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

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Form 10-Q for PENNYMAC FINANCIAL SERVICES, INC.


14-Nov-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.

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 on Form S-1, as amended (SEC File No. 333-186495) (the "Registration Statement"), and in Part II, Item 1A., Risk Factors, of this Quarterly Report on Form 10-Q, 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, we 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). With the net proceeds from the IPO, we bought Class A Units of Private National Mortgage Acceptance Company, LLC ("PennyMac") and became its sole managing member. We operate and control all of the business and affairs and consolidate the financial results of PennyMac.

Before the completion of the IPO, the limited liability company agreement of 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.

Before 2013, PennyMac made an election pursuant to Section 754 of the Internal Revenue Code which remains in effect. An exchange results in a special adjustment for PFSI that may increase PFSI's tax basis in the assets of PennyMac that otherwise would not have been available. These increases in tax basis may reduce the amount of tax that PFSI would otherwise be required to pay in the future and result in increases in investment in PennyMac deferred tax assets net of investment in PennyMac deferred tax liabilities.

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 Class A Units and (ii) certain other tax benefits related to our tax receivable agreement, including tax benefits attributable to payments under the tax receivable agreement.


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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.

PennyMac 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, 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. 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 nine months ended September 30, 2013, we managed PMT's acquisition of approximately $8.0 billion and $25.2 billion, respectively, in unpaid principal balance of newly originated, prime credit quality, first-lien residential mortgage loans. We purchased, for our own account, approximately $4.0 billion and $12.0 billion in unpaid principal balance of government-insured loans from PMT during the quarter and nine month period ended September 30, 2013. We also originated $282.5 million and $892.3 million in unpaid principal balance of residential mortgage loans through our retail channel during the quarter and nine month period ended September 30, 2013. During the quarter and nine months ended September 30, 2013, we increased our portfolio of loans that we serviced or subserviced from approximately $28.2 billion at December 31, 2012 to approximately $52.9 billion at September 30, 2013.


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During the quarter and nine months ended September 30, 2012, we managed PMT's acquisition of approximately $6.3 billion and $11.5 billion, respectively, in unpaid principal balance of newly originated, prime credit quality, first-lien residential mortgage loans. We purchased for our account approximately $2.6 billion and $5.0 billion, respectively, in unpaid principal balance of government-insured loans from PMT. We also originated $147.5 million and $302.6 million, respectively, in unpaid principal balance of residential mortgage loans through our retail channel during the quarter and nine months ended September 30, 2012, and increased our portfolio of loans that we serviced or subserviced from approximately $7.7 billion at December 31, 2011 to approximately $18.6 billion at September 30, 2012.

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 $2.1 billion as of September 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 third quarter of 2013, real U.S. gross domestic product expanded at an annual rate of 2.8% compared to revised 2.5% and 2.8% annual rates for the second quarter of 2013 and third quarter of 2012, respectively. Modest economic growth continued to affect unemployment rates during the second quarter of 2013. The national unemployment rate was 7.2% at September 30, 2013 and compares to a revised seasonally adjusted rate of 7.8% at September 30, 2012 and 7.6% at June 30, 2013. Delinquency rates on residential real estate loans remain elevated compared to historical rates. As reported by the Federal Reserve, during the second quarter of 2013, the delinquency rate on residential real estate loans held by commercial banks was 9.4%, a reduction from 10.6% during the second quarter of 2012.

Residential real estate activity appears to be improving. The seasonally adjusted annual rate of existing home sales for September 2013 was 10.7% higher than for September 2012 and the national median existing home price for all housing types was $199,200, an 11.7% increase from September 2012. On a national level, foreclosure filings during the third quarter of 2013 decreased by 27% as compared to the third 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 4.49% to a low of 4.37% during the third quarter of 2013 (Source: the Federal Home Loan Mortgage Corporation's Weekly Primary Mortgage Market Survey). During the first nine months of 2013, mortgage interest rates have ranged from a high of 4.58% to a low of 3.34%. During the third quarter of 2012, interest rates for the thirty-year fixed rate mortgage ranged from a high of 3.66% to a low of 3.40%.

Changes in fixed rate residential mortgage loan interest rates generally follow changes in long-term U.S. Treasury yields. Toward 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, market volumes for mortgage originations have declined led by a reduction in refinance activity.

Mortgage lenders originated an estimated $460 billion of home loans during the third quarter of 2013, down 18.6 percent from the second quarter of the year. That brought year-to-date volume for the origination market to slightly less than $1.6 trillion, up 3.9 percent from the pace set during the first nine months of 2012 (Source: Inside Mortgage Finance). However, mortgage originations are forecast to decline, with current industry estimates for the fourth quarter of 2013 totaling $280 billion (Source: average of Fannie Mae, Freddie Mac and Mortgage Bankers Association forecasts).


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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 third quarter of 2013, we reviewed 25 mortgage loan pools with unpaid principal balances totaling approximately $7.3 billion. This compares to our review of 23 mortgage loan pools with unpaid principal balances totaling approximately $3.8 billion during the third quarter of 2012. We managed the acquisition, on behalf of PMT, of distressed mortgage loans with fair values totaling $822 million during the third quarter of 2013 compared to $151 million during the third quarter of 2012.

In recent periods, we have seen increased competition from new and existing market participants in both our correspondent lending and retail lending 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 is 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) in 2012, margins narrowed in subsequent quarters and we expect them to continue to normalize toward their long-term averages in 2013 and 2014.


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Results of Operations



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



                                     Quarter ended September 30,         Nine months ended September 30,
                                        2013              2012              2013                 2012
                                                                (in thousands)
Revenue
Net gains on mortgage loans
held for sale at fair value        $        25,949    $     39,760    $         108,560    $          68,487
Loan origination fees                        6,280           2,752               18,260                5,439
Fulfillment fees from PennyMac
Mortgage Investment Trust                   18,327          17,258               68,625               31,097
Net servicing income                        21,399           6,112               59,510               25,346
Management fees                             10,540           6,114               29,375               15,163
Carried Interest from
Investment Funds                             2,812           3,355               10,411                7,254
Net interest income                            937            (128 )               (376 )                265
Change in fair value of
investment in and dividends
received from PennyMac Mortgage
Investment Trust                               165             314                  (68 )                630
Other                                          785             695                1,842                1,886
Total revenue                               87,194          76,232              296,139              155,567
Total expenses                              52,277          38,369              155,700               92,664
Provision for income taxes                   3,493               -                5,531                    -
Net income                         $        31,424    $     37,863    $         134,908    $          62,903

Pre-tax income by segment:
Mortgage Banking                   $        22,657    $     30,290    $         106,605    $          44,648
Investment Management                       12,260           7,573               33,834               18,255
                                   $        34,917    $     37,863    $         140,439    $          62,903
During the period:
Mortgage loans purchased and
originated for sale:
Government-insured or
guaranteed loans acquired from
PMT at fair value                  $     4,147,535    $  2,650,097    $      12,429,698    $       5,111,185
Retail production at fair value            282,440         149,006              895,405              304,402
                                   $     4,429,975    $  2,799,103    $      13,325,103    $       5,415,587
Unpaid principal balance of
mortgage loans fulfilled for
PMT                                $     3,681,771    $  2,488,443    $      12,792,482    $       4,828,117
At period end:
Unpaid principal balance of
mortgage loan servicing
portfolio
Mortgage loans held for sale       $       490,088    $    376,717    $         490,088    $         376,717
MSRs owned                              22,776,613       8,286,075           22,776,613            8,286,075
Subserviced                             29,605,633      10,313,879           29,605,633           10,313,879
                                   $    52,872,334    $ 18,976,671    $      52,872,334    $      18,976,671
Net assets of Advised Entities
PennyMac Mortgage Investment
Trust                              $     1,494,765    $  1,184,203    $       1,494,765    $       1,184,203
Investment Funds                           556,013         575,850              556,013              575,850
                                   $     2,050,778    $  1,760,053    $       2,050,778    $       1,760,053

Comparison of the quarters and nine months ended September 30, 2013 and 2012

Net income decreased by approximately $6.4 million or 17% and increased $72.0 million or 114% for the quarter and nine months ended September 30, 2013, respectively, when compared to the same periods in 2012.


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The decrease in net income from the quarter ended September 30, 2012 to the quarter ended September 30, 2013 is due to the contraction in the mortgage origination market and the resulting increased price competition, which had a negative effect on our margins during the quarter ended September 30, 2013. While our mortgage loan origination volume increased $1.6 billion or 58%, increased price competition in the mortgage market during the quarter ended September 30, 2013 caused a reduction in our net gain on mortgage loans held for sale at fair value of $13.8 million or 35%.

The increase in net income for the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012, primarily reflects growth in the Company's mortgage banking operations. Loan purchase and origination volume increased by approximately $7.9 billion or 146% in the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012 and the Company's loan servicing portfolio was approximately $52.9 billion at September 30, 2013, an increase of $33.9 billion or 179% from September 30, 2012. This growth was supplemented by growth in the Company's investment management segment due to an increase of $14.2 million or 94% in management fees for the nine months ended September 30, 2013, compared to the nine months ended September 30, 2012. These revenue increases were partly offset by increases in expenses of approximately $63.0 million or 68%, during the nine month periods ended September 30, 2013 as compared to the comparable periods in 2012. We incurred these increases in expenses to accommodate the Company's growth.

Net gains on mortgage loans held for sale at fair value

During the quarter and nine months ended September 30, 2013, we recognized net gains on mortgage loans held for sale at fair value totaling $25.9 million and $108.6 million, respectively. This compares to net gains on mortgage loans held for sale at fair value totaling $39.8 million and $68.5 million, respectively, during the quarter and nine months ended September 30, 2012.

The decrease in net gains on mortgage loans held for sale at fair value from the quarter ended September 30, 2012 to the quarter ended September 30, 2013 is due to the effect of increasing price competition in the mortgage market, which had a negative effect on our margins during the quarter ended September 30, 2013. The net gain for the quarters ended September 30, 2013 and 2012 included $60.1 million and $25.6 million, respectively, in fair value of MSRs received as part of proceeds on sales.

The increase in net gains on mortgage loans held for sale at fair value for the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012, was due to growth in the volume of mortgage loans that we purchased and originated and subsequently sold during 2013 as compared to 2012. The net gains for the nine months ended September 30, 2013 included $154.4 million in fair value of MSRs received as part of proceeds on sales. The net gains for the nine months ended September 30, 2012 included $51.0 million in fair value of MSRs received as part of proceeds on sales.


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

                                     Quarter ended September 30,         Nine months ended September 30,
                                        2013              2012               2013                 2012
                                                                (in thousands)
Cash (loss) gain:
Sales proceeds                     $       (93,725 )  $     26,676    $         (148,866 )  $         49,695
Hedging activities                          88,789         (19,574 )             128,670             (40,276 )
                                            (4,936 )         7,102               (20,196 )             9,419
Non-cash gain:
Receipt of MSRs in loan sale
transactions                                60,137          25,620               154,352              51,006
MSR recapture payable to
affiliate                                      (86 )             -                  (586 )                 -
Provision for losses relating
to representations and
warranties provided in loan
sales                                       (1,069 )          (918 )              (3,766 )            (1,856 )
Change in fair value relating
to mortgage loans and hedging
derivatives held for sale at
period end:
IRLCs                                       37,768          20,723                (2,382 )            25,528
Mortgage loans                              27,510           6,693                 7,876               8,636
Hedging derivatives                        (93,375 )       (19,460 )             (26,738 )           (24,246 )
                                   $        25,949    $     39,760    $          108,560    $         68,487
During the period:
Unpaid principal balance of
loans sold                         $     4,442,944    $  2,490,174    $       12,679,436    $      4,834,492
Interest rate lock commitments
issued, net of cancellations       $     3,699,970    $  2,274,847    $       12,280,205    $      3,539,763
At period end:
Fair value of mortgage loans
held for sale                      $       530,248    $    410,071    $          530,248    $        410,071
Commitments to fund and
purchase mortgage loans            $     1,163,531    $  1,470,590    $        1,163,531    $      1,470,590

Increase (decrease) in gains on
mortgage loans held for sale at
fair value due to:
Change in IRLCs fair value         $        17,045    $     19,324    $           27,910    $         24,428
Volume of loans sold                         7,532          17,981                68,494              41,143
Gain margin                                (38,388 )           112                  (512 )              (979 )
Total change                       $       (13,811 )  $     37,417    $           95,892    $         64,592

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 the 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 . . .

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