PennyMac Mortgage Investment Trust (PMT -0.40%) is a real estate investment trust (REIT) that specializes in holding mortgage-related assets. These assets include mortgage servicing rights, credit risk transfer securities, and the subordinate tranches of securitizations. PennyMac Mortgage Investment Trust is managed by PennyMac Financial Services (PFSI -0.87%), which performs sub-servicing services on behalf of PennyMac Mortgage Investment Trust. PennyMac Mortgage Investment Trust also buys and securitizes newly originated loans, which it then holds or sells into the market.
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Mortgage servicing rights are an esoteric asset
Mortgage servicing rights are an unusual asset. The mortgage servicer acts on behalf of the ultimate mortgage holder to handle the administrative tasks of the loan. The servicer will send out the monthly bills, collect the payments, forward the principal and interest payments, ensure property taxes are paid and work with the borrower in the event of a default. The servicer is paid 0.25% of the mortgage balance per year. So if the outstanding mortgage balance is $400,000, the servicer gets paid $1,000 annually on that loan. PennyMac Mortgage Investment Trust doesn't actually service the loans -- it uses an affiliate to perform the actual services (called sub-servicing), and it pays a fee to the sub-servicer.
The right to perform these services is worth something, and these mortgage servicing rights (MSRs) are capitalized on PennyMac Investment Trust's balance sheet as an asset. Mortgage servicing assets are one of the few assets that increase in value as interest rates rise. This is because the servicer is expected to collect that 0.25% fee for a longer period because the incentive for the borrower to refinance disappears. Nobody is going to swap a 3.5% mortgage for, say, a 5% one.
Mortgage servicing can be considered a hedge for the origination business
Mortgage servicing is often considered a hedge for mortgage originators. When rates are rising, originators generally see lower volume as refinance activity falls. This is bad for the origination business, but it is good news for the mortgage servicing book. Conversely, when rates fall, the mortgage servicing rights will decline as borrowers refinance their loans. The mortgage banker hopes to be the one that originates that refinance loan, where it earns fees and gains a new mortgage servicing asset. As a general rule, servicing will help insulate them from a rising rate environment, but mortgage bankers do best in a falling rate environment. Servicing is an imperfect hedge, but it is better than nothing.
At the end of the third quarter of 2022, PennyMac Mortgage Investment Trust had about 65% of its assets in interest-rate-sensitive assets, which basically represent mortgage servicing assets. The company allocated 22% to credit-sensitive assets, which are generally credit risk transfer securities. Credit risk transfer securities offload some of the credit risk that the government-sponsored entities Fannie Mae and Freddie Mac take when they insure loans. It most closely resembles a reinsurance product. The balance is allocated to correspondent production and corporate activities.
If the U.S. hits a recession next year, delinquencies will rise
If the U.S. hits a recession next year, defaults will probably increase on mortgages, which means that PennyMac Investment Trust will probably see losses on its credit risk transfer securities portfolio. In addition, a recession would usher in lower interest rates because the Federal Reserve will stop increasing rates and might even begin to cut them. This will be negative for the servicing book at some point, but rates have to fall substantially for the refinancing incentive to return.
The analyst community expects PennyMac Mortgage to earn $1.56 next year after reporting a loss this year. The annual dividend is $1.60, so the company has no room to maneuver if defaults tick up or servicing costs increase. At current levels, the stock has a dividend yield of 12.9%, which is below mREITs like Annaly Capital (NLY -0.21%) and AGNC Investment (AGNC -0.53%). Servicing has been a great business for the past year, but there is no guarantee that it will continue.
