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1 Reason PennyMac Financial Services Is Beating the Market

By Brent Nyitray, CFA - Jul 8, 2020 at 8:24AM

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Falling interest rates have created a refinance wave and this financial company is benefitting.

What if I told you there was a financial stock out there that was trading up over 22% year to date?

When you consider that the broader S&P 500 is essentially flat so far this year and the Financial Select Sector SPDR Fund ETF is down 25% year to date, it seems even more unlikely that a financial stock could be doing so well in this current economic environment.

No, we aren't talking about a fintech stock. It is stock for a company that operates in one of the most pedestrian businesses out there -- mortgage banking. While mortgage bankers struggled during the spring months due to COVID-19, they have emerged from the coronavirus crisis to an entirely different world from where they came. 

Mortgage document

Image source: Getty Images.

PennyMac gets cut in half and then more than doubles

PennyMac Financial Services (PFSI 1.02%) is a mortgage originator that also holds mortgage servicing rights. Like most companies operating in the mortgage space, PennyMac Financial's stock price was crushed in the March-thru-May timeframe as mortgage credit tightened and many mortgage real estate investment trusts (REITs) were forced to deleverage into an illiquid and declining market.

During the month of March, PennyMac Financial's stock price was more or less cut in half, although it has subsequently rallied 138%. Unlike PennyMac Mortgage Investment Trust, PennyMac Financial Services is not really a mortgage-backed securities (MBS) investor. It is instead a mortgage originator that holds servicing assets. While the mortgage REITs were getting margin calls from their repurchase agreement counterparties, PennyMac was originating mortgages and benefiting from the drop in mortgage rates. 

The drop in rates is huge

The drop in interest rates has meant an unexpected uptick in business for the whole mortgage banking sector, at least compared to pre-COVID. In response to economic weakness, the Federal Reserve cut its prime interest rate to near-zero and has reinstated its mortgage-backed securities purchasing program. This has pushed down mortgage rates, which is also helping make home purchases more affordable.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act does pose a risk to many loan servicers, who could face additional cash demands due to borrowers skipping payments. However, PennyMac Financial's advance obligations are mainly taxes and insurance, not principal and interest. This will be much less of a cash drain for the company if we see an increase in forbearance requests. 

Almost every mortgage in the U.S. is in the money

Black Knight Financial put out an interesting report this week discussing the growth in home equity in the first quarter. According to the report, tappable home equity (basically, equity that would be eligible for a cash-out refinance) increased to $6.5 trillion, which is a record. Not only that, but 90% of these homeowners have an "in-the-money" mortgage rate and over 75% have rates over 3.5%.

To put that $6.5 trillion number into perspective, the Mortgage Bankers Association has forecast that mortgage origination will come in around $2.5 trillion this year. As one of the biggest independent non-bank mortgage bankers out there, PennyMac Financial is poised to benefit from that big surge in activity. 

Mortgage bankers are at capacity and are raising prices

Most mortgage bankers are now bumping up against operational constraints and are to the point of almost turning away business. Many have taken the opportunity to raise margins (basically raise prices) so their businesses are now much more profitable.

When the banks start reporting earnings for the second quarter, most should report extremely strong mortgage banking results. PennyMac Financial is expected to earn $10.16 per share this year, which works out to be a price-to-earnings (P/E) ratio of about 4. If Quicken Loans does go forward with its IPO, it could draw added attention to the sector. 

The mortgage business is about to experience a long refinancing wave

Going forward, the mortgage banking industry is about to experience a refinancing wave similar to 2012. With almost every homeowner with a mortgage in a position to save money by refinancing, PennyMac Financial should have strong earnings for the foreseeable future. Once interest rates begin to rise, the mortgage banking business will suffer, but the servicing book will be positively affected. PennyMac's bright future is why the stock has recouped its COVID-driven losses and is trading near a 52-week high. 

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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