Pennymac Mortgage Investment Trust annual report, FY2016

PennyMac Mortgage Investment Trust — 2016 Form 10-K

Reporting period: Fiscal year ended December 31, 2016. The filing is an annual report, not a standalone fourth-quarter filing; selected Q4 results are included below. PMT is an externally managed mortgage REIT with correspondent-production and investment-activities segments. It aims to generate long-term returns primarily through dividends and secondarily through share-price appreciation.

Financial performance and key metrics

Metric	2016	2015
Net investment income	$272.1 million	$248.8 million
Expenses	$210.3 million	$175.5 million
Pre-tax income	$61.8 million	$73.3 million
Net income	$75.8 million	$90.1 million
Diluted EPS	$1.08	$1.16
Net interest income	$72.4 million	$76.6 million
Net interest margin / spread	1.51% / 1.26%	1.68% / 1.23%
Declared dividends per share	$1.88	$2.16

Net income fell about 16% year over year. The tax benefit of $14.0 million lifted net income above pre-tax income; most business activity is conducted through a taxable REIT subsidiary and is subject to corporate tax. Correspondent production pre-tax income increased to $70.5 million from $32.9 million, while investment activities shifted to a pre-tax loss of $8.7 million from income of $40.4 million.

For Q4 2016, net income was $31.2 million and diluted EPS was $0.44; the quarterly dividend declared was $0.47 per share.

Balance sheet, cash flow and liquidity

• At year-end, total assets were $6.36 billion, total liabilities $5.01 billion, and shareholders’ equity $1.35 billion. Book value was $20.26 per share, versus $20.28 a year earlier.
• Cash was $34.5 million and short-term investments were $122.1 million. Operating cash flow was negative $621.5 million; investing activities provided $194.0 million and financing activities provided $404.0 million. Cash declined $23.6 million during the year. The operating cash outflow primarily reflected the working-capital demands of growing mortgage-loan inventory.
• Year-end borrowings included $3.81 billion of repurchase and mortgage-loan participation financing, $275.1 million of notes payable, $246.1 million of exchangeable notes, $353.9 million of VIE asset-backed financing, and $150.0 million payable to PFSI. The filing reports a 3.58x leverage ratio, up from 2.81x in 2015; 98% of invested assets in financed classes were pledged.
• Most facilities are short-term and secured by assets. Lenders may make margin calls if collateral values decline. The filing states that debt facilities maturing between year-end and the report date had been renewed or extended.
• Contractual obligations totaled $6.51 billion, including $1.42 billion of commitments to purchase correspondent loans. Required cash, tangible-net-worth, profitability and leverage covenants apply. Management said liquidity was sufficient for current needs, while noting continued reliance on asset liquidations, borrowings and potential equity offerings.

Business changes and portfolio developments

• Correspondent loan purchases rose to $66.1 billion at fair value from $46.4 billion in 2015, including $42.2 billion of government-insured or guaranteed loans and $23.9 billion of Agency-eligible loans. PMT reported being the second-largest U.S. correspondent aggregator in 2016.
• PMT continued shifting away from distressed whole loans toward investments arising from correspondent production, including MSRs and credit risk transfer agreements (CRTs), and toward MBS. It made no distressed-loan acquisitions in 2016 and received $947.7 million from distressed-loan and REO liquidations, payoffs, paydowns and sales.
• At year-end, distressed mortgage loans were $1.35 billion, down from $2.10 billion; nonperforming loans were $743.0 million, down from $1.22 billion. Agency MBS increased to $865.1 million from $225.2 million. MSRs rose to $656.6 million from $459.7 million, while excess servicing spread (ESS) fell to $288.7 million from $412.4 million.
• CRT-related investments, including deposits and derivatives, were $465.7 million at year-end; mortgage loans sold under CRT agreements had $11.19 billion UPB. PMT reported $32.5 million of CRT gains for 2016.
• PMT repurchased 7.4 million common shares for $98.4 million during 2016, leaving $85.3 million available under its $200 million authorization. Common shares outstanding were about 66.7 million at year-end.

Management commentary, outlook and risks

Management attributed weaker investment results mainly to losses on ESS and mortgage loans. Lower mortgage rates during much of 2016 increased expected prepayments on underlying MSRs, weighing on ESS values. For distressed loans, management cited longer expected liquidation periods, higher holding costs, lower expected liquidation proceeds and higher redefault expectations. CRT gains and hedging results partly offset those losses. Correspondent production gains increased with higher loan volume and margins.

The filing cites industry estimates of $1.5 trillion in 2017 U.S. mortgage originations, down from an estimated $1.9 trillion in 2016; this is an industry forecast, not company guidance. Management highlighted continuing opportunity in CRT and MSRs, but described the jumbo securitization market as limited and reported only about $14 million of jumbo loan production in 2016, compared with $125 million in 2015. No specific company earnings or dividend guidance is provided. The board retains discretion over future distributions; PMT intends to distribute at least 90% of REIT taxable income but has no minimum dividend commitment.

• Valuation and earnings quality: Fair-value changes are significant, and Level 3 assets represented about 41% of total assets. Management reported non-cash items equal to 128% of net investment income, including fair-value effects and MSRs recognized in loan sales; reported income therefore does not equate to cash generated.
• Rates and prepayments: Rising rates can pressure MBS and correspondent loan values; falling rates can accelerate refinancing and reduce MSR and ESS values. Hedging may not fully offset these exposures.
• Funding and collateral: Short-term secured financing, margin calls, covenant requirements and lender concentration could constrain liquidity or force asset sales at unfavorable prices.
• Credit, servicing and housing: Borrower defaults, foreclosure delays, collateral values, loan modifications, repurchase claims and servicing advances can affect returns. Management noted that foreclosure activity was expected to remain above historical averages through 2017 and beyond.
• CRT, related parties and regulation: CRT returns depend partly on models and the continued availability and treatment of these structures. PMT relies heavily on affiliated manager PCM and servicer PLS; their agreements, fees, potential conflicts and performance are material considerations. Agency, CFPB, REIT and Investment Company Act requirements also create risks.
• Unusual and governance items: The prior Fannie Mae ESS acquisition agreement was terminated in February 2016, and PLS reacquired $59.0 million of related ESS. A new Ginnie Mae ESS financing structure was established in December 2016. David A. Spector became CEO effective January 1, 2017, succeeding Stanford L. Kurland, who became executive chairman.

The company reported no material legal proceedings at year-end. The financial statements received an unqualified audit opinion, and management and the auditor concluded internal control over financial reporting was effective as of December 31, 2016.

Important facts for investors to verify

• How much of earnings and dividend capacity is supported by realized cash flows versus non-cash fair-value adjustments and capitalized interest.
• Whether correspondent-production margins and volumes can support higher fulfillment expenses and a lower industry origination outlook.
• CRT portfolio loss exposure, collateral-deposit requirements, model assumptions and dependence on Fannie Mae programs.
• Repo maturities, available committed financing, margin-call headroom, covenant compliance and the ability to fund loan-purchase commitments.
• MSR and ESS valuation sensitivities to rates, prepayments, servicing costs and PLS performance, including the risks of affiliated-party arrangements.
• Whether dividends remain sustainable given the $1.88 declared per share versus $1.08 diluted EPS, recognizing that REIT taxable income differs from GAAP earnings.