennyMac Financial Services (PFSI +1.71%), the dramatic drop in yields has a push-pull effect on its business and balance sheet.
Is the drop in rates good or bad for mortgage originators? Read on to find out.
Different businesses for different rates
PennyMac Financial Services is one of the top non-bank mortgage originators in the United States. The company buys loans from smaller mortgage originators and then sells them to PennyMac Investment Trust (PMT +1.42%), which is a real estate investment trust (REIT) that holds mortgages as an investment. PennyMac Financial services earns fees and a gain on sale when it sells the mortgages to PennyMac Investment Trust. PennyMac Financial Services holds the mortgage servicing right (MSR), which is the right to collect payments from the borrower. These two businesses react differently to changes in interest rates. The idea is that the company will still perform well no matter what happens to interest rates.
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Falling rates mean more loans
This week, the Mortgage Bankers Association reported that mortgage applications increased 55% from the week before, driven by a 79% increase in refinances. The MBA also raised their origination forecast for 2020 to $2.6 trillion, an increase of 20% from 2019. The group had originally projected that growth would decline in 2020. For an originator like PennyMac Financial Services, more mortgage origination volume equals more fee income. That should be good news for the stock, and it is.
Mortgage servicing rights: An unusual asset
The other side of the coin is PennyMac's $2.9 billion MSR portfolio. While falling rates are great for originators, they are bad for mortgage servicing rights. Here is how servicing works: You know the bill you get every month from your bank for your monthly mortgage payment? It is worth something. The loan servicer, which may not be your bank, is in charge of collecting your payment, ensuring that taxes and insurance are paid, and making sure your payment goes to whoever owns your loan. As compensation, the servicer typically earns a percentage of the loan balance per year. So, if you have a $400,000 mortgage and the servicing fee is 0.25%, the servicer gets paid $1,000 a year to collect your payment. The right to perform that service is worth something, and it is valued as an asset on PennyMac's balance sheet.
Last year, PennyMac Financial Services earned $129 million from servicing fees, which accounted for almost a third of PennyMac's net income. The value of that servicing asset is a function of many things, but the biggest determinant is interest rates. The servicer gets that servicing fee as long as the loan exists. If the borrower never refinances, the servicing right could theoretically last 30 years. If the borrower refinances right away, the servicing right disappears and the holder of the servicing has to write down the asset to zero. This dynamic is referred to as prepayment risk. Last quarter, the average interest rate in the servicing portfolio was 3.95%. The current mortgage rate is 3.3%. In mortgage parlance, a lot of that book is "in the money" which means it is likely many borrowers will save money by refinancing. This makes the servicing book worth less, because a lot of those assets are about to go to zero.
Interest rate shocks
Servicing values run the gamut from 0.7% of the loan value to 1.4% of the loan value. PennyMac Financial Services' portfolio consists of $225 billion in loans, valued at $2.9 billion, or about 1.29%. In the company 10-K, Pennymac Financial Services conducts a shock analysis based on a number of factors, but the number to pay attention to is prepayment shock, which is the effect of falling interest rates. In an extreme interest rate drop scenario (which they don't quantify, but the 0.81% drop in the 10-year Treasury over the past month should certainly qualify), PennyMac could experience a $238 million decrease in the value of the servicing portfolio. A decrease of that magnitude would translate into about a $2.96 drop in book value per share, or about 11%.
Of course, PennyMac won't mark its MSR book until March 31, when it reports first-quarter earnings. Anything can happen to interest rates between now and then, but with the fed funds futures predicting another big cut in interest rates at the March meeting, it looks like a big rebound in interest rates probably isn't in the cards. That should be great news for the mortgage origination arm, but the servicing portfolio is going to suffer. Be careful with this one.
