PennyMac continues to grow

PennyMac (PMT) reported Q1 earnings this morning

PennyMac is somewhat of an odd type of REIT. It operates in three different segments: mortgage origination, servicing, and distressed assets. As an originator, they typically purchase loans from smaller originators instead of originating their own pipeline. They are launching a new jumbo product (jumbo loans are large-size loans which are above conforming limits), and anticipate doing their first private label securitization in the third quarter. They continue to retain servicing and their servicing portfolio has risen to $17 billion principal amount.

Highlights of the quarter

  • Earnings Per Share increased 8% to $.90
  • Return on equity jumped to 18% from 16% the prior quarter
  • Net Investment income declined
  • Origination volume decreased 26% from the previous quarter
  • Acquired $366 million unpaid principal balance (UPB) of distressed whole loans

Top-down look at the industry

Management noted that the housing recovery is firmly in place and competition is increasing in the origination market. The distressed whole loan market seems to be picking up again as sellers begin to let go of inventory. In fact, they have already committed to buy more loans in Q2 than they did in all of Q1. A lot of institutional money was raised to bid on distressed whole loans and for the most part, it hasn’t been able to be put to use.  Perhaps that is changing – it would be good to get a more balanced market again.

In origination, the market is becoming more competitive, with large players remaining active participants (think Wells Fargo (WFC)). Margins are decreasing, but are still above historical norms. Last year, margins were high as there was a huge chunk of capacity taken out of the market when Bank of America exited the correspondent business.

In mortgage servicing rights (MSRs), demand remains strong, and non-banks like PennyMac are taking advantage of the regulatory arbitrage created by Basel III. The large banks must fully reserve MSRs above a certain capital level, so they are selling them. This has created pressure on MSR pricing (along with regulatory fears). That said, MSR valuations are quite low at the moment, and PennyMac views them as an opportunity.

Impact on the mortgage REITs

PennyMac is really different than a Capstead (CMO) or an Annaly (NLY) or an American Capital (AGNC).  They generally purchase newly-issued MBS and rely on leverage to create a return. In fact, PennyMac  views mortgage spreads as too tight due to the Fed’s asset purchase program, also known as quantitative easing (QE), and they see limited return potential without taking significant risk. As far as interest rate risk and prepayment risk, PennyMac is going to be more sensitive to real estate pricing than interest rates – distressed whole loans generally trade at a discount to the underlying collateral value and the amount the borrower actually owes is more or less irrelevant. In other words, a $150,000 mortgage on a $100,000 house is going to trade at more or less the same level as a $250,000 mortgage on a $100,000 house. And since underwater homeowners generally don’t (can’t) prepay, prepayment risk is negligible as well. So there isn’t a lot of read-across to the other mortgage REITs, although PennyMac’s new jumbo push is going to compete directly with Redwood Trust (RWT).