Times are tough in the mortgage business. The Federal Reserve's aggressive tightening campaign has raised interest rates and choked off mortgage refinancing activity. Higher rates also have hurt the values of mortgage-backed securities. PennyMac Mortgage Trust (PMT -0.28%) , a real estate investment trust (REIT) that is tied to the mortgage market, has a 12% dividend yield. Is this sustainable?
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PennyMac has a diversified business model
PennyMac Mortgage Trust has three basic business strategies: Credit-sensitive strategies, Interest-rate-sensitive strategies, and correspondent production. These different strategies separate PennyMac Mortgage Trust from the typical mortgage REIT, which focuses on investment income from mortgage-backed securities.
PennyMac Mortgage Trust's credit-sensitive strategies are based on investments in credit risk transfer (CRT) securities. CRT securities offer a way for the government-sponsored agencies that support the mortgage market, Fannie Mae and Freddie Mac, to lay off some of their credit risk. These securities are not guaranteed by the government.
PennyMac's interest-rate-sensitive strategies focus primarily on mortgage servicing rights. Mortgage servicing is an unusual asset. The mortgage servicer administers the mortgage on behalf of the ultimate investor (the mortgage-backed security holder). The servicer sends out the monthly bills, collects the payments, ensures property taxes and insurance is paid, and works with the borrower in the event of default. The servicer is paid 0.25% (or one-quarter of one percent) as compensation. The right to perform this service is worth something, and mortgage servicing rights trade in the market.
PennyMac Mortgage Trust's final business is correspondent production, in which PennyMac buys completed loans from smaller lenders and either holds them or bundles and securitizes them, selling them to other investors. PennyMac is the largest correspondent lender in the U.S.
Low mortgage delinquencies are helping PennyMac
In the second quarter of 2023, PennyMac Mortgage Trust earned most of its income from credit-sensitive strategies. This is being driven by exceptionally low mortgage delinquency rates. Low delinquency rates are due to the strong economy and policy steps that were taken during the COVID-19 pandemic. Strong home prices help as well.
Data source: YCharts.
The interest-rate strategies struggled in Q2. As rates rose, mortgage-backed securities fell in value, and the amount that PennyMac earned on its interest-rate hedges wasn't enough to offset the losses. Mortgage servicing was profitable, as delinquencies remained low and interest rates remained high. Mortgage servicing is one of the very few financial assets that goes up in value when rates rise.
The correspondent business also struggled, as the mortgage origination business is in a deep freeze amid high interest rates. That said, PennyMac originated $21.1 billion in mortgages, which was little changed on a year-over-year basis. Most mortgage originators are seeing declines in volume on a year-over-year basis.
The dividend is higher than earnings right now
In the second quarter of 2023, PennyMac Mortgage Trust earned $0.16 per share in net income. Mark-to-market losses on the agency mortgage-backed securities portfolio were the main driver. This is well below the company's quarterly dividend of $0.40. PennyMac cut its dividend last year from $0.47 to $0.40 as mortgage-backed security underperformance drove a decline in the company's book value. On the earnings conference call, PennyMac said that its "run rate" expected earnings was closer to $0.30, which is based on projected returns on the different strategies.
PennyMac acknowledged on the earnings conference call that forecasted earnings don't cover the dividend. Chief Financial Officer Dan Perotti said the company would see how earnings develop over the next quarter before making any decisions on the dividend. Once the Fed stops raising interest rates, mortgage-backed securities begin to recover, which will be supportive for the dividend. That said, investors should be careful if they're thinking about buying PennyMac shares.
