Last year was simply awful for anyone involved in the mortgage space. Mortgage originators saw volumes collapse as the Fed hiked interest rates aggressively to halt inflation. Mortgage real estate investment trusts (REITs) watched their portfolios drop in value as mortgage-backed securities underperformed Treasuries.
That said, not all mortgage participants underperformed. Those that had a big focus on mortgage servicing did well. This explains how PennyMac Financial Services(NYSE: PFSI) remained profitable in 2022.
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How PennyMac Financial Services operates
PennyMac Financial Services is in the mortgage origination and servicing business. The company operates two basic business models on the origination side: consumer direct and correspondent lending. In the correspondent lending segment, PennyMac Financial Services buys completed loans from smaller originators and then sells them at a markup to another buyer. This is a low-margin business because competition is fierce. The other segment is consumer direct, where PennyMac sources loans directly from borrowers using technology. Rocket(NYSE: RKT) is the pioneer in this business model and it generally works best in a refinance wave.
In a purchase mortgage market, people will often get referred to a lender from a realtor and consumer direct struggles to compete, especially when a mortgage broker has access to several large lending partners. That said, consumer direct is a much higher-margin business than correspondent, and the mix of between correspondent and consumer direct can have outsize effects on gain on sale margin.
When mortgage origination is suffering, mortgage servicing often can pick up at least some of the slack. Mortgage servicing is an unusual asset. A mortgage servicer handles the administrative duties of managing a mortgage on behalf of the investor. The mortgage servicer sends out the monthly bills; ensures that property taxes and insurance are paid on time; forwards the principal and interest payments to Fannie Mae, Freddie Mac, or Ginnie Mae; and works with the borrower if they get behind in the payments. The servicer is paid 0.25% of the mortgage balance per year. So if a servicer is handling a $400,000 mortgage loan, the servicer will get paid $1,000 per year. The right to perform this service is worth something, and it is capitalized on the balance sheet as an asset.
Mortgage servicing assets increase in value as interest rates rise
Mortgage servicing is an unusual asset in that it increases in value as interest rates rise. This is because the chance of an early payoff declines. Nobody is going to refinance a 3.5% mortgage when rates are 6%, which means that PennyMac will get that servicing payment for a longer period, making it worth more. During the fourth quarter, pre-tax income from loan origination was a $9 million loss while servicing contributed $75.6 million in pre-tax profits. PennyMac Financials sees industry volume falling next year, which means that servicing will continue to hold up the business.
The Street consensus is that PennyMac Financial will make $6.55 per share this year, which gives the stock a forward price-to-earnings (P/E) ratio of 10. This is a low multiple given that 2023 will be probably be trough earnings year for the mortgage banking sector. That said, mortgage banking is such a cyclical industry that mortgage banks almost never trade with big multiples. A tech stock trading at 10 times earnings may be cheap, but a mortgage bank is not.
PennyMac Financial pays a $0.80 dividend (yielding 1.24% as of writing), which could certainly increase given the low payout ratio. That said, I think the mortgage banking industry will be in for another tough year, and if interest rates begin to fall, mortgage servicing valuations could get hit, while rates might not decline enough to bring back refinancing activity.
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Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
