PennyMac Mortgage Investment Trust — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014. Amounts below are in U.S. dollars; financial statement amounts are in millions unless otherwise noted.
Business context
PennyMac is an externally managed mortgage REIT with two segments: correspondent production, which purchases and resells newly originated mortgage loans, and investment activities, which holds distressed mortgage loans, real estate acquired through loan resolution (REO), mortgage-backed securities, mortgage servicing rights (MSRs) and excess servicing spread (ESS). Management’s stated objective is long-term risk-adjusted returns, principally through dividends and secondarily through capital appreciation.
Key financial metrics
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Net investment income | $120.6 | $115.6 | $197.2 | $223.4 |
| Income before taxes | $73.3 | $67.9 | $109.6 | $123.8 |
| Net income | $75.2 | $54.5 | $113.1 | $107.8 |
| Diluted earnings per share | $0.93 | $0.86 | $1.44 | $1.75 |
| Declared dividends per share | $0.59 | $0.57 | $1.18 | $1.14 |
| Net interest income | $26.7 | $12.7 | $46.2 | $18.3 |
| Net interest margin / spread | 2.97% / 2.25% | 2.16% / 1.00% | 2.67% / 1.91% | 1.67% / 0.38% |
Q2 net income increased 38% year over year, while six-month net income rose about 5%; diluted EPS declined about 18% for the six-month comparison, reflecting a substantially larger weighted-average share count. Q2 net investment income increased modestly, but the six-month total declined. Reported net investment income includes significant noncash fair-value changes and capitalized interest; it should not be read as cash earnings.
- Fair-value results: Q2 and six-month net gains on investments were $73.1 million and $115.7 million. Management attributed stronger investment-segment results principally to portfolio growth and valuation gains on mortgage loans. Q2 gains on loans held for investment and related forward-purchase loans included $63.7 million of valuation gains.
- Correspondent production: Gains on mortgage loans acquired for sale fell to $10.2 million in Q2 and $20.2 million for six months, from $44.4 million and $73.7 million, respectively. Management cited lower origination volume, reduced production margins, higher rates and increased competition.
- Balance sheet at June 30: Assets were $4.87 billion, up 13% from year-end 2013; shareholders’ equity was $1.58 billion. Cash was $37.9 million and short-term investments were $104.5 million. Book value was $21.27 per share.
- Debt and leverage: Repurchase-agreement borrowings were $2.70 billion, asset-backed VIE financing was $170.2 million, and exchangeable notes were $250 million; total reported borrowings were about $3.12 billion. The defined leverage ratio was 1.98x, versus 1.83x at year-end. Repo borrowings carried a 2.09% weighted-average rate at period-end; the notes bear 5.375% and mature in 2020.
- Liquidity and cash flow: Six-month operating cash flow was negative $570.5 million, investing cash flow was positive $112.8 million, and financing cash flow was positive $468.2 million, resulting in a $10.5 million increase in cash. The operating outflow was primarily associated with correspondent-loan inventory. Reported repo borrowing capacity was $1.17 billion, of which $344.9 million was committed and $828.9 million uncommitted.
Material changes versus comparable periods
- Investment activities improved: Q2 segment pretax income rose to $70.9 million from $39.8 million; six-month segment pretax income rose to $104.0 million from $90.1 million. Correspondent production pretax income fell to $2.4 million in Q2 from $28.1 million and to $5.5 million for six months from $37.0 million.
- Correspondent loan purchases for sale totaled $7.3 billion in Q2 and $12.3 billion for six months, down from $8.9 billion and $17.8 billion. The mortgage-loan inventory held for sale was $909.1 million at quarter-end, versus $458.1 million at December 31, 2013.
- REO rose to $240.5 million from $138.9 million at year-end; Q2 and six-month REO results were losses of $5.3 million and $12.0 million, respectively, greater than the prior-year losses.
- Repo debt increased by $662.2 million from year-end, while forward-purchase borrowings were fully repaid; total assets and equity also expanded. The company issued 3.45 million common shares during the first half, generating approximately $81.6 million net proceeds.
- 2013 comparative interest expense was reclassified into net interest income presentation. The filing says this presentation change did not alter previously reported net income, equity or cash flows.
Outlook, commentary and risks
- Management expected 2014 mortgage originations to remain below 2013 levels, citing industry forecasts averaging $1.2 trillion versus $1.9 trillion in 2013. It described distressed-loan opportunities as available but recent pricing as less attractive, and said it would remain selective. These are management observations, not company earnings guidance.
- The company relies heavily on short-term repurchase financing, which exposes it to renewals, margin calls and collateral-value declines. About 93% of the specified financed asset classes were pledged at quarter-end; the filing reports a 76% advance rate on pledged assets.
- Portfolio performance depends on borrower cures, property values, foreclosure and liquidation timing, and the accuracy of significant Level 3 fair-value estimates. Approximately 72% of the fair value of the distressed-loan portfolio was nonperforming; management also reported that about 38% of investments were nonperforming assets.
- Interest-rate, prepayment, credit, housing-price, liquidity and counterparty risks are material. Lower rates can reduce MSR and ESS values through faster refinancing; changes in rates and housing prices also affect loan and hedge valuations. The filing notes that modeled sensitivities are not earnings forecasts.
- Management expects effective tax rates to be volatile. The company has elected REIT treatment and generally must distribute at least 90% of taxable income; failure to qualify could adversely affect taxes and operations.
- Related-party dependence is significant: the manager and servicer are PFSI affiliates. Q2 management fees were $8.9 million, and servicing fees payable to PFSI were $14.2 million. The filing describes possible conflicts, contractual fees and a potential management-agreement termination fee.
- The representations-and-warranties liability was $11.9 million; pending repurchase claims covered loans with $19.8 million unpaid principal balance. Management said no material-adverse legal proceeding was pending and that reasonably possible losses beyond the recorded liability were not material, while warning repurchase activity could increase as sold loans season.
- After quarter-end, the company entered a Bank of America loan repo facility with capacity up to $550 million, including $350 million committed through January 30, 2015, guaranteed by the company. The parties also agreed to wind down the prior Bank of America repurchase agreement; matured repo agreements through the report date were extended, renewed or repaid.
Important facts for investors to verify
- How much of reported earnings came from cash realization versus noncash fair-value gains, capitalized interest and other estimates.
- Current committed financing availability, the status and renewal terms of short-term repo lines, and exposure to margin calls; distinguish committed from uncommitted capacity.
- Performance and valuation assumptions for nonperforming loans, REO, MSRs and ESS, including housing-price, discount-rate and prepayment assumptions.
- Whether correspondent production margins and loan volumes stabilize, and how the shift toward investment-segment earnings affects repeatability and per-share results.
- Growth in repurchase claims and actual recoveries from correspondent lenders, alongside the adequacy of the $11.9 million representation-and-warranty reserve.
- Dividend coverage by taxable income and cash generation, REIT qualification, and the potential dilution or expense implications of the $250 million exchangeable notes.