PennyMac Financial profits on servicing, notes recession risks

It was a challenging third quarter for the industry, but PennyMac Financial beat consensus estimates by reporting a modest profit driven by servicing gains. Its real estate investment trust affiliate, however, did not fare as well.

The company recorded $135.1 million in net income, compared to $129.2 million the previous quarter and $249.3 million a year earlier. Its earnings per share of $2.46 was above the Zacks Investment Research’s consensus of $1.12.

Like other lenders, PennyMac has been struggling with lower originations and production margins in what’s generally been a rising rate environment. But the company derived some benefits from servicing’s countercyclical nature.

For example, origination margins have gotten particularly thin in the correspondent channel, but PennyMac has been able to offset that to a degree by the value in its servicing business.

“It’s the lowest margin of the channels, but it is a good way to build a servicing portfolio,” said Gene Berman, an analyst at Moody’s Investors Service.

However, while servicing currently has upsides, it also has some exposure to a possible turn in the economic cycle, which was recently flagged in some investor reports.

Executives acknowledged this risk in the company’s earnings call, noting offsets it has in place in the event a recession materializes.

“The probability for a recession has increased in recent periods,” said David Spector, the company’s chairman and CEO. “While we recognize the challenges this may present for our servicing business, we believe the risks are mitigated by the fact that consumers are financially in a strong position given the equity built up in their homes over the last couple of years combined with low levels of unemployment at present.”

Home equity will provide more protection for some loans than others, but generally it should help when it comes to mortgages originated during the refinancing boom of the last couple years, said Warren Kornfeld, a senior vice president at Moody’s Investors Service.

“Newly originated cash out loans from the last year, new purchase loans in the last year … those are at higher risk,” he said.

To a certain extent, PennyMac Financial is buffered against that risk on government mortgages by agencies like the Federal Housing Administration, but it is responsible for temporarily advancing payments when borrowers don’t pay, which could impact its finances. 

Generally, if a recession were to materialize, some relief would likely come from monetary policymakers easing rates that could spur more refinancing, returning cash to mortgage companies that could help cover their advances. However, mortgage servicers still have to weather the transition when that occurs, and the fact that many borrowers lowered their rates in the past two years could limit refinancing activity.

PennyMac’s exposure to this risk is in some ways relatively higher than some other companies due to its role as a key servicer in the mortgage-backed securities market protected by Ginnie Mae, which helps fund loans for people with more affordability constraints and has vulnerabilities in a downturn. 

But on the other hand, it has a larger financial buffer against that risk than other companies.

In its most recent earnings presentation, PennyMac quantified its current risk-based capital adequacy under rules Ginnie has pending, which are aimed at accounting for servicing risk in particular. Those numbers, which PennyMac said Ginnie will apply at the operating company level, show its loan services unit had a 39% risk-based capital ratio in 3Q. Although this is lower than the current non-risk-weighted leverage ratio of 50% that Ginnie looks at now, it is far in excess of the required 6%, and indicates PennyMac so far is in a good position to meet a requirement other companies have expressed concerns about.

Alternative analyses of capital adequacy done at the holding company level with some adjustments for servicing rights show that PennyMac’s is favorable compared to other public, nonbank mortgage companies, according to analysts at Moody’s.

PennyMac has “strong levels of capital at this point in time,” said Kornfeld.

While PennyMac Financial and its affiliated real estate investment trust continued to bear up relatively well in the most recent quarter, some of their risks do bear watching.

In addition to having responsibility for advances and absorbing some of the losses that  government agencies don’t, PennyMac Financial has had some exposure to early buyout loans that have had a negative impact on its results at times. Kornfeld said he didn’t see similar EBO concerns in the third quarter results.

Credit risk transfers could be a concern for PennyMac Mortgage Investment Trust, which, like the REIT sector in general, has been challenged by the impact of market volatility. CRTs selectively absorb some loan losses when mortgages underperform.

“If we do have an increase in charge-offs PMT is going to bear that with their CRT exposure,” Kornfeld said.

PennyMac Financial, the main lender-servicer operating unit, would have some options to de-couple itself from the REIT in the event it became a concern, but to date it’s been helpful as a funding vehicle, said Kornfeld.

“We think that’s a credit positive, but with spreads widening the profitability of the REIT is relatively modest,” he said.

PennyMac Mortgage Investment Trust earned $1.5 million in net income during the third quarter, compared to a net loss of $82.1 million in the previous one. It took a net loss of $43.9 million a year ago. Its $0.01 earnings per share underperformed a $0.41 consensus estimate by Zacks Investment Research.