How Pennymac is navigating the double-edged sword of lower rates

The third-quarter financials for Pennymac Financial Services illustrate the double-edged sword of declining interest rates for mortgage companies. It can improve loan production and acquisitions but hurt their servicing portfolios.

When factoring both impacts on its earnings, the California-based lender delivered a profit of $69.4 million from July to September. That was less than its $98 million profit in the second quarter of 2024, according to filings with the Securities and Exchange Commission (SEC) on Tuesday. 

With lower rates and more opportunities to refinance mortgages, Pennymac generated a pretax income of $108 million in Q3 2024 in its production segment, up from $41.3 million in Q2 2024 and $25.2 million in Q3 2023.

This was a reflection of more volume rather than higher margins. In total, loan acquisitions and originations had an unpaid principal balance (UPB) of $31.7 billion in Q3, up 17% quarter over quarter and 26% year over year. 

By segment, production in its correspondent channel increased 19% on a quarterly basis to $28.3 billion in Q3 2024, with margins rising from 30 basis points to 33 bps. In the broker channel, volumes rose 23.2% from the second quarter to reach $5.3 billion, but margins dropped from 103 bps to 97 bps. The consumer direct channel had a 92% increase in production to $5.2 billion, with margins declining from 393 bps to 323 bps. 

“Our production segment pretax income nearly tripled from last quarter as lower mortgage rates provided us the opportunity to help many customers in our servicing portfolio lower their monthly mortgage payments through a refinance,” Pennymac chairman and CEO David Spector told analysts in an earnings call. 

“At the same time, our servicing portfolio — now near $650 billion in unpaid principal balance and nearly 2.6 million customers — continues to grow, driving increased revenue and cash flow contributions and providing low-cost leads for our consumer direct lending division.”

The company’s servicing segment delivered a pretax loss of $14.6 million in Q3 2024, compared to pretax gains of $88.5 million in Q2 2024 and $101.2 million in Q3 2023. 

Lower mortgage rates resulted in the decline of the fair value of its servicing assets by $402.4 million, which was partially offset by $242.1 million in hedge gains. When rates drop, prepayments increase as borrowers refinance, hurting the fair value of these assets. The pretax income was $151.4 million, excluding the valuation and non-recurring items. 

“Interest rates exhibited significant volatility during the quarter. The 10-year Treasury yield declined approximately 60 basis points during the third quarter and ranged from a high of 4.5% to a low of 3.6%,” chief financial officer Daniel Perotti told analysts.

Perotti said the company will “seek to moderate the impact of interest rate changes on the fair value of our MSRs through a comprehensive hedging strategy,” and it also will consider “production-related income, which was up significantly this quarter versus last quarter.”

Executives said the company still targets a hedge coverage ratio of about 80% on its mortgage servicing rights. Servicing assets will continue to be used to create more refinance opportunities. 

“As of Sept. 30, approximately $200 billion in unpaid principal balance, more than 30% of the loans in our portfolio, had a rate above 5%, $90 billion of which was government-insured or guaranteed loans, and $108 billion of which was conventional and other loans,” Spector said. 

The company’s refinance recapture rate is 52% for government loans and 34% for conventional loans. “We expect these recapture rates to continue improving given our multiyear investments, combined with the increased investment in our brand and use of targeted marketing strategy,” Spector said. 

He added that Pennymac made the decision earlier this year to increase capacity and will continue to look to grow, “just given the natural growth in the portfolio.”

The company’s total expenses were $317.9 million in Q3 2024, up from $272.3 million in the prior quarter. This increase was “primarily due to increased production segment expenses due to higher volumes and stock-based compensation expense,” the company said.