PennyMac Financial Services, Inc. Q3 FY2024 earnings call

• PFSI reported net income of $69 million for an annualized return on equity of 8%. Excluding fair value changes, annualized operating ROE was 20%. - Production segment pretax income nearly tripled due to lower mortgage rates enabling refinancing. - Servicing portfolio nears $650 billion in unpaid principal balance with nearly 2.6 million customers. - Consumer Direct had locks nearly doubling and originations up nearly 70% from last quarter. - Refinance recapture rates improved due to technology enhancements, expected to continue improving. - Introduced closed-end second lien product in 2022 to help borrowers access home equity. - Proprietary servicing system enhanced for operational efficiencies.

Production segment: Pretax income was $108 million, up from $41 million in the prior quarter due to higher volumes across all channels. Acquisition and origination volumes were $32 billion in unpaid principal balance, up 17%. Correspondent lending had total acquisitions of $26 billion, up from $23 billion in the prior quarter. Broker Direct locks were up 24% from last quarter and originations were up 8%. Consumer Direct lock volumes were up 93% from the prior quarter and originations were up 69%. Servicing segment: Recorded a pretax loss of $15 million. Excluding valuation-related changes in nonrecurring items, pretax income was $151 million. Loan servicing fees were up, custodial funds managed averaged $6.9 billion in the third quarter, up from $5.7 billion in the second quarter.

• Expect annualized operating returns on equity in the high teens to low 20s in 2025. - Production segment expected to have strong contribution in Q4 despite rate changes and seasonality. - Market origination volume expected to be $2.3 trillion in 2025 depending on interest rates.

• Interest rate volatility impacting MSR fair value. - Potential impact of delinquency uptick, but expected to be manageable with efficiency enhancements.

Q: Hoping you could share what you're seeing in terms of lock volume and consumer direct in the past couple of weeks as post the Fed as rates have started backing up?

A: David Spector said lock volume came off highs, down 30-ish%, but Broker Direct has share gains and Consumer Direct still sees good refinance activity but slowdown from highs.

Q: And I guess along those lines, if you could just talk about capacity management kind of as volumes ramped up your ability to kind of meet that from capacity? And then if volumes are off, kind of how that plays through today?

A: David Spector said they spent 2022-2023 running capacity tight, increased capacity earlier this year, will run excess capacity as it's least expensive and economic. Dan Perotti added loan officers focused on second lien opportunities when rates increase and can redirect to refinances when rates decline.

Q: First, can you speak to your near-term outlook for ROE following the really strong third quarter, just with rates have backed up a bit in recent weeks? And then for 2025, presentation states expected ROEs in the high teens to low 20s. Can you just discuss a little bit what's implied in the estimates from the origination side, and then ROE expected to be higher as you move through the year in 2025?

A: Dan Perotti said Q4 operating ROE dependent on rates, can achieve mid-teens if rates higher, higher if rates lower. 2025 ROEs in high teens to low 20s implied by production levels and interest rates.

Q: Actually, I wanted to go back to the MSR hedge. I mean, historically, your MSR hedge covered 80%. The mark, it was pretty close to that level this quarter, but you've been targeting higher levels recently. So, can you discuss the hedge performance this quarter just relative to your expectations?

A: Dan Perotti said hedge covered about 80% of MSR change before hedge costs, in line with targeting, but hedge costs exceeded normal range due to yield curve inversion and volatility, but costs have come back to normal range in Q4.

Q: Has anything that surprised you with that mini refi boom we just had that 1.5 months, for example, where the higher note rate borrowers more likely to refi any thoughts?

A: David Spector said inbound traffic, jumbo activity increase, broker share gains, and tripling of production surprised him, showing power of flywheel.

Q: I was wondering if you just give a subservicing update. I know you talked previously about expecting some subservicing deals to happen in Q4, I don't think I heard anything in the prepared remarks. Any update to that? Do you still expect that to happen and excited about the opportunity?

A: David Spector said expect one or two smaller customers by year-end, in discussions with larger clients, technology generating interest.

Q: So, your servicing margins kind of held steady at about 9.5 basis points the last two quarters. Can you maybe just talk about how sustainable that is into next year even as kind of delinquencies continue to tick up?

A: Dan Perotti said sustainable with efficiency enhancements and scale growth, expecting similar margins next year despite potential delinquency uptick offset by cost reductions.

Q: Looking at the chart of the servicing operating expenses on Slide 7, there's been a pretty consistent improvement there over the last few years. I guess as you look forward, would you say we're at a point where that improvement starts to level out a little bit? Or as you think over the next couple of years and some of the new technology on board comes on board? How much lower do you think the expense efficiencies can realistically get on the servicing side?

A: Dan Perotti said still significant room for expense efficiencies, expecting at least 30% further reduction in operating expense metric over time.

Q: Just looking at the production expenses, I think in your prepared remarks, you attributed the increase to the consumer direct channel. And kind of plugging the gap there, how should we think about Broker Direct kind of volume-related or variable expenses as that channel continues to gain market share?

A: Dan Perotti said variable expenses on broker side in mid-range double digits, expecting scale from growing channel.

Q: On Consumer Direct volume expectations, do you expect kind of the product mix from 3Q to kind of filter over to 4Q? Or are we going to see kind of more of a reversion back to second lien mix?

A: Dan Perotti said if rates stay higher, reversion to second lien mix; if rates dip, shift back to first lien refinances, depending on rate volatility.

Q: Just one quick one for me. I wanted to get your view on custodial balance earnings. I know there's probably going to be some seasonal declines in the fourth quarter. Just thoughts on how that part of the business trends into next year, if we do see a steeper decline in short-term rates. Is that something that could have an impact on servicing profitability? And how does that factor into your ROE expectations for next year?

A: Dan Perotti said decline in short-term rates would impact custodial earnings but offset by lower floating rate debt expense and lower realization of servicing cash flow, expecting offsets to maintain profitability.

Q: It looks like delinquencies increased sequentially by 70 basis points in FHA and 50 basis points in USDA portfolios. I know you mentioned it remains within expected levels and on a prior question, you cited that you don't expect a meaningful uptick in delinquencies next year. Can you just comment on what drove that sequential increase in delinquencies and kind of what gives you confidence on delinquency formation going forward for more of the recent Ginnie Mae originations if rates stay elevated?

A: David Spector said delinquency increase due to noise like business days, expects rates below 5% make staying in homes top priority, delinquencies to remain historically low.

Q: How should we think about refinancing the 5 3/8% bond in October 2025? I mean those are fairly low coupon, but they're now current. So how should we think about financing costs going forward?

A: David Spector said will look to refinance before maturity, have $3.8 billion liquidity including secured lines, expect to issue debt to refinance before maturity.