For mortgage originators and mortgage servicers like PennyMac Financial Services (PFSI 0.01%), the current economic environment represents the best and the worst conditions.
Initial giddiness over the Fed's aggressive moves to lower interest rates turned to fear as margin calls and forbearance became threats to the industry. So far, it looks like the most immediate threat to mortgage originators -- margin calls -- has passed.
Forbearance requests remain an issue, but the Federal Housing Finance Agency has added some much-needed clarity over the past month or so to ease uncertainty there. And PennyMac was able to secure an advance facility that takes many of the potential servicing liquidity issues off the table.
In other words, the big threats from the COVID-19 economic meltdown are largely in the past for this sector. While the real estate sector may face some challenges going forward, mortgage originators and servicers should be largely unaffected as refinance activity will dominate.
A record first quarter
PennyMac Financial Services reported earnings per share of $3.73 for the quarter ending March 31, which was a record for the home loan processor. Strong mortgage banking revenue driven by the dramatic drop in rates in March more than offset the valuation losses in the servicing book. Note that PennyMac Financial hedges its mortgage servicing book with interest rate futures trading, and the gains on the hedge more than offset the valuation-related losses on the mortgage-servicing-rights assets. Book value increased from $26.26 per share at the end of 2019 to $29.85 per share. Origination volume came in at $35.4 billion, down 17% from the fourth quarter and up 113% from the first quarter of 2019.
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The mortgage origination business is benefiting from record low interest rates. While the precipitous drop in rates did cause some liquidity issues for smaller and less-capitalized competitors, PennyMac had the capital to deal with some of the large cash requests from its counterparties. The tremendous drop in rates will kick off a refinancing wave that could eclipse the one in the immediate aftermath of the 2008-09 financial crisis, so PennyMac should see increases in volumes and margins. While the purchase market could be hurt by the COVID-19 crisis, refinance activity will pick up.
Servicing will be a drag
The servicing book will be a drag on performance, at least relative to the origination business. Servicing is the business of collecting monthly payments from a borrower and making sure that the principal, interest, taxes, and insurance payments all get routed to their proper places. The servicer also deals with missed payments, foreclosures, and the day-to-day administrative functions of the whole process. As compensation, the servicer usually collects a fee of 0.25% of the loan balance per year.
The right to perform this business is worth something, and servicers will capitalize the asset on their balance sheet based on a model. During the quarter, PennyMac's servicing book fell in value from $2.9 billion to $2.2 billion, but this was offset by $1 billion in hedging gains. Going forward, it is unlikely that PennyMac's interest rate hedges will be able to offset any losses on the servicing book.
Ordinarily, mortgage servicing is a thankless business (albeit profitable). Congress threw a wrench into this, however, with the CARES Act, which requires servicers to allow borrowers to skip payments for up to a year, pretty much no questions asked. As a servicer, PennyMac is required to reach into its own pocket to make missed payments to the ultimate investor in these loans. These are called advances, and they are a huge political football in Washington right now.
In addition, while loans are in forbearance, PennyMac won't be receiving any servicing fees. Lastly, forbearance is a labor-intensive business, and PennyMac's cost to service is going to increase. Since PennyMac also performs loan servicing for other clients, it will be able to pass on some of these increased costs, but not all of them. While PennyMac has the liquidity to deal with these headaches, servicing is going to be a lousy business for a while.
Valuation issues
PennyMac Financial Services is trading at 3.5 times expected 2020 earnings per share of $8.03. The company is also trading at a 5% discount to book value. Historically, the company has traded pretty close to book value, but it has traded at a 20% to 30% premium over the past few months. The P/E of 3.5 is definitely at the low end of its historical range.
PFSI PE Ratio data by YCharts.
Pain now for gain later?
Note that the forbearance issue will be a bit of a "pain now for gain later" situation. Why? Mortgage servicing rights are highly sensitive to assumptions about their maturity (in other words, how long the loans in the portfolio stick around). Getting 25 basis points a year for 10 years is worth a lot more than 25 basis points a year for three years. All those loans that go into forbearance will be shut out of the refinancing market for a long time. Once borrowers go into forbearance, they will be ineligible for a refinance for one year after the missed payments are paid back. So, say a borrower skips six months of payments, and at the end of the forbearance period works out a payment plan with the servicer to repay those six months of payments over the course of the next five years. That borrower will be ineligible to refinance for six years, which means the right to service that loan will increase in value. So, while PennyMac Financial will be out some money upfront, it will make it back once the borrower starts making payments again. For what it's worth, AGNC Investment Corp. is making a similar bet on its mortgage-backed securities portfolio.
PennyMac Financial Services pays a somewhat miserly dividend yield for a financial stock these days: only 1.6%. That said, it should benefit from what ought to be the best year for originators in a decade. The servicing portfolio is going to be an underperformer, but that should be more than offset by the origination book. PennyMac Financial earned 46% of its 2020 expected earnings estimate in the seasonally weakest quarter of the year. For PennyMac to miss that 2020 estimate, a lot will have to go wrong. While it is hard to love the financial sector at this point in the economic cycle, PennyMac Financial should be a solid performer.
