2020 will go down as the best year for mortgage bankers in almost two decades. The COVID-19 pandemic triggered aggressive action by the Federal Reserve, which responded by cutting the federal funds rate to zero and reinstated purchases of Treasuries and mortgage-backed securities. This precipitated a massive refinancing boom, which stimulated the economy by helping people cut their monthly mortgage payments. Can the party continue for big mortgage companies like PennyMac Financial Services (PFSI +1.71%)?
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The different mortgage business models
PennyMac Financial is the largest correspondent aggregator in the United States. This means that PennyMac generally buys completed mortgages from smaller originators, sells off the loan, and holds the servicing asset. This is a different model from the one used by Rocket, which is mainly a consumer-direct lender. Rocket does all the work of sourcing the loan, underwriting, and funding, and then sells the loan and holds the servicing asset. United Wholesale uses the wholesale model, in which independent brokers source the loans and the company does all the work of putting together and funding them. While PennyMac has business lines in the consumer-direct and wholesale models, it is mainly a correspondent aggregator.
For the fourth quarter, PennyMac reported revenue of $1 billion and earned $453 million, or $5.97 per share. Total origination volume rose 28% quarter over quarter and 64% year over year to $69.4 billion. For the full year, PennyMac earned $1.6 billion, or $20.92 per share on origination volume of $196.6 billion. This was a 67% increase from full-year 2019 volumes. At its current share price, PennyMac is trading at 3 times last year's earnings. The market would seem to be suggesting that 2020 was a one-off event. That may be pessimistic.
This year will be a drop-off from last year, but will still be fantastic
The final origination numbers for 2020 have yet to be tabulated, but they are expected to come in at around $4 trillion. Forecasts for next year see origination volumes falling to something like $3.3 trillion, which would still be phenomenal by recent historical standards.
The market seems to fear that there will be a price war between the major originators as they fight over volume. While this is possible, there is a lot of potential volume out there. Last fall, Black Knight Financial Services estimated that over 32 million borrowers could save 0.75% on their mortgage rates by refinancing. Since then, rates have only gone lower. Assuming a typical mortgage amount of $300,000, that could work out to $10 trillion of volume -- several years of volume at current run rates. Originators have been staffing up, and PennyMac increased its employee base by 60%. That said, certain critical positions like underwriter are in high demand, and increasing capacity isn't as easy as it might appear. Until then, there is no reason to cut price when the industry is operating at full capacity.
Don't forget one critical factor here: The Fed has a heavy influence on mortgage pricing, and it wants everyone to refinance because that is the easiest and quickest way to put money in people's pockets. The mortgage banks have the most powerful ally in the entire economy on their side.
Servicing will help once rates do rise
A big part of PennyMac's business is loan servicing, an interesting business line. Loan servicers handle the administrative tasks of the loan once it is made. They collect the monthly payments, send the principal and interest to whoever owns the mortgage-backed security, manage taxes and escrows, and perform loss mitigation if the borrower gets in trouble. They then receive 0.25% of the loan amount per year as a fee. For a typical $300,000 mortgage, that works out to $750. If the borrower makes the monthly payments without a hiccup, the servicer will keep almost all of it. That right is worth something, and it is an asset on the balance sheet. The value of that asset is highly dependent on how long it is expected to last. If the loan is expected to be outstanding for 10 years, it will be worth a lot more than if the loan is expected to be refinanced within two years. When rates rise, the expected life of the loan is extended, and the asset increases in value. Mortgage servicing assets are among the only financial assets out there that increase in value as rates rise.
During the fourth quarter, PennyMac saw its servicing portfolio take a $1.1 billion hit as rates fell and borrowers refinanced. The company did hedge that risk, and it made almost enough on its hedge to offset the loss. PennyMac expects its servicing portfolio will be a huge source of earnings once rates start rising. The servicing portfolio also helps feed PennyMac's consumer-direct lending arm. PennyMac believes that consumer-direct lending and servicing will become bigger drivers of earnings. The company is also getting into the wholesale business, which will put it in competition with wholesale lenders like United Wholesale and loanDepot, which went public on Thursday.
The knock on mortgage bankers is that they never get a multiple, unless business is lousy. If you look at all the major originators, they all trade with single-digit multiples during the boom times. This is a function of the highly cyclical nature of the business, and it was typical of the way the big industrial companies used to trade. PennyMac did raise its dividend 33% to $0.20 per quarter and increased its stock repurchase program to $1 billion. Book value increased 30% to $47.80, and the stock generally trades close to book value. So even if you don't get much in the way of multiple expansion, book value keeps increasing, which keeps a floor under the stock value. PennyMac Financial may not be the most exciting stock, but it is trading under 4 times the expected 2021 earnings per share of $16.66. As long as the mortgage party continues, it will be a winner.
