2022 was a challenging year for the mortgage space. Mortgage originators saw volumes collapse, and big participants folded or got out of the business altogether. As a result, mortgage real estate investment trusts (mREITs) struggled as mortgage-backed securities underperformed Treasuries. By the end of the year, mortgage REITs were reporting big declines in book value per share over the previous 12 months.
2023 has seen interest rates start to level off and other economic pressures ease a bit in the mortgage space. Is the worst over for PennyMac Mortgage Investment Trust (PMT 3.06%), one of the big mortgage REITs? The answer is "it depends." Let me explain.
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PennyMac has a number of strategies in the mortgage space
PennyMac Mortgage Trust is an mREIT with three segments utilizing differing business strategies:
- Credit-sensitive strategies include investments in distressed mortgage loans, real estate acquired in settlement of mortgage loans, credit risk transfer agreements, non-agency subordinated bonds, real estate held for investment, and small balance commercial real estate mortgage loans. These can involve purchasing credit risk transfer securities issued by Fannie Mae and Freddie Mac.
- Correspondent production is essentially PennyMac Mortgage Trust's mortgage banking business. It deals with purchasing, pooling, and reselling newly originated prime credit quality mortgage loans. These can be either direct loans or they can be in the form of mortgage-backed securities in capital markets.
- Interest-rate-sensitive strategies focus on investments in mortgage servicing rights and related interest rate hedging activities.
The third strategy with its focus on mortgage servicing was the star of the show in what was an otherwise rough year for PennyMac Mortgage Trust.
Mortgage servicing is an unusual asset. A mortgage servicer handles the administrative tasks of the mortgage loan on behalf of the investor. The servicer sends out the monthly bills, collects payments, forwards the principal and interest payments to the investor, ensures property taxes are paid, and works with the borrower in the event of a delinquency. The servicer is compensated 0.25% of the outstanding mortgage per year. In other words, if you have a $600,000 mortgage, the servicer gets $1,500 a year for sending out bills and statements.
The right to perform this duty is worth something, and it gets capitalized on the balance sheet as an asset. Mortgage servicing is one of the few assets out there that increases in value as interest rates rise. This is because rising rates remove the incentive for borrowers to refinance their mortgage.
That lack of incentive to refinance has been the status quo over the past six months or so. If you have a 3.5% mortgage, there is no incentive to pay it off and borrow money at 7%. This means the servicer on that $600,000 loan can expect to earn that $1,500 fee for a longer period of time, which makes the mortgage servicing right worth more. That dynamic drove last year's bull market in mortgage servicing rights and it helped PennyMac Mortgage Trust balance out losses in its other two segments.
But some events this month might indicate a change is coming.
The future path of interest rates may be changing
The banking crisis that dominated the news over the past month has caused many market participants to reevaluate their forecast for the federal funds rate this year. The fed funds futures index now sees a much better chance that the Federal Reserve will cut rates in 2023. Falling rates are not good for mortgage servicing rights.
According to one estimate, half of U.S. mortgages have a rate of 3.5% or less, and two-thirds have a rate of 4% or less. Mortgage rates will have to fall quite a bit before these borrowers will want to refinance, but the drop in rates will spur some refinance activity, which is bad for mortgage servicing rights. When a borrower refinances, the mortgage servicing right disappears.
PennyMac Mortgage Trust's mortgage servicing portfolio has $230 billion in unpaid principal balance, with an average servicing fee of 0.29%, which means the book generates about $667 million in annual revenue before expenses. The book is valued at $4 billion, which represents a multiple of 6.1 times the servicing fee. While mortgage servicing books are unique, this is an aggressive valuation. If rates drop and delinquencies rise, the valuation will fall.
PennyMac Mortgage Trust's management estimates that the diluted earnings per share from the company's current strategies will average about $0.40 per quarter. The mREIT just cut its quarterly dividend from $0.47 to $0.40, which means that it has almost no margin for error to cover the dividend.
PennyMac Mortgage Trust's investors are hoping that the economy reaches some equilibrium point that lets interest rates level off rather than fall. that will allow its two other segments to recover and its mortgage servicing segment to continue to perform well. If mortgage servicing valuations fall, the company may have to slash the dividend again. At current levels, the dividend yields 13.7%, but given the changing economic situation, that dividend is now not such a sure thing.
