Participants

David Spector; Chairman of the Board, Chief Executive Officer; PennyMac Financial Services Inc

Daniel Perotti; Chief Financial Officer, Senior Managing Director; PennyMac Financial Services Inc

Douglas Harter; Analyst; UBS Equities

Michael Kaye; Analyst; Wells Fargo Securities LLC

Terry Ma; Analyst; Barclays

Presentation

Operator

Good afternoon and welcome to PennyMac Financial Services Inc., fourth-quarter 2024 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 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 materials.
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. You may begin.

David Spector

Thank you, operator. Good afternoon, and thank you to everyone for participating in our fourth-quarter earnings call. For the fourth quarter, PFSI reported net income of $104 million, or diluted earnings per share of $1.95 for an annualized return on equity of 11%. Excluding the impact of fair value changes, PFSI produced an annualized operating ROE of 16%, driven by continued strength in our Servicing business and a solid contribution from our Production segment despite higher mortgage rates.
In total, loan originations and acquisitions were $36 billion in unpaid principal balance, up 13% from the prior quarter and driving the continued growth of our servicing portfolio to $666 billion in unpaid principal balance with 2.6 million customers.
Before I continue on, I would like to talk about a change that we are reporting our financial results and reporting segments. We took the opportunity to address our financial reporting for the evolution of our businesses and the way we manage them.
As a result, we have modified our segment definitions. The principal change we made was to remove the corporate overhead allocations from our business segments to better evaluate the performance of our operating businesses. We also determined that our Investment Management business was not an operational segment, and as such, the related results are now consolidated into corporate and other items.
Our two operating segments are now Production and Servicing, and we have included non-segment activities and activities related to our investment management business in corporate and other. Prior period amounts have been recast to conform these periods presentation to the current period presentation, and I encourage investors to view the Excel supplement posted on pfsi.pennymac.com for more detailed information.
Now back to our results. The fourth quarter marked the end of a very successful year for PFSI as you can see on slide 4 of our earnings presentation. We highlighted some of our key achievements in 2024, which demonstrates the earnings power of our balanced business model and the significant gains in operating leverage we achieved.
In the production segment, total acquisition and origination volumes were $116 billion in UPB, up 17% from 2023, driven by a nearly 70% increase in originations from the direct lending channels. Production segment revenues were up 47% from 2023, and despite the large mix shift, expenses remain contained, up only 13% from 2023.
Production segment pretax income in 2024 was $311 million, up from $116 million in 2023, including a significantly higher contribution in the third quarter when rates decline, highlighting our ability to rapidly address recapture opportunities and increase demand for refinances when mortgage rates decline.
Our large servicing business provides ongoing revenue and cashflow contributions in this higher rate environment and continues to provide the foundation for our strong financial performance. The unpaid principal balance of our servicing portfolio increased 10% from the prior year end as production volumes more than offset runoff from prepayments.
Servicing segment operating revenues were $1.5 billion, a 19% increase from the prior year, driven primarily by increased servicing fees and earnings on custodial balances due to growth in the owned portfolio. Operating expenses increased by only 3%, demonstrating the ability of our servicing workflows and technology to scale efficiently with our growth, while also providing our Servicing associates with the tools they need to best serve our customers.
In 2024, Servicing segment operating pre-tax income was $643 million, or 10.1 basis points of average servicing portfolio UPB, up from $535 million, or 9.3 basis points in 2023. In total, we delivered an operating return on equity of 17%; GAAP ROE was 9%; growth in book value per share was 6%; and we also increased our dividend to $0.30 cents per quarter, an increase of 50% from the previous dividend.
These strong yearly results demonstrate our commitment to operational excellence and our focus on delivering sustainable earnings through varying interest rate cycles by leveraging our balanced business model.
Turning to the origination market, current third-party estimates for total originations in 2025 average $2 trillion, reflecting growth in overall volume. Though mortgage rates are back up into the 7% range, we believe ongoing volatility in rates will present opportunities in the origination market from time to time.
As you can see on slide 6, our balanced and diversified business model with leadership positions in both production and servicing enable strong financial performance and a foundation for continued growth as an industry-leading mortgage company across different interest rate environments.
We achieved the mid-teens operating ROE in quarters characterized by higher mortgage rates and a 20% operating ROE in the third quarter, when mortgage rates declined. Because we retained the servicing rights on our loan production and have been one of the largest producer of mortgage loans in recent periods, we are uniquely positioned with a large and growing portfolio of borrowers who recently entered into mortgages at higher rates and who stand to benefit from a refinance in the future when interest rates decline.
On slide 7 of our earnings presentation, you can see that as of year end, $220 billion in unpaid principal balance or approximately one-third of the loans in our portfolio had a note rate above 5%. Approximately $100 billion were government loans, and approximately $120 billion will conventional and other loans.
The potential opportunity for earnings growth is highlighted on this slide, as well as our historical refinance recapture rates, which have improved significantly from five years ago as a result of our ongoing technology enhancements and process improvements. We expect these recapture rates to continue improving given our multi-year investments, combined with the increased investment in our brand as use of targeted marketing strategies.
As I briefly discussed, our large and growing servicing portfolio is a key asset, anchoring our core operational results in this higher interest rate environment and driving low-cost leads to our consumer direct division. Throughout our history, we have been focused on deploying new and emerging technologies to drive efficiencies and lower costs, as evidenced by the chart on the right side of slide 8, which highlights a decline in our per loan servicing expenses of more than 35% since 2019.
We have a platform in the mortgage industry that I believe is unmatched. And further, our best-in-class management team remains committed to unlocking additional efficiencies through continued investments in workflow and technologies.
It is for all of these reasons that I am confident in our ability to continue driving strong financial performance in this higher rate environment, bolstered by increases in the origination market in periods when mortgage rates decline. 2025 will be an exciting year for us.
I will now turn it over to Dan, who will review the drivers of PFSI's fourth-quarter financial performance.

Daniel Perotti

Thank you, David. PFSI reported net income of $104 million in the fourth quarter, or $1.95 in earnings per share, for an annualized ROE of 11%. These results included $68 million of fair value declines on MSRs net of hedges and costs, and the impact of these items on diluted earnings per share was negative $0.93. PFSI's Board of Directors declared a fourth quarter common share dividend of $0.30 per share.
Beginning with our production segment, pre-tax income was $78 million, down from $129 million in the prior quarter. Total acquisition and origination volumes were $36 billion in unpaid principal balance, up 13% from the prior quarter, as many loans originally locked in the third quarter were funded in the fourth quarter.
Total locked volumes were $36 billion in UPB, down 7% from the prior quarter due to higher mortgage rates. Of total acquisition and origination volumes, $32 billion was for PFSI's own account, and $4 billion was fee-based fulfillment activity for PMT.
PennyMac maintained its dominant position in correspondent lending in the fourth quarter, with total acquisitions of $28 billion, up from $26 billion in the prior quarter. Correspondent channel margins in the fourth quarter were 27 basis points, down from 33 basis points in the prior quarter.
However, the revenue contribution was essentially unchanged as increased volumes offset the lower margins. Increased volume in the quarter was primarily due to PMT retaining 19% of total conventional correspondent production in the fourth quarter, a decline from 42% in the third quarter.
In the first quarter of 2025, we expect PMT to retain approximately 15% to 25% of total conventional correspondent production, consistent with the fourth quarter. Of note, pursuant to a renewed mortgage banking agreement with PMT, beginning in the third quarter of 2025, all correspondent loans will initially be acquired by PFSI. However, PMT will retain the right to purchase up to 100% of non-government correspondent loan production.
In Broker Direct, we continue to see strong trends and continued growth in market share as we position PennyMac as a strong alternative to channel leaders. Originations in the channel were up 22% as many loans locked in the third quarter were funded in the fourth, while lock volume was down 17%, given the reversal in mortgage rates. The number of brokers approved to do business with us at year end was over 4,600, up 21% from the end of last year.
And we expect this number to continue growing as top brokers increasingly look for strength and diversification in their business partner. Broker channel margins were up slightly from the prior quarter, near normalized levels. Consumer Direct was similar, with originations up 40% from the third quarter and lock volumes down 30%.
Margins in the channel were up, given a higher mix of refinanced loans in the third quarter at lower margins. Activity in January was down due to higher mortgage rates and typical seasonality. Production expenses, net of loan origination expense, increased 12% from the prior quarter, due to higher funded volumes and increased capacity in the direct lending channels.
It is our preference to hold a level of excess origination capacity in the current market environment given our belief that volatility in interest and mortgage rates will provide pockets of opportunity from time to time and that we will need to be quick to react.
Turning to Servicing. The Servicing segment recorded pre-tax income of $87 million. Excluding valuation-related changes, pre-tax income was $168 million, or 10.3 basis points of average servicing portfolio UPB. Loan servicing fees were up from the prior quarter, primarily due to growth in PFSI's owned portfolio. And earnings on custodial balances and deposits and other income decreased due to lower short-term rates.
Custodial funds managed for PFSI's owned portfolio averaged $7.3 billion in the fourth quarter, up from $6.9 billion in the third quarter, primarily due to increased prepayments. Realization of MSR cash flows decreased $10 million from the prior quarter due to lower prepayment expectations as a result of higher mortgage rates.
Operating expenses were down $2 million from the prior quarter at $81 million, or 5 basis points of average servicing portfolio UPB. The fair value of PFSI's MSR increased by $540 million, driven by higher market interest rates. Pension losses and costs were $608 million, more than offsetting MSR fair value gains.
As David mentioned, results from our Investment Management business are now included within corporate and other. Corporate and other items contributed a pre-tax loss of $36 million, compared to $39 million in the prior quarter. PFSI recorded a provision for a tax expense of $25 million, resulting in an effective tax rate of 19.2%.
The reduction in the effective tax rate from the prior quarter was primarily due to a decline in the provision rate from 26.85% to 26.7% and the resulting repricing of expected taxes on deferred income. We ended the quarter with $3.3 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledged.
We'll now open it up for questions. Operator?

Question and Answer Session

Operator

(Operator Instructions) Thank you. I would like to remind everyone we will only take questions related to PennyMac Financial Services, Inc., or PFSI. (Operator Instructions) Doug Harter, UBS.

Douglas Harter

I'll go into a little bit more about the hedge performance this quarter, what drove the larger hedge loss. And I know in past quarters you had talked about changing the hedge strategy, the cost of it, and just give us an update on the strategy there.

Daniel Perotti

Sure. Sorry you cut a little bit, Doug, so I'm going to answer each of the questions that I heard and if there's some piece that I didn't answer, just let me know afterwards. In terms of the performance of the hedge in the fourth quarter, actually the overall hedge performs more or less in line with how we expected in terms of our insulation from changes in market rates.
One change that we did have during the quarter is that as interest rates increased significantly, when rates were at lower levels we had discussed, we were attempting to hedge in the 80% to 90% area as we moved up to higher rates where again in near term rallies, there's not as much of an impact to production. We moved that hedge ratio back towards 90% to 100% as rates increased and that's where we started the quarter and how we're currently -- what we're currently targeting today.
What we did see impact the net hedge results during the quarter that departed from that 90% to 100% hedge ratio, we did see hedge costs since we do utilize options and the curve was still flat inverted for a lot of the -- or for part of the quarter.
And then we did see some excess prepayments. We mentioned the prepayment fees were a bit higher in the fourth quarter due to the impact of rates being lower in the third quarter. Although that was baked into our model, the speeds were a bit in excess of what we had projected.
And for us that flows through into our changes in fair value. And so that had a little bit of a negative -- or a bit of a negative impact in the quarter as well. And so those components together account for most of the negative contribution on the hedge during the quarter.
As we're going into the first quarter, we've seen the hedge perform fairly well thus far. As I mentioned, we're hedging more in the 90% to 100% range currently given where we're sitting in the interest rate environment and the amount of production that we would see in just a in a near term rally or in a close rally where we're not rallying very significantly.

Douglas Harter

Great. Appreciate that, Dan.

Operator

Michael Kaye, Wells Fargo.

Michael Kaye

Hi. I have a quick question on the 2025 ROE guidance. It looks like you downgraded it from prior. Now wha kind of rate environment do you contemplate in that revised ROE guidance? Is that current rates on the low end or is it some improvement you just flushed that out a little bit?

Daniel Perotti

Yeah, that's really more or less assuming a rate environment that's pretty similar to where we are today. So we aren't really forecasting a significant decline in interest rates given with that mid-teens to high-teens operating ROE guidance. And so given what we're seeing and the production environment that we think is likely in that case and especially the refinance environment that's likely in that case that, as you mentioned, brings the operating ROE expectations from what we had communicated a quarter ago.
To the extent that we do see a meaningful rally or pockets of meaningful rallies from here, that would allow those operating ROEs to get back up into the 20s like we saw in Q3 or higher if there's a more sustained rally. But that operating ROE projection was really more contemplating the rates at levels that we're currently at.

Michael Kaye

Okay. A question on what's the impact to the PennyMac if the GSE acts as a conservatorship and just wondering how PennyMac is preparing for that potential? And maybe you could talk about how the benefit of having PMT benefits PFSI in that scenario?

David Spector

Well, you answered the question, Michael, so thank you. But let me take it from the top here. How are you doing?

Michael Kaye

Good.

David Spector

Good, good. So look, we, from day one, have managed this company to a range of outcomes. And I think in a period of time when the GSEs were 90%-plus of the market, we are leading mortgage -- residential mortgage lender and producer of mortgages and servicer.
And if the GSEs begin to retrace that, which we're starting to see parts of it, we're going to continue to operate better than anyone in the industry. I think that we, as you pointed out, we're uniquely positioned with PMT to have an investment vehicle to invest in credit-related investments.
And I think in the -- in Q4, we had two securitizations of investor loan and second home loans that execute better in the private markets than they do delivering to the GSEs. We closed our first deal for 2025 today.
We're on track to do a deal a month, which represents about 50% of that production with the remaining production going whole-loan, to whole-loan buyers like insurance companies.
What's important there is you can begin to see how we think about distribution as the GSE footprint gets reduced. And look, guarantee fees, if you listen to some people, they say they're going to go up with the new administration. But if guarantee fees were to go up, the ability to access all outlets in the market is a trademark of my career in this company. And so we'll continue to find whole-loan investors. We'll continue to do securitizations in PMT.
And PMT is going to thrive in that opportunity. PMT is expanding the loans that they're looking to do securitizations. There's opportunities in Jumbo. There's opportunities less so in closed-end seconds. But I will tell you that I think that PMT is going to – PMT had a great quarter in the fourth quarter. It's gone up to a really nice start in the first quarter. And that's something that we're going to leverage if we see the GSE retracement take place.
In addition, what's interesting about the Q4 results, and we're seeing it in January it's strong, is the amount of Jumbo volume we're doing. In the fourth quarter, we did almost $1 billion of Jumbo production across all three channels. We are on pace to do more than that in the first quarter.
And there we're, as I mentioned, we're looking to do a securitization in PMT in the first half of this year. But again, we're accessing the markets there as well -- the Holo markets there as well.
And then on the Consumer Direct side we had a really nice quarter in terms of closed-end second production in the fourth quarter. And that kind of, again, plays into our ability to distribute loans away from the agency. And we're building a great operation to access pools of capital, to be able to put on trades, to be able to settle trades.
And so, if we see in a marketplace where loans move away from the agencies, we're going to continue to be the leader in the industry in being able to maximize the economics. And that really, when you look at, when I look at our organizations between PFSI and PMT, that's the differentiator is our expertise to be able to price and execute and find best execution for our customers, our correspondents, and our brokers.

Michael Kaye

Okay, thank you.

Operator

Terry Ma, Barclays.

Terry Ma

Hey. Thank you. Good evening. I just had a follow up on the operating ROE range for 2025 of mid to high teens. I guess your exit rate for this year is already in the mid-teens. I'm just curious, what do you need to see to get to the high teens? Do you need to see many rate rallies or do you think you can continue to grind higher on the ROE scale even if rates stay where they are right now?

Daniel Perotti

I think, yeah, thanks, Terry. That's a great question. So as we see -- or if we see rates continue to stay at this high level, we do expect to continue to drift upwards in terms of operating ROE. I think the key aspect there is our efficiencies that we've gained over time in the servicing space and servicing portfolio.
So we have a page in the deck that shows our decrease in operating expenses over time with respect to our servicing portfolio that's gone down by 30% over the past few years since 2019. We expect to be able to continue to drive that down on a per unit basis, both as a function of scale as well as continuing to make our operations more efficient. And so on that basis, we would generally expect our -- even if we stay in the current environment, our operating ROE to drift upwards.
And so the mid to high teens I think to your point, depending on what you consider mid and high, we would generally expect to be drifting upwards towards the high teams over the year if we stay up in this rate level, if we stay up in this rate environment where we're gaining further efficiencies as we go through the year.

David Spector

Terry, a couple of things about 2024 that's really, I think, highlights the power of the company is that you look at the Q3 results and we had that brief rally and you can see how quickly the ROE can climb to 20% and even higher if a rally's protracted.
And then similarly, to speak about the operating scale, historically when you've had rallies, you recognize the lock when it's -- you recognize the gain in the lock when you take it, but a lot of the expenses hit when you closed the loan.
And so in Q4, we were closing out loans from the pipeline, and we still had a relatively very good ROE. And so I think that there's -- it speaks to the leverage that we have in our Production channels. And I think as you continue to see growth in the non-agency products, combined with the continued efficiencies that our Production teammates continue to isolate and perfect, it's a lot of it is in our control.
And then you take the piece that's not in control, and that's the market. And we know one thing for sure, rates go up and rates come down. And so our ability to be able to seize on that opportunity is vitally important. And that's one of the reasons why we've brought in some excess capacity in our Consumer Direct channel.
And so we have about an additional 100 LOs at the moment that are really focused on, at the moment, working for our customers who want cash out refinances or closed-end seconds or are looking to buy new homes. But likewise, as rates decline, we can pivot those LOs to focus on rate and term refi.
And historically when markets move, originators go out and they try to find additional capacity. But we're in a position because of the strength of the organization to be able to maintain that capacity and be able to do so while having products that they can offer our customer base.

Terry Ma

Got it. That's very helpful color. And then just to follow up, any color you can provide on what you're seeing? with respect to just delinquencies in your portfolio, it's 60-plus day delinquency rate, increased sequentially, but there are also the year-over-year increase also accelerated in the quarter. Thank you.

Operator

Excuse me, ladies and gentlemen, please stand by as it appears that the presenters got disconnected. One moment, please.