Mortgage origination is a feast-and-famine business, and the boom years of 2020 and 2021 turned into a bust in 2022. Much of the volume from these years disappeared as the Federal Reserve began to hike rates, which removed the incentive for homeowners to refinance. In addition, falling affordability has discouraged homeowners from selling and made it unaffordable for first-time homebuyers to purchase a starter home. Mortgage originators have struggled this year as well. That said, the Fed seems close to finishing up its tightening cycle, and mortgage rates have been falling recently. Is the worst behind for companies like PennyMac Financial Services (PFSI 2.84%)?
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PennyMac Financial Services is a correspondent lender
PennyMac Financial Services is one of the biggest correspondent lenders in the U.S. There are basically three types of business models in the mortgage banking business. The most common is retail, where a company employs loan officers (or technology) to originate loans, which the company funds and then sell to a third party. The best-known company in this market is Rocket (RKT 2.48%). The second most common is wholesale, which utilizes a network of non-exclusive mortgage brokers. The company then puts the loan together, funds it, and then sells it. The best example of a company using this strategy is UWM Corporation (UWMC 1.63%). Finally, there is the correspondent model, which buys completed loans from smaller retail shops and then sells them to a third party or securitizes them, packaging them into a single security that trades like a bond. This is PennyMac's model.
After rising all year, mortgage rates are beginning to fall
The biggest determinant of PennyMac's fortunes are mortgage rates, which are a function of the 10-year-bond yield and incremental interest a mortgage investor demands over the 10-year bond. During the past year, the mortgage rate has risen dramatically. However, it seems to have peaked in early November and has been declining since. Mortgage-backed security spreads have been declining as well, which is helping to improve things.
30-Year Mortgage Rate data by YCharts
It is way too early to call a turn in the mortgage banking business. That said, green shoots are beginning to appear. Given that there is no incentive for consumers to refinance their mortgages, the business will be driven by purchases, which are largely seasonal. The spring selling season generally kicks off in February, so we have a couple of months to go. This could coincide with the end of the Fed's tightening cycle as well.
Is the worst over for mortgage originators?
Next year will be nowhere near as good as 2020 and 2021 but it might not be as bad as 2022 either, especially if rates go down from here. Mortgage-backed security spreads have been tightening as well, which will help push mortgage rates lower, even if the 10-year-Treasury yield goes nowhere.
PennyMac Financial is trading at 6.3 times expected 2022 earnings per share, which probably represents an earnings trough. The mortgage business is highly cyclical, which means companies in it rarely trade at high price-to-earnings ratios. The company earned $14.87 per share in 2021, and is expected to earn $8.88 in 2022 and $7.03 in 2023. Note that 2022's earnings were front-loaded in the first and second quarters. We have seen some brokerages upgrade the mortgage bankers on a bet that the worst is over. One risk is that the Fed has to keep increasing rates to beat inflation. This could push up mortgage rates again. Because long-term rates now are below short-term rates (in other words, the yield curve is inverted), the market is signaling that it is unlikely. The biggest risk with PennyMac Financial is being early.
