PennyMac Financial Services Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
October 26, 2023

There are 10 speakers on the call.

Operator

Afternoon, and welcome to PennyMac Financial Services Inc. 3rd Quarter 2023 Earnings Call. Additional earnings materials, including presentation slides that will be referred to in this call are available on PennyMac Financial's website at pfsi.pennymac.com. Before we begin, let me remind you that this call may contain forward looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation this that could cause the company's actual results to differ materially as well as non GAAP measures that have been reconciled to their GAAP equivalent in the earnings material. This.

Operator

I would like to remind everyone, we will only take questions related to PennyMac Financial Services Inc. Or PFSI. This call. Call. Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer and Dan Perotti, PennyMac Financial's Chief Financial Officer.

Speaker 1

Thank you, operator. PennyMac Financial produced outstanding results in the 3rd quarter, quarter. Returning to a double digit annualized return on equity. While average mortgage rates were up 50 basis points from the prior quarter, call. We demonstrated the earnings power of our balanced business model with exceptionally strong operating income from our large and growing servicing business combined with continued profitability and production.

Speaker 1

As a result, book value per share grew 3% from the prior quarter. Call. As you can see on Slide 4 of the presentation, mortgage rates have continued to increase from record lows in recent years and are now near 8%. Call. As a result, many borrowers who locked in a low fixed rate mortgage have been incentivized to stay in their homes given their low mortgage payments.

Speaker 1

This. This has resulted in an extremely low inventory of homes for sale, driving expectations for the lowest unit origination volume quarter since 1990. Additionally, we believe quarterly run rate origination volumes are trending lower than the average 1.6 $1,000,000,000,000 estimates from 3rd parties for this year. Though the current origination market remains constrained, quarter. Mortgage banking companies with large servicing portfolios are better positioned to offset the decline in profitability that has resulted from these lower origination volumes.

Speaker 1

Looking at Page 5 of our presentation, our balanced business model as a top 5 servicer and the top 2 producer of mortgage loans is a key differentiator that enables PennyMac Financial to profitably maneuver through varying interest rate cycles. Our servicing portfolio has steadily grown to nearly $600,000,000,000 and unpaid principal balance and 2,400,000 customers. This consistent growth is driven by our ability segment drives the majority of our earnings in a higher rate environment, a large portion of which is cash earnings in the form of servicing fees and placement fee income on custodial balances and deposits. Our multi channel approach to production enables consistent access to the origination market. In the current high rate environment, our correspondent and broker direct channels of production provide strong access to the purchase market.

Speaker 1

As we add these higher note rate mortgages to our portfolio, call. We are creating additional opportunities for our consumer direct business to offer our customers a new lower rate mortgage when interest rates decline. Quarter. As of September 30, nearly 20% of our servicing portfolio consisted of mortgages with note rates in excess of 5%. Quarter.

Speaker 1

Turning to slide 6. Revenue from servicing and placement fees has increased significantly in recent years due to growth in the portfolio and increasing short term interest rates. At the same time, operating expenses as a percentage of total the servicing portfolio UPB continue to decrease, demonstrating the operational scale and efficiency gains we have achieved. This. The substantial accumulation of home equity in recent years across the country has driven a large opportunity in the closed end second lien product, enabling borrowers to tap the equity they have built up in their homes without relinquishing their low rate first lien mortgage.

Speaker 1

Call. The 2,400,000 customers we have active servicing relationships with represent cost effective leads for our consumer direct channel this and we've been actively marketing to those who would benefit from a closed end second product. Since the launch of our closed end second lien product last year to our servicing portfolio customers. We have originated for sale into the secondary market approximately $450,000,000 in unpaid principal balance, call, including approximately $200,000,000 in the 3rd quarter. I'm excited to announce in the 4th quarter, call.

Speaker 1

We'll be launching a marketing campaign to non portfolio customers representing a significant opportunity for our consumer direct group call to attract additional customers given we currently service only about 4% of total U. S. Mortgage debt outstanding. Call. PennyMac Financial continues to lead the industry with strong financial performance given its large and balanced business model.

Speaker 1

Call. I'm extraordinarily proud of this management team's ability to successfully navigate the challenging mortgage landscape, call, while also positioning the company to generate increasingly stronger returns over time. I will now turn it over to Dan, who will review the drivers of PFSI's 3rd quarter financial performance.

Speaker 2

Thank you, David. PFSI reported net income of $93,000,000 in the 3rd quarter quarter were $1.77 in earnings per share for an annualized return on equity of 11%. Book value per share was up 3% from the prior quarter to $71.56 PFSI's Board of Directors also declared a 3rd quarter cash dividend of $0.20 per share. Quarter. Production segment pretax income was $25,000,000 in the quarter.

Speaker 2

Total acquisition and origination volume were $25,100,000,000 in unpaid principal balance, quarter, up from the prior quarter despite the continuation of a challenging origination market. Dollars 22,300,000,000 was for PFSI's own account and $2,800,000,000 fee based fulfillment activity for PMT. As you can see on Slide 10, PennyMac maintained its dominant position in correspondent lending with total acquisitions of $21,500,000,000 with margins in the channel unchanged from the prior quarter. Notably, the number of correspondent sellers we maintain relationships with increased to 829 from 800 at June 30. October volumes continued to be strong and correspondent with $8,900,000,000 positions and $9,400,000,000 in locks.

Speaker 2

In Broker Direct, we continue to see strong trends as volumes, margins, market share and the number of brokers approved to do business with us all increased from the prior quarter. Block volumes were up 6% from the prior quarter despite a smaller origination market and we expect to continue gaining market share as the top brokers increasingly see PennyMac as a strong alternative to the 2 top channel lenders. October volumes in Broker Direct were $800,000,000 in originations this and $1,000,000,000 in locks. In Consumer Direct, volumes remain low, but margins increased meaningfully from the prior quarter due to a greater proportion of closed end second liens, which have lower average balances. Production expenses, net of loan origination expense, were up slightly due to the overall increase in volumes.

Speaker 2

Turning to Page 14, the Servicing segment performed very well the Q3 with a contribution of $101,000,000 to pre tax income, up from $47,000,000 in the prior quarter. Quarter. The increase was primarily driven by strong operating results and lower net valuation related changes. Excluding valuation related changes, servicing pre tax income was $120,000,000 or 8.2 basis points of average servicing portfolio UPB, up from $75,000,000 or 5.3 basis points in the prior quarter. Loan servicing fees were up from the prior quarter primarily due to growth in PFSI's own portfolio as PFSI has been acquiring a larger portion of conventional correspondent production in recent periods.

Speaker 2

EBO income increased $9,000,000 from the prior quarter, driven by redeliveries of reperforming loans for certain EBO investors. Primarily from increased placement fee income on custodial balances due to higher short term interest rates, while interest expense was down due to lower average balances of secured debt outstanding. Quarter. Operating expenses increased slightly from the prior quarter, but remain low as a percentage of average servicing portfolio UPB. The fair value of PFSI's MSR before realization of cash flows increased by $399,000,000 during the quarter, driven by higher market interest rates, which resulted in projections for decreasing prepayments and an increased contribution from placement fees on custodial balances.

Speaker 2

Quarter. Hedging losses were $424,000,000 also driven by higher market interest rates. The net impact of MSR and hedge fair value changes on PFSI's pre tax income was negative $25,000,000 and the impact on earnings per share was negative $0.34 quarter. And finally, the Investment Management segment contributed $400,000 to pre tax income during the quarter. Assets under management increased slightly from the prior quarter this Q2 of PMT's strong Q3 results.

Speaker 2

This quarter demonstrates our ability to drive improvement in ROE, now back to the double digits. Call. While we expect normal seasonality and a higher rate environment to have some impact in the next couple of quarters, we expect our strategic position and the strength of our model to continue to drive our returns higher over time. We'll now open it up for questions. Operator?

Operator

Thank We'll now take your first question from Kevin Barker of Piper Sandler. Your line is open.

Speaker 3

Great. Thanks for taking my questions. Congrats on a good quarter. This. Just wanted to follow-up on some of the margins and the growth in the origination side.

Speaker 3

It seems like correspondent was fairly strong with margins flat. We've seen one of your competitors mentioned that there's been a pickup in competition despite the pullback from several large banks. What are you seeing in that market and you feel like the competitive environment is increasing or fairly stable? Thank you.

Speaker 1

Kevin, how are you? Look, I think in Correspondent, we had a really strong quarter and correspondent. And I think it's really for a couple of reasons. One, clearly, we're seeing the bank stepping back. We saw that really started in the Q2.

Speaker 1

It's continuing as a lot of banks are looking at the Basel issues that they're thing. And I think that you're going to see more of that business in correspondent. It's kind of moved out of the banks, but it's going to continue call to stay out of the banks. I think that another reason correspond so strong is the fact that sellers are not really retaining services. And so if you recall, during meteor times of margins, sellers would retain servicing because margins were at kind of the higher levels, and they can retain that servicing.

Speaker 1

But right now, we're seeing many sellers not retaining the servicing. And so they're selling the whole loans 2 correspondent aggregators versus selling to, for example, the GSEs where they would they could retain the servicing. From my perspective, call. As it pertains to PennyMac, I think we're seeing a flight to quality from the point of view that was a leading correspondent aggregator And we're seeing many of our customers continuing to deliver product to us, and perhaps not delivering as much to some of the lower market share participants in the market. I was generally I was very pleased with the increase in sellers.

Speaker 1

And while The sellers themselves are smaller, so it's not meaningful to the UPB. I think it just it kind of talks to the slight to quality issue. I mean for us to add this. Almost 30 sellers in a quarter is a pretty big number. And so I think that it all adds up to a really good quarter from a production stand point from a share perspective and also from a margin perspective.

Speaker 1

And I believe that the margin story should hang in there in Q4 and that's what we're seeing to date. And I think from a correspondent perspective, we're in a very good place.

Speaker 3

Call. Great. Thank you. And then just a follow-up on the broker channel as well. You've seen an increase in fallout locks And then an increase in margin as well.

Speaker 3

Obviously, there's been quite a bit of attrition within that channel over the last year. Just love to hear a little bit more about what you're seeing from a competitive standpoint within the broker channel. Thank you.

Speaker 1

Yes. So on the broker side, we're seeing some very good traction being made in Especially with top brokers, as they themselves are getting concerned with the share of the top 2 participants. And so they're in need of a strong alternative. And so we're positioning ourselves as that strong alternative. And we're really Between that and the technology that we've spent a long time creating to really In working with brokers to address their needs, we're seeing very good feedback on the technology.

Speaker 1

And so I'm really happy to see that it that we saw margin that we saw share growth quarter. Last quarter, we saw margin growth. Now some of that margin growth has to do with some execution enhancements after pricing. And so I think the margins that we saw this quarter were very good, but I continue I would expect them to continue to stay at the high end. And Mike, in all three production divisions, we're seeing pricing stay rational.

Speaker 1

And I think that that's this. I don't see that changing. And I think if anything, over the next couple of quarters, if you do see consolidation this. That could provide some additional margin opportunity margin expansion opportunity for us.

Speaker 3

Great. David, thank you for all the detail. Very

Speaker 1

helpful. Thanks, Kevin.

Operator

Your next question comes from the line of Bose George of KBW. Your line is open.

Speaker 4

Hey, everyone. Good afternoon. Can I just ask first, your servicing fee Increased, it's 26.7, so it's up 1.7 basis points? I mean, could we see that go down if you do excess transactions? Or should we see the servicing fee kind of Same this level going forward.

Speaker 2

This is Dan. Hi, Bose. We Generally, are expecting the servicing fee most likely to go up over in basis points to go up over the next few quarters. We could see some impacts from sales of excess. But overall given the servicing that we're bringing on, the fact that the significant bulk of the overall servicing that we're generating since the conventional correspondent volumes are now going through to PFSI and they are retaining those as MSR, the bulk of those rather than PMT retaining it over the last couple of quarters.

Speaker 2

That's contributed to the increase in the basis points of servicing fee. We do evaluate sales of excess, extent that we see that as a benefit in terms of our deployment of capital. And so our overall lean I would expect fact over the next few quarters as we're bringing on additional servicing some of it at higher servicing fee levels would be to see that servicing fee and basis points go up over the next couple of quarters.

Operator

This. Okay.

Speaker 4

Okay, great. Thanks. And then actually going back to the gain on sale margin, in that Slide 11, The gain on sale margin by channel has gone up the last over last quarter last year. And but then there's that other line item that kind of offset that. So if I look at the total gain on sale margin, it actually went down a little bit quarter over quarter.

Speaker 4

So I was just curious like what that line is and also should we look at this on kind of a at that bottom line basis or should we look at the line items?

Speaker 2

Sure. Generally speaking, I would say you should look at the line items and that will generally tell you quarter. Margins are performing on a channel by channel basis. The shift in the overall margin quarter over quarter was really based primarily on the mix of volume. So we had greater, a greater proportion of correspondent loans coming through in the Q3 as opposed to some of the earlier quarters.

Speaker 2

I mean those are overall if you look at the blend this lower margin for that volume. And so that overall is what is driving down The basis points on an aggregate basis quarter over quarter.

Speaker 4

Okay. And that other line is that sort of is that hedging or what kind of flows through there?

Speaker 2

The other line has a couple of components. The first is really just, timing really some timing elements When we're looking at locks and these are income associated with locks, there are certain elements from an accounting point of view quarter where we only earn the income at time of funding. So those could get shifted to a different period. But in order to track what we're expecting to what we see as the margin in that channel. We're really looking at what our expectation is for the lock gain in that period.

Speaker 2

And so if we have a timing difference that could shift. And then if we do have to your point any sort of hedging gain loss or other elements of that nature that can also this time enter into that line.

Speaker 4

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Michael Kaye of Wells Fargo. Your line is open.

Speaker 5

Hi, good evening. Quarter. On the production segment, do you think you could keep the profitability at these levels, just given we're entering the slower seasonal winter months, quarter. Plus mortgage rates are much higher, can that potentially swing back to losses?

Speaker 1

This? Look, I think under the things we can't control and clearly from what we're seeing in October, I would expect Q4 to be profitable in production. We've got an industry leading correspondent franchise That continues to operate at the levels that you saw in the Q3. We have rational pricing taking place in the market. And so I don't see the margins really coming under severe pressure to swing it to be unprofitable slide.

Speaker 1

And similar story can be said on broker as well. I mean, we're making inroads in broker. Call. And while the current run rate of production is closer to a $1,200,000,000,000 market, this It's still more than enough to keep us operating profitably. I'll tell you, I think that really In the consumer direct channel, the product that I'm really enthusiastic about is closed end seconds.

Speaker 1

Quarter. We had a very good quarter in closed end seconds where we originated $200,000,000 in the Q3 alone. We've originated $450,000,000 to date. This. And the margins are very nice.

Speaker 1

It's a profitable product for us. We sell them all into the secondary market. So there isn't we're not retaining them. We do retain the servicing on them as we currently service the first on these loans as well. Quarter.

Speaker 1

And one of the real added benefits is that it keeps capacity in place for our consumer direct channel. And Emily, we will see a rate decline and having that capacity in place will be very important for us to be able to seize on the opportunity to refinance borrowers and higher rate mortgages. And so I'm enthusiastic about what we're call. In Q4, and I think that we're setting ourselves up to continue to grow ROEs in this? In an environment that's higher for longer or in an environment where rates are declining.

Speaker 5

It's good to hear. Call. Just on expenses, I know you took a lot out, you were early, But I don't think anyone was thinking or anyone was planning for mortgage rates to be where they are now. I mean, are you positioned okay call. On expenses in production or do you think there could be potentially more trimming just this.

Speaker 5

Given the environment, it's probably worse than most of us were expecting.

Speaker 1

But I think on the production and servicing side, We are very good at being able to bring up staffing or take down staffing based on the gearing ratios that we see for the market we're in. I think that there is a from my perspective and the rest of the organization, we're running a core functionality call. And we're not we're clearly not sized for a $1,200,000,000,000 market nor are we going to put ourselves in that position. Call. Having said that, we're doing some things like looking at our technology infrastructure and I suspect we're going to be looking to reduce expenses there.

Speaker 1

We're doing things like this. If there's attrition, we make our management team jump through hoops before we hire to replace that. But by and large, to your point, we did we took our medicine early. We knew what we needed to do. We did it, I think, 3 or 4 times in 'twenty two alone.

Speaker 1

But having said that, it's given us the opportunity to focus on growing ROE, which we did this quarter, getting it back up into the double digits.

Speaker 5

This. Your

Operator

next question comes from the line of Eric Hagen of BTIG. Your line is open.

Speaker 6

Hey, good afternoon. How are you doing guys? First question here, I mean, can you talk about how you're maybe adjusting or pricing for different borrower credit characteristics, any changes to the credit box, even more generally as rates have moved up this high. Like whether you're this? Intentionally targeting higher quality loans because rates are high and affordability is this constraint?

Speaker 6

Thank you.

Speaker 1

This? Yes. Hey, Eric. Look, I think that if you the way we think about pricing mortgages is Number 1, we only buy loans that are saleable to the GSEs or that meet FHA, VA or USDA guidelines. Having said that, I would say in late in the Q3 of last year alone, we made some conscious decisions in terms of pricing risk attributes to take into account higher rates.

Speaker 1

And so along those lines, a lot of the lower FICO FHA loans and VA and USDA loans, we believe We're going to require, I would say, a higher return in the investment for servicing, given that In higher rate environments, typically, you see delinquencies increase, you see correspondent sellers stretching and while we get while we diligence loans and we underwrite in this. Inevitably, you do start to see delinquencies go up. I think it's I think this move, while again, is a little bit on the early side, I'd rather be early than late as you can well imagine. And I think it's bearing out. If you look at the FICO's and the LTVs of our production versus the rest of the market, this.

Speaker 1

I think it's meaningful. It's something that the management team looks at on a regular basis. But I don't see it. We're not arbitrarily making changes to the credit box.

Speaker 2

This. And you can see, Eric, if you look on Page 33 of the deck, are the characteristics of the loans that we're acquiring, especially corresponding over time. The FICO has increased significantly and a lot of that is in response to some of the factors that David was talking about and some of the changes that we made, going back to the Q3 of last year.

Speaker 6

Yes. No, that's helpful. Hey, with the hedging results in the period, would you say that's a function of the level of rates or is it this. Interest rate volatility, is there sort of like an ideal environment you feel like for hedging the MSR and maybe even kind of teasing apart and talking through the Hedging results in the quarter would be helpful. And any hedging through October as well?

Speaker 6

Thanks guys.

Speaker 2

Call? Sure. So we talked a little bit last quarter about the elevated hedging costs that we are seeing from volatility being very high and some of the impacts of the inverted yield curve as a lot of that abated this quarter. We saw pretty meaningful deinversion of the curve as well as vol come down. And we saw our hedge costs decline meaningfully.

Speaker 2

Our overall profile and our strategy at this point is really given how high interest rates are typically when rates were lower or more balanced I would say in terms of the moneyness of our servicing portfolio. We targeted a hedge ratio that was less than 100%. So that we would allow for gains in a sell off because origination volume would decline and for potential losses, limited losses in a rally because we would see an uptick in origination income. With rates at this level where so much of the servicing portfolio is meaningfully out of the money, we've really flattened that hedge profile and are targeting profile that's fairly close to 100%. So when we take out the cost of servicing, I mean the cost of hedging rather and then look at what our hedge ratio was compared to the change in value.

Speaker 2

We actually come up to pretty close to 100% given the change in value that we saw during the quarter. Overall, there was relatively from our perspective little leakage given the size of the servicing portfolio and the MSR asset in the change in interest rates that we saw during the quarter. To your point and Given where we are in rates and the fact that so much of our servicing portfolio is out of the money, we would expect this that this targeting of the hedge ratio closer to 100% is where we'd be probably at least for the next few periods, barring a meaningful interest rate rally. This. Yes, I think that sort of covers where hopefully what we saw during the quarter here as well is what you might expect to see going forward.

Speaker 6

Got it. Okay. So into October there hasn't been a lot of slippage it sounds like this

Speaker 2

October has been pretty contained as well.

Speaker 6

Okay, great. Thank you guys very much.

Operator

Your next question comes from the line of Kyle Joseph of Jefferies. Your line is open.

Speaker 7

This. Hey, good morning, guys or sorry, good afternoon. A lot of my questions have been answered, but I just wanted to walk through the 2nd lien product. And quarter. I know you emphasize that it's really been catching ground and whatnot, but just walk us through the kind of the impacts on the P and L and the balance sheet specifically and what it will what in terms of volumes and margins and whatnot and whether you'd expect that to continue.

Speaker 2

So the 2nd lien product overall, as David mentioned, we originated about $200,000,000 of it during the quarter. I think we mentioned in our We mentioned in the presentation that we are also looking at opening that up to beyond our just originating for our servicing portfolio to market to the market at large, which is obviously even greater opportunity than what tab in our servicing portfolio. So we could we do expect that continue to increase. It's been increasing over the past few quarters. If you look at the margin trends that we've seen In Consumer Direct, which is the channel in which we're originating these loans, that's been increasing pretty meaningfully on a basis points basis over the past few quarters.

Speaker 2

So, a lot of that is due to the blend of the second lien product this versus the 1st liens because we are originating a greater proportion of 2nd liens. And so Given the smaller balance of the 2nd lien product, we have a higher basis point target in terms of our gross margin there. So just given the blend, it's a bit above what the blend was here. So up into the 500 basis points or 600 basis points in terms of margin On a UPB basis, where the overall UPBs of these loans can be $75,000,000 to essentially $100,000 And so that's really the revenue side on the production side they it's pretty similar expense wise to what we see for a normal consumer direct loan. So on a normal scale, a little bit under in terms of basis points what you would see in terms of what we collect in terms of the revenue.

Speaker 2

So we have It's a profitable contribution to the overall production business, but not as significantly profitable as if we were refinancing loans in a rally. But to David's point, if we do see an interest rate rally, one of the benefits of the 2nd lien product or production is that we're able to keep the staff on hand in a profitable enterprise. And then when we do see the interest rate rally, we'll be able to shift those resources over to refinancing loans into 1st liens from this the higher note rate balances that we've added over the past couple of quarters through correspondent.

Speaker 7

Got it. Very helpful. Thanks for answering my question.

Operator

Call. Your next question comes from the line of Jay McCanless of Wedbush. Your line is open.

Speaker 8

This. Hey, good afternoon, everyone. Two questions from me. I guess, if you take this. The 2nd lien loans that you're originating outside of your channel, I mean, what's kind of the annual market size or market opportunity you think could be out there?

Speaker 1

Hi, Jade. Look, I think that clearly and we've got a if you go to Slide 8, you can see the opportunity for 2nd lien expansion. I think that I would be disappointed if we didn't see production volumes grow in the second lien space. We did $200,000,000 last quarter. We have a very big servicing portfolio with a lot of tappable equity on its own.

Speaker 1

We have 60% of the borrowers in the United States have a mortgage loan with a no rate 4% or lower. And I think that one of the things in my years of experience is products as people get As people understand products more generally accept in the marketplace, you just see demand for them go up. And you're seeing more and more people taking out second liens. And this is one of the reasons why we are introducing it in our consumer direct channel for non portfolio customers. We are going to test it out in broker direct.

Speaker 4

And I would expect that

Speaker 1

to be sometime this late Q4, early Q1. But I think suffice it to say, it's a product that's here to stay, Given the fact that we do have so many mortgage loans below 4%, people have a lot of equity in their properties. And so this. It's something that they're going to want to life events are going to take place, so they're going to want to tap the equity. I think as we stay higher for longer, Obviously, you'll see more and more second liens being done.

Speaker 1

But I think that I think it's just it's a product that's necessary this. Really given what's taken place the last 3 or 4 years with people just refinanced into low rate mortgages.

Speaker 8

That's great. Thank you for the detail. I guess the other question, share repurchase, any thought to doing that at these levels?

Speaker 1

Share repurchase,

Speaker 2

it's obviously something that we've slowed down on from the levels that we had been at previously with that, that we haven't done any share repurchases this quarter. Something that we continue to look at, but a couple of factors that we take into account. Our overall leverage ratio. So we are targeting to be if we look at our non funding debt, We're at 1.2 times leverage ratio this quarter. We've been in this area slightly above 1 times.

Speaker 2

And then we're very cognizant that we want to maintain that leverage ratio below 1.5 times, as we look out into the next few periods and ensure that our leverage ratio is in a good position to be able to facilitate any unsecured debt that opportunities that we might see or might want to engage in. So while certainly quarter. Where the stock price has been recently it's a more attractive proposition. It's something that we're weighing against Maintaining our leverage ratio in the area that it currently is as well as other potential capital deployment whether it's in the $25,000,000,000 of correspondent servicing this that we're adding a quarter or any other potential opportunities that might arise.

Speaker 8

This. Okay. That sounds great. Thanks for taking our questions.

Operator

Your next question comes from the line of Priya Rangarajan of RBC Capital Markets. Your line is open.

Speaker 9

Hey, guys. Thank you so much for the call. On the 2nd lien program that you have, quarter. Are you seeing any consumer behavior difference between a cash out 3.5 versus a second lien product? Are they like Going on for the like do they have a preference in terms of which product they do they choose?

Speaker 1

Well, one of the reasons hi, Priya, it's David. One of the reasons we came out with product because I didn't like what I was seeing in the market with people who are starting to refi out of low rate first lien. And so from my perspective, we needed the product to give borrowers the ability to tap their equity without getting out of 1st lien mortgages. From when a borrower calls in for cash out refinance, we expose them and offer them the 2nd lien product as a viable product. We don't we pay the loan officer the same amount.

Speaker 1

So there's no incentive for them to do a cash out refi versus a second lien mortgage. This. We want to really be focused on the compliance aspect of this product. And I think it's meaningful in terms of and I think it speaks to why we're doing so many 2nd lien versus cash out refinances. I there are life events that you require cash out or cash out refinances or refinances to take place.

Speaker 1

But I generally am of the view that if borrowers want to tap their equity, this. The 2nd lien product is the place for them to go. Now we do have minimum FICO's on the product. So for the lower FICO product, if you see cash out refinances in the marketplace, that's probably the reason why. But generally speaking, given the high credit quality quarter.

Speaker 1

Of our servicing portfolio, 2nd lien is the product that I really want to see our borrowers using to tap the equity.

Speaker 9

That's very helpful color. Secondly, on the origination side, As you look into 2024, to the extent that the market don't change so much from an existing sales of house market, How are you thinking about gain on sale margins? Do you think that the industry has rationalized enough that you should see stable margins? Or Can gain on sale actually go higher as there is more consolidation?

Speaker 1

Well, look, I think the gain on sale margins quarter. For this year, it may remain relatively stable. There's some ebbs and flows that take place during a month or so. But I think generally speaking, we are seeing In on sale margins stabilized. And as I mentioned earlier, I think in correspondent, we're starting to see a little bit of opportunity with the bank stepping back for us to increase margin.

Speaker 1

I think that look, from a mortgage size perspective, mortgage market size, Given where the application index is showing, right now, we're probably running at $1,200,000,000,000 $1,300,000,000,000 run rate. Given the average balance, we're at a unit run rate that we haven't seen since 1990. I generally think we will see this. Rates come down when I don't I'm not in the prediction business, but I think when you look at the market as a whole, It's generally thought in the second half of next year, you'll start to see some pressure come off of rates. Having said that, as I said, I'm generally I'm very pleased with where margins are.

Speaker 1

There's rational pricing taking place in all three channels. Call. And I suspect that in Q4 and a little bit in Q1, given the high level of rates, You're going to start to see some more consolidation taking place, which will only lend itself to margins at a minimum staying stable.

Speaker 9

Got it. And then finally, from a credit perspective, you guys obviously did not do a dividend this quarter. Given where your debt trades, have you guys thought about doing open market purchases, tender, like your 2025 refinancing? Anything would be really helpful color. Thank you so much.

Speaker 4

Sorry, the

Speaker 2

so we did do a dividend this quarter just to be clear in Yes, I misheard you. So we did issue quarterly dividend, but we're not Currently, as I mentioned, we are looking at potential opportunities in the unsecured debt space or in the high yield space, Have not seized upon that yet. We've additionally been raising we've increased some of our we're in the process of looking at potential opportunities On the secured side, to replace or move out, some of our debt maturities there, Unless we or to the extent that we see an opportunity that makes sense for us in the high yield market, we potentially would look at If there's how to address our maturity for unsecured debt that's coming up not till later in 2025. But that still is a bit off and we think that there's a pretty large window of opportunity here between here quarter and when that maturity comes. And so we're not we don't necessarily expect anything in the near term.

Speaker 9

Thank you. And I meant share buyback, sorry. Thank you.

Operator

And your last question comes from the line of Kevin Barker of Piper Sandler. Your line is open.

Speaker 3

Thank you. I just wanted to follow-up on the interest income, which has been fairly strong. This. Obviously, you have some different moving parts with higher interest rates, higher custodial balances And then some seasonality associated with it, combined with some decline in debt. So maybe could you just provide us a little bit more color on What do you expect from the direction of interest income just given higher custodial balances and then interest expense on the other side given lower origination volume just seasonally?

Speaker 3

Thanks.

Speaker 2

So overall when we look at The interest income to your point, there's a number of different moving pieces. So we tend to look at it on The interest income related to production and then the interest income related to servicing. Interest income related to production given some of the changes to in the yield curve toward the end of last quarter, the beginning of this quarter would tend to push up call? The note rate of mortgage rates versus the short term rates have stayed relatively stable. So we'd expect That relationship between our financing lines and the note rates on the loans that are coming in to increase this that interest spread.

Speaker 2

So that would generally move the interest income on the production side in a positive direction. On the servicing side, a couple of factors. So one, as we noted in our servicing income sort of disclosure, our servicing profitability slide, slide 14 this in the slide deck. We did see interest expense decline quarter over quarter due to a lower draw on our servicing financing lines. We are keeping somewhat less cash.

Speaker 2

You may have seen the cash balance in our the cash balance on our balance sheet declined somewhat. So we have begun to reduce The overall cash that we're holding on the balance sheet, we had been holding somewhat elevated levels due to the some of the market turmoil that we saw earlier in the year. So we've begun to reduce that, that really reduces some of the interest expense that we're seeing on the financing lines, would also reduce somewhat the interest income that we're earning on that cash, but overall since we're paying a spread of 300 basis points to 400 basis points on the servicing lines, would bring down that interest expense and create an overall positive benefit. On the interest on the custodials, this. We do expect that to probably come down a little bit quarter over quarter just as to your point The overall custodial balances or the escrow account balances tend to come down in the Q4 and be a little bit lower in the Q4 and Q1 due to seasonal tax payments that typically occur toward the end of the year or very beginning of the year.

Speaker 2

So Hopefully, I know that was a lot of different components, but a couple of different countervailing effects. But overall, I would say probably interest income ends up in a pretty similar place with all those effects as what we saw in this quarter if we're looking out into the quarter.

Speaker 3

Yes, that's very helpful. Just from a seasonality perspective, what percent of the cost deal of the balance Would you expect to decline in the Q4 and then in the Q1 just due to seasonality?

Speaker 4

Yes. Typically,

Speaker 2

the average is lowest in the Q1 Because the tax payments happen through the Q4. So I think compared to the Q3, this? I don't know the percentages off the top of my head. But I think roughly in this? In the Q4 down 10% to 15% and then in the Q1 a bit higher than that probably down 20% or a little bit more.

Speaker 3

Okay. Thanks for taking my questions, Dan.

Operator

Call. We have no further questions at this time. I'll now turn it back to Mr. Spector for closing remarks.

Speaker 1

Call. Well, thank you everyone for joining today. We appreciate the time and the thoughtful questions. And call. If you have any additional questions, please don't hesitate to reach out to our IR team and I look forward to speaking to all of you real soon.

Operator

Call. This concludes today's conference call. You may now disconnect.

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Earnings Conference Call
PennyMac Financial Services Q3 2023
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