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PFSI > SEC Filings for PFSI > Form 10-Q on 15-May-2014All Recent SEC Filings

Show all filings for PENNYMAC FINANCIAL SERVICES, INC.

Form 10-Q for PENNYMAC FINANCIAL SERVICES, INC.


15-May-2014

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 the risks discussed under the heading "Risk Factors," as well as our consolidated financial statements, related notes, and the other financial information appearing elsewhere in this Quarterly Report on Form 10-Q and our 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 we assume 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 approximately 12.8 million 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.

Before 2013, PennyMac made an election pursuant to Section 754 of the Internal Revenue Code which remains in effect. As a result of this election, an exchange pursuant to the exchange agreement results in a special adjustment for PFSI that may increase PFSI's tax basis in certain 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.

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 (activities which we refer to as mortgage banking) 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 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.


Table of Contents

We conduct our business in three segments: loan production, loan servicing 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 under the ticker symbol PMT. PCM also manages PNMAC Mortgage Opportunity Fund, LLC and PNMAC Mortgage Opportunity Fund, LP, both registered under the Investment Company Act, an affiliate of these funds, 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

Production

Our loan production segment is comprised of two primary businesses:
correspondent lending and retail lending.

In correspondent lending we manage, 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.

In retail lending we originate 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.

During the quarter ended March 31, 2014, we managed PMT's acquisition of newly originated, prime credit quality, first lien residential mortgage loans with fair values totaling $5.0 billion. During the quarter ended March 31, 2014, we purchased, for our own account, approximately $3.1 billion of government-insured loans at fair value from PMT and originated $318.3 million of residential mortgage loans at fair value through our retail channel.

During the quarter ended March 31, 2013, we managed PMT's acquisition of newly originated, prime credit quality, first lien residential mortgage loans with fair values totaling $8.8 billion. We purchased, for our own account, approximately $3.5 billion of government-insured loans at fair value from PMT during the quarter ended March 31, 2013. We also originated $268.1 million of residential mortgage loans at fair value through our retail channel during the quarter ended March 31, 2013.

Servicing.

Our loan servicing segment 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, which are securities issued by institutions that are not affiliated with any Agency.

During the quarter ended March 31, 2014, we increased our portfolio of loans that we serviced or subserviced from approximately $78.2 billion in UPB at December 31, 2013 to approximately $83.8 billion in UPB at March 31, 2014.

During the quarter ended March 31, 2013, we increased our portfolio of loans that we serviced or subserviced from approximately $28.2 billion in UPB at December 31, 2012 to approximately $36.2 billion in UPB at March 31, 2013.

Investment Management

We are an investment manager through an indirect subsidiary, PCM. PCM currently manages PMT and the Investment Funds. PMT and the Investment Funds had combined net assets of approximately $2.1 billion as of March 31, 2014. For these activities, we earn management fees as a percentage of net assets and incentive compensation based on investment performance.


Table of Contents

Observations on Current Market Conditions

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. During the first quarter of 2014, real U.S. gross domestic product expanded at an annual rate of 0.1% compared to revised 1.1% and 2.6% annual rates for the first and fourth quarters of 2013, respectively. The national unemployment rate was 6.7% at March 31, 2014 and compares to a revised seasonally adjusted rate of 7.5% at March 31, 2013 and 6.7% at December 31, 2013. While delinquency rates on residential real estate loans continue to decrease, they remain elevated compared to historical rates. As reported by the Federal Reserve Bank, during the fourth quarter of 2013, the delinquency rate on residential real estate loans held by commercial banks was 8.2%, a reduction from 10.0% during the fourth quarter of 2012.

In addition to economic trends, residential real estate activity was impacted by severe winter weather in many parts of the country during the first quarter of 2014. The seasonally adjusted annual rate of existing home sales for March 2014 was 7.5% lower than for March 2013 and the national median existing home price for all housing types was $198,500, a 7.9% increase from March 2013. On a national level, foreclosure filings during the first quarter of 2014 decreased by 23% as compared to the first quarter of 2013. Foreclosure activity across the country decreased throughout 2013; however, it is expected to remain above historical average levels through 2014 and beyond.

Thirty-year fixed mortgage interest rates ranged from a low of 4.30% to a high of 4.43% during the first quarter of 2014 compared to a low of 3.41% and a high of 3.57% during the first quarter of 2013 (Source: the Federal Home Loan Mortgage Corporation's Weekly Primary Mortgage Market Survey).

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 of 2013, 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 decreased led by a reduction in refinance activity.

Mortgage lenders originated an estimated $235 billion of home loans during the quarter ended March 31, 2014, down 58.0% percent from the quarter ended March 31, 2013. Mortgage originations are forecast to continue to decline, with current industry estimates for 2014 totaling $1.2 trillion compared to $1.9 trillion for 2013 (Source: Average of Fannie Mae, Freddie Mac and Mortgage Bankers Association forecasts).

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 first quarter of 2014, we reviewed 37 mortgage loan pools with UPB totaling approximately $9.2 billion. This compares to our review of 27 mortgage loan pools with unpaid principal balances totaling approximately $5.7 billion during the first quarter of 2013. While we expect to see a continued supply of distressed whole loans, we believe the pricing for recent transactions has been less attractive. We remain patient and selective for PMT in making new investments in distressed whole loans and we continue to monitor the market to assess best execution opportunities for existing distressed portfolio investments held by the Advised Entities.

In recent periods, we have seen increased competition from new and existing market participants for loan production, 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 acquired for sale. During the first several months of 2013, gains on mortgage loans acquired for sale benefited from wider secondary spreads (the difference between interest rates charged to borrowers and yields on mortgage-backed securities in the secondary market); however, secondary spreads narrowed in subsequent months and we expect them to continue to normalize toward their long-term averages in 2014.

During the quarter ended March 31, 2014, we completed acquisitions of MSRs with UPB totaling $2.4 billion, which were partially financed through sale of excess servicing spread to PMT. We continue to see opportunities to acquire MSRs on a bulk and flow basis from banks and independent mortgage lenders. However, recent scrutiny by the Agencies and regulators of similar transactions and the related servicing transfers may reduce the willingness of banks and other lenders to pursue MSR sales and, as a result, reduce the volume of MSRs available for us to acquire.


Table of Contents

Results of Operations



Our results of operations are summarized below:



                                                         Quarter ended March 31,
                                                           2014            2013
                                                              (in thousands)
Revenue
Net gains on mortgage loans held for sale at fair
value                                                  $     34,538    $     39,957
Loan origination fees                                         6,880           5,668
Fulfillment fees from PennyMac Mortgage Investment
Trust                                                         8,902          28,244
Net loan servicing fees                                      43,764          16,042
Management fees                                              10,109           8,406
Carried Interest from Investment Funds                        2,157           4,737
Net interest expense                                         (2,276 )        (1,588 )
Change in fair value of investment in and dividends
received from PennyMac Mortgage Investment Trust                115              88
Other                                                         1,303             814
Total net revenue                                           105,492         102,368
Total expenses                                               56,431          47,075
Provision for income taxes                                    5,523               -
Net income                                             $     43,538    $     55,293

Income before provision for income taxes by
segment:
Mortgage banking:
Production                                             $     25,954    $     43,610
Servicing                                                    17,113           2,380
Total mortgage banking                                       43,067          45,990
Investment management                                         5,994           9,303
                                                       $     49,061    $     55,293
During the period:
Interest rate lock commitments issued                  $  3,540,895    $  3,696,564
Mortgage loans purchased and originated for sale:
Government-insured or guaranteed loans acquired
from PennyMac Mortgage Investment Trust at fair
value                                                  $  3,130,530    $  3,548,397
Retail production at fair value, net                        317,915         268,125
                                                       $  3,448,445    $  3,816,522
UPB of mortgage loans fulfilled for PennyMac
Mortgage Investment Trust                              $  1,919,578    $  4,786,826
At period end:
UPB of mortgage loan servicing portfolio:
MSRs owned                                             $ 50,109,643    $ 14,586,623
Subserviced                                              33,073,476      21,386,113
Mortgage loans held for sale                                660,470         193,894
                                                       $ 83,843,589    $ 36,166,630
Net assets of Advised Entities
PennyMac Mortgage Investment Trust                     $  1,543,282    $  1,222,429
Investment Funds                                            561,638         552,520
                                                       $  2,104,920    $  1,774,949


Table of Contents

Comparison of the quarters ended March 31, 2014 and 2013

Net income decreased by approximately 11.8 million or 21% from $55.3 million for the quarter ended March 31, 2013 to $43.5 million for the quarter ended March 31, 2014. The decrease in net income from the quarter ended March 31, 2013 to the quarter ended March 31, 2014 is primarily due to the effects of the contraction in the mortgage loan origination market, partially offset by growth in our mortgage loan servicing portfolio. Our mortgage loan production decreased by $778.4 million or 19% for the quarter ended March 31, 2014 when compared to the quarter ended March 31, 2013 while our servicing portfolio increased from $36.2 billion at March 31, 2013 to $83.8 billion at March 31, 2014.

Fulfillment fee income on mortgage loans we fulfill for PMT decreased by $19.3 million and net gains on mortgage loans held for sale decreased by $5.4 million. The decrease was primarily due to a decrease in funding volume of mortgage loans at PMT and the contraction in the mortgage loan origination market. We also recognized a provision for income taxes relating to income attributable to our common stockholders. Since we were a pass-through tax entity before our IPO, we did not recognize any provision for income taxes for the quarter ended March 31, 2013. Offsetting these declines in net income was an increase in net loan servicing fees of $27.7 million, reflecting continued growth in our MSR portfolio from our loan production activities and from MSR purchases.

Net gains on mortgage loans held for sale at fair value

During the quarter ended March 31, 2014, we recognized net gains on mortgage loans held for sale at fair value totaling $34.5 million. This compares to net gains on mortgage loans held for sale at fair value totaling $40.0 million for the quarter ended March 31, 2013.

The decrease in net gains on mortgage loans held for sale at fair value from the quarter ended March 31, 2013 to the quarter ended March 31, 2014 is due to the effect of increasing price competition in the mortgage loan origination market, which had a negative effect on our margins during the quarter ended March 31, 2014, and to a lesser extent, to a reduction in the volume of mortgage loan sales during the quarter. The net gains for the quarters ended March 31, 2014 and 2013 included $37.5 million and $41.7 million, respectively, in fair value of MSRs received as part of proceeds on sales.


Table of Contents

Our gains on mortgage loans held for sale are summarized below:

                                                        Quarter ended March 31,
                                                         2014             2013
                                                            (in thousands)
Cash gain (loss):
Sales proceeds                                       $       4,481    $    (11,823 )
Hedging activities                                         (10,256 )        17,621
                                                            (5,775 )         5,798
Non-cash gain:
Receipt of MSRs in loan sale transactions                   37,514          41,736
MSR recapture payable to PennyMac Mortgage
Investment Trust                                            (1,898 )          (133 )
Provision for losses relating to representations
and warranties on loans sold                                  (851 )        (1,244 )
Change in fair value relating to mortgage loans
and hedging derivatives held at period end:
IRLCs                                                        7,536           1,497
Mortgage loans                                               7,828          (2,392 )
Hedging derivatives                                         (9,816 )        (5,305 )
                                                     $      34,538    $     39,957

Increase (decrease) in net gains on mortgage
loans held for sale at fair value due to:
Net change in fair value of IRLCs                    $       6,039    $      1,314
Volume of mortgage loans sold                               (6,552 )        32,956
Gain margin                                                 (4,906 )        (8,250 )
Total change                                         $      (5,419 )  $     26,020

During the period:
UPB of mortgage loans sold                           $   3,143,566    $  3,857,150
Interest rate lock commitments issued, net of
cancellations:
Conventional mortgage loans                          $      65,044    $    203,746
Government-insured or guaranteed loans                   3,475,851       3,492,818
                                                     $   3,540,895    $  3,696,564
Period end:
Mortgage loans held for sale at fair value           $     717,476    $    203,661
Commitments to fund and purchase mortgage loans      $   1,202,126    $  1,701,082

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 upon 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 market interest rates.


Table of Contents

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 rising interest rates increase the pull-through rate for loans that have decreased in fair value.

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

                          March 31, 2014   December 31, 2013
                                        Range
Key inputs                        (Weighted average)
Pull-through rate         60.8% - 98.0%      62.1% - 98.1%
                             (78.5%)            (81.7%)
MSR value expressed as:
Servicing fee multiple      1.9 - 5.1          2.0 - 5.0
                              (3.7)              (3.7)
Percentage of UPB          0.4% - 2.4%        0.4% - 2.4%
                              (1.0%)            (0.9%)

We receive non-cash proceeds on sale of mortgage loans in the form of MSRs. MSRs represent the value of a contract that obligates us to service mortgage loans on behalf of the purchaser of the loan in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We recognize MSRs at our estimate of the fair value of the contract to service the loans.

As economic fundamentals influence the loans we sell with servicing rights retained, our estimate of the fair value of MSRs will also change. As a result, we will record changes in fair value as a component of Net loan servicing fees for the MSRs we carry at fair value, and we may recognize changes in fair value relating to our MSRs carried at the lower of amortized cost or fair value depending on the relationship of the asset's fair value to its carrying value at the measurement date.

Following are the key inputs used in determining the fair value of MSRs at the time of initial recognition:

                                                                   Quarter ended March 31,
                                                      2014                                        2013
                                                                            Range
. . .
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