Last year was difficult for the mortgage industry. The Fed's aggressive series of interest rate hikes pushed up mortgage rates, which largely eliminated the incentive for borrowers to refinance their home loans. This caused mortgage origination volumes to fall from $4.4 trillion in 2021 to $2.2 trillion in 2022. It resulted in many companies exiting the business, folding, or severely cutting back costs.
Mortgage real estate investment trusts (REITs), which hold mortgage-backed securities and loans, also saw a decrease in book values per share as these assets underperformed Treasuries. One such mortgage REIT, PennyMac Mortgage Investment Trust (PMT 2.19%), has struggled this year and was forced to cut its dividend. Is another cut in store?
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PennyMac has three basic strategies: credit-sensitive strategies, interest rate-sensitive strategies, and correspondent production. Credit-sensitive strategies involve investments in Credit Risk Transfer bonds, which act as a kind of reinsurance for the government-sponsored entities Fannie Mae and Freddie Mac. The interest rate strategies include investments in mortgage servicing rights, and the correspondent production strategy covers mortgage originations.
Mortgage servicing rights have been the engine of profitability for the past year. A mortgage servicer performs the administrative duties of handling a mortgage on behalf of the ultimate mortgage investor. The servicer sends out the monthly bills; collects payments; ensures that principal, interest, and property taxes are paid, and deals with delinquencies.
The servicer is paid a percentage of the outstanding mortgage, which is typically 0.25%, although it can be higher. This means if the outstanding mortgage is $400,000, the servicer is paid $1,000 per year. The right to perform that service is worth something, and it is listed on the balance sheet as an asset.
Every mortgage servicing portfolio is different, and therefore valuations can vary. Holders of servicing rights run a complicated model that spits out a valuation. PennyMac's portfolio of mortgage-servicing rights has an unpaid principal balance of $230 billion and a weighted average servicing fee of 0.29%. This means that the portfolio typically pays about $667 million in fees per year before expenses.
Mortgage servicing rights are generally quoted as a multiple of the servicing fee, the same way that stocks are quoted in terms of their price-to-earnings ratio. PennyMac is valuing the servicing portfolio at $4 billion, or 6 times the $667 million servicing fee, which is fully valued. This means that valuation is probably more likely to fall than increase in the future. Mortgage servicing rights were trading at a lot lower levels before the Fed started hiking rates.
The current market for mortgage servicing rights is heavily weighted toward buyers, not sellers. Many thinly capitalized mortgage originators are selling their servicing portfolios to raise cash to get them through the hard times until rates fall. Buyers are not paying anywhere near the 6 multiple for servicing rights in the secondary market.
PennyMac's correspondent production arm purchased $20.8 billion in morgage originations in the fourth quarter, which was down 7% compared to the third quarter of 2022 and off 37% from a year ago. The company sees total U.S. mortgage origination volume falling from $2.2 trillion in 2022 to a range of $1.6 trillion to $1.9 trillion in 2023. It sees opportunities as big lenders like Wells Fargo get out of the correspondent lending business. That said, origination volumes will probably decline again in 2023.
Over the next year, PennyMac expects the quarterly run-rate return for its three strategies to average $0.40 per share, or a 10% annualized return on common equity. This gives the company no room to maneuver on the quarterly dividend, which is also $0.40 per share.
If the U.S. enters a recession and delinquencies increase on the REIT's mortgage-servicing portfolio, the value will fall as servicing costs rise. This would hurt the credit-risk transfer portfolio as well. So investors should understand that PennyMac Mortgage Investment Trust's 11.1% dividend yield is not a sure thing.
