The COVID-19 crisis has unleashed a mortgage refinancing wave that comes around once every 20 years or so.

When the economy slammed to a halt, the Federal Reserve cut interest rates as a low as it could and began buying up mortgage-backed securities in order to stabilize the market. These measures drove mortgage rates from 3.72% at the beginning of the year to 2.78% now, according to Freddie Mac. Black Knight Financial estimated that almost 75% of the mortgage market could save 0.75% on their mortgage by refinancing.

Who have been the winners so far? One is PennyMac Financial (NYSE:PFSI), which just reported record earnings.

Picture of a mortgage document, house keys, and a calculator

Image source: Getty Images.

Blowout quarter

In the third quarter, PennyMac reported earnings of $535.2 million, or $7.03 per share, on revenue of $1.1 billion. Total volume came in at $54.2 billion, up 44% from the June quarter and 55% from a year ago. Book value per share increased to $41.67 from $34.26. 

PennyMac's servicing portfolio grew to $401.9 billion in principal, which was up 4% from the second quarter and 15% from the third quarter of 2019. The company saw a push-pull effect, in which higher production volumes fought with refinancing runoff. PennyMac Financial's mortgage servicing rights (MSR) took a $37 million fair-value hit, which was partially offset by $9.7 million in hedging and other gains. The net impact of these items was a pre-tax loss of $27.4 million and a $0.26 decrease in diluted earnings per share. Mortgage servicing assets represent the right to receive compensation for handling the administrative tasks (collecting payments, ensuring taxes are paid) on behalf of the mortgage investor. The servicing portfolio will struggle to perform in the current environment with interest rates so low. That said, once interest rates start heading upward, the servicing book will increase in value, which should offset the declines in income from lower origination volume.

Be aware of the different mortgage banking business models

When comparing PennyMac Financial to a retail mortgage banker like Rocket, it is critical to understand the different business models. PennyMac Financial is mainly an aggregator, which means it buys finished loans from smaller bankers and sells them. As a result, PennyMac's gain on sale margins is much lower than Rocket's, which originates most of its production in-house. For the third quarter, PennyMac earned $535 million on $54 billion in origination, or about 1%. In the second quarter (the third hasn't been reported yet), Rocket earned $3.4 billion on $72.3 billion in origination, which works out to a 4.7% net profit margin. The retail business is more profitable, but it can be hard to scale quickly.

PennyMac could support a higher dividend

PennyMac Financial declared a third-quarter cash dividend of $0.15 per share and repurchased about 118,000 shares of common stock at an approximate value of $6.9 million. The $0.15 dividend seems pretty miserly given that the company earned $7.03 this quarter, which works out to be a 2% payout ratio. It is interesting that with the company generating so much cash it is not raising the dividend at all. The company did not take questions on the conference call, so this issue wasn't addressed. As PennyMac Financial builds cash on the balance sheet, the question of excess capital will be asked more and more.

The Street estimates that PennyMac Financial will earn $17.53 this year, which is surprising since it has already earned $15.15. Given that the refinancing wave shows no sign of stopping, the company should easily top that number. This works out to be a price-to-earnings ratio (P/E) of just over 3. In fact, the Street estimates PennyMac Financial will earn $12.28 next year, which works out to be a P/E of 4.6. The mortgage banking business is highly cyclical, which means that earnings will fall once rates rise. That said, the party should last a while longer and investors are certainly not paying up for the business.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.