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PFSI > SEC Filings for PFSI > Form 10-Q on 14-Aug-2013All Recent SEC Filings

Show all filings for PENNYMAC FINANCIAL SERVICES, INC.

Form 10-Q for PENNYMAC FINANCIAL SERVICES, INC.


14-Aug-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward-Looking Statements

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and the related notes of PennyMac Financial Services, Inc. included within this Quarterly Report on Form 10-Q and the final prospectus of PennyMac Financial Services, Inc. dated May 8, 2013 included as part of its Registration Statement on Form S-1, as amended (SEC File No. 333-186495) (the "Registration Statement").

Statements contained in this Quarterly Report on Form 10-Q may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors, which may cause actual results to be materially different from those expressed or implied in such statements. You can identify these forward-looking statements by words such as "may," "will," "should," "expect," "anticipate," "believe," "estimate," "intend," "plan" and other similar expressions. You should consider our forward-looking statements in light of a number of factors, including those described in "Factors that May Affect Our Future Results" and the risks discussed under the heading "Risk Factors" in the Company's final prospectus included as part of its Registration Statement, as well as its consolidated financial statements, related notes, and the other financial information appearing elsewhere in this Quarterly Report on Form 10-Q and its other filings with the United States Securities and Exchange Commission ("SEC"). The forward-looking statements contained in this Quarterly Report on Form 10-Q are made as of the date hereof and the Company assumes no obligation to update or supplement any forward-looking statements.

Overview

The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of our consolidated results of operations and financial condition. Unless the context indicates otherwise, references in this Quarterly Report on Form 10-Q to the words "we," "us," "our" and the "Company" refer to PennyMac Financial Services, Inc. ("PFSI").

Initial Public Offering and Recapitalization

On May 14, 2013, PFSI completed an initial public offering ("IPO") in which we sold approximately 12.8 million shares of Class A Common Stock par value $0.0001 per share ("Class A Common Stock") for cash consideration of $16.875 per share (net of underwriting discounts).

Before the completion of the IPO, the limited liability company agreement of Private National Mortgage Acceptance Company, LLC ("PennyMac") was amended and restated to, among other things, change its capital structure by converting the different classes of interests held by its existing unitholders into Class A Units. PennyMac and its existing unitholders also entered into an exchange agreement under which (subject to the terms of the exchange agreement) they have the right to exchange their Class A Units for shares of our Class A Common Stock on a one-for-one basis, subject to customary conversion rate adjustments for stock splits, stock dividends, reclassifications and certain other transactions that would cause the number of outstanding shares of Class A Common Stock to be different than the number of Class A Units that PFSI owns.

With the net proceeds from the IPO, we bought Class A Units of PennyMac and became its sole managing member. We operate and control all of the business and affairs and consolidate the financial results of PennyMac.

As part of the IPO, we entered into a tax receivable agreement with the then-existing unitholders of PennyMac that provides for payment to such owners of 85% of the tax benefits, if any, that we are deemed to realize under certain circumstances as a result of (i) increases in tax basis resulting from exchanges of New Holdings Units and (ii) certain other tax benefits related to our tax receivable agreement, including tax benefits attributable to payments under the tax receivable agreement.

Our Company

We are a specialty financial services firm with a comprehensive mortgage platform and integrated business focused on the production and servicing of U.S. residential mortgage loans and the management of investments related to the U.S. residential mortgage market. We believe that our operating capabilities, specialized expertise, access to long-term investment capital, and our management's deep experience across all aspects of the mortgage business will allow us to profitably grow these activities and capitalize on other related opportunities as they arise in the future.


Table of Contents

PNMAC was founded in 2008 by members of its executive leadership team and two strategic partners, BlackRock Mortgage Ventures, LLC, together with its affiliates, and HC Partners LLC, formerly known as Highfields Capital Investments LLC, together with its affiliates.

We conduct our business in two segments: mortgage banking and investment management. Our principal mortgage banking subsidiary, PennyMac Loan Services, LLC, ("PLS"), is a non-bank producer and servicer of mortgage loans in the United States. Our principal investment management subsidiary, PNMAC Capital Management, LLC, ("PCM"), is an SEC registered investment adviser. PCM manages PennyMac Mortgage Investment Trust ("PMT"), a mortgage real estate investment trust ("REIT"), listed on the New York Stock Exchange. PCM also manages PNMAC Mortgage Opportunity Fund, LLC and PNMAC Mortgage Opportunity Fund, LP, both registered under the Investment Company Act of 1940, as amended, and PNMAC Mortgage Opportunity Fund Investors, LLC. We refer to these funds collectively as our "Investment Funds" and, together with PMT, as our "Advised Entities."

Mortgage Banking

Our mortgage banking segment is comprised of three primary businesses:
correspondent lending, retail lending, and loan servicing.

Correspondent Lending. Our correspondent lending business manages, on behalf of PMT and for our own account, the acquisition of newly originated, prime credit quality, first-lien residential mortgage loans that have been underwritten to investor guidelines. PMT acquires, from approved correspondent sellers, newly originated loans, primarily "conventional" residential mortgage loans guaranteed by the Agencies and "government-insured" residential mortgage loans insured or guaranteed by the FHA or the VA and eligible to back securities guaranteed by Ginnie Mae. For conventional loans, we perform fulfillment activities for PMT and earn a fulfillment fee for each loan purchased by PMT. In the case of government-insured loans, we purchase them from PMT at PMT's cost plus a sourcing fee and fulfill them for our own account.

Retail Lending. Our retail lending business originates new prime credit quality, first-lien residential conventional and government-insured mortgage loans on a national basis to allow customers to purchase or refinance their homes. We conduct this business through a consumer direct model, which relies on the Internet and call center-based staff to acquire and interact with customers across the country. We do not have a "brick and mortar" branch network and have been developing our consumer direct operations with call centers strategically positioned across the United States.

Loan Servicing. Our loan servicing business performs loan administration, collection and default activities, including the collection and remittance of loan payments; response to customer inquiries; accounting for principal and interest; holding custodial (impound) funds for the payment of property taxes and insurance premiums; counseling delinquent mortgagors; and supervising foreclosures and property dispositions. We service a diverse portfolio of loans both as the owner of MSRs and on behalf of other MSR or mortgage owners. We provide prime servicing for conventional and government-insured loans, as well as special servicing for distressed loans that have been acquired as investments by our Advised Entities, and loans in "private-label" MBS securities, which are securities issued by institutions that are not affiliated with any Agency.

During the quarter and six months ended June 30, 2013, we managed PMT's acquisition of approximately $8.9 billion and $17.8 billion, respectively, in unpaid principal balance of newly originated, prime credit quality, first-lien residential mortgage loans. We purchased, for our own account, approximately $4.5 billion and $7.9 billion in unpaid principal balance of government-insured loans from PMT during the quarter and six month period ended June 30, 2013. We also originated $343.3 million and $609.8 million of residential mortgage loans through our retail channel during the quarter and six month period ended June 30, 2013. During the quarter and six months ended June 30, 2013, we increased our portfolio of loans that we serviced or subserviced from approximately $36.2 billion at December 31, 2012 to approximately $44.4 billion at June 30, 2013.

During the quarter and six months ended June 30, 2012, we managed PMT's acquisition of approximately $3.5 billion and $5.4 billion, respectively, in unpaid principal balance of newly originated, prime credit quality, first-lien residential mortgage loans. We purchased for our account approximately $1.5 billion and $2.3 billion, respectively, in unpaid principal balance of government-insured loans from PMT. We also originated $93.2 million and $155.0 million, respectively, of residential mortgage loans through our retail channel during the quarter and six months ended June 30, 2012, and increased our portfolio of loans that we serviced or subserviced from approximately $7.7 billion at December 31, 2011 to approximately $12.5 billion at June 30, 2012.


Table of Contents

Investment Management

We are an investment manager through our indirect wholly-owned subsidiary, PCM. PCM currently manages PMT and the Investment Funds, which had combined net assets of approximately $1.8 billion as of June 30, 2013. For these activities, we earn management fees as a percentage of net assets and incentive compensation based on investment performance.

Observations on Current Market Opportunities

Our business is affected by macroeconomic conditions in the United States, including economic growth, unemployment rates, the residential housing market and interest rate levels and expectations. The U.S. economy continues its pattern of modest growth as reflected in recent economic data. During the second quarter of 2013, real U.S. gross domestic product expanded at an annual rate of 1.7% compared to revised 1.1% and 1.2% annual rates for the first quarter of 2013 and second quarter of 2012, respectively. Modest economic growth continued to affect unemployment rates during the second quarter of 2013. The national unemployment rate was 7.6% at June 30, 2013 and compares to a revised seasonally adjusted rate of 8.2% at June 30, 2012 and 7.6% at March 31, 2013. Delinquency rates on residential real estate loans remain elevated compared to historical rates. As reported by the Federal Reserve, during the first quarter of 2013, the delinquency rate on residential real estate loans held by commercial banks was 9.7%, a reduction from 10.5% during the second quarter of 2012.

Residential real estate activity appears to be improving. The seasonally adjusted annual rate of existing home sales for June 2013 was 15.2% higher than for June 2012 and the national median existing home price for all housing types was $214,200, a 13.5% increase from June 2012. On a national level, foreclosure filings during the second quarter of 2013 decreased by 23% as compared to the second quarter of 2012. Foreclosure activity across the country is expected to remain above historical average levels through the remainder of 2013 and beyond.

Thirty-year fixed rate mortgage interest rates ranged from a high of 4.07% to a low of 3.45% during the second quarter of 2013 (Source: the Federal Home Loan Mortgage Corporation's Weekly Primary Mortgage Market Survey). During the first six months of 2013, mortgage interest rates have ranged from a high of 4.46% to a low of 3.34%. During the second quarter of 2012, interest rates for the thirty-year fixed rate mortgage ranged from a high of 3.98% to a low of 3.66%.

Fixed rate residential mortgage loan interest rates are generally indexed to long-term U.S. Treasury yields. Towards the end of the second quarter, an increase in these treasury yields led to an increase in mortgage loan interest rates. As a result of this increase in mortgage loan interest rates, refinance activity across the market has declined.

Mortgage lenders originated an estimated $495.0 billion of home loans during the second quarter of 2013, down 1.0 percent from the first three months of the year. That pushed year-to-date production volume to slightly less than $1 trillion, and put the market 14.4 percent ahead of the pace set during the first six months of 2012 (Source: Inside Mortgage Finance). However, mortgage originations are forecast to decline, with current industry estimates for the second half of 2013 totaling $500 billion.

In our capacity as an investment manager, we continue to see substantial volumes of distressed residential mortgage loan sales (sales of loan pools that consist of either nonperforming loans, troubled but performing loans or a combination thereof) offered for sale by a limited number of sellers. During the second quarter of 2013, we reviewed 36 mortgage loan pools with unpaid principal balances totaling approximately $11.1 billion and one pool of real estate acquired in settlement of loans totaling approximately $108 million. This compares to our review of 27 mortgage loan pools with unpaid principal balances totaling approximately $2.5 billion and one pool of real estate acquired in settlement of loans totaling approximately $30 million during the second quarter of 2012. We managed the acquisition, on behalf of PMT, of distressed mortgage loans, including forward purchases, with fair values totaling $443 million during the quarter ended June 30, 2013 and none during the quarter ended June 30, 2012.

In recent periods, we have seen increased competition from new and existing market participants in both our correspondent lending and retail origination businesses, as well as reductions in the overall level of refinancing activity. We believe that this change in supply and demand within the marketplace has been driving lower production margins in recent periods, which will be reflected in our results of operations in our gains on mortgage loans held for sale. Although margins on gains from mortgage loans held for sale benefitted from wider secondary spreads (the difference between interest rates charged to borrowers and yields on mortgage-backed securities in the secondary market) early in the fourth quarter of 2012, margins narrowed as the quarter progressed and into the first quarter of 2013. While production margins remained elevated from a historical perspective during the second quarter of 2013, we expect them to continue to normalize toward their long-term averages in 2013.


Table of Contents

Results of Operations



Our results of operations are summarized below for the periods presented:



                                          Quarter ended June 30,             Six months ended June 30,
                                          2013              2012               2013               2012
                                                                (in thousands)
Revenue
Net gains on mortgage loans held
for sale at fair value               $       42,654    $       14,790    $          82,611    $     28,727
Loan origination fees                         6,312             2,452               11,980           2,687
Fulfillment fees from PennyMac
Mortgage Investment Trust                    22,054             7,715               50,298          13,839
Net servicing income                         22,069             7,658               38,111          19,234
Management fees from Advised
Entities                                     10,429             4,856               18,835           9,049
Carried Interest from Investment
Funds                                         2,862             2,110                7,599           3,899
Interest                                      4,474             2,146                6,217           2,577
Change in fair value of
investment in and dividends
received from PennyMac Mortgage
Investment Trust                               (320 )             121                 (233 )           316
Other                                           243               721                1,057           1,191
Total revenue                               110,777            42,569              216,475          81,519
Total expenses                               60,548            32,091              110,953          56,479
Provision for income taxes                    2,038                 -                2,038               -
Net income                           $       48,191    $       10,478    $         103,484    $     25,040

Income before provision for
income taxes by segment:
Mortgage banking                     $       39,885    $        4,891    $          83,716    $     15,176
Investment management                        10,344             5,587               21,806           9,864
                                     $       50,229    $       10,478    $         105,522    $     25,040
During the period:
Mortgage loans purchased and
originated for sale:
Government-insured or guaranteed
loans acquired from PMT at fair
value                                $    4,733,767    $    1,620,123    $       8,282,163    $  2,458,243
Retail production at fair value             344,840            93,607              612,966         155,498
                                     $    5,078,607    $    1,713,730    $       8,895,129    $  2,613,741
Unpaid principal balance of
mortgage loans fulfilled for PMT     $    4,323,885    $    1,537,636    $       9,110,711    $  2,336,843
At period end:
Unpaid principal balance of
mortgage loan servicing portfolio
Mortgage loans held for sale         $      653,789    $      231,084    $         653,789    $    231,084
MSRs owned                               18,242,514         5,511,129           18,242,514       5,511,129
Subservicing                             25,509,373         6,507,359           25,509,373       6,507,359

                                     $   44,405,676    $   12,249,572    $      44,405,676    $ 12,249,572
Net assets of Advised Entities
PennyMac Mortgage Investment
Trust                                $    1,244,181    $      805,673    $       1,244,181    $    805,673
Investment Funds                            561,790           616,793              561,790         616,793
                                     $    1,805,971    $    1,422,466    $       1,805,971    $  1,422,466


Table of Contents

Comparison of the quarters and six months ended June 30, 2013 and 2012

Net income increased by approximately $37.7 million or 360% and $78.4 or 313% for the quarter and six months ended June 30, 2013, respectively, when compared to the same period in 2012. The increase in net income primarily reflects growth in the Company's mortgage banking operations. Loan purchase and origination volume increased by approximately $3.4 billion or 196% and $6.3 billion or 240%, respectively, in the quarter and six months ended June 30, 2013 as compared to the quarter and six months ended June 30, 2012 and the Company's loan servicing portfolio was approximately $44.4 billion at June 30, 2013, an increase of $32.2 billion or 263% from June 30, 2012. This growth was supplemented by growth in the Company's investment management segment due to an increase of $5.6 million and $9.8 million or 115% and 108% in management fees for the quarter and six months ended June 30, 2013, compared to the quarter and six months ended June 30, 2012, respectively, reflecting the recognition of approximately $3.9 million of performance incentive fees related to our management of PMT, along with an increase of approximately $383.5 million or 27% in net assets under management from June 30, 2012 to June 30, 2013. These revenue increases were partly offset by increases in expenses of approximately $28.5 million or 89% and $54.5 million or 96%, respectively, during the quarter and six-month periods ended June 30, 2013 as compared to the comparable periods in 2012. We incurred these increases in expenses to accommodate our growth.

Net gains on mortgage loans held for sale at fair value

During the quarter and six months ended June 30, 2013, we recognized net gains on mortgage loans held for sale at fair value totaling $42.7 million and $82.6 million, respectively. This compares to recognized net gains on mortgage loans held for sale at fair value totaling $14.8 million and $28.7 million, respectively, during the quarter and six months ended June 30, 2012. The increase was due to growth in the volume of mortgage loans that we purchased and originated and subsequently sold during the quarter and six months ended June 30, 2013 as compared to the same periods in 2012. The net gain for the quarter and six months ended June 30, 2013 included $52.5 million and $94.2 million, respectively, in fair value of MSRs received as part of proceeds on sales. The net gain for the quarter and six months ended June 30, 2012 included $15.1 million and $25.4 million, respectively, in fair value of MSRs received as part of proceeds on sales.

We recognized gains on mortgage loans held for sale as summarized below:

                                      Quarter ended June 30,         Six months ended June 30,
                                        2013           2012             2013            2012
                                                           (in thousands)
Cash (loss) gain on sale:
Proceeds from sales                 $    (43,318 )  $    17,319    $      (55,141 )  $    23,019
Hedging activities                        22,260        (14,670 )          39,881        (20,702 )
                                         (21,058 )        2,649           (15,260 )        2,317
Non-cash changes in fair value:
Change in fair value of IRLCs            (41,647 )        4,622           (40,150 )        4,805
MSRs received as proceeds on
sale                                      52,478         15,085            94,214         25,386
MSR recapture payable to
affiliate                                   (366 )            -              (500 )            -
Provision for representations
and warranties on loans sold              (1,453 )         (627 )          (2,697 )         (938 )
Change in fair value relating to
mortgage loans and hedging
instruments held for sale at
period end:
Mortgage loans                           (17,242 )        1,917           (19,633 )        1,943
Hedging instruments                       71,942         (8,856 )          66,637         (4,786 )
Total non-cash changes in fair
value relating to loans and
hedging instruments held at
period end                                54,700         (6,939 )          47,004         (2,843 )
Total non-cash changes in fair
value                                     63,712         12,141            97,871         26,410
                                    $     42,654    $    14,790    $       82,611    $    28,727

Unpaid principal balance of
loans sold during the period        $  4,377,043    $ 1,566,714    $    8,236,132    $ 2,344,318
Interest rate lock commitments
issued during the period, net of
cancellations                       $  4,887,855    $ 1,887,662    $    8,584,419    $ 2,994,556
At period end:
Fair value of mortgage loans
held for sale                       $    656,341    $   448,384    $      656,341    $   448,384
Commitments to fund and purchase
mortgage loans                      $  1,767,314    $   849,845    $    1,767,314    $   849,845

Increase (decrease) in net gains
on mortgage loans held for sale
at fair value due to:
Net change in fair value of
IRLCs                               $    (46,268 )  $     4,956    $      (44,955 )  $     5,104
Volume of loans sold                      35,344         10,371            83,283         23,409
Gain margin                               38,788         (1,290 )          15,556         (1,339 )
Total change                        $     27,864    $    14,037    $       53,884    $    27,174


Table of Contents

We recognize a substantial portion of our gain on mortgage loans held for sale at fair value before we fund or purchase the loan. In the course of our correspondent and retail lending activities, we make contractual commitments to PMT and to mortgage loan applicants to purchase or fund mortgage loans at specified terms. We call these commitments interest rate lock commitments ("IRLCs"). We recognize the value of IRLCs at the time we make a commitment to PMT or the borrower.

We estimate the fair value of an IRLC based on quoted Agency MBS prices, our estimate of the fair value of the MSRs we expect to receive in the sale of the loans and the probability that the mortgage loan will fund or be purchased as a percentage of the commitment we have made (the "pull-through rate"). We update our estimates of the value of the IRLCs as the mortgage loans move through the purchase or loan process for changes in our estimate of probability the loan will fund and for changes in interest rates.

An active, observable market for IRLCs does not exist. Therefore, we estimate the fair value of IRLCs using methods and assumptions we believe that market participants use in pricing IRLCs. The significant unobservable inputs used in the fair value measurement of the Company's IRLCs are the pull-through rate and the MSR component of the Company's estimate of the value of the mortgage loans we have committed to purchase. Significant changes in the pull-through rate and the MSR component of the IRLCs, in isolation, could result in a significant change in fair value measurement. The financial effects of changes in these assumptions are generally inversely correlated as increasing interest rates have a positive effect on the fair value of the MSR component of IRLC value, but increase the pull-through rate for loans that have decreased in fair value in comparison to the agreed-upon purchase price.

Following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs:

                                         June 30, 2013   December 31, 2012
                                                       Range
                                                (Weighted average)
Key Inputs
Pull-through rate                        57.8 - 98.0%      61.6% - 98.1%
                                            (81.3%)           (79.1%)
MSR value expressed as:
Servicing fee multiple                     1.7 - 5.2         3.2 - 4.2
                                             (4.5)             (4.0)
Percentage of unpaid principal balance    0.4% - 2.6%       0.6% - 2.2%
                                            (1.2%)            (0.9%)

MSRs represent the value of a contract that obligates us to service mortgage . . .

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