Pennymac Mortgage Investment Trust annual report, FY2014

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PennyMac Mortgage Investment Trust (NYSE: PMT) — 2014 Form 10-K

Business context and period. The filing covers the fiscal year ended December 31, 2014; it is an annual report, not a standalone fourth-quarter filing. PMT is an externally managed mortgage finance REIT focused on residential mortgage loans and related assets. Its two main activities are correspondent loan production and investment in distressed loans, real estate owned (REO), mortgage-backed securities (MBS), mortgage servicing rights (MSRs) and excess servicing spread (ESS). PennyMac Financial Services affiliates provide management and servicing, and PMT has no employees.

Financial performance and position

  • Income: Net investment income was $356.7 million, down 12.0% from $405.5 million in 2013. Net income was $194.5 million, down 2.8% from $200.2 million. Diluted EPS fell to $2.47 from $2.96; basic EPS was $2.62 versus $3.13. The 2014 result included a $15.1 million income tax benefit, compared with a $14.4 million provision in 2013.
  • Income mix and earnings quality: Net investment income included $201.8 million of net gains on investments, $86.8 million of net interest income, $37.9 million of net loan servicing fees and $35.6 million of gains on mortgage loans acquired for sale. REO results were a $32.5 million loss. The filing reports $235.7 million of non-cash fair-value and interest adjustments; reported income therefore does not equal current-period cash generation.
  • Margins: Net interest margin was 2.45%, compared with 2.13% in 2013; net interest spread was 1.90%, versus 1.06%. Net interest income increased to $86.8 million from $57.6 million as the investment portfolio grew. These measures do not capture the full effect of fair-value gains and losses.
  • Cash flow: Operating activities used $366.0 million, versus $242.8 million used in 2013, principally reflecting growth in loans held for sale and receipt of MSRs as loan-sale consideration. Investing activities provided $28.0 million, compared with $1.0 billion used in 2013. Financing activities provided $387.0 million, down from $1.27 billion. Cash increased $49.0 million to $76.4 million; short-term investments were $139.9 million.
  • Assets and equity: Total assets rose 13.8% to $4.90 billion; shareholders’ equity was $1.58 billion, up from $1.47 billion. Book value per share was $21.18, versus $20.82. At year-end, the portfolio included $2.73 billion of mortgage loans at fair value, $637.7 million of loans held for sale, $357.8 million of MSRs, $303.2 million of REO, $307.4 million of MBS and $191.2 million of ESS.
  • Debt and leverage: Total borrowings were $3.17 billion, including $2.73 billion under repurchase agreements, $20.2 million under a mortgage-loan participation and sale agreement, $165.9 million of asset-backed financing and $250 million of 5.375% exchangeable notes due 2020. The reported leverage ratio was 2.01x borrowings to year-end equity, up from 1.83x. Most repo funding is short term and secured by pledged assets; margin calls and covenant requirements can constrain liquidity.
  • Dividends and shares: Dividends declared were $2.40 per share, down from $2.87 in 2013; dividends paid were $2.38 per share. Quarterly declarations were $0.59, $0.59, $0.61 and $0.61. The year-end share price was $21.09, compared with $23.42 a year earlier. PMT issued about 3.8 million shares in 2014 and received approximately $89.5 million net.

Material changes versus 2013

  • Correspondent production purchases declined to $28.4 billion from $32.0 billion. Segment pretax income fell 80% to $8.8 million from $43.9 million, reflecting lower volume and narrower gain-on-sale margins amid increased competition and a smaller mortgage market.
  • Investment-activities pretax income decreased modestly to $170.6 million from $174.0 million. The average investment portfolio grew 63% to about $2.9 billion, while higher servicing and resolution costs offset part of the increased investment income.
  • Distressed mortgage and REO purchases fell to $560.5 million from $1.31 billion; liquidation proceeds rose to $788.0 million from $392.1 million. Management said it remained selective because recent purchase pricing was generally less attractive.
  • Net gains on mortgage loans acquired for sale declined to $35.6 million from $98.7 million. Conversely, net interest income increased, supported by portfolio growth and lower average financing costs.
  • REO carrying value more than doubled to $303.2 million, and net REO losses widened to $32.5 million from $13.5 million, reflecting increased property valuation adjustments and a larger inventory.
  • ESS fair-value results moved to a $20.8 million loss from a $2.4 million gain, as falling mortgage rates raised expected prepayments. MSRs also recorded a $16.6 million fair-value decrease, before other servicing and hedge effects.

Outlook, risks and notable items

  • Management outlook: Management cited industry forecasts of roughly $1.2 trillion in U.S. mortgage originations for 2015, approximately flat with 2014. It expected continued distressed-loan supply but said pricing had become less attractive, and described a patient, selective investment approach. It planned to expand correspondent sellers and products, retain MSRs, acquire ESS and pursue small-balance commercial mortgage loans. No company earnings or dividend guidance was provided.
  • Market conditions: Management reported improving employment and declining delinquencies, but slower housing-market improvement. Lower mortgage rates during 2014 increased refinancing expectations and pressured ESS and MSR valuations; competition weighed on correspondent margins. Management noted that distressed-loan resolution and cash realization can take substantial time.
  • Valuation uncertainty: At year-end, 62% of total assets were measured using Level 3 inputs, which are significant unobservable assumptions. Mortgage-loan values are particularly sensitive to home-price assumptions; the filing estimates a 10% decrease in property values would reduce the fair value of the mortgage-loan portfolio by about $143.9 million. Actual realizations may differ materially from estimates.
  • Funding and liquidity: Repo borrowing involves short maturities, collateral haircuts, margin calls and financial covenants. Some assets, including MSRs and ESS, lack direct secured financing. The company depends on continued access to debt and equity markets and on maintaining minimum cash and tangible-net-worth levels.
  • Other principal risks: Credit losses, foreclosure delays, borrower defaults, prepayments, interest-rate changes, counterparty and repurchase exposure, Agency/GSE policy changes, mortgage regulation, REIT qualification and Investment Company Act compliance are key risks. Reliance on affiliated manager and servicer creates operating and potential conflict-of-interest risks.
  • Related-party and unusual items: PMT paid its affiliates $35.0 million in management fees, including $11.7 million in incentive fees, and $52.5 million in servicing fees. It purchased $99.7 million of ESS from PFSI. The reported cash-flow pattern reflects that a substantial portion of income is fair-value based and cash may arrive only after loan payoff, sale or property liquidation.
  • Subsequent events: After year-end, PLS entered into letters of intent to acquire Agency MSR portfolios, with PMT intending to purchase approximately $29 million and $140 million of associated ESS, subject to closing conditions. PMT also entered a new JPMorgan repurchase facility of up to $500 million in February 2015.
  • Contingencies and controls: PMT reported no material legal proceedings at December 31, 2014. The independent auditor issued unqualified opinions on the financial statements and internal controls; management concluded disclosure controls and internal control over financial reporting were effective.

Most important facts for investors to verify

  1. How much of reported earnings and book value depends on Level 3 valuations and non-cash fair-value changes, and how those estimates compare with subsequent loan and REO realizations.
  2. Whether operating cash flow, loan liquidations and available financing can support dividends, portfolio funding and margin-call needs without relying on repeated equity issuance.
  3. Whether correspondent margins and volumes stabilize, and whether distressed-loan acquisitions can earn adequate returns at current purchase prices.
  4. How falling rates, prepayment speeds and servicing costs affect the value and cash flows of MSRs and ESS, including the risks tied to affiliated servicing and ESS transactions.
  5. Repurchase-agreement maturities, borrowing capacity, covenant headroom, collateral requirements and lender/counterparty concentration.
  6. Credit performance and resolution progress for the nonperforming-loan and growing REO portfolios, including the assumptions behind recoveries and repurchase liabilities.
  7. Future dividend decisions, REIT qualification and the effect of taxable income, cash-flow timing and financing covenants on distributions.