The Long and Short of It
Q3 2022 hedge fund letters, conferences and more
1. PennyMac Financial Services is a NYSE-traded mortgage lender with a $2.3 billion market capitalization. A force in the government-backed loan market, PennyMac is now the second largest issuer in the $2 trillion Ginnie Mae mortgage-backed securities (MBS) universe.
2. In September, PennyMac’s loan portfolio stood at $236.2 billion, 91 percent of which is loans backed by the Department of Veterans Affairs and the Federal Housing Administration.
3. The Federal Reserve’s sharp rate hikes have devastated the lender’s earnings. Through June 30, PennyMac’s revenue was down approximately 30 percent when compared to the same period last year, and its net income dropped more than 47 percent in the same timeframe.
4. Given the Fed’s stated remarks about meeting its target rate, continued hikes are likely through early next year. Many economists’ models point to a U.S. economic slowdown next year, with several forecasting a recession.
5. A recession would be a disaster for PennyMac’s highly leveraged borrower base, leading to big spikes in both delinquencies and defaults.
6. PennyMac’s operational and risk disclosures are staggeringly inadequate, leaving investors and stakeholders in the dark about its substantial risk concentration and where the lender’s profits really come from.
7. For example, from January 2020 through June 30, more than 50 percent of PennyMac’s net income came not from mortgage origination or gains-on-sale but from “early buyouts.” Discussed in more detail below, EBOs are a risk management tool in the Ginnie Mae system where the lender buys, modifies, and then has the option to resell its own delinquent, higher-coupon loans back into the MBS market. Unfortunately for PennyMac, the Fed’s rate hikes have made the EBO process unprofitable.
8. For PennyMac, losing EBO profits is brutal. Last year, just under 83 percent, or $831.3 million, of PennyMac’s $1 billion in net income came from EBOs.
9. The Ginnie Mae system is a rules-based system originally designed for a marketplace where the majority of participants were large commercial banks. Larger banks have primarily abandoned Ginnie Mae loan issuance, however. Now, independent mortgage banks like PennyMac — which generally possess a mere fraction of a commercial bank’s cash and resources — make over 80 percent of the loans in Ginnie Mae-backed MBS.
10. The most important rule in the Ginnie Mae system is that lenders are responsible for ensuring that a delinquent loan’s principal and interest payments are made to investors. Issuers with delinquencies have two choices: (1) buy the troubled loan out of the pool at face value and quickly try to modify it to get the loan current, or (2) leave the delinquent loan in the pool but use their own cash to make P&I payments to bond investors.
11. Delinquencies are mounting across PennyMac’s portfolio, and that will pose a threat to PennyMac’s balance sheet. As of the end of August, 5 percent of PennyMac’s portfolio, or $11.9 billion, was delinquent. About 2 percent of borrowers were 90 days or more delinquent. If the 90 days or more delinquency rate is greater than 5 percent, Ginnie Mae has the right to seize a lender’s portfolio. (Through December 31, however, Ginnie Mae has suspended its “acceptable delinquency threshold.”)
12. PennyMac’s management discloses little about its sizable credit risk. For instance, few know that PennyMac has a $108.1 billion VA loan portfolio.
13. The VA’s loan guarantee covers only 25 percent of a loan’s value. Should a VA borrower default, PennyMac is then on the hook for 75 percent of the loan’s unpaid principal balance.
14. Estimates of VA borrower default levels run from 2 percent to the 5.3 percent posited by a recent Congressional Budget Office study.
15. The problem for PennyMac’s investors isn’t what default estimate is the most accurate; it’s that in the context of a $108.1 billion portfolio, any percentage will prove large in absolute dollar terms.
16. A notional 1 percent default rate could mean a write-down of as much as $810 million. That’s troubling, when you consider that as of June 30, PennyMac had $3.4 billion of shareholder equity.
17. Management’s recent capital allocation decisions are baffling. Last year, PennyMac spent over $958 million buying shares back at an average price per share of $62.35, near its all-time high. Since 2019, the company has spent $1.43 billion — out of an approved $2 billion — on this project. During PennyMac’s second quarter conference call, CEO David Spector said buying back the stock at the then-current market prices was “highly accretive” to earnings because book value was above the share price. Narrowly, this is a fair explanation, but it completely ignores last year’s macroeconomic environment. Given the mounting inflation pressure that was widely discussed in the second half of last year, it is improbable that a company led by a 36-year veteran of the MBS markets expected that the ultra low rates would continue indefinitely. So using cash for short-term gains while ignoring the trouble brewing in the company’s immediate future looks like a costly trade-off.
18. At the same time, PennyMac has $1.3 billion in debt due next year: $650 million to be repaid in each of February and August.
19. Tellingly, PennyMac’s CFO, on the second quarter call, noted that PennyMac can extend the maturity of this $1.3 billion debt if “market dislocations” occur.
20. PennyMac has no investors or research analysts on its quarterly earnings calls, which might better be described as “live podcasts.” As management is literally reading from a script, it seems probable that those remarks about maturities and market dislocations weren’t there by accident — and were likely ordered by lawyers.
Editor’s note: In conjunction with this article’s release, FFJ is using a so-called balance sheet partner. FFJ will receive a percentage of any profits realized from the balance sheet partner’s use of securities to profit from a decline in PennyMac’s share price. FFJ has no input into or involvement with these trades. The balance sheet partner has no input into or involvement with FFJ’s editorial content.
PennyMac Financial Services is in a world of trouble.
Admittedly, those are strange words to read about a company that since the start of 2020 has logged close to $2.75 billion in net income.
The Westlake Village, California-based mortgage lender is a big player in U.S. government-backed mortgage loans, with Department of Veterans Affairs and Federal Housing Administration borrowers comprising more than 91 percent of its $236.2 billion loan portfolio. Bankrate.com, in an April article, said PennyMac originated 208,680 mortgages last year, enough to make it the 10th largest mortgage originator of 2021.
(PennyMac refers to this as a portfolio of mortgage servicing rights. But in the plainest sense of the word, these are loans that PennyMac issued, services, and bears the risk for. Former Ginnie Mae president Ted Tozer, a current PennyMac board member, wrote a primer on Ginnie Mae for the Milken Institute that discusses at length the challenges loans can pose for issuers.)
There is no question PennyMac’s Securities and Exchange Commission filings suggest that its challenge has been navigating prosperity, not peril.
Consider its 2021 proxy statement. Those soaring compensation packages awarded to senior management are a function of record profits, after all, not losses that might indicate a crisis.
And while executive pay excesses are common within the financial services industry, it is rare to see a CEO paid $25.9 million over a two-year stretch for not delivering results.
Except that everything about PennyMac’s past two and a half years can be categorized as “BT,” short for “before tightening.”
Once the Federal Reserve’s aggressive interest rate increases began in March — propelling conventional 30-year mortgage rates to 6.66 percent from 3.01 percent a year ago — much of PennyMac’s economic opportunity set disappeared. For FHA and VA borrowers, the sticker shock is even more pronounced, as a Rocket Mortgage advertisement on October 9 offered annual percentage rates of, respectively, 7.604 and 7.029.
Through June 30, according to SEC filings, the company’s mortgage origination revenues are down nearly 60 percent from last year, reflecting the new reality that financing a house purchase has become much more expensive. (Relief measures are unlikely anytime soon.) What’s more, higher rates took away the profitability that allowed PennyMac to rake in millions by exercising its option to buy out — and later resell — its own delinquent loans.
These repeated hits to its income statement may make the repayment of a $1.3 billion secured term note issuance next year — $650 million in February and again in August — difficult. (Daniel Perotti, PennyMac’s CFO, said on a recent conference call that the lender can extend the maturity for two years in the event of a “ market dislocation,” but did not specify what constitutes a dislocation.) Coincidentally, the note holder is Credit Suisse, the giant Swiss bank battling the perception it is financially troubled. Moreover, Credit Suisse has publicly put its securitized product group, the unit that made those loans to PennyMac, up for sale.
But every financial institution, from the smallest credit union to Citigroup, is navigating this rate volatility, and perhaps even the prospect of a recession next year.
What PennyMac is facing, however, is more like a reckoning, where shareholders will be forced to absorb the consequences of a series of recent management decisions.
Similarly, given the outsize role PennyMac plays within the government-backed mortgage loan market, any troubles it experiences could have real consequences for the Ginnie Mae system.
Explosive VA loan growth
In March 2020, as the Fed lowered rates in response to the COVID-19 pandemic, PennyMac made a no-holds-barred push to capitalize on the then-nascent housing boom.
One of the areas where the lender made the biggest inroads was in Veterans Administration-backed loans.
In 2019, the company did $2.6 billion in VA loans; in 2020, it made $10.4 billion of such loans, and by the end of last year, it had done another almost $18 billion. All told, PennyMac issued $29.8 billion in VA loans in the two and a half years from the first quarter of 2020 through June 30.
Astoundingly, for all the fury of that issuance pace, there are no references to it in any PennyMac call transcript, SEC filing or investor presentation. For that matter, there is no discussion or breakout of the company’s portfolio construction at all.
But PennyMac’s investors really could have used a heads-up about its VA loan binge.
The VA, essentially alone among government mortgage-assistance programs, will not guarantee 100 percent of the loan’s value.
The way it works is that for home loans with a value over $144,000, the VA will guarantee the lesser of 25 percent of the loan’s value or $104,250.
(For a $250,000 home loan, as an example, the VA would guarantee $62,500. To be sure, the VA does provide guarantees above 25 percent, but those are for loan values that are unusually low for the current environment.)
So PennyMac has exposed itself to a great deal of credit risk.
Getting a handle on what that risk looks like becomes a lot more pressing given the size of its VA loan portfolio, which at the end of August was $108.1 billion in unpaid principal balance across more than 405,000 loans.
[PennyMac does not release any meaningful portfolio composition detail. FFJ obtained portfolio and monthly delinquency data from sources across brokerage trading desks and from MBS portfolio managers.]
Because even a relatively modest annual VA loan default rate — like the 2 percent figure noted in a 2019 VA Office of the Inspector General report — could prove devastating to PennyMac’s finances.
Given that PennyMac had $3.4 billion of equity as of June 30, if even 1 percent of its VA loan portfolio were to default, that’s a prospective $810 million write-down.
And that’s a best-case scenario. Pair up continuing rate hikes and even a brief recession, and it’s safe to assume the number of VA borrowers defaulting will only climb.
To that end, the Congressional Budget Office released a study in September 2021 that ought to give some pause. It estimated that the default rate for VA residential mortgages issued in 2022 will be 5.8 percent.
The trend has, in fact, already begun: The delinquency rate for PennyMac’s VA loans is climbing, with 2.7 percent of its borrowers, or approximately 11,000 loans, in arrears as of August 31. That’s up from 2.1 percent in April.
A world of risk
The attempt to come to terms with PennyMac’s VA portfolio suggests a bigger question: What is the risk to the broader portfolio?
Ginnie Mae’s monthly Global Markets Analysis Report publishes statistics that offer a snapshot of borrower credit trends across its issuer base. (PennyMac originated 11.4 percent of the loans Ginnie Mae analyzed.)
What the report drives home is the gulf between the credit profiles of the borrowers in the Ginnie Mae system as a whole, and those in Freddie Mac’s and Fannie Mae’s conventional (or conforming) portfolios.
A chart in the September Ginnie Mae report, juxtaposing the FICO scores of VA, FHA, Fannie and Freddie borrowers, shows that a significant portion of VA and FHA borrowers, 20 percent and 40 percent, respectively, are at or near a subprime classification.
A pair of other charts in the report which look at borrower financial metrics — debt-to-income, a person’s monthly debt payments divided by their gross income, and loan-to value, the measurement of mortgage size divided by the property’s appraised value — tell the same story.
And the story is that their borrower base is frequently highly leveraged, with relatively little financial flexibility for unforeseen circumstances.
Like the VA loan pool, PennyMac’s FHA loan pool is massive: 566,001 loans that have an unpaid principal balance of $107.3 billion.
Delinquencies in its FHA book are increasing, and at a much more rapid clip than VA loans. In April, PennyMac’s FHA loan delinquencies were at 5 percent. At the end of August, just over 39,000 loans, or 6.9 percent of this portfolio, were in arrears.
If there is a saving grace for the PennyMac shareholder, it is that the FHA book’s problems don’t bear any credit risk.
That’s because the Department of Housing and Urban Development — the parent of both Ginnie Mae and the FHA — guarantees 100 percent of each FHA loan.
But that doesn’t mean an FHA loan default will be painless.
Ted Tozer, the former Ginnie Mae president and current PennyMac board member referenced above, wrote that each FHA default would eventually cost the lender $10,000.
Tozer also made some interesting remarks about the prospects for the Ginnie Mae system at a June 30 presentation. When an audience member asked about the effects of a rapid 4 percent rate hike, Tozer, while expressing cautious optimism on borrower delinquencies, said, “If we go into a recession, all bets are off.”
What’s left undisclosed
Before piecing together how PennyMac could possibly find itself in dire straits so soon after reporting net income of over $1.6 billion and $1 billion, respectively, in the past two years, it is first necessary to understand the lender’s disclosure issue.
PennyMac’s SEC filings and investor presentations may be long and detailed, but in the end, they rarely reveal much.
Or at least, they rarely offer the basic information necessary for understanding how the PennyMac business model really works.
For example, the lender’s 2021 10-K annual report is 93 pages long and provides in rich detail management’s assessment of its employee relations and a breakout of where its loan origination fees come from.
Yet like the VA loan example above, what PennyMac doesn’t discuss in its filings or quarterly calls are the very issues an investor or stakeholder needs to know.
Like how the remarkable earnings of the past two years were heavily a function of PennyMac’s use of an arcane Ginnie Mae risk-management feature called “early buyout.”
Known as an EBO, it’s the option a lender has to repurchase loans it has made whose borrowers are 90 days or more delinquent.
(By taking the loan out of the Ginnie Mae pool, it ensures that the delinquency doesn’t threaten investor principal or interest payments.)
Assuming the lender can work with the borrower to have them start making payments again for 90 days after an EBO, the lender is permitted to re-securitize the loan and sell it to brokers.
When rates are dropping, a lender’s ability to resell EBO loans that were originally issued with higher interest rates becomes immensely lucrative.
According to MBS pricing data from last August, trading desks bid an average of $104.56 for a newly issued Ginnie Mae 3 percent MBS. A Ginnie Mae 4 percent MBS was fetching a bid of around $105.80.
(Recall that PennyMac had paid par, or the full value of each loan, for the then-delinquent loan three or four months prior.)
To be fair, PennyMac’s quarterly investor presentations do disclose EBO revenues and their associated costs, albeit toward the rear of the document. And management has, in its quarterly calls, made very brief references to EBO trends. The resulting net EBO profit figure reveals that EBOs have in some years represented half or more of the company’s earnings.
From 2018 through the first six months of this year, the EBO process produced over $1.7 billion in profit for PennyMac, equivalent to 47.7 percent of its net income.
For the past two years, EBO-derived income constituted 50 percent of the company’s net income; last year, incredibly, it made up 82.8 percent.
Unmistakably, EBOs have been a win-win policy for Ginnie Mae and its issuers: Ginnie Mae gets delinquent loans quickly harvested out of the MBS pools it guarantees, and the lenders can turn a liability into a low-risk, high-margin profit in four months.
All they need for this dynamic to continue is interest rates that are lower than those of the delinquent loans.
Last year, Ginnie Mae lenders were selling bonds with a 1.5 percent interest rate into the market. Now they are selling brokers 6 percent MBS, and in short order, they will likely sell 7 percent MBS.
Those Ginnie Mae 3 and 4 percent MBS that brokers paid $104.56 and $105.80 for last summer? They are now trading at around $89 and $95, respectively.
The existential threat of delinquencies
PennyMac’s delinquencies are mounting, and that should make its shareholders very anxious.
At the end of August, 5 percent of PennyMac’s portfolio of 1,111,172 loans were in arrears, totaling $11.9 billion in loans. That’s up from 3.8 percent and $8.5 billion in March.
Ginnie Mae’s system relies on a series of bright line rules, the most important of which deal with delinquent loans.
When a Ginnie Mae system borrower is delinquent, the lender must immediately use one of two approaches to address the situation.
In the first, the lender leaves the delinquent loan in its Ginnie Mae MBS pool and assumes the loan’s scheduled principal and interest payments. The second is the EBO scenario described above, which rate hikes have made cost prohibitive for the foreseeable future.
The former means PennyMac must step in to make loan payments for a growing number of delinquent borrowers; the latter requires it to make an increasing number of large, lump-sum transactions, each of which will now entail a loss.
(In certain circumstances, some lender principal and interest payments are able to be recouped, but not until the default process has started.)
With an estimated 55,500 loans currently in arrears, little imagination is necessary to see the damage either option could wreak on PennyMac’s balance sheet.
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