Update: Mr. Cooper & PennyMac Financial

April 29, 2023 | Premium Service | As we watch yet another large regional bank head for failure with First Republic Bank (FRC), we return to the relatively blissful world of mortgage lending and servicing. There is not much lending at present in the world of 1-4 family mortgages, so most firms are relying on servicing income to carry the load on earnings. The big concern: future mortgage delinquency rates.

Penny Mac Financial (PFSI) and Mr. Cooper (COOP) reported and both firms managed to deliver good results despite the dismal state of the secondary mortgage industry. Estimates of production for 2023 continue to fall, although Q1 2023 will hopefully be the low for this cycle. Our mortgage surveillance list is shown below:

Source: Bloomberg

The good news for both of these leading mortgage issuers is that they are using their significant servicing books to ride out the famine of 2023 in the mortgage lending space. The bad news is that one issuer, PFSI, has seen a major change in its management team that may be significant to market participants and investors over the course of the next year.

“PennyMac Financial Services Inc. (PFSI) and PennyMac Mortgage Investment Trust (PMT) announced Thursday that Vandy Fartaj is stepping down from his position as senior managing director and chief investment officer of both PFSI and PMT, “in order to pursue other interests,” reported National Mortgage Professional in March. “He is being replaced by William Chang.”

Since March and the departure of Fartaj, there has been a discernible change in the market behavior of PFSI, with the leading aggregator of conventional loans now taking several steps back in terms of pricing behavior. Leading conventional shops such as the AmeriHome unit of Western Alliance Bank (WAL) and other issuers are taking market share as PFSI retreats.

One competitor told The IRA that AmeriHome and rising issuers such as Planet Mortgage essentially had the conventional market to themselves in March and April. Some issuers found themselves overpaying for loans, not realizing that PSFI had backed away from the conventional market. This fact helped several issuers turn in strong production volumes in March and April.

More to the point, the highly regarded Fartaj reportedly played an important moderating role at PennyMac, balancing the natural tendency to wave through all production with an astute view of valuation and pricing, both for loans and mortgage servicing rights (MSRs).

Given that most loans underwritten since 2020 will be underwater in the next down cycle in residential home prices (say 2026-2027, for now), paying up for conventional loans may not be the best choice. The table below from the PFSI earnings presentation shows total industry mortgage production and interest rates in the secondary mortgage market.

Over the past year, PFSI has steadily increased the average note rate on its servicing book, from 4.4% in Q2 2022 to just shy of 6% in Q1 2023. A higher note rate provides for better recapture opportunities in the event that interest rates fall, but it also means that the MSR will run off more quickly. The question remains, however, whether PennyMac will continue to drive average note rates higher. In the event of a sharp decline in interest rates, prepayments could jump and force PFSI to meet margin calls on MSR financing.

PFSI claims over 17% market share in correspondent lending, citing Inside Mortgage Finance, through Q1 2023. Where will that number be in Q2 2023? The fact that PFSI did not take questions from analysts at the end of the company’s Q1 2023 earnings presentation is not likely to inspire great confidence. Given market trends, we wonder if PFSI will still be able to claim market leadership in conventional correspondent in Q2 2023. In this regard, note that PFSI intends to increase correspondent purchases from its REIT affiliate PMT in Q2 2023.

The table below shows trends in the PFSI servicing book. Notice that prepayments were only $10 billion in Q1 2023.

Of note, PFSI reported an increased valuation for its MSR at the end of 2022, but a decrease of $90 million in Q1 2023 before the effect of hedge results. The rally in the bond market since Q3 2022 caused some issuers such as COOP to take successive negative marks on the MSR, but PFSI did not do so until Q1 2023. If the 10-year Treasury note were to rally back toward 3%, MSR valuations would likely fall from current levels and force PFSI to take larger negative marks.

Of particular note, on Page 16 of the PFSI presentation, the issuer states: "No P&I advances are outstanding, as prepayment activity continues to sufficiently cover remittance obligations…” Like the rest of the industry, mortgage delinquency rates for PFSI decreased from the prior quarter and remained below pre-pandemic levels.

Mr. Cooper

At COOP, originations rebounded from a dismal Q4 for the industry and have moved higher along with many other issuers, who reported strong profits in February and March of 2023. Unlike PFSI, COOP’s production leads with direct to consumer (DTC), with correspondent a close second. The focus on DTC has enabled COOP to expand origination margins at a time when much (but not all) of the industry is seeing margins. The table below from COOP’s earnings presentation shows origination results.

Mr. Cooper

COOP continues to drive toward $1 trillion in total loans serviced in terms of assets under management (AUM) with several acquisitions during the quarter. Of note, the COOP MSR valuation trends and multiples are relatively conservative. More, unlike PFSI, COOP seems more focused on how much of the MSR book is out of the money (and therefore unlikely to prepay) than generating refinance events. The table below is from the COOP earnings presentation.

Mr. Cooper

Of interest, COOP is carrying just shy of $1 billion in advances on delinquent loans at the end of Q1 2023 vs zero for PFSI. COOP has only a bit more Ginnie Mae exposure in terms of delinquency than does PFSI, thus the fact that the latter continues to report zero advances is even more remarkable. One veteran banker notes that when delinquent loans are 2x prepays on a Ginnie Mae pool, that means that the custodial account is empty and the servicer must use corporate cash to fund advances.

COOP has plenty of borrowing capacity for advances or MSR acquisitions, and has largely hedged its MSR position against falling interest rates. “Our goal is to bring down the capital ratio over time, primarily by investing in MSR acquisitions and our own stock,” COOP CEO Jay Bray told analysts. “The quickest way for us to re-leverage the balance sheet would be to issue high yield notes, but we don't view the trading levels for our bonds as consistent with our strong credit profile. So we'll wait for a more opportune time to tap that market.”

Bottom line: Both PFSI and COOP are navigating the current market well, but we have questions about where the former is headed. With COOP, the direction is clearly to build AUM for the servicing book and use superior funding to extend the lead over other issuers. The DTC channel combined with a rational approach to correspondent seems to be delivering good results for COOP. At some point, however, PSFI must address the twin issues of the team and market strategy going forward.

To us, there is quite a difference between the two strategies. COOP takes comfort from relatively low note rates, but PFSI has been pushing the note rate up to catch future refinance events. The structural changes in the industry with 3/4 of all loans below 4.5% suggest that the MSR-centric view of COOP is the correct strategy. Even a significant rate decrease may not move the needle in terms of originations.

Disclosure 4/28/2023

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