PennyMac Mortgage Investment Trust: Q3 2014 Form 10-Q
Business context and period. Unaudited results cover the quarter and nine months ended September 30, 2014, compared with the corresponding 2013 periods. PMT is an externally managed mortgage REIT with correspondent loan production and investment activities, including distressed mortgage loans, real estate acquired through loan resolutions (REO), mortgage-backed securities (MBS), mortgage servicing rights (MSRs) and excess servicing spread (ESS). Amounts below are in U.S. dollars; financial statement figures are generally in millions unless noted.
Financial performance and position
- Income and earnings: Q3 net investment income was $106.5 million versus $86.1 million; net income was $54.9 million versus $39.7 million. Diluted EPS was $0.69 versus $0.57. For nine months, net investment income was $303.7 million versus $309.4 million and net income was $168.0 million versus $147.5 million; diluted EPS declined to $2.13 from $2.29.
- Income mix: Q3 net interest income was $19.2 million versus $15.8 million; net gains on investments were $70.4 million versus $49.1 million. Nine-month net interest income was $65.4 million versus $34.1 million, and investment gains were $186.1 million versus $159.9 million. These totals include significant noncash fair-value changes.
- Margins: Net interest margin was 2.07% for Q3 and 2.47% for the first nine months, compared with 2.02% and 1.81%, respectively, in 2013. Net interest spread was 1.50% and 1.78%, versus 1.00% and 1.30%.
- Cash flow: For nine months, operating activities used $383.4 million, investing activities provided $308.3 million and financing activities provided $94.2 million; cash increased $19.1 million to $46.5 million. Operating cash use primarily reflected correspondent loan inventory growth. Net income should not be read as cash generation: fair-value gains and other noncash items were material.
- Balance sheet and liquidity: At September 30, total assets were $4.605 billion, liabilities $3.017 billion and shareholders’ equity $1.588 billion, compared with $4.311 billion, $2.844 billion and $1.467 billion at year-end 2013. Cash was $46.5 million and short-term investments $37.5 million. Repurchase borrowings were $2.417 billion; the company also had $166.8 million of nonrecourse VIE financing and $250 million of 5.375% exchangeable notes due 2020. No forward-purchase borrowings remained outstanding. Reported leverage was 1.78x, using total borrowings divided by equity.
- Funding capacity: Repurchase facilities had $1.473 billion of stated available capacity at quarter-end ($579.0 million committed and $894.3 million uncommitted). Repurchase funding is short-term, subject to renewal and margin calls; management reported that all agreements maturing between quarter-end and the report date had been extended, renewed or repaid.
- Portfolio and distributions: Mortgage loans at fair value were $2.562 billion, mortgage loans held for sale $688.9 million, REO $275.2 million, MSRs $345.8 million and ESS $187.4 million. The company declared dividends of $0.61 per share for Q3, versus $0.57; nine-month declared dividends were $1.79 versus $1.71. Book value was $21.42 per share.
Material changes versus comparable periods
- Q3 earnings improved, mainly from higher gains on investment mortgage loans and a larger investment portfolio. Nine-month diluted EPS nevertheless fell year over year, notwithstanding higher net income, amid share-count growth and weaker correspondent production contribution.
- Correspondent loan purchases were $20.8 billion for nine months, down from $26.0 billion. Net gains on loans acquired for sale fell to $29.7 million from $84.7 million, which management attributed to lower production margins, increased competition and higher mortgage rates than in early 2013.
- Investment activity was less acquisition-driven: PMT made no distressed-loan or REO purchases in Q3, citing less attractive pricing, and bought $287.5 million of distressed mortgage loans over nine months versus $1.028 billion a year earlier. Meanwhile, REO rose to $275.2 million from $148.1 million at year-end 2013, and REO losses increased to $23.9 million for nine months from $7.5 million, reflecting valuation write-downs and portfolio growth.
- Repurchase borrowings increased from $2.040 billion at year-end, while forward-purchase borrowings of $226.6 million were fully repaid. Equity increased to $1.588 billion, including $82.5 million in gross proceeds from share offerings during the nine months.
Outlook, risks and unusual items
- Outlook: PMT gave no quantified company earnings or dividend guidance. Management described lower industry mortgage originations, continued production-margin pressure and selective investment in distressed loans. It cited an industry forecast of $1.1 trillion in 2014 mortgage originations versus $1.9 trillion in 2013, and said it expected distressed-loan supply to continue but recent pricing was less attractive.
- Key risks: The portfolio is exposed to borrower defaults, home-price changes, foreclosure delays, prepayment and interest-rate movements, and counterparty and financing risks. A substantial portion of investment assets is nonperforming; management estimated about 45% of specified investment assets were nonperforming at quarter-end. Approximately 71% of the fair value of distressed mortgage loans was nonperforming.
- Valuation and earnings quality: Many assets are Level 3 fair-value measurements based on unobservable assumptions. Nine-month net investment income included $212.6 million of identified noncash fair-value and interest adjustments. Mortgage-loan gains and REO values depend on estimates, market conditions and resolution outcomes; management cautioned that its sensitivity analyses are not earnings forecasts.
- Liquidity and operating risks: Short-term repo financing creates refinancing and margin-call exposure, and substantial assets are pledged. MSRs and ESS generally lacked direct secured financing, which management said could constrain liquidity or investment capacity. PMT also depends on affiliated manager PCM and servicer PLS; related-party fees and transactions are significant. REIT status requires distribution of at least 90% of taxable income.
- Contingencies and subsequent events: The liability for representations and warranties was $13.2 million; pending repurchase claims covered loans with $20.0 million unpaid principal balance. Management said repurchase losses could change materially, although it considered reasonably possible losses beyond the reserve not material. No litigation was identified as likely to have a material adverse effect. On October 1, PMT closed an approximately $166 million asset-backed note transaction through subsidiaries; agreements maturing after quarter-end through the report date were extended or renewed. Management reported effective disclosure controls and no material change in internal control over financial reporting.
Important facts for investors to verify
- How much reported earnings and book value depend on Level 3 valuations and whether those gains convert to cash through loan payoffs, sales or property resolutions.
- Repo maturities, committed versus uncommitted availability, collateral and margin-call terms, and compliance with cash, net-worth and leverage covenants.
- Trends in distressed-loan delinquencies, modifications, defaults, REO inventory and valuation write-downs, including the effect of foreclosure timing and home prices.
- Correspondent production volumes and margins, and the sustainability of dividend coverage given lower nine-month diluted EPS and material noncash income.
- Related-party servicing, management and fulfillment fees; counterparty exposure; and the scope and development of repurchase and indemnification claims.