Business context and reporting period
PennyMac Financial Services, Inc. (PFSI) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2020. Its businesses are mortgage loan production, servicing, and investment management; the investment management business and some servicing activities are conducted for PennyMac Mortgage Investment Trust (PMT).
Key financial metrics
Amounts below are in millions of dollars, except per-share data and percentages.
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Total net revenue | $821.6 | $303.0 | $1,543.5 | $550.7 |
| Income before taxes | $480.4 | $99.6 | $895.1 | $159.9 |
| Net income | $352.7 | $72.7 | $658.9 | $118.8 |
| Diluted EPS | $4.39 | $0.92 | $8.11 | $1.50 |
| Net interest income (expense) | $(5.9) | $18.0 | $5.2 | $38.8 |
| Net loan servicing fees | $22.3 | $59.1 | $280.1 | $139.7 |
- Q2 pretax margin was approximately 58.5% and net margin 42.9%, versus 32.9% and 24.0%, respectively, in Q2 2019. These margins reflect a period with unusually strong production results and significant fair-value movements.
- Six-month operating cash flow was $365.6, compared with cash used of $881.9 in 2019. Investing cash flow was $986.1; financing cash flow was $(629.9). Cash and restricted cash increased $721.8 to $910.4.
- At June 30, total assets were $23.23 billion, liabilities $20.75 billion, and stockholders’ equity $2.48 billion. Cash was $910.3 million, including $896.1 million pledged to creditors. Mortgage servicing rights (MSRs) were $2.21 billion, down from $2.93 billion at year-end 2019.
- Reported short-term debt was $4.30 billion and long-term debt $1.46 billion. Separately, $13.76 billion of loans eligible for repurchase was matched by an equal liability; this sharp balance-sheet increase largely reflects delinquent loans and should not be read as equivalent to an increase in net debt.
- The servicing portfolio totaled $388.3 billion in unpaid principal balance, up from $368.7 billion at December 31, 2019.
Material changes versus the prior comparable period
- Q2 net revenue rose about 171% year over year, and net income rose about 385%. Management attributed the increase mainly to higher production volume and improved gain-on-sale margins amid low rates and constrained industry capacity.
- Q2 net gains on loans held for sale increased to $682.2 million from $147.5 million. Loan origination fees increased to $58.9 million from $36.9 million, and PMT fulfillment fees to $52.8 million from $29.6 million.
- Servicing fees themselves grew with portfolio expansion, but Q2 net loan servicing fees fell to $22.3 million from $59.1 million, primarily due to MSR, servicing-liability and excess-servicing-spread valuation changes, net of hedging. The servicing segment reported a Q2 pretax loss of $62.4 million, versus a $2.7 million loss.
- Total expenses rose to $341.3 million from $203.4 million, driven mainly by higher compensation, servicing and loan-origination costs as activity and staffing expanded.
- Q2 net interest turned to an expense, chiefly reflecting lower custodial-fund placement income and higher interest shortfalls from loan payoffs; lower borrowing rates partly offset these factors. Six-month net interest income also declined year over year.
- MSR fair value declined about 24% from December 31, 2019. Management said lower-rate-driven prepayment expectations, expected servicing costs, and increased market-required returns contributed to the decline; hedging results and changes in excess servicing spread partly offset the impact.
Outlook, risks, contingencies and unusual items
- COVID-19 and forbearance: The filing reports that 11% of the company’s predominantly government-insured or guaranteed MSR portfolio was in forbearance and delinquent at June 30. COVID-related forbearance loans shown in the servicing portfolio totaled $35.4 billion. Management warned of servicing-cost increases, required principal-and-interest and escrow advances, reduced servicing income, and uncertain effects on liquidity, capital and MSR values.
- Funding and liquidity: PFSI said it believed liquidity was sufficient and that it complied with applicable debt and Agency covenants. It had $910.3 million in cash, an unused $150 million corporate revolving line, and $2.09 billion of reported uncommitted repurchase borrowing capacity, which depends on eligible collateral and margin requirements. A new facility provides up to $600 million of capacity for specified Ginnie Mae servicing advances. Management noted ongoing discussions with lenders about additional advance financing.
- Leverage and commitments: Repurchase funding is generally short term and subject to margin calls; the filing lists multiple facility maturities in 2020 and 2021. Commitments to purchase and fund mortgage loans were $12.2 billion. Aggregate contractual obligations were $18.3 billion. Management said facilities maturing between June 30 and the report date had been renewed or extended.
- PMT exposure: PMT generated 9% of Q2 net revenue, down from 31% a year earlier. PMT reported a $130 million net loss for the first half; PFSI said it did not expect to earn performance incentive fees from PMT for the foreseeable future. Agreements with PMT were renewed for five years; revised MSR recapture and service fee terms became effective July 1, 2020.
- Industry outlook: Management cited third-party forecasts of approximately $3.0 trillion in U.S. mortgage originations for 2020 and $2.3 trillion for 2021. These are market forecasts, not company earnings guidance. The filing provides no specific PFSI earnings or EPS guidance.
- Capital returns: The board increased the share repurchase authorization to $500 million. PFSI repurchased 6.98 million shares from The BlackRock Foundation for $237.2 million, or $34 per share. It declared a $0.12-per-share Q2 dividend and subsequently announced a $0.15-per-share dividend payable August 28, 2020.
- Litigation and other exposures: A shareholder fiduciary-duty action and a Black Knight trade-secret and contract dispute remained pending; management considers them without merit, but potential loss ranges could not be estimated. The representation-and-warranty liability was $25.9 million, with $192.1 billion UPB of loans subject to representations and warranties. The filing also notes regulatory oversight and fair-value estimates that rely substantially on unobservable Level 3 inputs.
- The company adopted the credit-loss accounting standard effective January 1, 2020; adoption had no reported effect on income, equity or cash flows. Management stated disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- How much of the Q2 earnings surge reflects sustainable production economics versus volatile fair-value and hedging effects, and whether production margins can persist.
- Trends in COVID-related forbearance, delinquencies, servicing advances, advance-financing availability and related credit-loss provisions.
- MSR valuation assumptions and hedge effectiveness, including sensitivity to prepayments, discount spreads and servicing costs.
- Near-term renewal and maturity terms for short-term funding, collateral and margin-call exposure, and liquidity headroom under stressed conditions.
- Execution and economics of the revised PMT agreements, PMT’s recovery and the timing, if any, of future incentive fees.
- Developments in the pending litigation, representation-and-warranty claims, and Agency capital or liquidity requirement changes.