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February 7, 2022 | Last week saw the start of the reporting season for publicly listed mortgage companies, with loanDepot (LDI) and PennyMac Financial Services (PFSI) issuing earnings results for Q4 and the full year. “Economic forecasts for 2022 total originations average $3.1 trillion,” PFSI observed. “While a large market by historical standards, it reflects a substantial decline from a record 2021 ‒ Excess industry capacity established in recent years will need to be right-sized” — all comments familiar to readers of the Premium Service of The Institutional Risk Analyst.
Among the larger issuers, PFSI, which is the external manager of PennyMac Investment Trust (PMT) REIT, has some of the better reporting. In addition to informing investors about forward volumes, PFSI also illustrates that primary/secondary spreads have fallen back toward 1% after widening last summer. As we never tire of reminding our readers, profits for financial companies are directly tied to spreads. Wider is better.
The fact that $2 trillion or so in the estimated 2022 volume is likely to be purchase mortgages provides little reason for great joy. Purchase is the most costly type of mortgage origination. The fact that PFSI is focused on consumer direct, which is a lower cost execution channel, is a positive.
Rising servicing income and falling prepayments on mortgage servicing rights is another positive. But production pretax income for PFSI in 2021 was half of 2020 and that downward progression will continue in 2022, led by falling correspondent volumes. Correspondent was down 50% YOY, from almost $60 billion in Q4 2020 to $33 billion in Q4 2021.
As we see the FOMC raising interest rates and ending both new purchases and even reinvestment of principal returns for the system open market account (SOMA), the importance of servicing portfolios grows. Both as a source of new loans and because of monthly cash flows, the yield on the MSR is a big part of future earnings. At a little over $500 billion, PennyMac Loan Services ranks sixth among primary servicers, according to Inside Mortgage Finance.
LDI, on the other hand, is not a very large servicer and ranks 16th in terms of owned servicing, again according to IMF. At $162 billion in unpaid principal balance of the loans, the LDI MSR is valued at 122bp. Between the end of 2020 and 2021, the value of the LDI MSR rose to just below $2 billion from $1.1 billion at the end of 2020.
Some observers remarked on the fact that LDI wrote down the MSR $118 million in Q4 2021. Our question is why didn’t LDI write down more. Sure, 5x cash flow is where the bulk market is for conventional MSRs. But 122bp does not strike us as a particularly conservative mark given that LDI wrote down $445 million in MSR in 2021. Call it a “rainy day” mark, something that is easier when you do your MSR valuation work in-house.
PFSI, by comparison, took down the value of its predominantly GNMA MSR portfolio by just $44.2 million for a period end multiple of just 4.1x the cash flow from the $278 billion in UPB. But more telling is the fact that production expenses, net of LO compensation, went from 24% of net revenues in Q4 2020 to 69% in Q4 2021 (Pg 10 of LDI Presentation), suggesting that cost cutting will be a priority in 2022.
PFSI has one of the longest and most stable operating profiles in the industry, even during the roller coaster years of QE and COVID. During 2020, PFSI delivered a return on equity north of 60%. The following year 2021 was half that rate., reflecting the decline in lending volumes and gain-on-sale (GOS) margins. Like the rest of the industry, PFSI believes in the virtuous cycle of lending and servicing, a proven formula unless and until delinquency becomes significant.
Notice in the chart below for LDI that operating expenses in 2021 rose above 2020 levels even as revenue fell in 2021 below the previous year. PFSI also saw production expenses rise through 2021 even as revenue and volumes softened. This is the traditional operating profile of the mortgage finance business, rushing to catch an opportunity c/o the FOMC in 2020-21, followed by a painful retrenching in terms of operating expenses in 2022. LDI’s GOS margin was 4.41% in 2020 and 2.9% in 2021, a trend that may continue into 2022.
LDI’s total expenses were up $800 million in 2021, a fact that will need to be addressed before the end of Q1 in terms of variable expenses. But then again, the entire industry is going to be dealing with layoffs and other efforts to rein in costs after a record year in 2020 and part of 2021. In that sense, the layoffs announced by Better Mortgage before the end of last year may have been prescient. Cost cutting is the name of the game in residential mortgages in 2022.
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