EDGAR 10-K Filing

Company CIK: 1464423
Filing Year: 2021
Filename: 1464423_10-K_2021_0001564590-21-009173.json

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ITEM 1. BUSINESS
Item 1.
Business
The following description of our business should be read in conjunction with the information included elsewhere in this Report. This description contains forward-looking statements that involve risks and uncertainties. Actual results could differ significantly from the projections and results discussed in the forward-looking statements due to the factors described under the caption “Risk Factors” and elsewhere in this Report. References in this Report to “we,” “our,” “us,” “PMT,” or the “Company” refer to PennyMac Mortgage Investment Trust and its consolidated subsidiaries, unless otherwise indicated.
Our Company
We are a specialty finance company that invests primarily in mortgage-related assets. We were organized in Maryland and began operations in 2009. We conduct substantially all of our operations, and make substantially all of our investments, through PennyMac Operating Partnership, L.P. (our “Operating Partnership”) and its subsidiaries. A wholly-owned subsidiary of ours is the sole general partner, and we are the sole limited partner, of our Operating Partnership. Certain of the activities conducted or investments made by us that are described below are conducted or made through a wholly-owned subsidiary that is a taxable REIT subsidiary (“TRS”) of our Operating Partnership.
The management of our business and execution of our operations is performed on our behalf by subsidiaries of PennyMac Financial Services, Inc. (“PFSI” or “PennyMac”). PFSI is a specialty financial services firm focused on the production and servicing of loans and the management of investments related to the U.S. mortgage market. Specifically:
•
We are managed by PNMAC Capital Management, LLC (“PCM” or our “Manager”), a wholly-owned subsidiary of PennyMac and an investment adviser registered with the United States Securities and Exchange Commission (“SEC”) that specializes in, and focuses on, U.S. mortgage assets.
•
Our loan production and servicing activities (as described below) are performed on our behalf by another wholly-owned PennyMac subsidiary, PennyMac Loan Services, LLC (“PLS” or our “Servicer”).
Our investment focus is on residential mortgage-backed securities (“MBS”) and mortgage-related assets that we create through our correspondent production activities, including credit risk transfer (“CRT”) investments in CRT agreements (“CRT Agreements”) and CRT securities (together, “CRT arrangements”) and mortgage servicing rights (“MSRs”). We have acquired these investments largely by purchasing, pooling and selling newly originated prime credit quality residential loans (“correspondent production”), retaining the MSRs relating to such loans and investing in CRT arrangements associated with certain of such loans.
Our business includes four segments: credit sensitive strategies, interest rate sensitive strategies, correspondent production, and corporate.
•
The credit sensitive strategies segment represents the Company’s investments in CRT arrangements, distressed loans, real estate, and non-Agency subordinated bonds.
•
The interest rate sensitive strategies segment represents the Company’s investments in MSRs, excess servicing spread (“ESS”), Agency and senior non-Agency MBS and the related interest rate hedging activities.
•
The correspondent production segment represents the Company’s operations aimed at serving as an intermediary between lenders and the capital markets by purchasing, pooling and reselling newly originated prime credit quality loans either directly or in the form of MBS, using the services of PCM and PLS.
The Company primarily sells the loans it acquires through its correspondent production activities to government-sponsored entities such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or to PLS for sale into securitizations guaranteed by the Government National Mortgage Association (“Ginnie Mae”). Fannie Mae, Freddie Mac and Ginnie Mae are each referred to as an “Agency” and, collectively, as the “Agencies.”
•
The corporate segment includes management fee and corporate expense amounts and certain interest income.
Following is a summary of our segment results for the years presented:
Year ended December 31,
(in thousands)
Net investment income:
Credit sensitive strategies
$
(305,340
)
$
191,865
$
110,271
Interest rate sensitive strategies
174,558
50,650
133,613
Correspondent production
597,222
242,762
105,606
Corporate
2,911
3,538
1,577
$
469,351
$
488,815
$
351,067
Pretax income:
Credit sensitive strategies
$
(317,143
)
$
182,176
$
87,251
Interest rate sensitive strategies
105,697
1,148
98,432
Correspondent production
344,639
64,593
16,472
Corporate
(53,463
)
(57,276
)
(44,167
)
$
79,730
$
190,641
$
157,988
Total assets at year end:
Credit sensitive strategies
$
2,920,558
$
2,364,749
$
1,602,776
Interest rate sensitive strategies
4,593,127
4,993,840
4,373,488
Correspondent production
3,781,010
4,216,806
1,698,656
Corporate
197,316
195,956
138,441
$
11,492,011
$
11,771,351
$
7,813,361
In our correspondent production segment, we purchase Agency-eligible loans, jumbo loans and home equity lines of credit. A jumbo loan is a loan in an amount that exceeds the maximum loan amount for eligible loans under Agency guidelines. We then sell Agency-eligible loans meeting the guidelines of Fannie Mae and Freddie Mac on a servicing-retained basis whereby we retain the related MSRs; government loans (insured by the Federal Housing Administration or guaranteed by the Veterans Administration or U.S. Department of Agriculture), which we sell on a servicing-released basis to PLS, a Ginnie Mae approved issuer and servicer, for which we earn sourcing fees as described in Note 4 - Transactions with Related Parties to the financial statements included in this Report; and jumbo loans, which we generally sell on a servicing-retained basis.
Our correspondent production segment involves purchases of loans from approved mortgage originators that meet specific criteria related to management experience, financial strength, risk management controls and loan quality. During 2020, we were the largest correspondent aggregator in the United States as ranked by Inside Mortgage Finance. As of December 31, 2020, we had 714 approved sellers with delegated underwriting authority, primarily independent mortgage originators and small banks located across the United States. PLS also serves as a source of correspondent production to us. During 2020, we purchased $2.3 billion in total unpaid principal balance (“UPB”) of mortgage loans and $2.6 million of home equity lines of credit from PLS.
Following is a summary of our correspondent production activities:
Year ended December 31,
(in thousands)
Correspondent loan purchases at fair value:
Agency-eligible
$
106,472,654
$
63,989,938
$
30,176,215
Government-insured or guaranteed-for sale
to PLS
63,574,547
50,499,641
37,764,019
Jumbo
-
12,839
67,501
Home equity lines of credit
2,569
5,182
-
Commercial
-
-
7,263
$
170,049,770
$
114,507,600
$
68,014,998
Interest rate lock commitments issued
$
185,414,040
$
114,895,643
$
66,723,338
Fair value of loans at year end pending sale to:
Nonaffiliates
$
3,085,910
$
3,653,410
$
1,557,649
PLS
460,414
490,383
86,308
$
3,546,324
$
4,143,793
$
1,643,957
Number of approved sellers at year-end (1)
(1)
Includes only sellers with delegated underwriting authority
The sale of loans to nonaffiliates from our correspondent production activities serves as the source of our investments in MSRs and CRT arrangements, which are summarized below:
Year ended December 31,
(in thousands)
Sales of loans acquired for sale:
To nonaffiliates
$
106,306,805
$
61,128,081
$
29,369,656
To PennyMac Financial Services, Inc.
63,618,185
50,110,085
37,967,724
$
169,924,990
$
111,238,166
$
67,337,380
Net gain on loans acquired for sale
$
379,922
$
170,164
$
59,185
Investment activities resulting from correspondent production:
Receipt of MSRs as proceeds from sales of loans
$
1,158,475
$
837,706
$
356,755
Investments in CRT arrangements:
Deposits securing CRT arrangements
1,700,000
933,370
596,626
Recognition of firm commitment to purchase CRT securities (1)
(38,161
)
99,305
30,595
Change in face amount of firm commitment to
purchase CRT securities and commitment
to fund Deposits securing CRT arrangements
(1,502,203
)
897,151
122,581
Total investments in CRT arrangements
159,636
1,929,826
749,802
Total investments resulting from correspondent activities
$
1,318,111
$
2,767,532
$
1,106,557
(1)
Initial recognition of firm commitment upon sale of loans.
We also invest in MBS and ESS on MSRs acquired by PLS. We historically invested in distressed mortgage assets (loans and real estate acquired in settlement of loans (“REO”)). We have substantially liquidated our investment in distressed loans and continue the liquidation of our investment in REO.
Following is a summary of our acquisitions of other mortgage-related investments:
Year ended December 31,
(in thousands)
MBS
$
2,332,096
$
1,250,289
$
1,810,877
ESS
2,093
1,757
2,688
$
2,334,189
$
1,252,046
$
1,813,565
Our portfolio of mortgage investments was comprised of the following:
December 31,
(in thousands)
Credit sensitive assets:
CRT arrangements (1)
$
2,617,509
$
2,114,868
$
1,234,477
Firm commitment to purchase credit risk transfer
securities
-
109,513
37,994
Distressed loans at fair value
8,027
14,426
117,732
REO and real estate held for investment
28,709
65,583
128,791
Subordinated interest in loans held in VIE
8,981
13,007
14,074
Other (2)
6,576
5,647
8,559
2,669,802
2,213,531
1,503,633
Interest rate sensitive assets:
MBS
2,213,922
2,839,633
2,610,422
MSRs
1,755,236
1,535,705
1,162,369
ESS
131,750
178,586
216,110
Net interest rate lock commitments
72,386
11,154
11,988
Net interest rate hedges (3)
(123,490
)
195,895
161,251
4,049,804
4,760,973
4,162,140
$
6,719,606
$
6,974,504
$
5,665,773
(1)
Investments in CRT arrangements include deposits securing CRT arrangements, CRT strips, CRT derivatives and interest-only security payable.
(2)
Comprised of small balance commercial loans and home equity lines of credit.
(3)
Derivative assets, net of derivative liabilities, excluding interest rate lock commitments (“IRLCs”), CRT derivatives and repurchase agreements derivatives.
Over time, our targeted asset classes may change as a result of changes in the opportunities that are available in the market, among other factors. We may not continue to invest in certain of the investments described above if we believe those types of investments will not provide us with suitable returns or if we believe other types of our targeted assets provide us with better returns.
Investment Policies
Our board of trustees has adopted the policies set forth below for our investments and borrowings. PCM reviews its compliance with our investment policies regularly and reports periodically to our board of trustees regarding such compliance.
•
No investment shall be made that would cause us to fail to qualify as a REIT for U.S. federal income tax purposes;
•
No investment shall be made that would cause us to be regulated as an investment company under the Investment Company Act; and
•
With the exception of real estate and housing, no single industry shall represent greater than 20% of the investments or total risk exposure in our portfolio.
These investment policies may be changed by a majority of our board of trustees without the approval of, or prior notice to, our shareholders.
We have not adopted a policy that expressly prohibits our trustees, officers, shareholders or affiliates from having a direct or indirect financial interest in any investment to be acquired or disposed of by us or in any transaction to which we are a party or have an interest. We do not have a policy that expressly prohibits any such persons from engaging for their own account in business
activities of the types conducted by us. However, our code of business conduct and ethics contains a conflicts of interest policy that prohibits our trustees and officers, as well as employees of PennyMac and its subsidiaries who provide services to us, from engaging in any transaction that involves an actual or apparent conflict of interest with us without the appropriate approval. We also have written policies and procedures for the review and approval of related party transactions, including oversight by designated committees of our board of trustees and PFSI’s board of directors.
Our Financing Activities
We have pursued growth of our investment portfolio by using a combination of equity and borrowings, primarily in the form of borrowings under agreements to repurchase. We use borrowings to finance our investments and not to speculate on changes in interest rates.
Equity financing
Preferred Shares of Beneficial Interest
Preferred shares of beneficial interest are summarized below:
Preferred
Dividends per share, year ended
December 31,
Shared Series
Description (1)
Number
of shares
Liquidation
preference
Issuance
discount
Carrying
value
Fixed-to-floating rate cumulative
redeemable preferred
(in thousands, except dividends per share)
A
8.125% Issued March 2017
4,600
$
115,000
$
3,828
$
111,172
$
2.03
$
2.03
$
2.03
B
8.00% Issued July 2017
7,800
195,000
6,465
188,535
$
2.00
$
2.00
$
2.00
12,400
$
310,000
$
10,293
$
299,707
(1)
Par value is $0.01 per share for both series.
The Company’s Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest (the “Series A Preferred Shares”) pay cumulative dividends at a fixed rate of 8.125% per annum based on the $25.00 per share liquidation preference to, but not including, March 15, 2024. From, and including, March 15, 2024 and thereafter, the Company will pay cumulative dividends on the Series A Preferred Shares at a floating rate equal to three-month LIBOR as calculated on each applicable dividend determination date plus a spread of 5.831% per annum based on the $25.00 per share liquidation preference.
The Company’s Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest (the “Series B Preferred Shares”) (together with the Series A Preferred Shares, the “Preferred Shares”) pay cumulative dividends at a fixed rate of 8.00% per annum based on the $25.00 per share liquidation preference to, but not including, June 15, 2024. From, and including, June 15, 2024 and thereafter, the Company will pay cumulative dividends on the Series B Preferred Shares at a floating rate equal to three-month LIBOR as calculated on each applicable dividend determination date plus a spread of 5.99% per annum based on the $25.00 per share liquidation preference.
We pay quarterly cumulative dividends on the Preferred Shares on the 15th day of each March, June, September and December, provided that if any dividend payment date is not a business day, then the dividend that would otherwise be payable on that dividend payment date may be paid on the following business day.
The Series A and Series B Preferred Shares will not be redeemable before March 15, 2024 and June 15, 2024, respectively, except in connection with the Company’s qualification as a REIT for U.S. federal income tax purposes or upon the occurrence of a change of control. On or after the date the Preferred Shares become redeemable, or 120 days after the first date on which such change of control occurs, the Company may, at its option, redeem any or all of the Preferred Shares at $25.00 per share plus any accumulated and unpaid dividends thereon to, but not including, the redemption date.
The Preferred Shares have no stated maturity, are not subject to any sinking fund or mandatory redemption and will remain outstanding indefinitely unless redeemed or repurchased by the Company or converted into common shares in connection with a change of control by the holders of the Preferred Shares.
Common Shares of Beneficial Interest
Underwritten Equity Offerings
During 2019, we completed the following underwritten offerings of common shares:
Year ended December 31, 2019
(in thousands)
Number of common shares issued
33,527
Gross proceeds
$
719,777
Net proceeds
$
710,752
“At-The-Market” (ATM) Equity Offering Program
On March 14, 2019, we entered into separate equity distribution agreements to sell from time to time, through an ATM equity offering program under which the counterparties will act as sales agent and/or principal, our common shares having an aggregate offering price of up to $200 million. Following is a summary of the activities under the ATM equity offering program:
Year ended December 31,
(in thousands)
Number of common shares issued
5,463
Gross proceeds
$
5,654
$
119,905
Net proceeds
$
5,597
$
118,705
At December 31, 2020, the Company had approximately $74.4 million of common shares of beneficial interest available for issuance under its ATM equity offering program.
Common Share Repurchases
During August 2015, our board of trustees authorized a common share repurchase program. Under the program, as amended, the Company may repurchase up to $300 million of its outstanding common shares of beneficial interest.
The following table summarizes our share repurchase activity:
Year ended December 31,
Cumulative
total (1)
(in thousands, except per-share amounts)
Common shares repurchased
2,767
-
17,498
Cost of common shares repurchased
$
37,267
$
-
$
10,719
$
253,892
Average cost per share
$
13.46
$
-
$
15.96
$
14.51
(1)
Amounts represent the share repurchase program total from its inception in August 2015 through December 31, 2020.
The repurchased common shares were canceled upon settlement of the repurchase transactions and returned to the authorized but unissued common share pool.
Debt financing
During 2013, our wholly-owned subsidiary, PennyMac Corp. (“PMC”), issued in a private offering $250 million principal amount of 5.375% Exchangeable Senior Notes due May 1, 2020 (the “2020 Notes”). The net proceeds were used to fund our business and investment activities, including the acquisition of distressed loans or other investments; the funding of the continued growth of our correspondent production business, including the purchase of jumbo loans; the repayment of other indebtedness; and general business purposes. The 2020 Notes were repaid during the year ended December 31, 2020.
In December 2016, our wholly-owned subsidiary, PennyMac Holdings, LLC (“PMH”), entered into a master repurchase agreement with PLS, pursuant to which PMH sells to PLS participation certificates representing a beneficial interest in Ginnie Mae ESS under an agreement to repurchase. The purchase price is based upon a percentage of the market value of the ESS. Pursuant to the master repurchase agreement, PMH grants to PLS a security interest in all of its right, title and interest in, to and under the ESS and PLS, in turn, re-pledges such ESS along with its interest in all of its Ginnie Mae MSRs under a repurchase agreement to a special purpose entity, which issues variable funding notes and term notes that are secured by such Ginnie Mae assets. The notes are repaid through the cash flows received by the special purpose entity as the lender under its repurchase agreement with PLS, which, in turn, receives cash flows from us under our repurchase agreement secured by the Ginnie Mae ESS. The total unpaid principal balance (“UPB”) outstanding under this facility as of December 31, 2020 was $80.9 million.
During 2018, the Company, through the PMT ISSUER TRUST (“FMSR Issuer Trust”), issued an aggregate principal amount of $450 million in secured term notes (the “2018-FT1 Notes”) to qualified institutional buyers under Rule 144A of the Securities Act of 1933, as amended (the “Securities Act”). The 2018-FT1 Notes bear interest at a rate equal to one-month LIBOR plus 2.35% per annum, payable each month beginning in May 2018, on the 25th day of such month or, if such 25th day is not a business day, the next business day. The 2018-FT1 Notes mature on April 25, 2023 or, if extended pursuant to the terms of the related term note indenture supplement, April 25, 2025 (unless earlier redeemed in accordance with their terms).
The 2018-FT1 Notes rank pari passu with the Series 2017-VF1 Note dated December 20, 2017 (the “FMSR VFN”) pledged to Credit Suisse under an agreement to repurchase. The 2018-FT1 Notes and the FMSR VFN are secured by certain participation certificates relating to Fannie Mae MSRs and ESS relating to such MSRs. The total UPB outstanding under such agreement to repurchase as of December 31, 2020 was $450.0 million.
During 2018, the Company, through PMC and PMH, entered into a Loan and Security Agreement with Credit Suisse First Boston Mortgage Capital LLC, pursuant to which PMC and PMH may finance certain mortgage servicing rights (inclusive of any related excess servicing spread arising therefrom and that may be transferred from PMC to PMH from time to time) relating to mortgage loans pooled into Freddie Mac securities (collectively, the “Freddie MSRs”), in an aggregate loan amount not to exceed $175 million, all of which is committed. The loan amount matured on February 1, 2020.
On March 29, 2019, we, through our indirect subsidiary, PMT CREDIT RISK TRANSFER TRUST 2019-1R, issued an aggregate principal amount of $295.7 million in secured term notes (the “2019-1R Notes”) to qualified institutional buyers under Rule 144A of the Securities Act. The 2019-1R Notes bear interest at a rate equal to one-month LIBOR plus 2.00% per annum, with an initial payment date that occurred on April 29, 2019 and, with respect to each calendar month thereafter, a payment date that shall occur on the second business day following the latest underlying payment date of all of the underlying series in that calendar month. The 2019-1R Notes mature on March 29, 2022 or, if extended pursuant to the terms of the related indenture, March 27, 2024 (unless earlier redeemed in accordance with their terms). The total UPB outstanding under these notes as of December 31, 2020 was $167.1 million.
On June 11, 2019, we, through our indirect subsidiary, PMT CREDIT RISK TRANSFER TRUST 2019-2R, issued an aggregate principal amount of $638.0 million in secured term notes (the “2019-2R Notes”) to qualified institutional buyers under Rule 144A of the Securities Act. The 2019-2R Notes bear interest at a rate equal to one-month LIBOR plus 2.75% per annum, with an initial payment date of June 27, 2019 and, with respect to each calendar month thereafter, a payment date that shall occur on the second business day following the latest underlying payment date of all of the underlying series in that calendar month. The 2019-2R Notes mature on May 29, 2023 or, if extended pursuant to the terms of the related indenture, June 28, 2025 (unless earlier redeemed in accordance with their terms). The total UPB outstanding under these notes as of December 31, 2020 was $436.5 million.
On October 16, 2019, we, through our indirect subsidiary, PMT CREDIT RISK TRANSFER TRUST 2019-3R, issued an aggregate principal amount of $375.0 million in secured term notes (the “2019-3R Notes”) to qualified institutional buyers under Rule 144A of the Securities Act. The 2019-3R Notes bear interest at a rate equal to one-month LIBOR plus 2.70% per annum, with an initial payment date of November 27, 2019 and, with respect to each calendar month thereafter, a payment date that shall occur on the second business day following the latest underlying payment date of all of the underlying series in that calendar month. The 2019-3R Notes mature on October 27, 2022 or, if extended pursuant to the terms of the related indenture, October 29, 2024 (unless earlier redeemed in accordance with their terms). The total UPB outstanding under these notes as of December 31, 2020 was $185.6 million.
On November 4, 2019, our wholly-owned subsidiary, PMC, issued in a private offering $210 million principal amount of Exchangeable Senior Notes due 2024 (the “2024 Notes”), bearing interest at a rate equal to 5.50% per year, payable semiannually in arrears on May 1 and November 1 of each year, beginning on May 1, 2020. The 2024 Notes will mature on November 1, 2024. The 2024 Notes are fully and unconditionally guaranteed by the Company and are exchangeable into cash or common shares, or a combination of cash and common shares. The common shares are exchangeable at a rate of 40.1010 common shares per $1,000 principal amount of the 2024 Notes as of December 31, 2019, subject to adjustment upon the occurrence of certain events, but will not be adjusted for any accrued and unpaid interest. The proceeds are used for general corporate purposes, including funding investment
activity, which may include investments in CRT arrangements, MSRs, MBS and new products such as, home equity lines of credit, non-qualified mortgage loans, as well as working capital.
On February 14, 2020, through our indirect subsidiary, PMT CREDIT RISK TRANSFER TRUST 2020-1R, we issued an aggregate principal amount of $350 million in secured term notes (the “2020-1R Notes”) to qualified institutional buyers under Rule 144A of the Securities Act. The 2020-1R Notes bear interest at a rate equal to one-month LIBOR plus 2.35% per annum, with an initial payment date of March 27, 2020 and, with respect to each calendar month thereafter, a payment date that shall occur on the second business day following the latest underlying payment date of all of the underlying series in that calendar month. The 2020-1R Notes mature on March 1, 2023 or, if extended pursuant to the terms of the related indenture, February 27, 2025 (unless earlier redeemed in accordance with their terms).
On December 22, 2020, through our indirect subsidiary, PMT CREDIT RISK TRANSFER TRUST 2020-2R, we issued an aggregate principal amount of $500 million in secured term notes (the “2020-2R Notes”) to qualified institutional buyers under Rule 144A of the Securities Act. The 2020-2R Notes bear interest at a rate equal to one-month LIBOR plus 3.81% per annum, with an initial payment date of January 27, 2021 and, with respect to each calendar month thereafter, a payment date that shall occur on the second business day following the latest underlying payment date of all of the underlying series in that calendar month. The 2020-2R Notes mature in December 28, 2022 unless earlier redeemed in accordance with their terms.
We maintain multiple master repurchase agreements and mortgage loan participation and sale agreements with money center banks to fund newly originated prime loans purchased from correspondent sellers. The total UPB outstanding under the facilities in existence as of December 31, 2020 was $6.3 billion.
Our borrowings are made under agreements that include various covenants, including the maintenance of profitability and specified levels of cash, adjusted tangible net worth and overall leverage limits. Our ability to borrow under these facilities is limited by the amount of qualifying assets that we hold and that are eligible to be pledged to secure such borrowings and our ability to fund any applicable margin requirements. We are not otherwise required to maintain any specific debt-to-equity ratio, and we believe the appropriate leverage for the particular assets we finance depends on, among other things, the credit quality and risk of such assets. Our declaration of trust and bylaws do not limit the amount of indebtedness we can incur, and our board of trustees has discretion to deviate from or change our financing strategy at any time.
Subject to maintaining our qualification as a REIT and exclusion from registration under the Investment Company Act, we may hedge the interest rate risk associated with the financing of our portfolio.
Our Manager and Our Servicer
We are externally managed and advised by PCM pursuant to a management agreement. PCM specializes in and focuses on investments in U.S. mortgage assets. PCM has also served as the investment manager to two private investment funds, which were liquidated during 2018.
PCM is responsible for administering our business activities and day-to-day operations, including developing our investment strategies, and sourcing and acquiring mortgage-related assets for our investment portfolio. Pursuant to the terms of the management agreement, PCM provides us with our senior management team, including our officers and support personnel. PCM is subject to the supervision and oversight of our board of trustees and has the functions and authority specified in the management agreement.
We also have a loan servicing agreement with PLS, pursuant to which PLS provides primary and special servicing for our portfolio of residential loans and MSRs. PLS’ loan servicing activities include collecting principal, interest and escrow account payments, accounting for and remitting collections to investors in the loans, responding to customer inquiries, and default management activities, including managing loss mitigation, which may include, among other things, collection activities, loan workouts, modifications and refinancings, foreclosures, short sales and sales of REO. Servicing fee rates are based on the delinquency status, activities performed, and other characteristics of the loans serviced and total servicing compensation is established at levels that our Manager believes are competitive with those charged by other primary servicers and specialty servicers. PLS also provided special servicing to the private investment funds and the entities in which those funds invested. PLS acted as the servicer for loans with UPB totaling approximately $426.8 billion, of which $174.4 billion was subserviced for us as of December 31, 2020.
Operating and Regulatory Structure
Taxation - REIT Qualification
We have elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986 (the “Internal Revenue Code”) beginning with our taxable year ended December 31, 2009. Our qualification as a REIT depends upon our ability to meet on a continuing basis, through actual investment and operating results, various complex requirements under the Internal Revenue Code relating to, among other things, the sources of our gross income, the composition and values of our assets, our distribution levels and the diversity of ownership of our common shares. We believe that we are organized in conformity with the requirements for qualification and taxation as a REIT under the Internal Revenue Code, and that our manner of operation enables us to meet the requirements for qualification and taxation as a REIT.
As a REIT, we generally are not subject to U.S. federal income tax on the REIT taxable income we distribute to our shareholders. If we fail to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal income tax at regular corporate rates and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year during which we lost our REIT qualification. Accordingly, our failure to qualify as a REIT could have a material adverse impact on our results of operations and amounts available for distribution to our shareholders.
Even though we have elected to be taxed as a REIT, we are subject to some U.S. federal, state and local taxes on our income or property. A portion of our business is conducted through, and a portion of our income is earned in, our TRS that is subject to corporate income taxation. In general, a TRS of ours may hold assets and engage in activities that we cannot hold or engage in directly and may engage in any real estate or non-real estate related business. A TRS is subject to U.S. federal, state and local corporate income taxes. To maintain our REIT election, at the end of each quarter no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs.
If our TRS generates net income, our TRS can declare dividends to us, which will be included in our taxable income and necessitate a distribution to our shareholders. Conversely, if we retain earnings at the TRS level, no distribution is required and we can increase shareholders’ equity of the consolidated entity. As discussed in Section 1A of this Report entitled Risk Factors, the combination of the requirement to maintain no more than 20% of our assets in the TRS coupled with the effect of TRS dividends on our income tests creates compliance complexities for us in the maintenance of our qualified REIT status.
The dividends paid deduction of a REIT for qualifying dividends to its shareholders is computed using our taxable income as opposed to net income reported on our financial statements. Taxable income generally differs from net income reported on our financial statements because the determination of taxable income is based on tax laws and regulations and not financial accounting principles.
Licensing
We and PLS are required to be licensed to conduct business in certain jurisdictions. PLS is, or is taking steps to become, licensed in those jurisdictions and for those activities where it believes it is cost effective and appropriate to become licensed. Through our wholly owned subsidiaries, we are also licensed, or are taking steps to become licensed, in those jurisdictions and for those activities where we believe it is cost effective and appropriate to become licensed. In jurisdictions in which neither we nor PLS is licensed, we do not conduct activity for which a license is required. Our failure or the failure by PLS to obtain any necessary licenses promptly, comply with applicable licensing laws or satisfy the various requirements or to maintain them over time could materially and adversely impact our business.
Competition
In our correspondent production activities, we compete with large financial institutions and with other independent residential loan producers and servicers such as Wells Fargo, JP Morgan Chase, AmeriHome Mortgage and Mr. Cooper. We compete on the basis of product offerings, technical knowledge, and loan quality, speed of execution, rate and fees.
In acquiring mortgage assets, we compete with specialty finance companies, private funds, other mortgage REITs, thrifts, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, governmental bodies and other entities, which may also be focused on acquiring mortgage-related assets, and therefore may increase competition for the available supply of mortgage assets suitable for purchase.
Many of our competitors are significantly larger than we are and have stronger financial positions and greater access to capital and other resources than we have and may have other advantages over us. Such advantages include the ability to obtain lower-cost financing, such as deposits, and operational efficiencies arising from their larger size.
Some of our competitors may have higher risk tolerances or different risk assessments and may not be subject to the operating constraints associated with REIT tax compliance or maintenance of an exclusion from the Investment Company Act, any of which could allow them to consider a wider variety of investments and funding strategies and to establish more relationships with sellers of mortgage assets than we can.
Because the availability of mortgage assets may fluctuate, the competition for assets and sources of financing may increase. Increased competition for assets may result in our accepting lower returns for acquisitions of residential loans and other assets or adversely influence our ability to bid for such assets at levels that allow us to acquire the assets. An increase in the competition for sources of funding could adversely affect the availability and terms of financing, and thereby adversely affect the market price of our common shares.
To address this competition, we have access to PCM’s professionals and their industry expertise, which we believe provides us with a competitive advantage and helps us assess investment risks and determine appropriate pricing for certain potential investments. We expect this relationship to enable us to compete more effectively for attractive investment opportunities. Furthermore, we believe that our access to PLS’s servicing expertise provides us with a competitive advantage over other companies with a similar focus. However, we can provide no assurance that we will be able to achieve our business goals or expectations due to the competitive and other risks that we face.
Human Capital Resources
We have one employee. All of our officers are employees of PennyMac or its affiliates. Our long-term growth and success is highly dependent upon PennyMac’s employees and PennyMac’s ability to create a diverse and inclusive workplace that represents a broad spectrum of backgrounds, ideas and perspectives. As part of these efforts, PennyMac strives to offer competitive compensation and benefits, foster a community where everyone feels a greater sense of belonging and purpose, and provide employees with the opportunity to give back and make an impact in the communities where its employees live and serve.
During 2020, PennyMac’s workforce grew from over 4,000 domestic employees as of the fiscal year ended December 31, 2019 to over 6,000 domestic employees as of the fiscal year ended December 31, 2020. At the end of fiscal year 2020, PennyMac’s workforce was 46.7% male and 53.3% female, and the ethnicity of PennyMac’s workforce was 43.7% White, 16.8% Black, 23.4% Hispanic, 10.3% Asian and 5.8% other.
Recruiting and Employee Retention
We and PennyMac believe in attracting, developing and engaging the best talent, while providing a supportive work environment that prioritizes the health and safety of PennyMac’s and our employees. PennyMac’s and our compensation programs are designed to motivate and reward those who possess the necessary skills to support business strategy and create long-term stockholder value. PennyMac employee compensation may include base salary, annual cash incentives, long-term equity incentives as well as life and health insurance and 401(k) plan matching contributions. Our compensation program consists of long-term equity incentives to further align certain of PennyMac’s key employees who influence our business with our shareholders and our long-term business objectives.
Employees receive regular training to help further enhance their career development objectives and PennyMac also actively manages an enterprise-wide mentoring program. PennyMac has partnered with an external vendor to establish a comprehensive, fully integrated wellness program designed to enhance the productivity of PennyMac’s employees. PennyMac supports the U.S. military through its continued focus on recruiting and creating opportunities for veterans. For example, PennyMac established the Veterans Engaging Mentorships, Relationships, and Growth program to further its efforts to hire, support, and create a community of veterans and veteran families.
Diversity and Inclusion
We and PennyMac believe that building a diverse and inclusive, high-performing workforce where PennyMac’s employees bring varied perspectives and experiences to work every day creates a positive influence in PennyMac’s workplace, community and business operations. Our Board of Trustees, Nominating and Corporate Governance Committee and Risk Committee provide regular oversight on PennyMac’s sustainability, diversity and inclusion programs and initiatives. During 2020, PennyMac established leadership goals and created customized initiatives that focused on PennyMac’s continued effort to increase women and underrepresented minorities in management positions throughout the company and its business divisions. As it relates to gender diversity, PennyMac established the Women Empowering Mentorships, Relationships, and Growth program to emphasize career growth, networking, and learning opportunities for women at the management level. PennyMac also fosters a more inclusive culture
through a variety of other diversity and inclusion initiatives, including corporate training, special events, community outreach and corporate philanthropy.
Community Involvement
PennyMac’s corporate philanthropy program is governed by a philosophy of giving that prioritizes the support of causes and issues that are important in our local communities, and drives a culture of employee engagement and collaboration throughout our and PennyMac’s organization. PennyMac is committed to empowering its employees to be a positive influence in the communities where its employees live and serve, and believes that this commitment supports its efforts to attract and engage employees and improve retention. During the 2020 fiscal year, PennyMac established a separate donor advisor fund to make donations to various local and national charitable organizations.
Available Information
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and amendments to those reports filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge at www.pennymacmortgageinvestmenttrust.com through the investor relations section of our website as soon as reasonably practicable after electronically filing such material with the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding our filings at www.sec.gov. The above references to our website and the SEC’s website do not constitute incorporation by reference of the information contained on those websites and should not be considered part of this document.

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ITEM 1A. RISK FACTORS
Item 1A.
Risk Factors
Summary Risk Factors
We are subject to a number of risks that, if realized, could have a material adverse effect on our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders. Some of our more significant challenges and risks include, but are not limited to, the following, which are described in greater detail below:
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Our business, financial condition and results of operations may be adversely affected by the ongoing COVID-19 pandemic.
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The COVID-19 pandemic and the CARES Act have significantly increased the number of borrowers in forbearance whose loans are in our CRT arrangements which may lead to significant future credit or fair value losses.
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We operate in a highly regulated industry and the continually changing federal, state and local laws and regulations could materially and adversely affect our business, financial condition and results of operations.
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New CFPB and state rules and regulations and more stringent enforcement of existing rules and regulations by the CFPB or state regulators could result in enforcement actions, fines, penalties and the inherent reputational harm that results from such actions.
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We are highly dependent on U.S. government-sponsored entities and government agencies, and any changes in these entities, their current roles or the leadership at such entities or their regulators could materially and adversely affect our business, liquidity, financial condition and results of operations.
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Our business prospects, financial condition, liquidity and results of operations could be adversely impacted by the CFPB’s final General Qualified Mortgage (“QM”) loan rule for certain GSE eligible loans and its impact on the ability to repay rules.
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We and/or PLS are required to have various Agency approvals and state licenses in order to conduct our business and there is no assurance we and/or PLS will be able to obtain or maintain those Agency approvals or state licenses.
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Our or PLS’ inability to meet certain net worth and liquidity requirements imposed by the Agencies could have a material adverse effect on our business, financial condition and results of operation.
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Difficult conditions in the mortgage, real estate and financial markets and the economy generally may adversely affect the performance and fair value of our investments.
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A disruption in the MBS market could materially and adversely affect our business, financial condition and results of operations.
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We have a substantial amount of indebtedness, which may limit our financial and operating activities, expose us to substantial increases in costs due to interest rate fluctuations, expose us to the risk of default under our debt obligations and may adversely affect our ability to incur additional debt to fund future needs.
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We finance our investments with borrowings, which may materially and adversely affect our return on our investments and may reduce cash available for distribution to our shareholders.
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We may not be able to raise the debt or equity capital required to finance our assets and grow our businesses.
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Interest rate fluctuations could significantly decrease our results of operations and cash flows and the fair value of our investments.
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Our correspondent production activities could subject us to increased risk of loss.
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The success and growth of our correspondent production activities will depend, in part, upon PLS’ ability to adapt to and implement technological changes and to successfully develop, implement and protect its proprietary technology.
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We are not an approved Ginnie Mae issuer and an increase in the percentage or amount of government loans we acquire could be detrimental to our results of operations.
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Our retention of credit risk underlying loans we sell to the GSEs is inherently uncertain and exposes us to significant risk of loss.
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The Federal Housing Finance Agency (“FHFA”) has instructed government-sponsored entities to gradually wind down new lender risk share transactions such as CRT investments as of the end of 2020. If we are unable to find a suitable alternative investment to investing in CRTs with similar returns, our business, liquidity, financial condition and results of operations could be materially and adversely affected.
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A portion of our investments is in the form of loans, and the loans in which we invest subject us to costs and losses arising from delinquency and foreclosure, as well as the risks associated with residential real estate and residential real estate-related investments, any of which could result in losses to us.
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Our acquisition of mortgage servicing rights exposes us to significant risks.
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Our acquisition of excess servicing spread has exposed us to significant risks.
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The failure of PLS or any other servicer to effectively service our portfolio of MSRs and loans would materially and adversely affect us.
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We are subject to certain risks associated with investing in real estate and real estate related assets, including risks of loss from adverse weather conditions, man-made or natural disasters, pandemics, such as COVID-19, terrorist attacks, and the effects of climate change, which may cause disruptions in our operations and could materially and adversely affect the real estate industry generally and our business, financial condition, liquidity and results of operations.
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We may be materially and adversely affected by risks affecting borrowers or the asset or property types in which our investments may be concentrated at any given time, as well as from unfavorable changes in the related geographic regions.
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Many of our investments are illiquid and we may not be able to adjust our portfolio in response to changes in economic and other conditions.
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Fair values of many of our investments are estimates and the realization of reduced values from our recorded estimates may materially and adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to our shareholders.
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We are required to make servicing advances that can be subject to delays in recovery or may not be recoverable in certain circumstances, which could adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
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We are dependent upon PCM and PLS and their resources and may not find suitable replacements if any of our service agreements with PCM or PLS are terminated.
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The management fee structure could cause disincentive and/or create greater investment risk.
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Termination of our management agreement is difficult and costly.
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Certain provisions of Maryland law, our staggered board of trustees and certain provisions in our declaration of trust could each inhibit a change in our control.
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Failure to maintain exemptions or exclusions from registration under the Investment Company Act of 1940 could materially and adversely affect us.
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Our failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our shareholders.
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Even if we qualify as a REIT, we face tax liabilities that reduce our cash flow, and a significant portion of our income may be earned through taxable REIT subsidiaries, or TRSs, that are subject to U.S. federal income taxation.
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The percentage of our assets represented by a TRS and the amount of our income that we can receive in the form of TRS dividends are subject to statutory limitations that could jeopardize our REIT status.
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The risk management efforts of our Manager may not be effective.
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Cybersecurity risks, cyber incidents and technology failures may adversely affect our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships, all of which could negatively impact our financial results.
The above list is not exhaustive, and we face additional challenges and risks. Please carefully consider all of the information in this Report, including the matters set forth below in this Item 1A.
Risk Factors
In addition to the other information set forth in this Report, you should carefully consider the following factors, which could materially adversely affect our business, financial condition, liquidity and results of operations in future periods. The risks described below are not the only risks that we face. Additional risks not presently known to us or that we currently deem immaterial may also materially adversely affect our business, financial condition, liquidity and results of operations in future periods.
Risks Related to Our Business
Our business, financial condition and results of operations may be adversely affected by the ongoing COVID-19 pandemic.
The COVID-19 pandemic has created unprecedented economic, financial and public health disruptions that have adversely affected, and are likely to continue to adversely affect, our business, financial condition and results of operations. The extent to which the COVID-19 pandemic continues to negatively affect our business, financial condition and results of operations will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to COVID-19 pandemic.
The federal government enacted the CARES Act, which allows borrowers with federally-backed loans to request temporary payment forbearance in response to the increased borrower hardships resulting from the COVID-19 pandemic. The initial forbearance period is up to 180 days, subject to a further extension of up to 180 days. In addition, in February 2021 the federal government announced an additional extension of three to six months depending on loan type. As a result of the CARES Act forbearance requirements, we have experienced continued elevated delinquencies in our servicing portfolio that may require us to finance substantial amounts of advances of principal and interest payments to the holders of the securities holding those loans, as well as advances of property taxes, insurance premiums and other expenses to protect investors’ interests in the properties securing the loans. In fiscal year 2020, elevated prepayment activity was sufficient to cover principal and interest payment advances required under the CARES Act, however, in the future elevated prepayment activity may be insufficient to cover required principal and interest advances. We also expect the effects of the CARES Act forbearance requirements to reduce our servicing fee income and increase our servicing expenses due to the increased number of delinquent loans and significant levels of forbearance that we have granted and continue to grant, as well as the resolution of loans that we expect to ultimately default as the result of the COVID-19 pandemic. As of December 31, 2020, 2.1% of the loans in our MSR portfolio were in COVID-19 related forbearance plans and delinquent resulting in an increase in the level of servicing advances we have been required to make due to borrower delinquencies.
Financial markets have experienced substantial volatility and reduced liquidity, resulting in unprecedented federal government intervention to lower the federal funds rate to near zero and support market liquidity by purchasing assets in many financial markets, including the mortgage-backed securities market. The CARES Act forbearance requirements and the decline in interest rates and financial markets in early 2020 have negatively impacted the fair value of our servicing assets and CRT arrangements. In addition, the CARES Act forbearance requirements and the decline in the value of financial assets linked to consumer credit performance in early 2020 caused us to report material losses.
Further market volatility or economic weakness may result in additional declines in the value of our credit assets and make it increasingly difficult to optimize our hedging activities. Also, our liquidity and/or regulatory capital could be adversely impacted by volatility and disruptions in the capital and credit markets. In addition, if we fail to meet or satisfy any of the covenants in our repurchase agreements or other financing arrangements as a result of the impact of the COVID-19 pandemic, we would be in default under these agreements, which could result in a cross-default or cross-acceleration under other financing arrangements, and our lenders could elect to declare outstanding amounts due and payable (or such amounts may automatically become due and payable), terminate their commitments, require the posting of additional collateral and enforce their respective interests against existing collateral.
We may also have difficulty accessing debt and equity capital on attractive terms, or at all, as a result of the impact of the COVID-19 pandemic, which may adversely affect our access to capital necessary to fund our operations or address maturing liabilities on a timely basis. This includes renewals of our existing financing arrangements with our lenders who may be adversely impacted by the volatility and dislocations in the financial markets and may not be willing or able to continue to extend us credit on the same terms, or on favorable terms, or at all.
In addition, our business could be disrupted if our Manager is unable to operate due to changing governmental restrictions such as travel bans and quarantines placed or reinstituted on its employees or operations, including successfully operating its and our business from remote locations, ensuring the protection of its employees’ health, and maintaining its information technology infrastructure.
Federal, state, and local executive, legislative and regulatory responses to the ongoing COVID-19 pandemic are rapidly evolving, may be inconsistent and conflict in scope or application, and may be subject to change without advance notice. These regulatory responses may impose additional compliance obligations, may extend existing CARES Act forbearance requirements and delay our licensing efforts, which may negatively impact our business. In addition, the CARES Act and other federal, state and local regulations are subject to interpretation given the existing ambiguities in the rules and regulations, which may result in future class action and other litigation risk.
Governmental authorities have taken additional measures to stabilize the financial markets and support the economy including providing monetary relief and extending foreclosure and eviction moratoria. The outcome of these measures are unknown and they may not be sufficient to address the current market dislocations or avert severe and prolonged reductions in economic activity. We may also face increased risks of disputes with our business partners, litigation and governmental and regulatory scrutiny as a result of the effects of the COVID-19 pandemic. The scope and duration of the COVID-19 pandemic and the efficacy of the extraordinary measures put in place to address it are currently unknown. Even after the COVID-19 pandemic subsides, the economy may not fully recover for some time and we may be materially and adversely affected by a prolonged recession or economic downturn.
To the extent the COVID-19 pandemic adversely affects our business, financial condition and results of operations, it may also have the effect of heightening many of the other risks described in this Item 1A.
The COVID-19 pandemic and the CARES Act have significantly increased the number of borrowers who are in forbearance whose loans are in our CRT arrangements which may lead to significant future credit or fair value losses.
On March 27, 2020, the federal government enacted the CARES Act, which allows borrowers with federally-backed loans to request temporary payment forbearance if they attest that they are directly or indirectly experiencing any financial hardship resulting from the COVID-19 pandemic. The initial forbearance period is up to 180 days, subject to further extension of up to 180 days. In addition, in February 2021 the federal government announced an additional extension of three to six months depending on loan type.
The CARES Act also precludes loan servicers like us from reporting borrowers subject to forbearance plans as delinquent to the credit reporting agencies even though the federally-backed loans may still be characterized as delinquent for the purposes of our CRT arrangements with Fannie Mae. Our CRT arrangements are structured such that we retain a portion of the credit risk and an interest-only ownership interest in the reference loans and, under certain of our CRT Agreements, may be required to realize losses in the event of a loan delinquency of 180 days or more even where there is ultimately no loss realized with respect to such loan (e.g., as a result of a borrower’s re-performance).
Although these CRT Agreements were amended in 2018 to ensure that forbearances resulting from Hurricane Harvey and Hurricane Irma were not considered to be delinquent for the purposes of the 180 day delinquency fixed loss severity schedule, Fannie Mae and its regulator, the Federal Housing Finance Authority, announced that they will not provide similar treatment for forbearances resulting from the COVID-19 pandemic for certain of our CRT Agreements.
Given the federal government mandate to approve requested forbearances upon the request of a borrower and subject only to his or her attestation of the COVID-19 pandemic impact, we expect the number of forbearances requested and approved under our CRT arrangements will result in credit losses and fair value losses that may be material and that may require us to write down the value of the assets significantly. In the event of a foreclosure, the proceeds upon the sale of such underlying real estate may not be sufficient to repay the borrower’s mortgage loan obligation, which could result in losses to our CRT arrangements and to us. Any such losses we incur may reduce distributions to our shareholders and may materially and adversely affect our results of operations, our financial condition, and the market value of our common shares.
We operate in a highly regulated industry and the continually changing federal, state and local laws and regulations could materially and adversely affect our business, financial condition and results of operations.
We are required to comply with a wide array of federal, state and local laws and regulations that regulate, among other things, the manner in which we conduct our loan production and servicing businesses. These regulations directly impact our business and require constant compliance, monitoring and internal and external audits. PLS and the service providers it uses, including outside counsel retained to process foreclosures and bankruptcies, must also comply with some of these legal requirements.
Our failure or the failure of PLS to operate effectively and in compliance with these laws, regulations and rules could subject us to lawsuits or governmental actions and damage our reputation, which could materially and adversely affect our business, financial condition and results of operations. In addition, our failure or the failure of PLS to comply with these laws, regulations and rules may result in increased costs of doing business, reduced payments by borrowers, modification of the original terms of loans, permanent
forgiveness of debt, delays in the foreclosure process, increased servicing advances, litigation, reputational damage, enforcement actions, and repurchase and indemnification obligations.
The failure of our correspondent sellers to comply with any applicable laws, regulations and rules may also result in these adverse consequences. PLS has in place a due diligence program designed to assess areas of risk with respect to loans we acquire from such correspondent sellers. However, we may not detect every violation of law and, to the extent any correspondent sellers, third party originators, servicers or brokers with whom we do business fail to comply with applicable laws or regulations and any of their loans or MSRs become part of our assets, it could subject us, as an assignee or purchaser of the related loans or MSRs, to monetary penalties or other losses. While we may have contractual rights to seek indemnity or repurchase from certain of these lenders, third party originators, servicers or brokers, if any of them are unable to fulfill their indemnity or repurchase obligations to us to a material extent, our business, liquidity, financial condition and results of operations could be materially and adversely affected. Our service providers and other vendors are also required to operate in compliance with applicable laws, regulations and rules. Our failure to adequately manage service providers and other vendors to mitigate risks of noncompliance with applicable laws may also have these negative results.
The recent outcome of the 2020 U.S. Presidential and Congressional elections could result in significant policy changes or regulatory uncertainty in our industry and may result in increased regulatory scrutiny and enforcement actions. While it is not possible to predict when and whether significant policy or regulatory changes would occur, any such changes on the federal, state or local level could significantly impact, among other things, our operating expenses, the availability of mortgage financing, interest rates, consumer spending, the economy and the geopolitical landscape. To the extent that the new government administration takes action by proposing and/or passing regulatory policies that could have a negative impact on our industry, such actions may have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our shareholders. To the extent any such state regulators impose new minimum net worth, capital ratio and liquidity standards that are overly burdensome, such actions may have a material adverse effect on our business, financial condition and results of operations.
The Financial Stability Oversight Council (“FSOC”) and Conference of State Bank Supervisors (“CSBS”) have been reviewing whether state chartered nonbank mortgage servicers should be subject to "safety and soundness" standards similar to those imposed by federal law on insured depository institutions, even though nonbank mortgage servicers do not hold any funds in federally insured deposit accounts. For example, on September 29, 2020, the CSBS, released proposed prudential standards for state oversight of nonbank mortgage servicers. The proposed CSBS prudential standards would include revised minimum net worth, capital ratio and liquidity standards similar to existing FHFA requirements and would require servicers to maintain sufficient allowable assets to cover normal operating expenses in addition to the amounts required for servicing expenses. In addition, the FSOC has encouraged state regulators to work to develop prudential and corporate governance standards for nonbank mortgage servicers and has issued guidance describing the process FSOC would follow if it were to consider making a determination to subject a nonbank financial company to supervision by the Board of Governors of the Federal Reserve System and prudential standards.
New CFPB and state rules and regulations or more stringent enforcement of existing rules and regulations by the CFPB or state regulators could result in enforcement actions, fines, penalties and the inherent reputational harm that results from such actions.
The CFPB has regulatory authority over certain aspects of our business as a result of our residential mortgage banking activities, including, without limitation, the authority to conduct investigations, bring enforcement actions, impose monetary penalties, require remediation of practices, pursue administrative proceedings or litigation, and obtain cease and desist orders for violations of applicable federal consumer financial laws. Although there was a decline in enforcement actions by the CFPB under the prior federal administration, examinations by state regulators and enforcement actions in the residential mortgage and servicing sectors by state attorneys general have increased and may continue to increase under the new federal administration. Failure to comply with the CFPB and state laws, rules or regulations to which we are subject, whether actual or alleged, could have a material adverse effect on our business, liquidity, financial condition and results of operations.
Our or PLS’ failure to comply with the laws, rules or regulations to which we are subject, whether actual or alleged, would expose us or PLS to fines, penalties or potential litigation liabilities, including costs, settlements and judgments, any of which could have a material adverse effect on our or PLS’ business, liquidity, financial condition and results of operations and our ability to make distributions to our shareholders.
We are highly dependent on U.S. government-sponsored entities and government agencies, and any changes in these entities, their current roles or the leadership at such entities or their regulators could materially and adversely affect our business, liquidity, financial condition and results of operations.
Our ability to generate revenues through loan sales depends on programs administered by the Agencies and others that facilitate the issuance of MBS in the secondary market. Presently, almost all of the newly originated loans that we acquire from mortgage lenders through our correspondent production activities qualify under existing standards for inclusion in mortgage securities backed by the Agencies. We also derive other material financial benefits from these relationships, including the ability to avoid certain loan inventory finance costs through streamlined loan funding and sale procedures.
A number of legislative proposals have been introduced in recent years that would wind down or phase out the GSEs, including a proposal by the prior federal administration to end the conservatorship and privatize Fannie Mae and Freddie Mac. On November 18, 2020, the FHFA finalized new regulatory capital rules for Fannie Mae and Freddie Mac that requires them to increase their capital to $280 billion. The FHFA did not specify how the new regulatory capital requirements will be achieved or a timeframe for meeting the capital target, however, any increase in guaranty fees or other costs imposed by Fannie Mae and Freddie Mac to raise additional capital may have a negative impact on the mortgage market and could reduce Fannie Mae and Freddie Mac’s future role in the mortgage industry. It is not possible to predict the scope and nature of the actions that the U.S. government, including the new federal administration, will ultimately take with respect to the GSEs. Any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and their regulators or the U.S. federal government, and any changes in leadership at any of these entities could adversely affect our business and prospects. Any discontinuation of, or significant reduction in, the operation of Fannie Mae or Freddie Mac or any significant adverse change in their capital structure, financial condition, activity levels in the primary or secondary mortgage markets or underwriting criteria could materially and adversely affect our business, liquidity, financial condition, results of operations and our ability to make distributions to our shareholders.
Elimination of the traditional roles of Fannie Mae and Freddie Mac, or any changes to the nature or extent of the guarantees provided by Fannie Mae and Freddie Mac or the fees, terms and guidelines that govern our selling and servicing relationships with them could also materially and adversely affect our business, including our ability to sell and securitize loans that we acquire through our correspondent production activities, and the performance, liquidity and market value of our investments. Moreover, any changes to the nature of the GSEs or their guarantee obligations could redefine what constitutes an Agency MBS and could have broad adverse implications for the market and our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Our ability to generate revenues from newly originated loans that we acquire through our correspondent production activities is also highly dependent on the fact that the Agencies have not historically acquired such loans directly from mortgage lenders, but have instead relied on banks and non-bank aggregators such as us to acquire, aggregate and securitize or otherwise sell such loans to investors in the secondary market. Certain of the Agencies have approved new and smaller lenders that traditionally may not have qualified for such approvals. To the extent that mortgage lenders choose to sell directly to the Agencies rather than through loan aggregators like us, this reduces the number of loans available for purchase, and it could materially and adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders. Similarly, to the extent the Agencies increase the number of purchases and sales for their own accounts, our business and results of operations could be materially and adversely affected.
Our business prospects, financial condition, liquidity and results of operations could be adversely impacted by the CFPB’s final General Qualified Mortgage (“QM”) loan rule for certain GSE eligible loans and its impact on the ability to repay rules.
The Dodd-Frank Act provides that a lender must make “a reasonable, good faith determination” of each borrower’s ability to repay a loan, but may presume that a borrower will be able to repay a loan if such loan has certain characteristics that meet the QM definition. The CFPB adopted its QM definition that establishes rigorous underwriting and product feature requirements for a loan to be deemed a QM. Within those regulations, the CFPB created a special exemption for the GSEs that is generally referred to as the “QM patch,” which allows any GSE-eligible loan to be deemed a QM. The QM patch effectively provides QM designation for GSE eligible loans that have a debt-to-income ratio in excess of 43%, which represents a meaningful portion of the loans currently purchased by the GSEs. Without the QM patch or an alternative, loans with debt-to-income ratios above 43% would not be designated as QMs unless they were insured by a federal agency such as the FHA or VA, which have each adopted their own QM definition that does not currently have a debt-to-income ratio limitation. In October 2020, the CFPB issued a rule providing that the QM patch will expire on the earlier of the implementation of a final amendment revising the “General QM loan” definition or upon the date that the GSEs exit conservatorship. On December 11, 2020, the CFPB issued final General QM loan rules replacing the debt-to-income ratio limitations with a price-based approach, which may have significant implications for the U.S. housing and mortgage market since we do not know how the credit markets and borrowers will respond to the new regulations. Failure to establish effective operational
procedures to comply with the final General QM loan rules could materially and adversely affect our business, financial condition, liquidity and results of operations.
We and/or PLS are required to have various Agency approvals and state licenses in order to conduct our business and there is no assurance we and/or PLS will be able to obtain or maintain those Agency approvals or state licenses.
Because we and PLS are not federally chartered depository institutions, neither we nor PLS benefits from exemptions to state mortgage lending, loan servicing or debt collection licensing and regulatory requirements. Accordingly, PLS is licensed, or is taking steps to become licensed, in those jurisdictions, and for those activities, where it is required to be licensed and believes it is cost effective and appropriate to become licensed.
Our failure or the failure by PLS to obtain any necessary licenses, comply with applicable licensing laws or satisfy the various requirements to maintain them over time could restrict our direct business activities, result in litigation or civil and other monetary penalties, or cause us to default under certain of our lending arrangements, any of which could materially and adversely impact our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We and PLS are also required to hold the Agency approvals in order to sell loans to the Agencies and service such loans on their behalf. Our failure, or the failure of PLS, to satisfy the various requirements necessary to maintain such Agency approvals over time would also restrict our direct business activities and could adversely impact our business.
In addition, we and PLS are subject to periodic examinations by federal and state regulators, which can result in increases in our administrative costs, and we or PLS may be required to pay substantial penalties imposed by these regulators due to compliance errors, or we or PLS may lose our licenses. Negative publicity or fines and penalties incurred in one jurisdiction may cause investigations or other actions by regulators in other jurisdictions and could adversely impact our business.
Our or PLS’ inability to meet certain net worth and liquidity requirements imposed by the Agencies could have a material adverse effect on our business, financial condition and results of operation.
We and our servicers are subject to minimum financial eligibility requirements for Agency mortgage sellers/servicers and MBS issuers, as applicable. These eligibility requirements align the minimum financial requirements for mortgage sellers/servicers and MBS issuers to do business with the Agencies. These minimum financial requirements, which are described in Liquidity and Capital Resources, include net worth, capital ratio and/or liquidity criteria in order to set a minimum level of capital needed to adequately absorb potential losses and a minimum amount of liquidity needed to service Agency loans and MBS and cover the associated financial obligations and risks.
In order to meet these minimum financial requirements, we and PLS are required to maintain rather than spend or invest, cash and cash equivalents in amounts that may adversely affect our or its business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders, and this could significantly impede us and PLS, as non-bank mortgage lenders, from growing our respective businesses and place us at a competitive disadvantage in relation to federally chartered banks and certain other financial institutions. To the extent that such minimum financial requirements are not met, the Agencies may suspend or terminate Agency approval or certain agreements with us or PLS, which could cause us or PLS to cross default under financing arrangements and/or have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Market and Financial Risks
A prolonged economic slowdown, recession or declining real estate values could materially and adversely affect us.
The risks associated with our investments are more acute during periods of economic slowdown or recession, especially if these periods are accompanied by high unemployment and declining real estate values. The ongoing impact of the COVID-19 pandemic, a weakening economy, high unemployment and declining real estate values significantly increase the likelihood that borrowers will default on their debt service obligations and that we will incur losses on our investments in the event of a default on a particular investment because the fair value of any collateral we foreclose upon may be insufficient to cover the full amount of such investment or may require a significant amount of time to realize. These factors may also increase the likelihood of re-default rates even after we have completed loan modifications. Any period of increased payment delinquencies, foreclosures or losses could adversely affect the net interest income generated from our portfolio and our ability to make and finance future investments, which would materially and adversely affect our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
Difficult conditions in the mortgage, real estate and financial markets and the economy generally may adversely affect the performance and fair value of our investments.
The success of our business strategies and our results of operations are materially affected by current conditions in the mortgage markets, the financial markets and the economy generally. Continuing concerns over factors including the ongoing impact of the COVID-19 pandemic, inflation, deflation, unemployment, personal and business income taxes, healthcare, energy costs, domestic political issues, climate change, the availability and cost of credit, the mortgage markets and the real estate markets have contributed to increased volatility and unclear expectations for the economy and markets going forward. The mortgage markets have been and continue to be affected by changes in the lending landscape, defaults, credit losses and significant liquidity concerns. A destabilization of the real estate and mortgage markets or deterioration in these markets may adversely affect the performance and fair value of our investments, reduce our loan production volume, lower our margins, reduce the profitability of servicing mortgages or adversely affect our ability to sell loans that we acquire, either at a profit or at all. Any of the foregoing could materially and adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
A disruption in the MBS market could materially and adversely affect our business, financial condition and results of operations.
In our correspondent production activities, we deliver newly originated Agency-eligible loans that we acquire to Fannie Mae or Freddie Mac to be pooled into Agency MBS securities or transfer government loans that we acquire to PLS, which pools them into Ginnie Mae MBS securities. In addition, due to the ongoing COVID-19 pandemic, the Federal Reserve has enacted monetary policies to purchase MBS on the open market that has and may continue to impact the liquidity of the MBS market. Any significant disruption or period of illiquidity in the general MBS market would directly affect our liquidity because no existing alternative secondary market would likely be able to accommodate on a timely basis the volume of loans that we typically acquire and sell in any given period. Accordingly, if the MBS market experiences a period of illiquidity, we might be prevented from selling the loans that we acquire into the secondary market in a timely manner or at favorable prices or we may be required to repay a portion of the debt securing these assets, which could materially and adversely affect our business, financial condition, results of operations and our ability to make distributions to our shareholders.
We have a substantial amount of indebtedness, which may limit our financial and operating activities, expose us to substantial increases in costs due to interest rate fluctuations, expose us to the risk of default under our debt obligations and may adversely affect our ability to incur additional debt to fund future needs.
As of December 31, 2020, we had $8.7 billion of total indebtedness outstanding (approximately $8.5 billion of which was secured) and up to $4.6 billion of additional capacity under our secured borrowings and other secured debt financing arrangements. This substantial indebtedness and any future indebtedness we incur could have adverse consequences and, for example, could:
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require us to dedicate a substantial portion of cash flow from operations to the payment of principal and interest on indebtedness, including indebtedness we may incur in the future, thereby reducing the funds available for operations, capital expenditures and other general corporate purposes;
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make it more difficult for us to satisfy our obligations with respect to our indebtedness, and any failure to comply with the obligations of any of our debt instruments, including any restrictive covenants, could result in an event of default under the agreements governing our other indebtedness which, if not cured or waived, could result in the acceleration of our indebtedness;
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subject us to increased sensitivity to interest rate increases;
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make us more vulnerable to economic downturns, adverse industry conditions or catastrophic external events, including the COVID-19 pandemic;
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limit our ability to withstand competitive pressures;
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reduce our flexibility in planning for or responding to changing business, industry and economic conditions or restrict our ability to carry on activities important to our growth; and/or
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place us at a competitive disadvantage to competitors that have relatively less debt than we have.
In addition, our substantial level of indebtedness could limit our ability to obtain additional financing on acceptable terms, or at all, for working capital and general corporate purposes. Our liquidity needs vary significantly from time to time and may be affected by general economic conditions, industry trends, performance and many other factors outside our control.
We finance our investments with borrowings, which may materially and adversely affect our return on our investments and may reduce cash available for distribution to our shareholders.
We currently leverage and, to the extent available, intend to continue to leverage our investments through borrowings, the level of which may vary based on our investment portfolio characteristics and market conditions. We generally finance our investments with relatively short-term facilities until a sufficient portfolio is accumulated or longer-term financing becomes available. As a result, we are subject to the risks that we would not be able to obtain suitable non-recourse long-term financing or otherwise acquire, during the period that any short-term facilities are available, sufficient eligible assets or securities to maximize the efficiency of a securitization. We also bear the risk that we would not be able to obtain new short-term facilities or to renew any short-term facilities after they expire should we need more time to obtain long-term financing or seek and acquire sufficient eligible assets or securities for a securitization. If we are unable to obtain and renew short-term facilities or to consummate securitizations to finance our investments on a long-term basis, we may be required to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or unfavorable price.
Specifically, we have financed certain of our investments through repurchase agreements, pursuant to which we sell securities (including securities we retain through our CRT investments) or loans to lenders (i.e., repurchase agreement counterparties) and receive cash from the lenders. We currently finance our CRT investments through a combination of term notes and repurchase agreements. Unlike MBS and other securities we finance under repurchase agreements, our CRT investment is illiquid in nature and may be subject to greater fluctuations in fair value. Further, the size of our CRT investment makes it a greater likelihood that any margin call could be material in nature, and our inability to satisfy any such margin call or liquidate the underlying collateral may result in significant losses to us.
We also currently finance certain of our MSRs and ESS under secured financing arrangements. Our Freddie Mac MSRs are pledged to secure borrowings under a loan and security agreement, while our Fannie Mae MSRs are pledged to a special purpose entity, which issues variable funding notes and term notes that are secured by such Fannie Mae MSRs and repaid through the cash flows received by the special purpose entity as the lender under a repurchase agreement with PMC. Our Ginnie Mae ESS is sold under a repurchase agreement to PLS as part of a structured finance transaction. PLS, in turn, pledges such ESS along with all of its Ginnie Mae MSRs under a repurchase agreement to a special purpose entity, which issues variable funding notes and term notes that are secured by such Ginnie Mae assets. The notes are repaid through the cash flows received by the special purpose entity as the lender under its repurchase agreement with PLS, which, in turn, receives cash flows from us under our repurchase agreement secured by the Ginnie Mae ESS. In each case, a decrease in the value of the pledged collateral can result in a margin call. Any such margin call may require that we liquidate assets at a disadvantageous time or provide that the secured parties may sell the collateral, either of which could result in significant losses to us. Each of the secured financing arrangements pursuant to which we finance MSRs and ESS is further subject to the terms of an acknowledgement agreement with Fannie Mae, Freddie Mac or Ginnie Mae, as applicable, pursuant to which our and the secured parties’ rights are subordinate in all respects to the rights of the applicable Agency. Any extinguishment of our and the secured parties’ rights in the related collateral could result in significant losses to us.
We may in the future utilize other sources of borrowings, including term loans, bank credit facilities and structured financing arrangements, among others. The amount of leverage we employ varies depending on the asset class being financed, our available capital, our ability to obtain and access financing arrangements with lenders and the lenders’ and rating agencies’ estimate of, among other things, the stability of our investment portfolio’s cash flow.
Our return on our investments and cash available for distribution to our shareholders may be reduced to the extent that changes in market conditions increase the cost of our financing relative to the income that can be derived from the investments acquired. Our debt service payments also reduce cash flow available for distribution to shareholders. In the event we are unable to meet our debt service obligations, we risk the loss of some or all of our assets to foreclosure or sale to satisfy the obligations.
Our financing agreements contain financial and restrictive covenants that could adversely affect our financial condition and our ability to operate our businesses.
The lenders under our repurchase agreements require us and/or our subsidiaries to comply with various financial covenants, including those relating to tangible net worth, profitability and our ratio of total liabilities to tangible net worth. Our lenders also require us to maintain minimum amounts of cash or cash equivalents sufficient to maintain a specified liquidity position. If we are unable to maintain these liquidity levels, we could be forced to sell additional investments at a loss and our financial condition could deteriorate rapidly.
Our existing financing agreements also contain certain events of default and other financial and non-financial covenants and restrictions that impact our flexibility to determine our operating policies and investment strategies. If we default on our obligations under a credit or financing agreement, fail to comply with certain covenants and restrictions or breach our representations and are unable to cure, the lender may be able to terminate the transaction or its commitments, accelerate any amounts outstanding, require us to post additional collateral or repurchase the assets, and/or cease entering into any other credit transactions with us.
Because our financing agreements typically contain cross-default provisions, a default that occurs under any one agreement could allow the lenders under our other agreements to also declare a default, thereby exposing us to a variety of lender remedies, such as those described above, and potential losses arising therefrom. Any losses that we incur on our credit and financing agreements could materially and adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
As the servicer of the assets subject to our repurchase agreements, PLS is also subject to various financial covenants, including those relating to tangible net worth, liquidity, profitability and its ratio of total liabilities to tangible net worth. PLS’ failure to comply with any of these covenants would generally result in a servicer termination event or event of default under one or more of our repurchase agreements. Thus, in addition to relying upon PCM to manage our financial covenants, we rely upon PLS to manage its own financial covenants in order to ensure our compliance with our repurchase agreements and our continued access to liquidity and capital. A servicer termination event or event of default resulting from PLS’ breach of its financial or other covenants could materially and adversely impact our business, financial condition, liquidity, results of operations and our ability to make distributions to shareholders.
We may not be able to raise the debt or equity capital required to finance our assets and grow our businesses.
The growth of our businesses requires continued access to debt and equity capital that may or may not be available on favorable terms or at the desired times, or at all. In addition, we invest in certain assets, including MSRs and ESS, for which financing has historically been difficult to obtain. Our inability to continue to maintain debt financing for MSRs and ESS could require us to seek equity capital that may be more costly or unavailable to us.
We are also dependent on a limited number of banking institutions that extend us credit on terms that we have determined to be commercially reasonable. These banking institutions are subject to their own regulatory supervision, liquidity and capital requirements, risk management frameworks and risk thresholds and tolerances, any of which may change materially and negatively impact their willingness to extend credit to us specifically or mortgage lenders and servicers generally. Such actions may increase our cost of capital and limit or otherwise eliminate our access to capital, in which case our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders would be materially and adversely affected.
In addition, our ability to finance ESS relating to Ginnie Mae MSRs is currently dependent on pass through financing we obtain through PLS, which retains the MSRs associated with the ESS we acquire. After our initial acquisition of ESS, we then finance the acquired ESS with PLS under a repurchase agreement, and PLS, in turn, re-pledges the ESS (along with the related MSRs it retains) under a master repurchase agreement with a special purpose entity, which issues variable funding notes and term notes that are secured by such Ginnie Mae MSRs and ESS and repaid through the cash received by the special purpose entity as the lender under a repurchase agreement with PLS. There can be no assurance this pass through financing will continue to be available to us.
This financing arrangement also subjects us to the credit risk of PLS. To the extent PLS does not apply our payments of principal and interest under the repurchase agreement to the allocable portion of its borrowings under the master repurchase agreement, or to the extent PLS otherwise defaults under the master repurchase agreement, our ESS would be at a risk of total loss. In addition, we provide a guarantee for the amount of borrowings under the master repurchase agreement that are allocable to the pass through financing of our ESS. In the event we are unable to satisfy our obligations under the guaranty following a default by PLS, this could cause us to default under other financing arrangements and/or have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We can provide no assurance that we will have access to any debt or equity capital on favorable terms or at the desired times, or at all. Our inability to raise such capital or obtain financing on favorable terms could materially and adversely impact our business, financial condition, liquidity, results of operations and our ability to make distributions to shareholders.
In addition, we have been authorized to repurchase up to $300 million of our common shares pursuant to a share repurchase program approved by our board of trustees. As of December 31, 2020, we had $46.1 million remaining under the current board of trustees authorization, and we may continue to repurchase shares to the extent we believe it is in the Company’s best interest to do so. Increased activity in our share repurchase program will have the effect of reducing our common shares outstanding, market value and shareholders’ equity, any or all of which could adversely affect the assessment by our lenders, credit providers or other counterparties regarding our net worth and, therefore, negatively impact our ability to raise new capital.
Interest rate fluctuations could significantly decrease our results of operations and cash flows and the fair value of our investments.
Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations present a variety of risks to our
operations. Our primary interest rate exposures relate to the yield on our investments, their fair values and the financing cost of our debt, as well as any derivative financial instruments that we utilize for hedging purposes.
Changes in interest rates affect our net interest income, which is the difference between the interest income we earn on our interest earning investments and the interest expense we incur in financing these investments. Interest rate fluctuations resulting in our interest expense exceeding interest income may result in operating losses for us. An increase in prevailing interest rates could adversely affect the volume of newly originated mortgages available for purchase in our correspondent production activities.
Changes in the level of interest rates also may affect our ability to make investments, the fair value of our investments (including our pipeline of loan commitments) and any related hedging instruments, the value of newly originated loans acquired through our correspondent production segment, and our ability to realize gains from the disposition of assets. Changes in interest rates may also affect borrower default rates and may impact our ability to refinance or modify loans and/or to sell REO. Decreasing interest rates may cause a large number of borrowers to refinance, which may result in the loss of mortgage servicing business and write-downs of the associated MSRs and ESS. Any such scenario could materially and adversely affect us.
We are subject to risks associated with the expected discontinuation of LIBOR.
In July 2017, the head of the United Kingdom Financial Conduct Authority (“FCA”), which regulates the LIBOR administrator, announced the phase out of the use of LIBOR by the end of 2021. However, for U.S. dollar LIBOR, it now appears that the relevant date may be deferred to June 30, 2023 for the most common rates (overnight and one, three, six and 12 months). The LIBOR administrator has published a consultation regarding its intention to cease publication of U.S. dollar LIBOR as of June 30, 2023 (instead of December 31, 2021, as previously expected) based on continued rate submissions from banks. The FCA and other regulators have stated that they welcome the LIBOR administrator’s action. An extension to 2023 would mean that many legacy U.S. dollar LIBOR contracts would terminate before related LIBOR rates cease to be published. However, the same regulators emphasized that, despite any continued publication of U.S. dollar LIBOR through June 30, 2023, no new contracts using U.S. dollar LIBOR should be entered into after December 31, 2021. Moreover, the LIBOR administrator’s consultation also relates to the LIBOR administrator’s intention to cease publication of non-U.S. dollar LIBOR after December 31, 2021. There is no assurance that LIBOR will continue to be published until any particular date.
To identify a set of alternative interest reference rates to LIBOR, the U.S. Federal Reserve established the Alternative Reference Rates Committee (“ARRC”), a U.S. based working group composed of large U.S. financial institutions. ARRC has identified the Secured Overnight Financing Rate as its preferred replacement for LIBOR, but it is unclear how their preference may impact the risks we maintain to the cessation of LIBOR, or if other benchmarks may emerge as a replacement for LIBOR.
The expected and actual discontinuation of LIBOR could have a significant impact on the financial markets and our business activities. We rely on financing arrangements and liabilities under which our cost of borrowing is based on LIBOR. We also hold assets and instruments used to hedge the value of certain assets that depend for their value on LIBOR. We anticipate significant challenges as it relates to the transition away from LIBOR for all of our LIBOR-based assets, financing arrangements, and liabilities, regardless whether their maturity dates fall before or after the anticipated discontinuation date after December 31, 2021 or June 30, 2023, as applicable. These challenges will include, but will not be limited to, amending agreements underlying our existing and/or new LIBOR-based assets, financing arrangements, and liabilities with appropriate fallback language prior to the discontinuation of LIBOR, and the possibility that LIBOR may deteriorate as a viable benchmark to ensure a fair cost of funds for our LIBOR-linked liabilities, interest income for our LIBOR-linked assets, and/or the determination of fair value for certain of our assets and hedges using LIBOR as a benchmark rate or used to develop a market discount rate. In addition, the transition to using any new benchmark rate or other financial metric may require changes to existing transaction data, products, systems, models, operations and pricing processes.
We also anticipate additional risks to our current business activities as they relate to the discontinuation of LIBOR. We service LIBOR-based adjustable rate mortgages (“ARMs”) for which the underlying mortgage notes incorporate fallback provisions, but we cannot anticipate the response of our borrowers or note holders to such risks. We also rely on financial models that incorporate LIBOR into their methodologies for financial planning and reporting.
Due to these risks, we expect both the impending and actual discontinuation of LIBOR could materially affect our interest expense and earnings, our cost of capital, and the fair value of certain of our assets and the instruments we use to hedge their value. For the same reason, we also can provide no assurance that changes in the value of our hedge instruments will effectively offset changes in the value of the assets they are expected to hedge. Furthermore, the transition away from widely used benchmark rates like LIBOR could result in customers or other market participants challenging the determination of their interest payments, disputing the interpretations or implementation of contract “fallback” provisions and other transition related changes. Our inability to manage these risks effectively may materially and adversely affect our business, financial condition, liquidity and results of operations.
We are subject to market risk and declines in credit quality and changes in credit spreads, which may adversely affect investment income and cause realized and unrealized losses.
We are exposed to the credit markets and subject to the risk that we will incur losses due to adverse changes in credit spreads. Adverse changes to these spreads may occur due to changes in fiscal policy, the ongoing impact of the COVID-19 pandemic, the economic climate, the liquidity of a market or market segment, insolvency or financial distress of key market makers or participants, or changes in market perceptions of credit worthiness and/or risk tolerance.
We are subject to risks associated with potential declines in our credit quality, credit quality related to specific issuers or specific industries, and a general weakening in the economy, all of which are typically reflected through credit spreads. Credit spread is the additional yield on fixed income securities above the risk-free rate (typically referenced as the yield on U.S. Treasury securities) that market participants require to compensate them for assuming credit, liquidity and/or prepayment risks. Credit spreads vary (i.e., increase or decrease) in response to the market’s perception of risk and liquidity in a specific issuer or specific sector and are influenced by the credit ratings, and the reliability of those ratings, published by external rating agencies. A decline in the quality of our investment portfolio as a result of adverse economic conditions or otherwise could cause additional realized and unrealized losses on our investments.
A decline in credit spreads could have an adverse effect on our investment income as we invest cash in new investments that may earn less than the portfolio’s average yield. An increase in credit spreads could have an adverse effect on the value of our investment portfolio by decreasing the fair values of the credit sensitive investments in our investment portfolio. Any such scenario could materially and adversely affect us.
Hedging against interest rate exposure may materially and adversely affect our results of operations and cash flows.
We pursue hedging strategies in a manner that is consistent with the REIT qualification requirements to reduce our exposure to interest rates. The strategies are intended to mitigate the effect of interest rate fluctuations on the fair value of the assets at our TRS as well as debt used to acquire or carry real estate assets at entities other than our TRS. To manage this price risk, we use derivative financial instruments acquired with the intention of moderating the risk that changes in market interest rates will result in unfavorable changes in the fair value of our assets, primarily prepayment exposure on our MSR investments as well as IRLCs and our inventory of loans held for sale as well as MBS and CRTs. For example, with respect to our IRLCs and inventory of loans held for sale, we may use MBS forward sale contracts to lock in the price at which we will sell the mortgage loans or resulting MBS, and MBS put options to mitigate the risk of our IRLCs not closing at the rate we expect. In addition, with respect to our MSRs, we may use MBS forward purchase and sale contracts to address exposures to smaller interest rate shifts with Treasury and interest rate swap futures, and use options and swaptions to achieve target coverage levels for larger interest rate shocks.
Our hedging activity will vary in scope based on the risks being mitigated, the level of interest rates, the type of investments held, and other changing market conditions such as those resulting from the ongoing COVID-19 pandemic. Hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities, and our interest rate hedging may fail to protect or could adversely affect us because, among other things:
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interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
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available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;
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the duration of the hedge may not match the duration of the related liability or asset;
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the credit quality of the hedging counterparty owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
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the hedging counterparty owing the money in the hedging transaction may default on its obligation to pay.
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the federal tax regulations applicable to REITs limit our hedge activity outside of the TRS to hedging interest rate fluctuations with respect to debt used to acquire or carry real estate assets.
In addition, we may fail to recalculate, re-adjust and execute hedges in an efficient manner. Any hedging activity, which is intended to limit losses, may materially and adversely affect our results of operations and cash flows. Therefore, while we may enter into such transactions seeking to reduce interest rate risk, unanticipated changes in interest rates may result in worse overall investment performance than if we had not engaged in any such hedging transactions. A liquid secondary market may not exist for a hedging instrument purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in significant losses. In addition, the degree of correlation between price movements of the instruments used in hedging strategies and price movements in the portfolio positions or liabilities being hedged may vary materially. Moreover, for a variety of reasons, we may not establish an effective correlation between such hedging instruments and the portfolio positions or liabilities being hedged. Any
such ineffective correlation may prevent us from achieving the intended hedge and expose us to risk of loss. Numerous regulations currently apply to hedging and any new regulations or changes in existing regulations may significantly increase our administrative or compliance costs. Our derivative agreements generally provide for the daily mark to market of our hedge exposures. If a hedge counterparty determines that its exposure to us exceeds its exposure threshold, it may initiate a margin call and require us to post collateral. If we are unable to satisfy a margin call, we would be in default of our agreement, which could have a material adverse effect on our business, financial condition, liquidity and results of operations.
We utilize derivative financial instruments, which could subject us to risk of loss.
We utilize derivative financial instruments for hedging purposes, which may include swaps, options and futures. However, the prices of derivative financial instruments, including futures and options, are highly volatile, as are payments made pursuant to swap agreements. As a result, the cost of utilizing derivatives may reduce our income that would otherwise be available for distribution to shareholders or for other purposes, and the derivative instruments that we utilize may fail to effectively hedge our positions. We are also subject to credit risk with regard to the counterparties involved in the derivative transactions.
The use of derivative instruments is also subject to an increasing number of laws and regulations, including the Dodd-Frank Act and other federal regulations. These laws and regulations are complex, compliance with them may be costly and time consuming, and our failure to comply with any of these laws and regulations could subject us to lawsuits or government actions and damage our reputation, which could materially and adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We may change our investment strategies and policies without shareholder consent, and this may materially and adversely affect the market value of our common shares and our ability to make distributions to our shareholders.
PCM is authorized by our board of trustees to follow very broad investment policies and, therefore, it has great latitude in determining the types of assets that are proper investments for us, as well as the individual investment decisions. In the future, PCM may make investments with lower rates of return than those anticipated under current market conditions and/or may make investments with greater risks to achieve those anticipated returns. Our board of trustees will periodically review our investment policies and our investment portfolio but will not review or approve each proposed investment by PCM unless it falls outside our investment policies or constitutes a related party transaction.
In addition, in conducting periodic reviews, our board of trustees will rely primarily on information provided to it by PCM. Furthermore, PCM may use complex strategies, and transactions entered into by PCM may be costly, difficult or impossible to unwind by the time they are reviewed by our board of trustees. We also may change our investment strategies and policies and targeted asset classes at any time without the consent of our shareholders, and this could result in our making investments that are different in type from, and possibly riskier than our current investments or the investments currently contemplated. Changes in our investment strategies and policies and targeted asset classes may expose us to new risks or increase our exposure to interest rate risk, counterparty risk, default risk and real estate market fluctuations, and this could materially and adversely affect the market value of our common shares and our ability to make distributions to our shareholders.
Our correspondent production activities could subject us to increased risk of loss.
In our correspondent production activities, we acquire newly originated loans from mortgage lenders and sell or securitize those loans to or through the Agencies or other third party investors. We also sell the resulting securities into the MBS markets. However, there can be no assurance that PLS will continue to be successful in operating this business on our behalf or that we will continue to be able to capitalize on these opportunities on favorable terms or at all. In particular, we have committed, and expect to continue to commit, capital and other resources to this operation; however, PLS may not be able to continue to source sufficient asset acquisition opportunities to justify the expenditure of such capital and other resources. In the event that PLS is unable to continue to source sufficient opportunities for this operation, there can be no assurance that we would be able to acquire such assets on favorable terms or at all, or that such assets, if acquired, would be profitable to us. In addition, we may be unable to finance the acquisition of these assets and/or may be unable to sell the resulting MBS in the secondary mortgage market on favorable terms or at all. We are also subject to the risk that the fair value of the acquired loans may decrease prior to their disposition. The occurrence of any of these risks could adversely impact our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
The success and growth of our correspondent production activities will depend, in part, upon PLS’ ability to adapt to and implement technological changes and to successfully develop, implement and protect its proprietary technology.
Our success in the mortgage industry is highly dependent upon the ability of our servicer, PLS, to adapt to constant technological changes, successfully enhance its current information technology solutions through the use of third-party and proprietary technologies, and introduce new solutions and services that more efficiently address our needs.
Our correspondent production activities are currently dependent, in part, upon the ability of PLS to effectively interface with our mortgage lenders and other third parties and to efficiently process loan fundings and closings. The correspondent production process is becoming more dependent upon technological advancement, and our correspondent sellers expect and require certain conveniences and service levels. In this regard, PLS has transitioned to a workflow-driven, cloud-based loan acquisition platform. While we anticipate that PLS’ cloud-based system will increase scalability and produce other efficiencies, there can be no assurance that PLS’ cloud-based system will prove to be effective or that such correspondent sellers will easily adapt to PLS’ cloud-based system. Any failure to effectively or timely transition to the new system and meet our expectations and the expectations of our correspondent sellers could have a material adverse effect on our business, financial condition and results of operations.
The development, implementation and protection of these technologies and becoming more proficient with it may also require significant capital expenditures by PLS. As these technological advancements increase in the future, PLS will need to further develop and invest in these technological capabilities to remain competitive. Moreover, litigation has become required for PLS to protect its technologies and such litigation is expected to be time consuming and result in substantial costs and diversion of PLS resources. Any failure of PLS to develop, implement, execute or maintain its technological capabilities and any litigation costs associated with protection of its technologies could adversely affect PLS and its ability to effectively perform its loan production and servicing activities on our behalf, which could adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We are not an approved Ginnie Mae issuer and an increase in the percentage or amount of government loans we acquire could be detrimental to our results of operations.
Government-insured or guaranteed loans that are typically securitized through the Ginnie Mae program accounted for 37% of our purchases in 2020. We are not approved as a Ginnie Mae issuer and rely heavily on PLS to acquire such loans from us. As a result, we are unable to produce or own Ginnie Mae MSRs and we earn significantly less income in connection with our acquisition of government loans as opposed to conventional loans. Further, market demand for government loans over conventional loans may increase or PLS may offer pricing to our approved correspondent sellers for government loans that is more competitive in the market than pricing for conventional loans, the result of which may be our acquisition of a greater proportion or amount of government loans. Any significant increase in the percentage or amount of government loans we acquire could adversely impact our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Risks Related to Our Investments
Our retention of credit risk underlying loans we sell to the GSEs is inherently uncertain and exposes us to significant risk of loss.
In conjunction with our correspondent business, we have entered into CRT arrangements with Fannie Mae, whereby we sell pools of loans into Fannie Mae-guaranteed securitizations while retaining a portion of the credit risk and an interest-only (“IO”) ownership interest in such loans or purchasing Agency securities that absorb losses incurred by such loans. Our retention of credit risk subjects us to risks associated with delinquency and foreclosure similar to the risks associated with owning the underlying loans, and exposes us to risk of loss greater than the risks associated with selling the loans to Fannie Mae without the retention of such credit risk. Delinquency can result from many factors including unemployment, weak economic conditions or real estate values, or catastrophic events such as man-made or natural disaster, the ongoing COVID-19 pandemic, war or terrorist attack. Further, the risks associated with delinquency and foreclosure may in some instances be greater than the risks associated with owning the underlying loans because the structure of certain of the CRT Agreements provides that we may be required to realize losses in the event of delinquency or foreclosure even where there is ultimately no loss realized with respect to the underlying loan (e.g., as a result of a borrower’s re-performance). We are also exposed to market risk and, as a result of prevailing market conditions or the economy generally, may be required to recognize losses associated with adverse changes to the fair value of the CRT Agreements. Any loss we incur may be significant and may reduce distributions to our shareholders and materially and adversely affect the market value of our common shares.
The Federal Housing Finance Agency (“FHFA”) has instructed government-sponsored entities to gradually wind down new lender risk share transactions such as CRT investments as of the end of 2020. If we are unable to find a suitable alternative
investment to investing in CRTs with similar returns, our business, liquidity, financial condition and results of operations could be materially and adversely affected.
The Federal Housing Finance Agency (“FHFA”) has instructed government-sponsored entities to gradually wind down new lender risk share transactions such as CRT investments as of the end of 2020 and accordingly we do not expect to make any new CRT investments. As of December 31, 2020, we continued to hold net CRT-related investments (comprised of deposits securing CRT arrangements, CRT derivatives, CRT strips, interest-only security payable) totaling $2.6 billion. If we are unable to find suitable alternative investments comparable to CRTs, our business, liquidity, financial condition and results of operations could be materially and adversely affected.
A portion of our investments is in the form of loans, and the loans in which we invest subject us to costs and losses arising from delinquency and foreclosure, as well as the risks associated with residential real estate and residential real estate-related investments, any of which could result in losses to us.
We have invested in performing and nonperforming residential loans and, through our correspondent production business, newly originated prime credit quality residential loans. Residential loans are typically secured by single-family residential property and are subject to risks and costs associated with delinquency and foreclosure and the resulting risks of loss.
Our investments in loans also subject us to the risks of residential real estate and residential real estate-related investments, including, among others: (i) declines in the value of residential real estate; (ii) risks related to general and local economic conditions, including those resulting from the ongoing COVID-19 pandemic; (iii) lack of available mortgage funding for borrowers to refinance or sell their homes; (iv) overbuilding; (v) increases in property taxes and operating expenses; (vi) changes in zoning laws; (vii) costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems, such as indoor mold; (viii) casualty or condemnation losses; (ix) uninsured damages from floods, earthquakes or other natural disasters; (x) limitations on and variations in rents; (xi) fluctuations in interest rates; (xii) fraud by borrowers, originators and/or sellers of loans; (xiii) undetected deficiencies and/or inaccuracies in underlying loan documentation and calculations; and (xiv) failure of the borrower to adequately maintain the property. To the extent that assets underlying our investments are concentrated geographically, by property type or in certain other respects, we may be subject to certain of the foregoing risks to a greater extent.
Additionally, we may be required to foreclose on a loan and such actions may subject us to greater concentration of the risks of the residential real estate markets and risks related to the ownership and management of real property. In the event of a foreclosure, we may assume direct ownership of the underlying real estate. The liquidation proceeds upon sale of such real estate may not be sufficient to recover our investment in the loan, resulting in a loss to us. In addition, the foreclosure process may be lengthy and expensive, and any delays or costs involved in the effectuation of a foreclosure of the loan or a liquidation of the underlying property may further reduce the proceeds and thus increase the loss.
In the event of the bankruptcy of a loan borrower, the loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law.
Our acquisition of mortgage servicing rights exposes us to significant risks.
MSRs arise from contractual agreements between us and the investors (or their agents) in mortgage securities and loans that we service on their behalf. We generally acquire MSRs in connection with our sale of loans to the Agencies where we assume the obligation to service such loans on their behalf. Any MSRs we acquire are initially recorded at fair value on our balance sheet. The determination of the fair value of MSRs requires our management to make numerous estimates and assumptions. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with MSRs based upon assumptions involving interest rates as well as the prepayment rates, delinquencies and foreclosure rates of the underlying serviced loans as well as the ongoing impact of the COVID-19 pandemic. The ultimate realization of the MSRs may be materially different than the values of such MSRs as may be reflected in our consolidated balance sheet as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. Accordingly, there may be material uncertainty about the fair value of any MSRs we acquire.
Prepayment speeds significantly affect MSRs. Prepayment speed is the measurement of how quickly borrowers pay down the unpaid principal balance of their loans or how quickly loans are otherwise brought current, modified, liquidated or charged off. We base the price we pay for MSRs on, among other things, our projection of the cash flows from the related pool of loans. Our expectation of prepayment speeds is a significant assumption underlying those cash flow projections. If prepayment speed expectations increase significantly, the fair value of the MSRs could decline and we may be required to record a non-cash charge,
which would have a negative impact on our financial results. Furthermore, a significant increase in prepayment speeds could materially reduce the ultimate cash flows we receive from MSRs, and we could ultimately receive substantially less than what we paid for such assets. Moreover, delinquency rates have a significant impact on the valuation of any MSRs. An increase in delinquencies generally results in lower revenue because typically we only collect servicing fees from Agencies or mortgage owners for performing loans. Our expectation of delinquencies is also a significant assumption underlying our cash flow projections. If delinquencies are significantly greater than we expect, the estimated fair value of the MSRs could be diminished. When the estimated fair value of MSRs is reduced, we could suffer a loss, which could have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Changes in interest rates are a key driver of the performance of MSRs. Historically, the fair value of MSRs has increased when interest rates rise and decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. We may pursue, in a manner that is consistent with our qualification as a REIT, various hedging strategies to seek to reduce our exposure to adverse changes in fair value resulting from changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us. To the extent we do not utilize derivative financial instruments to hedge against changes in fair value of MSRs or the derivatives we use in our hedging activities do not perform as expected, our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders would be more susceptible to volatility due to changes in the fair value of, or cash flows from, MSRs as interest rates change. Furthermore, MSRs and the related servicing activities are subject to numerous federal, state and local laws and regulations and may be subject to various judicial and administrative decisions imposing various requirements and restrictions on our business. The federal government enacted the CARES Act, which allows borrowers with federally-backed loans to request temporary payment forbearance in response to the increased borrower hardships resulting from the COVID-19 pandemic.
Our failure to comply, or the failure of the servicer to comply, with the laws, rules or regulations to which we or they are subject by virtue of ownership of MSRs, whether actual or alleged, could expose us to fines, penalties or potential litigation liabilities, including costs, settlements and judgments, any of which could have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Our acquisition of excess servicing spread (“ESS”) has exposed us to significant risks.
We have previously acquired from PLS the right to receive certain ESS arising from MSRs owned or acquired by PLS. The ESS represents the difference between PLS’ contractual servicing fee with the applicable Agency and a base servicing fee that PLS retains as compensation for servicing or subservicing the related loans pursuant to the applicable servicing contract.
Because the ESS is a component of the related MSR, the risks of owning the ESS are similar to the risks of owning an MSR. We also record our ESS assets at fair value, which is based on many of the same estimates and assumptions used to value our MSR assets, thereby creating the same potential for material differences between the recorded fair value of the ESS and the actual value that is ultimately realized. Also, the performance of our ESS assets are impacted by the same drivers as our MSR assets, namely interest rates, prepayment speeds, delinquency rates and the ongoing impact of the COVID-19 pandemic. Because of the inherent uncertainty in the estimates and assumptions and the potential for significant change in the impact of the drivers, there may be material uncertainty about the fair value of any ESS we acquire, and this could ultimately have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Further, as a condition to our purchase of the ESS, we were required to subordinate our interests to those of the applicable Agency. To the extent PLS fails to maintain its Agency approvals, such failure could result in PLS’ loss of the applicable MSR in its entirety, thereby extinguishing our interest in the related ESS. With respect to our ESS relating to PLS’ Ginnie Mae MSRs, we sold our interest in such ESS to PLS under a repurchase agreement and PLS, in turn, pledged such ESS along with its interest in all of its Ginnie Mae MSRs to a special purpose entity, which issues variable funding notes and term notes that are secured by such Ginnie Mae assets and repaid through the cash flows received by the special purpose entity as the lender under a repurchase agreement with PLS. Accordingly, our interest in the Ginnie Mae ESS is also subordinated to the rights of an indenture trustee on behalf of the note holders to which the special purpose entity issues its variable funding notes and term notes under an indenture, pursuant to which the indenture trustee has a blanket lien on all of PLS’ Ginnie Mae MSRs (including the ESS we acquired). The indenture trustee, on behalf of the note holders, may liquidate our Ginnie Mae ESS along with the related MSRs to the extent there exists an event of default under the indenture. In the event our ESS is liquidated as a result of certain actions or inactions of PLS, we may be entitled to seek indemnity under the applicable spread acquisition agreement; however, this would be an unsecured claim. In either situation, our loss of the ESS could have a material adverse effect on our business, financial condition, results of operations and our ability to make distributions to our shareholders.
We cannot independently protect our MSR or ESS assets from borrower refinancing and are dependent upon PLS to do so for our benefit.
While PLS has agreed pursuant to the terms of an MSR recapture agreement to transfer cash to us in an amount equal to a tiered recapture fee ranging from 30% to 40% of the fair value of the MSRs relating to loans it refinances, we are not independently capable of protecting our MSR assets from borrower refinancing through targeted solicitations to, and origination of, refinance loans for borrowers in our servicing portfolio. Accordingly, unlike traditional mortgage originators and many servicers, we must rely upon PLS to refinance loans in our servicing portfolio that would otherwise be targeted by other lenders. There can be no assurance that PLS will either have or allocate the time and resources required to effectively and efficiently protect our MSR assets. Its failure to do so, or the termination of our MSR recapture agreement, could result in accelerated runoff of our MSR assets, decreasing its fair value and adversely impacting our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Similarly, while PLS has agreed pursuant to the terms of our spread acquisition agreements to transfer to us a portion of the ESS relating to loans it refinances, we are not independently capable of protecting our ESS assets from borrower refinancing by other lenders through targeted solicitations to, and origination of, refinance loans for borrowers in our portfolio of ESS. Accordingly, we must also rely upon PLS to refinance these loans that would otherwise be targeted by other lenders. There can be no assurance that PLS will either have or allocate the required time and resources or otherwise be capable of effectively and efficiently soliciting these loans. Its failure to do so, or the termination of our spread acquisition agreements, could result in accelerated repayment of the loans underlying our ESS assets, decreasing their value and adversely impacting our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Investments in subordinated loans and subordinated MBS could subject us to increased risk of losses.
Our investments in subordinated loans or subordinated MBS could subject us to increased risk of losses. In the event a borrower defaults on a subordinated loan and lacks sufficient assets to satisfy such loan, we may lose all or a significant part of our investment. In the event a borrower becomes subject to bankruptcy proceedings, we will not have any recourse to the assets, if any, of the borrower that are not pledged to secure our loan. If a borrower defaults on our subordinated loan or on its senior debt (i.e., a first-lien loan), or in the event of a borrower bankruptcy, our subordinated loan will be satisfied only after all senior debt is paid in full. As a result, we may not recover all or even a significant part of our investment, which could result in losses.
In general, losses on an asset securing a loan included in a securitization will be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit provided by the borrower, if any, and then by the “first loss” subordinated security holder and then by the “second loss” subordinated security holder. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit and any classes of securities junior to those in which we invest, we may not recover all or even a significant part of our investment, which could result in losses.
In addition, if the underlying mortgage portfolio has been serviced ineffectively by the loan servicer or overvalued by the originator, or if the fair values of the assets subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related MBS, the securities in which we invest may suffer significant losses. The prices of these types of lower credit quality investments are generally more sensitive to adverse actual or perceived economic downturns or individual issuer developments than more highly rated investments. An economic downturn or a projection of an economic downturn, for example, could cause a decline in the price of lower credit quality investments because the ability of obligors to make principal and interest payments or to refinance may be impaired.
The failure of PLS or any other servicer to effectively service our portfolio of MSRs and loans would materially and adversely affect us.
Pursuant to our loan servicing agreement, PLS provides us with primary and special servicing. PLS’ loan servicing activities include collecting principal, interest and escrow account payments, if any, with respect to loans, as well as managing loss mitigation, which may include, among other things, collection activities, loan workouts, modifications, foreclosures, short sales and sales of REO. The ability of PLS or any other servicer or subservicer to effectively service our portfolio of loans is critical to our success, particularly given our large investment in MSRs and our strategy of maximizing the fair value of the distressed loans that we acquire through proprietary loan modification programs, special servicing and other initiatives focused on keeping borrowers in their homes; or in the case of nonperforming loans, effecting property resolutions in a timely, orderly and economically efficient manner. The failure of PLS or any other servicer or subservicer to effectively service our portfolio of MSRs and loans would adversely impact our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
In addition, our ability, through PLS, to promptly foreclose upon defaulted loans and liquidate the underlying real property plays a critical role in our valuation of the assets in which we invest and our expected return on those investments. There are a variety of factors that may inhibit our ability, through PLS, to foreclose upon a loan and liquidate the real property within the time frames we model as part of our valuation process or within the statutes of limitation under applicable state law, and this could increase our cost of doing business and/or diminish the expected return on investment.
We are subject to certain risks associated with investing in real estate and real estate related assets, including risks of loss from adverse weather conditions, man-made or natural disasters, pandemics, such as COVID-19 pandemic, terrorist attacks, and the effects of climate change, which may cause disruptions in our operations and could materially and adversely affect the real estate industry generally and our business, financial condition, liquidity and results of operations.
Weather conditions and man-made or natural disasters such as hurricanes, tornadoes, earthquakes, pandemics, such as COVID-19 pandemic, floods, droughts, fires and other environmental conditions can adversely impact properties that we own or that collateralize loans we own or service or on which we bear credit risk, as well as properties where we conduct business. Future adverse weather conditions and man-made or natural disasters could also adversely impact the demand for, and value of, our assets, as well as the cost to service or manage such assets, directly impact the value of our assets through damage, destruction or loss, and thereafter materially impact the availability or cost of insurance to protect against these events. Terrorist attacks and other acts of violence may cause disruptions in U.S. financial markets and negatively impact the U.S. economy in general.
Potentially adverse consequences of global warming and climate change, including rising sea levels and increased intensity of extreme weather events, could similarly have an impact on our properties and the local economies of certain areas in which we operate. Although we believe our owned real estate and the properties collateralizing our loan assets or underlying our MSR and CRT assets are appropriately covered by insurance, we cannot predict at this time if we or our borrowers will be able to obtain such coverage at a reasonable cost in the future. There also is a risk that one or more of our property insurers may not be able to fulfill their obligations with respect to claims payments due to a deterioration in its financial condition or may even cancel policies due to the increasing costs of providing insurance coverage in certain geographic areas.
Certain types of losses, generally of a catastrophic nature, that result from events described above such as earthquakes, floods, hurricanes, tornados, terrorism, acts of war and pandemics, such as COVID-19 pandemic, may also be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations and other factors, including terrorism or acts of war, also might make the insurance proceeds insufficient to repair or replace a property if it is damaged or destroyed. Under these circumstances, the insurance proceeds received might not be adequate to restore our economic position with respect to the affected real property. Any uninsured loss could result in the loss of cash flow from, and the asset value of, the affected property, which could have an adverse effect on our business, financial condition, liquidity and results of operations.
Catastrophic events may disrupt our business.
Our corporate headquarters are located in Westlake Village, California and we have additional locations around the greater Los Angeles metropolitan area and elsewhere in the State of California. Many areas of California, including the immediate area around our corporate headquarters, have experienced extensive damage and property loss due to a series of large wildfires in the past several years. California and the other states in which we operate are also prone to other types of natural disasters. In the event of a major earthquake, hurricane, or catastrophic event such as fire, flood, power loss, telecommunications failure, cyber attack, pandemic, war, or terrorist attack, we may be unable to continue our operations and may endure significant business interruptions, reputational harm, delays in servicing our customers and working with our partners, interruptions in the availability of our technology and systems, breaches of data security, and loss of critical data, all of which could have an adverse effect on our future operating results.
Many of our investments are unrated or, where any credit ratings are assigned to our investments, they will be subject to ongoing evaluations and revisions and we can provide no assurance that those ratings will not be downgraded.
Many of our current investments are not, and many of our future investments will not be, rated by any rating agency. Therefore, PCM’s assessment of the fair value and pricing of our investments may be difficult and the accuracy of such assessment is inherently uncertain. However, certain of our investments may be rated. If rating agencies assign a lower-than expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our investments in the future, the fair value of these investments could significantly decline, which would materially and adversely affect the fair value of our investment portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt service obligations to us.
We may be materially and adversely affected by risks affecting borrowers or the asset or property types in which our investments may be concentrated at any given time, as well as from unfavorable changes in the related geographic regions.
Our assets are not subject to any geographic, diversification or concentration limitations except that we will be concentrated in mortgage-related investments. Accordingly, our investment portfolio may be concentrated by geography, asset, property type and/or borrower, increasing the risk of loss to us if the particular concentration in our portfolio is subject to greater risks or is undergoing adverse developments. In addition, adverse conditions in the areas where the properties securing or otherwise underlying our investments are located (including business layoffs or downsizing, industry slowdowns, changing demographics and other factors) and local real estate conditions (such as oversupply or reduced demand) may have an adverse effect on the value of our investments. A material decline in the demand for real estate in these areas may materially and adversely affect us. Concentration or a lack of diversification can increase the correlation of non-performance and foreclosure risks among our investments.
Many of our investments are illiquid and we may not be able to adjust our portfolio in response to changes in economic and other conditions.
Our investments in distressed loans, MSRs, ESS, CRT arrangements, securities and loans held in a consolidated variable interest entity may be illiquid. As a result, it may be difficult or impossible to obtain or validate third-party pricing on the investments we purchase. Illiquid investments typically experience greater price volatility, as a ready market does not exist, and can be more difficult to value. The contractual restrictions on transfer or the illiquidity of our investments may make it difficult for us to sell such investments if the need or desire arises, which could impair our ability to satisfy margin calls or certain REIT tests. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the recorded value, or may not be able to obtain any liquidation proceeds at all, thus exposing us to a material or total loss.
Fair values of many of our investments are estimates and the realization of reduced values from our recorded estimates may materially and adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to our shareholders.
The fair values of some of our investments are not readily determinable. We measure the fair value of these investments monthly, but the fair value at which our assets are recorded may differ from the values we ultimately realize. Ultimate realization of the fair value of an asset depends to a great extent on economic and other conditions that change during the time period over which the investment is held and are beyond the control of PCM, us or our board of trustees. Further, fair value is only an estimate based on good faith judgment of the price at which an investment can be sold since transacted prices of investments can only be determined by negotiation between a willing buyer and seller.
In certain cases, PCM’s estimation of the fair value of our investments includes inputs provided by third-party dealers and pricing services, and valuations of certain securities or other assets in which we invest are often difficult to obtain and are subject to judgments that may vary among market participants. Changes in the estimated fair values of those assets are directly charged or credited to earnings for the period. If we were to liquidate a particular asset, the realized value may be more than or less than the amount at which such asset was recorded. Accordingly, in either event, the fair value of our common shares could be materially and adversely affected by our determinations regarding the fair value of our investments, and such valuations may fluctuate over short periods of time.
PCM utilizes analytical models and data in connection with the valuation of our investments, and any incorrect, misleading or incomplete information used in connection therewith would subject us to potential risks.
Given the illiquidity and complexity of our investments and strategies, PCM must rely heavily on models and data, including analytical models (both proprietary models developed by PCM and those supplied by third parties) and information and data supplied by third parties. If any third party information is intentionally or negligently misrepresented and not detected, then our model and data results could be materially impacted. Models and data are used to value investments or potential investments and also in connection with hedging our investments. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, PCM may be induced to buy certain investments at prices that are too high, to sell certain other investments at prices that are too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.
Liability relating to environmental matters may impact the fair value of properties that we own or that underlie our investments.
Under various U.S. federal, state and local laws, an owner or operator of real property may become liable for the costs of removal of certain hazardous substances released on its property. These laws often impose liability without regard to whether the owner or operator was responsible for, or aware of, the release of such hazardous substances. The presence of hazardous substances
may also adversely affect an owner’s ability to sell real estate, borrow using the real estate as collateral or make debt payments to us. In addition, if we take title to a property, the presence of hazardous substances may adversely affect our ability to sell the property, and we may become liable to a governmental entity or to third parties for various fines, damages or remediation costs. Any of these liabilities or events may materially and adversely affect the fair value of the relevant asset and/or our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We depend on the accuracy and completeness of information about borrowers and counterparties and any misrepresented information could adversely affect our business, financial condition and results of operations.
In connection with our correspondent production activities, we may rely on information furnished by or on behalf of borrowers and counterparties, including financial statements and other financial information. We also may rely on representations of borrowers and counterparties as to the accuracy and completeness of that information and, with respect to audited financial statements, on reports of independent auditors. If any of this information is intentionally or negligently misrepresented and such misrepresentation is not detected prior to loan funding, the fair value of the loan may be significantly lower than expected. Our controls and processes may not have detected or may not detect all misrepresented information in our loan acquisitions or from our business clients. Any such misrepresented information could materially and adversely affect our business, financial condition, results of operations and our ability to make distributions to our shareholders.
We are subject to counterparty risk and may be unable to seek indemnity or require our counterparties to repurchase loans if they breach representations and warranties, which could cause us to suffer losses.
When we purchase mortgage assets, our counterparty typically makes customary representations and warranties to us about such assets. Our residential loan purchase agreements may entitle us to seek indemnity or demand repurchase or substitution of the loans in the event our counterparty breaches a representation or warranty given to us. However, there can be no assurance that our loan purchase agreements will contain appropriate representations and warranties, that we will be able to enforce our contractual right to demand repurchase or substitution, or that our counterparty will remain solvent or otherwise be willing and able to honor its obligations under our loan purchase agreements. Our inability to obtain indemnity or require repurchase of a significant number of loans could materially and adversely affect our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
We may be required to repurchase loans or indemnify investors if we breach representations and warranties, which could materially and adversely affect our earnings.
When we sell loans, we are required to make customary representations and warranties about such loans to the loan purchaser. As part of our correspondent production activities, PLS re-underwrites a percentage of the loans that we acquire, and we rely upon PLS to ensure quality underwriting by our correspondent sellers, accurate third-party appraisals, and strict compliance with the representations and warranties that we require from our correspondent sellers and that are required from us by our investors.
Our residential loan sale agreements may require us to repurchase or substitute loans or indemnify the purchaser against future losses in the event we breach a representation or warranty given to the loan purchaser or in the event of an early payment default on a loan. The remedies available to the Agencies, other purchasers and insurers of loans may be broader than those available to us against the originator or correspondent lender, and if a purchaser or insurer enforces its remedies against us, we may not be able to enforce the remedies we have against the sellers. The repurchased loans typically can only be financed at a steep discount to their repurchase price, if at all. Repurchased loans are also typically sold at a discount to the unpaid principal balance, which in some cases can be significant. Significant repurchase activity could materially and adversely affect our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
We are required to make servicing advances that can be subject to delays in recovery or may not be recoverable in certain circumstances, which could adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
During any period in which a borrower is not making payments, we may be required under our servicing agreements in respect of our MSRs to advance our own funds to pass through scheduled principal and interest payments to security holders of the MBS into which the loans are sold, pay property taxes and insurance premiums, legal expenses and other protective advances. We also advance funds under these agreements to maintain, repair and market real estate properties on behalf of investors. As home values change, we may have to reconsider certain of the assumptions underlying our decisions to make advances and, in certain situations, our contractual obligations may require us to make advances for which we may not be reimbursed. In addition, if a loan serviced by us is in default or becomes delinquent, the repayment to us of the advance may be delayed until the loan is repaid or refinanced or a liquidation occurs.
Federal, state or local regulatory actions may increase the amount of servicing advances that we are required to make, lengthen the time it takes for us to be reimbursed for such advances and increase the costs incurred while the loan is delinquent. The federal
government enacted the CARES Act, which allows borrowers with federally-backed loans to request temporary payment forbearance in response to the increased borrower hardships resulting from the COVID-19 pandemic.
A delay in our ability to collect advances may adversely affect our liquidity, and our inability to be reimbursed for advances could have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Risks Related to Our Management and Relationship with Our Manager and Its Affiliates
We are dependent upon PCM and PLS and their resources and may not find suitable replacements if any of our service agreements with PCM or PLS are terminated.
We are externally advised and managed by PCM, which, pursuant to our management agreement, makes all or substantially all of our investment, financing and risk management decisions, and has significant discretion as to the implementation of our operating policies and strategies. Under our loan servicing agreement with PLS, PLS provides primary servicing and special servicing for our portfolios of loans and MSRs, and under our mortgage banking services agreement with PLS, PLS provides fulfillment and disposition-related services in connection with our correspondent production business. The costs of these services increase our operating costs and may reduce our net income, but we rely on PCM and PLS to provide these services under these agreements because we have few employees and limited in-house capability to perform the activities independently.
No assurance can be given that the strategies of PCM, PLS or their affiliates under any of these agreements will be successful, that any of them will conduct complete and accurate due diligence or provide sound advice, or that any of them will act in our best interests with respect to the allocation of their resources to our business. The failure of any of them to do any of the above, conduct the business in accordance with applicable laws and regulations or hold all licenses or registrations necessary to conduct the business as currently operated would materially and adversely affect our ability to continue to execute our business plan.
In addition, the terms of these agreements extend until June 30, 2025, subject to automatic renewal for additional 18-month periods, but any of the agreements may be terminated earlier under certain circumstances or otherwise non-renewed. See “Termination of our management agreement is difficult and costly” below. If any agreement is terminated or not renewed and not replaced by a new agreement, it would materially and adversely affect our ability to continue to execute our business plan.
If our management agreement or loan servicing agreement is terminated or not renewed, we will have to obtain the services from another service provider. We may not be able to replace these services in a timely manner or on favorable terms, or at all. With respect to our mortgage banking services agreement, the services provided by PLS are inherently unique and not widely available, if at all. This is particularly true because we are not a Ginnie Mae licensed issuer, yet we are able to acquire government loans from our correspondent sellers that we know will ultimately be purchased from us by PLS. While we generally have exclusive rights to these services from PLS during the term of our mortgage banking services agreement, in the event of a termination we may not be able to replace these services in a timely manner or on favorable terms, or at all, and we ultimately would be required to compete against PLS as it relates to our correspondent business activities.
The management fee structure could cause disincentive and/or create greater investment risk.
Pursuant to our management agreement, PCM is entitled to receive a base management fee that is based on our shareholders’ equity (as defined in our management agreement) at the end of each quarter. As a result, significant base management fees would be payable to PCM for a given quarter even if we experience a net loss during that quarter. PCM’s right to non-performance-based compensation may not provide sufficient incentive to PCM to devote its time and effort to source and maximize risk-adjusted returns on our investment portfolio, which could, in turn, materially and adversely affect the market price of our common shares and/or our ability to make distributions to our shareholders.
Conversely, PCM is also entitled to receive incentive compensation under our management agreement based on our performance in each quarter. In evaluating investments and other management strategies, the opportunity to earn incentive compensation based on our net income may lead PCM to place undue emphasis on higher yielding investments and the maximization of short-term income at the expense of other criteria, such as preservation of capital, maintenance of sufficient liquidity and/or management of market risk, in order to achieve higher incentive compensation. Investments with higher yield potential are generally riskier and more speculative.
The servicing fee structure could create a conflict of interest.
For its services under our loan servicing agreement, PLS is entitled to servicing fees that we believe are competitive with those charged by primary servicers and specialty servicers and include fixed per-loan monthly amounts based on the delinquency, bankruptcy and/or foreclosure status of the serviced loan or the REO, as well as activity fees that generally are fixed dollar amounts. PLS is also entitled to customary ancillary income and certain market-based fees and charges, including boarding and deboarding fees, liquidation and disposition fees, and assumption, modification and origination fees. Because certain of these fees are earned upon reaching a specific milestone, this fee structure may provide PLS with an incentive to foreclose more aggressively or liquidate assets for less than their fair value.
On our behalf, PLS also refinances performing loans and originates new loans to facilitate the disposition of real estate that we acquire through foreclosure. In order to provide PLS with an incentive to produce such loans, PLS is entitled to receive origination fees and other compensation based on market-based pricing and terms that are consistent with the pricing and terms offered by PLS to unaffiliated third parties on a retail basis. This may provide PLS with an incentive to refinance a greater proportion of our loans than it otherwise would and/or to refinance loans on our behalf instead of arranging the refinancings with a third party lender, either of which might give rise to a potential or perceived conflict of interest.
Termination of our management agreement is difficult and costly.
It is difficult and costly to terminate, without cause, our management agreement. Our management agreement provides that it may be terminated by us without cause under limited circumstances and the payment to PCM of a significant termination fee. The cost to us of terminating our management agreement may adversely affect our desire or ability to terminate our management agreement with PCM without cause. PCM may also terminate our management agreement upon at least 60 days’ prior written notice if we default in the performance of any material term of our management agreement and the default continues for a period of 30 days after written notice to us, or where we terminate our loan servicing agreement, our mortgage banking services agreement or certain other of our related party agreements with PCM or PLS without cause (at any time other than at the end of the current term or any automatic renewal term), whereupon in any case we would be required to pay to PCM a significant termination fee. As a result, our desire or ability to terminate any of our related party agreements may be adversely affected to the extent such termination would trigger the right of PCM to terminate the management agreement and our obligation to pay PCM a significant termination fee.
Existing or future entities or accounts managed by PCM may compete with us for, or may participate in, investments, any of which could result in conflicts of interest.
Although our agreements with PCM and PLS provide us with certain exclusivity and other rights and we and PCM have adopted an allocation policy to specifically address some of the conflicts relating to our investment opportunities, there is no assurance that these measures will be adequate to address all of the conflicts that may arise or will address such conflicts in a manner that is favorable to us. Certain of the funds that PCM may advise in the future may have investment objectives that overlap with ours, including funds which have different fee structures, and potential conflicts may arise with respect to decisions regarding how to allocate investment opportunities among those funds and us. We are also limited in our ability to acquire assets that are not qualifying real estate assets and/or real estate related assets, whereas other entities or accounts that PCM may manage in the future may not be so limited. In addition, PCM and the other entities or accounts managed by PCM in the future may participate in some of our investments, which may not be the result of arm’s length negotiations and may involve or later result in potential conflicts between our interests in the investments and those of PCM or such other entities.
We may encounter conflicts of interest in our Manager’s efforts to appropriately allocate its time and services between its own activities and the management of us, and the loss of the services of our Manager’s management team could adversely affect us.
Pursuant to our management agreement, PCM is obligated to provide us with the services of its senior management team, and the members of that team are required to devote such time to us as is necessary and appropriate, commensurate with our level of activity. The members of PCM’s senior management team may have conflicts in allocating their time and services between the operations of PFSI and our activities, and other entities or accounts that they may manage in the future.
Our failure to appropriately address various issues that may give rise to reputational risk could cause harm to our business and adversely affect our business, financial condition and results of operations.
Our business is subject to significant reputational risks. If we fail, or appear to fail, to address various issues that may give rise to reputational risk, we could significantly harm our business. Such issues include, but are not limited to, actual or perceived conflicts of interest, violations of legal or regulatory requirements, and any of the other risks discussed in this Item 1A. Similarly, market rumors and actual or perceived association with counterparties whose own reputations are under question could harm our business.
As we expand the scope of our businesses, we confront potential conflicts of interest relating to our investment activities that are managed by PCM. The SEC and certain other regulators continue to scrutinize potential conflicts of interest, and as we expand the scope of our business, we continue to monitor and address any conflicts between our interests and those of PFSI. We have implemented procedures and controls to be followed when real or potential conflicts of interest arise, but it is possible that potential or perceived conflicts could give rise to the dissatisfaction of, or litigation by, our investors or regulatory enforcement actions. Appropriately dealing with conflicts of interest is complex and difficult, and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with one or more potential or actual conflicts of interest. Regulatory scrutiny, litigation or reputational risk incurred in connection with conflicts of interest would adversely affect our business in a number of ways and may adversely affect our results of operations. Reputational risk incurred in connection with conflicts of interest could negatively affect our financial condition and business, strain our working relationships with regulators and government agencies, expose us to litigation and regulatory action, impact our ability to attract and retain customers, trading counterparties, investors and employees and adversely affect our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
Reputational damage can result from our actual or alleged conduct in any number of activities, including lending and debt collection practices, corporate governance, and actions taken by government regulators and community organizations in response to those activities. Negative public opinion can also result from social media and media coverage, whether accurate or not. In addition, various private third party organizations have developed ratings processes for evaluating companies on their approach to environmental, social and governance (“ESG”) matters. These third party ESG ratings may be used by some investors to assist with their investment and voting decisions. Any unfavorable ESG ratings may lead to reputational damage and negative sentiment among our investors and other stakeholders. These factors could impair our working relationships with government agencies and investors, expose us to litigation and regulatory action, negatively affect our ability to attract and retain customers, trading counterparties and employees, significantly harm our stock price and ability to raise capital, and adversely affect our results of operations.
PCM and PLS both have limited liability and indemnity rights.
Our agreements with PCM and PLS provide that PCM and PLS will not assume any responsibility other than to provide the services specified in the applicable agreements. Our management agreement further provides that PCM will not be responsible for any action of our board of trustees in following or declining to follow its advice or recommendations. In addition, each of PCM and PLS and their respective affiliates, including each such entity’s managers, officers, trustees, directors, employees and members, will be held harmless from, and indemnified by us against, certain liabilities on customary terms. As a result, to the extent we are damaged through certain actions or inactions of PCM or PLS, our recourse is limited and we may not be able to recover our losses.
Risks Related to Our Organization and Structure
Certain provisions of Maryland law, our staggered board of trustees and certain provisions in our declaration of trust could each inhibit a change in our control.
Certain provisions of the Maryland General Corporation Law (the “MGCL”) applicable to a Maryland real estate investment trust may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change in our control under circumstances that otherwise could provide the holders of our common shares with the opportunity to realize a premium over the then prevailing market price of such common shares.
In addition, our board of trustees is divided into three classes of trustees. Trustees of each class will be elected for three-year terms upon the expiration of their current terms, and each year one class of trustees will be elected by our shareholders. The staggered terms of our trustees may reduce the possibility of a tender offer or an attempt at a change in control, even though a tender offer or change in control might be in the best interests of our shareholders.
Further, our declaration of trust authorizes us to issue additional authorized but unissued common shares and preferred shares. Our board of trustees may, without shareholder approval, increase the aggregate number of our authorized common shares or the number of shares of any class or series that we have authority to issue and classify or reclassify any unissued common shares or preferred shares and may set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board may establish a class or series of common shares or preferred shares or take other actions that could delay or prevent a transaction or a change in our control that might involve a premium price for our common shares or otherwise be in the best interests of our shareholders.
Our rights and the rights of our shareholders to take action against our trustees and officers are limited, which could limit shareholder recourse in the event of actions not in the best interest of our shareholders.
Our declaration of trust limits the liability of our present and former trustees and officers to us and our shareholders for money damages to the maximum extent permitted under Maryland law. Under current Maryland law, our present and former trustees and officers will not have any liability to us or our shareholders for money damages other than liability resulting from either (a) actual
receipt of an improper benefit or profit in money, property or services or (b) active and deliberate dishonesty by the trustee or officer that was established by a final judgment and is material to the cause of action.
Our declaration of trust authorizes us to indemnify our present and former trustees and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each present and former trustee or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made, or threatened to be made, a party by reason of his or her service to us. In addition, we may be obligated to pay or reimburse the expenses incurred by our present and former trustees and officers without requiring a preliminary determination of their ultimate entitlement to indemnification. As a result, we and our shareholders may have more limited rights against our present and former trustees and officers than might otherwise exist absent the current provisions in our declaration of trust and bylaws or that might exist with other companies, which could limit shareholder recourse in the event of actions not in the best interest of our shareholders.
Our declaration of trust contains provisions that make removal of our trustees difficult, which could make it difficult for our shareholders to effect changes to our management.
Our declaration of trust provides that, subject to the rights of holders of any series of preferred shares, a trustee may be removed only for “cause” (as defined in our declaration of trust), and then only by the affirmative vote of at least two-thirds of the votes entitled to be cast generally in the election of trustees. Vacancies generally may be filled only by a majority of the remaining trustees in office, even if less than a quorum, for the full term of the class of trustees in which the vacancy occurred. These requirements make it more difficult to change our management by removing and replacing trustees and may prevent a change in our control that is in the best interests of our shareholders.
Our bylaws include an exclusive forum provision that could limit our shareholders’ ability to obtain a judicial forum viewed by the shareholders as more favorable for disputes with us or our trustees or officers.
Our bylaws provide that the Circuit Court for Baltimore City, Maryland, or, if that Court does not have jurisdiction, the United States District Court for the District of Maryland, Baltimore Division, is the exclusive forum for any derivative action or proceeding brought on our behalf; any action asserting a claim of breach of fiduciary duty; any action asserting a claim against us arising pursuant to any provision of the Maryland REIT Law; or any action asserting a claim against us that is governed by the internal affairs doctrine. This exclusive forum provision may limit a shareholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our trustees or officers, which may discourage such lawsuits against us and our trustees and officers. Alternatively, if a court were to find the choice of forum provision contained in our bylaws to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions, which could adversely affect our business and financial condition.
Failure to maintain exemptions or exclusions from registration under the Investment Company Act of 1940 could materially and adversely affect us.
Because we are organized as a holding company that conducts business primarily through PennyMac Operating Partnership, L.P. and its wholly-owned subsidiaries, our status under the Investment Company Act of 1940, or the Investment Company Act, is dependent upon the status of our Operating Partnership which, as a holding company, in turn, will have its status determined by the status of its subsidiaries. If our Operating Partnership or one or more of its subsidiaries fail to maintain their exceptions or exclusions from the Investment Company Act and we do not have available to us another basis on which we may avoid registration, we may have to register under the Investment Company Act. This could subject us to substantial regulation with respect to our capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration, and other matters. It could also cause the breach of covenants we or our subsidiaries have made under certain of our financing arrangements, which could result in an event of default, acceleration of debt and/or termination.
There can be no assurance that the laws and regulations governing the Investment Company Act status of REITs, including guidance and interpretations from the Division of Investment Management of the SEC regarding the exceptions and exclusions therefrom, will not change in a manner that adversely affects our operations. If the SEC takes action that could result in our or our subsidiaries’ failure to maintain an exception or exclusion from the Investment Company Act, we could, among other things, be required to (a) restructure our operations to avoid being required to register as an investment company, (b) effect sales of our assets in a manner that, or at a time when, we would not otherwise choose to do so or (c) register as an investment company (which, among other things, would require us to comply with the leverage constraints applicable to investment companies), any of which could negatively affect the value of our common shares, the sustainability of our business model, our financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Further, a loss of our Investment Company Act exceptions or exclusions would allow PCM to terminate our management agreement with us, and our loan servicing agreement with PLS is subject to early termination in the event our management agreement is terminated for any reason. If either of these agreements is terminated, we will have to obtain the services on our own, and we may
not be able to replace these services in a timely manner or on favorable terms, or at all. This would have a material adverse effect on our ability to continue to execute our business strategy and would likely negatively affect our financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
The failure of PennyMac Corp. to avail itself of an appropriate exemption from registration as an investment company under the Investment Company Act could have a material and adverse effect on our business.
We intend to operate so that we and each of our subsidiaries are not required to register as investment companies under the Investment Company Act. We believe that our subsidiary, PennyMac Corp. (“PMC”), qualifies for one or more exemptions under the Investment Company Act because of the historical and current composition of its assets and income; however, there can be no assurances that the composition of PMC’s assets and income will remain the same over time such that one or more exemptions will continue to be applicable.
If PMC is required to register as an investment company, we would be required to comply with a variety of substantive requirements under the Investment Company Act that impose, among other things: limitations on capital structure; restrictions on specified investments; prohibitions on transactions with affiliates; compliance with reporting, record keeping, voting and proxy disclosure; and, other rules and regulations that would significantly increase our operating expenses. Further, if PMC was or is required to register as an investment company, PMC would be in breach of various representations and warranties contained in its credit and other agreements resulting in a default as to certain of our contracts and obligations. This could also subject us to civil or criminal actions or regulatory proceedings, or result in a court appointed receiver to take control of us and liquidate our business, any or all of which could have a material adverse effect on our business, financial condition, liquidity, results of operations, and ability to make distributions to our shareholders.
Rapid changes in the fair values of our investments may make it more difficult for us to maintain our REIT qualification or exclusion from the Investment Company Act.
If the fair value or income potential of our residential loans and other real estate-related assets declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase certain real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exclusion from the Investment Company Act. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish, particularly given the illiquid nature of our investments. We may have to make investment decisions, including the liquidation of investments at a disadvantageous time or on unfavorable terms, that we otherwise would not make absent our REIT and Investment Company Act considerations, and such liquidations could have a material adverse effect on our business, financial condition, liquidity, results of operations, and ability to make distributions to our shareholders.
Risks Related to Taxation
Our failure to qualify as a REIT would result in higher taxes and reduced cash available for distribution to our shareholders.
We are organized and operate in a manner so as to qualify as a REIT for U.S. federal income tax purposes. Our qualification as a REIT depends on our satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements on a continuing basis. If we were to lose our REIT status in any taxable year, corporate-level income taxes, including applicable state and local taxes, would apply to all of our taxable income at federal and state tax rates, and distributions to our shareholders would not be deductible by us in computing our taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our shareholders, which in turn would have an adverse impact on the value of our common shares. Unless we were entitled to relief under certain Internal Revenue Code provisions, we also would be disqualified from taxation as a REIT for the four taxable years following the year during which we ceased to qualify as a REIT.
Even if we qualify as a REIT, we face tax liabilities that reduce our cash flow, and a significant portion of our income may be earned through taxable REIT subsidiaries, or TRSs that are subject to U.S. federal income taxation
Even if we qualify for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income and assets, including taxes on any undistributed income, taxes on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes, such as mortgage recording taxes. Any of these taxes would decrease cash available for distribution to our shareholders.
We also engage in business activities that are required to be conducted in a TRS. In order to meet the REIT qualification requirements, or to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or
inventory, we hold a significant portion of our assets through, and derive a significant portion of our taxable income and gains in, a TRS, subject to the limitation that securities in TRSs may not represent more than 20% of our assets in order for us to remain qualified as a REIT. All taxable income and gains derived from the assets held from time to time in our TRS are subject to regular corporate income taxation.
The percentage of our assets represented by a TRS and the amount of our income that we can receive in the form of TRS dividends are subject to statutory limitations that could jeopardize our REIT status.
Currently, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs at the end of each quarter. We may potentially have to modify our activities or the capital structure of those TRSs in order to comply with this limitation and maintain our qualification as a REIT. While we intend to manage our affairs so as to satisfy this requirement, there can be no assurance that we will be able to do so in all market circumstances and even if we are able to do so, compliance with this rule may reduce our flexibility in operating our business. Although a TRS is subject to U.S. federal, state and local income tax on its taxable income, we may from time to time need to make distributions of such after-tax income in order to keep the value of our TRS below 20% of our total assets. However, for purposes of one of the tests we must satisfy to qualify as a REIT, at least 75% of our gross income must in each taxable year generally be from real estate assets. While we monitor our compliance with both this income test and the limitation on the percentage of our assets represented by TRS securities, the two may at times be in conflict with one another. That is, it is possible that we may wish to distribute a dividend from a TRS in order to reduce the value of our TRS below 20% of the required percentage of our assets, but be unable to do so without violating the requirement that 75% of our gross income in the taxable year be derived from real estate assets. There can be no assurance that we will be able to comply with either or both of these tests in all market conditions. Our inability to comply with both of these tests could have a material adverse effect on our business, financial condition, liquidity, results of operations, qualification as a REIT and ability to make distributions to our shareholders.
Ordinary dividends payable by REITs do not generally qualify for the reduced tax rates applicable to certain corporate dividends.
The Internal Revenue Code provides for a 20% maximum federal income tax rate for dividends paid by regular United States corporations to eligible domestic shareholders that are individuals, trusts or estates. Dividends paid by REITs are generally not eligible for these reduced rates. H.R. 1, commonly known as the 2017 Tax Cuts and Job Act (the “Tax Act”), which was enacted on December 22, 2017, generally may allow domestic shareholders to deduct from their taxable income one-fifth of the REIT ordinary dividends payable to them for taxable years beginning after December 31, 2017 and before January 1, 2026. To qualify for this deduction, the shareholder receiving such dividend must hold the dividend-paying REIT shares for at least 46 days (taking into account certain special holding period rules) of the 91-day period beginning 45 days before the shares become ex-dividend, and cannot be under an obligation to make related payments with respect to a position in substantially similar or related property. However, even if a domestic shareholder qualifies for this deduction, the effective rate for such REIT dividends still remains higher than rates for regular corporate dividends paid to high-taxed individuals. The more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive as a federal income tax matter than investments in the stocks of non-REIT corporations that pay dividends, which could materially and adversely affect the value of the stock of REITs, including our common shares.
Certain of our historic investments in CRT Agreements may not be eligible REIT assets and we have therefore held such investments in our TRS, resulting in a significant portion of our income from these investments being subject to U.S. federal and state income taxation in order not to jeopardize our REIT status.
Our new investments in CRT securities are structured with the intention of satisfying our REIT qualification requirements. Accordingly, in general we expect to hold investments in such CRT securities in the REIT based on the advice of our tax advisors. However, with respect to certain of our historic investments in CRT Agreements, the REIT eligibility of the assets subject to the CRT Agreements and the income relating thereto remains uncertain. Accordingly, in general we currently hold such investments in our TRS, although we have on occasion based on the advice of tax advisors held such positions in the REIT and may do so in the future as well, depending on the precise structure of such investments and our level of certainty that such investments are in a form consistent with their characterization as qualifying assets for a REIT. If the Internal Revenue Service (“IRS”) were to take a position adverse to our interpretation, the consequences of such action could materially and adversely affect our business, financial condition, liquidity, results of operations, and our ability to make distributions to our shareholders.
We have not established a minimum distribution payment level and no assurance can be given that we will be able to make distributions to our shareholders in the future at current levels or at all.
We are generally required to distribute to our shareholders at least 90% of our taxable income each year for us to qualify as a REIT under the Internal Revenue Code, which requirement we currently intend to satisfy. To the extent we satisfy the 90%
distribution requirement but distribute less than 100% of our taxable income, we will be subject to U.S. federal corporate income tax on our undistributed taxable income. We have not established a minimum distribution payment level, and our ability to make distributions to our shareholders may be materially and adversely affected by the risk factors discussed in this Report and any subsequent Quarterly Reports on Form 10-Q. Although we have made, and anticipate continuing to make, quarterly distributions to our shareholders, our board of trustees has the sole discretion to determine the timing, form and amount of any future distributions to our shareholders, and such determination will depend upon, among other factors, our historical and projected results of operations, financial condition, cash flows and liquidity, maintenance of our REIT qualification and other tax considerations, capital expenditure and other expense obligations, debt covenants, contractual prohibitions or other limitations and applicable law and such other matters as our board of trustees may deem relevant from time to time. Among the factors that could impair our ability to continue to make distributions to our shareholders are:
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our inability to invest the net proceeds from our equity offerings;
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our inability to make attractive risk-adjusted returns on our current and future investments;
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non-cash earnings or unanticipated expenses that reduce our cash flow;
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defaults in our investment portfolio or decreases in its value;
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reduced cash flows caused by delays in repayment or liquidation of our investments; and
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the fact that anticipated operating expense levels may not prove accurate, as actual results may vary from estimates.
As a result, no assurance can be given that we will be able to continue to make distributions to our shareholders in the future or that the level of any future distributions will achieve a market yield or increase or even be maintained over time, or that future dividends might not be a combination of stock and cash, as permitted under Internal Revenue Service guidelines, any of which could materially and adversely affect the market price of our common shares.
The REIT distribution requirements could materially and adversely affect our ability to execute our business strategies.
We intend to continue to make distributions to our shareholders to comply with the requirements of the Internal Revenue Code and to avoid paying corporate income tax on undistributed income. However, differences in timing between the recognition of taxable income and the actual receipt of cash could require us to sell assets, borrow funds on a short-term or long-term basis, or issue equity to meet the distribution requirements of the Internal Revenue Code. We may find it difficult or impossible to meet distribution requirements in certain circumstances. Due to the nature of the assets in which we invest and may invest and to our accounting elections for such assets, we may be required to recognize taxable income from those assets in advance of our receipt of cash flow on or proceeds from disposition of such assets.
In addition, pursuant to the Tax Act, we generally will be required to recognize certain amounts in income no later than the time such amounts are reflected on our financial statements filed with the SEC. The application of this rule may require the accrual of income with respect to loans, MBS, and other types of debt securities or interests in debt securities held by us, such as original issue discount or market discount, earlier than would be the case under other provisions of the Internal Revenue Code, although the precise application of this rule to our business is unclear at this time in various respects.
As a result, to the extent such income is not realized within a TRS, the requirement to distribute a substantial portion of our net taxable income could cause us to: (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms, (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt or (iv) make a taxable distribution of our shares as part of a distribution in which shareholders may elect to receive shares or (subject to a limit measured as a percentage of the total distribution) cash, in order to comply with REIT requirements.
We may be required to report taxable income early in our holding period for certain investments in excess of the economic income we ultimately realize from them.
We acquire and/or expect to acquire in the secondary market debt instruments that we may significantly modify for less than their face amount, MBS issued with original issue discount, MBS acquired at a market discount, or debt instruments or MBS that are delinquent as to mandatory principal and interest payments. In each case, we may be required to report income regardless of whether corresponding cash payments are received or are ultimately collectible. If we eventually collect less than we had previously reported as income, there may be a bad debt deduction available to us at that time or we may record a capital loss in a disposition of such asset, but our ability to benefit from that bad debt deduction would depend on our having taxable income or capital gains, respectively, in that later taxable year or a subsequent taxable year. This possible “income early, losses later” phenomenon could materially and adversely affect us and our shareholders if it were persistent and in significant amounts.
The share ownership limits applicable to us that are imposed by the Internal Revenue Code for REITs and our declaration of trust may restrict our business combination opportunities.
In order for us to maintain our qualification as a REIT under the Internal Revenue Code, not more than 50% in value of our outstanding shares may be owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at any time during the last half of each taxable year following our first year. Our declaration of trust, with certain exceptions, authorizes our board of trustees to take the actions that are necessary and desirable to preserve our qualification as a REIT. Under our declaration of trust, no person may own more than 9.8% by vote or value, whichever is more restrictive, of our outstanding common shares or more than 9.8% by vote or value, whichever is more restrictive, of our outstanding shares of beneficial interest. Our board may grant an exemption to the share ownership limits in its sole discretion, subject to certain conditions and the receipt of certain representations and undertakings. These share ownership limits are based upon direct or indirect ownership by “individuals,” which term includes certain entities.
Ownership limitations are common in the organizational documents of REITs and are intended, among other purposes, to provide added assurance of compliance with the tax law requirements and to minimize administrative burdens. However, our share ownership limits might also delay or prevent a transaction or a change in our control that might involve a premium price for our common shares or otherwise be in the best interests of our shareholders.
Complying with the REIT requirements can be difficult and may cause us to forego otherwise attractive opportunities or liquidate otherwise attractive investments.
To qualify as a REIT for U.S. federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our shareholders and the ownership of our shares. We may be required to make distributions to our shareholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with the REIT requirements may hinder our ability to make certain attractive investments or require us to liquidate from our portfolio otherwise attractive investments. If we are compelled to liquidate our investments, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory. These actions could have the effect of reducing our income and amounts available for distribution to our shareholders.
Complying with the REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets, liabilities and operations. Under current law, any income from a hedging transaction we enter into either (i) to manage risk of interest rate changes with respect to borrowings made or to be made to acquire or carry real estate assets, (ii) to manage risk of currency fluctuations with respect to items of income that qualify for purposes of the REIT 75% or 95% gross income tests or assets that generate such income, or (iii) to hedge another instrument that hedges risks described in clause (i) or (ii) for a period following the extinguishment of the liability or the disposition of the asset that was previously hedged by the instrument, provided, that, in each case, such instrument is properly identified under applicable Treasury regulations, will not be treated as qualifying income for purposes of the REIT gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise be subject to.
The tax on prohibited transactions limits our ability to engage in transactions, including certain methods of securitizing loans that would be treated as sales for U.S. federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including loans, held primarily for sale to customers in the ordinary course of business. We would be subject to this tax if we were to sell loans that we held primarily for sale to customers in a securitization transaction effected through the REIT. Therefore, in order to avoid the prohibited transactions tax, we engage in such sales of loans through the TRS. We may hold a substantial amount of assets in one or more TRSs that are subject to corporate income tax on its earnings, which may reduce the cash flow generated by us and our subsidiaries in the aggregate, and our ability to make distributions to our shareholders.
The taxable mortgage pool (“TMP”) rules may increase the taxes that we or our shareholders may incur, and may limit the manner in which we effect future securitizations.
Certain of our securitizations that involve the issuance of indebtedness rather than sales may likely be considered to result in the creation of TMPs for U.S. federal income tax purposes. A TMP is always classified as a corporation for U.S. federal income tax purposes. However, as long as a REIT owns 100% of a TMP, such classification generally does not result in the imposition of corporate income tax, because the TMP is a “qualified REIT subsidiary.”
In the case of such wholly-REIT owned TMPs, certain categories of our shareholders, such as foreign shareholders otherwise eligible for treaty benefits, shareholders with net operating losses, and tax exempt shareholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income received from us that is attributable to the TMP, or “excess inclusion income.” In addition, to the extent that our shares are owned in record name by tax exempt “disqualified organizations,” such as certain government-related entities that are not subject to tax on unrelated business income, we may incur a corporate level tax on our allocable portion of excess inclusion income from such a wholly-REIT owned TMP. In that case and to the extent feasible, we may reduce the amount of our distributions to any disqualified organization whose share ownership gave rise to the tax, or we may bear such tax as a general corporate expense. To the extent that our shares owned by disqualified organizations are held in record name by a broker/dealer or other nominee, the broker/dealer or other nominee would be liable for the corporate level tax on the portion of our excess inclusion income allocable to the shares held by the broker/dealer or other nominee on behalf of disqualified organizations. While we intend to attempt to minimize the portion of our distributions that is subject to these rules, the law is unclear concerning computation of excess inclusion income, and its amount could be significant.
In the case of any TMP that would be taxable as a domestic corporation if it were not wholly-REIT owned, we would be precluded from selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. This marketing limitation may prevent us from selling more junior or non-investment grade debt securities in such securitizations and maximizing our proceeds realized in those offerings.
New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT.
The rules dealing with federal income taxation, including the present U.S. federal income tax treatment of REITs, may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the U.S. federal income tax treatment of an investment in our common shares. Changes to the tax laws, including the U.S. federal tax rules that affect REITs, are constantly under review by persons involved in the legislative process, the IRS and the U.S. Treasury, which results in statutory changes as well as frequent revisions to Treasury Regulations and interpretations. Revisions in U.S. federal tax laws and interpretations thereof could materially and adversely affect us and our shareholders.
We also may enter into certain transactions where the REIT eligibility of the assets subject to such transactions is uncertain. In circumstances where the application of these rules and regulations affecting our investments is not clear, we may have to interpret them and their application to us. If the IRS were to take a position adverse to our interpretation, the consequences of such action could materially and adversely affect our business, financial condition, liquidity, results of operations, and our ability to make distributions to our shareholders.
An IRS administrative pronouncement with respect to investments by REITs in distressed debt secured by both real and personal property, if interpreted adversely to us, could cause us to pay penalty taxes or potentially to lose our REIT status.
Most of the distressed loans that we historically acquired were acquired by us at a discount from their outstanding principal amount, because our pricing was generally based on the value of the underlying real estate that secures those loans.
Treasury Regulation Section 1.856-5(c) (the “interest apportionment regulation”) provides rules for determining what portion of the interest income from loans that are secured by both real and personal property is treated as “interest on obligations secured by mortgages on real property or on interests in real property.” Under the interest apportionment regulation, if a mortgage covers both real property and other property, a REIT is required to apportion its annual interest income to the real property security based on a fraction, the numerator of which is the value of the real property securing the loan, determined when the REIT commits to acquire the loan, and the denominator of which is the highest “principal amount” of the loan during the year. The IRS issued Revenue Procedure 2011-16, which contains an example regarding the application of the interest apportionment regulation. The example interprets the “principal amount” of the loan to be the face amount of the loan, despite the Internal Revenue Code requiring taxpayers to treat any market discount, that is the difference between the purchase price of the loan and its face amount, for all purposes (other than certain withholding and information reporting purposes) as interest rather than principal.
The interest apportionment regulation applies only if the debt in question is secured both by real property and personal property. We believe that all of the loans that we acquired at a discount under the circumstances contemplated by Revenue Procedure 2011-16 are secured only by real property and no other property value is taken into account in our underwriting and pricing. Accordingly, we believe that the interest apportionment regulation does not apply to our portfolio.
Nevertheless, if the IRS were to assert successfully that our loans were secured by property other than real estate, that the interest apportionment regulation applied for purposes of our REIT testing, and that the position taken in Revenue Procedure 2011-16
should be applied to our portfolio, then depending upon the value of the real property securing our loans and their face amount, and the sources of our gross income generally, we might not be able to meet the 75% REIT gross income test, and possibly the asset tests applicable to REITs. If we did not meet this test, we could potentially either lose our REIT status or be required to pay a tax penalty to the IRS.
With respect to the 75% REIT asset test, Revenue Procedure 2011-16 provides a safe harbor under which the IRS will not challenge a REIT’s treatment of a loan as being a real estate asset in an amount equal to the lesser of (1) the fair market value of the real property securing the loan determined as of the date the REIT committed to acquire the loan or (2) the fair market value of the loan on the date of the relevant quarterly REIT asset testing date. This safe harbor, if it applied to us, would help us comply with the REIT asset tests following the acquisition of distressed debt if the value of the real property securing the loan were to subsequently decline. However, if the value of the real property securing the loan were to increase, the safe harbor rule of Revenue Procedure 2011-16, read literally, could have the peculiar effect of causing the corresponding increase in the value of the loan to not be treated as a real estate asset. We do not believe, however, that this was the intended result in situations in which the value of a loan has increased because the value of the real property securing the loan has increased, or that this safe harbor rule applies to debt that is secured solely by real property. However, for taxable years beginning after December 31, 2015, Internal Revenue Code Section 856(c)(9) was added and clarifies Revenue Procedure 2011-16. Subparagraph (B) of Section 856(c)(9) allows a REIT to treat personal property that is secured by a mortgage on both real property and personal property as a real estate asset, and the interest income as derived from a mortgage secured by real property, if the fair value of the personal property does not exceed fifteen percent 15% of the total fair value of all property secured by the mortgage. Nevertheless, if the IRS took the position that the safe harbor rule applied in these scenarios, then we might not be able to meet the various quarterly REIT asset tests if the value of the real estate securing our loans increased, and thus the value of our loans increased by a corresponding amount. If we did not meet one or more of these tests, then we could potentially either lose our REIT status or be required to pay a tax penalty to the IRS.
General Risks
The risk management efforts of our Manager may not be effective.
We could incur substantial losses and our business operations could be disrupted if our Manager is unable to effectively identify, manage, monitor, and mitigate financial risks, such as credit risk, interest rate risk, prepayment risk, liquidity risk, and other market-related risks, as well as operational and legal risks related to our business, assets, and liabilities. We also are subject to various other laws, regulations and rules that are not industry specific, including health and safety laws, environmental laws and other federal, state and local laws, regulations and rules in the jurisdictions in which we operate. Our Manager’s risk management policies, procedures, and techniques may not be sufficient to identify all of the risks to which we are exposed, mitigate the risks we have identified, or identify additional risks to which we may become subject in the future. Expansion of our business activities may also result in our being exposed to risks to which we have not previously been exposed or may increase our exposure to certain types of risks, and our Manager may not effectively identify, manage, monitor, and mitigate these risks as our business activity changes or increases.
We could be harmed by misconduct or fraud that is difficult to detect.
We are exposed to risks relating to misconduct by our employees, employees of PennyMac and its subsidiaries, contractors we use, or other third parties with whom we have relationships. For example, such employees could execute unauthorized transactions, use our assets improperly or without authorization, perform improper activities, use confidential information for improper purposes, or misrecord or otherwise try to hide improper activities from us. This type of misconduct could also relate to our assets managed by PCM. This type of misconduct can be difficult to detect and if not prevented or detected could result in claims or enforcement actions against us or losses. Accordingly, misconduct by the employees of PennyMac and its subsidiaries, contractors, or others could subject us to losses or regulatory sanctions and seriously harm our reputation. Our controls may not be effective in detecting this type of activity.
If we fail to maintain an effective system of internal controls, we may not be able to accurately determine our financial results or prevent fraud.
Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We may in the future discover areas of our internal controls that need improvement. Section 404 of the Sarbanes-Oxley Act requires us to evaluate and report on our internal control over financial reporting and have our independent auditors annually attest to our evaluation, as well as issue their own opinion on our internal control over financial reporting. While we have undertaken substantial work to comply with Section 404, we cannot be certain that we will be successful in maintaining adequate control over our financial reporting and financial processes. In addition, the ongoing COVID-19 pandemic has created unique challenges resulting from employees working remotely.
Furthermore, as we continue to grow our business, our internal controls will become more complex, and we will require significantly more resources to ensure our internal controls remain effective.
If we or our independent auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could result in an event of default under one or more of our lending arrangements and/or reduce the market value of our common shares. Additionally, the existence of any material weakness or significant deficiency could require management to devote significant time and incur significant expense to remediate any such material weakness or significant deficiency, and management may not be able to remediate any such material weakness or significant deficiency in a timely manner, or at all. Accordingly, our failure to maintain effective internal control over financial reporting could result in misstatements of our financial results or restatements of our financial statements or otherwise have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
Cybersecurity risks, cyber incidents and technology failures may adversely affect our business by causing a disruption to our operations, a compromise or corruption of our confidential information, and/or damage to our business relationships, all of which could negatively impact our financial results.
A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of our information resources. These incidents may be an intentional attack or an unintentional event and could involve gaining unauthorized access to our information systems for purposes of theft of certain personally identifiable information of consumers, misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. The result of these incidents may include disrupted operations, misstated or unreliable financial data, liability for stolen assets or information, increased cybersecurity protection and insurance costs, litigation and damage to our investor relationships.
As our reliance on rapidly changing technologies has increased, so have the risks posed to our information systems, both internal and those provided to us by third-party service providers such as cloud-based computing service providers. System disruptions and failures caused by fire, power loss, telecommunications outages, unauthorized intrusion, computer viruses and disabling devices, natural disasters and other similar events may interrupt or delay our ability to provide services to our customers.
Despite efforts by PCM to ensure the integrity of its systems, its investment in significant physical and technological security measures, employee training, contractual precautions and business continuity plans, and its implementation of policies and procedures designed to help mitigate cybersecurity risks and cyber intrusions, there can be no assurance that any such cyber intrusions will not occur or, if they do occur, that they will be adequately addressed. We also may not be able to anticipate or implement effective preventive measures against all security breaches, especially because the methods of attack change frequently or are not recognized until launched, and because security attacks can originate from a wide variety of sources, including third parties such as persons involved with organized crime or associated with external service providers. We are also held accountable for the actions and inactions of our third-party vendors regarding cybersecurity and other consumer-related matters.
Any of the foregoing events could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, additional regulatory scrutiny, significant litigation exposure and harm to our reputation, any of which could have a material adverse effect on our business, financial condition, liquidity, results of operations and our ability to make distributions to our shareholders.
The industry in which we operate is highly competitive, and is likely to become more competitive, and our inability to compete successfully or decreased margins resulting from increased competition could adversely affect our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.
We operate in a highly competitive industry that could become even more competitive as a result of economic, legislative, regulatory and technological changes. We compete in our investment activities with other mortgage REITs, specialty finance companies, private funds, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, depository institutions, governmental bodies and other entities, many of which focus on acquiring mortgage assets. In addition, large commercial banks and savings institutions and other independent mortgage lenders and servicers are becoming increasingly competitive in the acquisition of newly originated loans. Many of these institutions have competitive advantages over us, including size, financial strength, access to capital, cost of funds, federal pre-emption and higher risk tolerance. Additionally, our existing and potential competitors may decide to modify their business models to compete more directly with our correspondent production business. Competition may result in fewer investments, higher prices, acceptance of greater risk, lower yields and a narrower spread of yields over our financing costs. Moreover, if more non-bank entities enter these markets and as more commercial banks aggressively compete, our correspondent production activities may generate lower volumes and/or margins.
Future issuances of debt securities, which would rank senior to our common shares, and future issuances of equity securities, which would dilute the holdings of our existing shareholders and may be senior to our common shares, may materially and adversely affect the market price of our common shares.
In order to grow our business, we may rely on additional common and preferred equity issuances, which may rank senior and/or be dilutive to our current shareholders, or on less efficient forms of debt financing that rank senior to our shareholders and require a larger portion of our cash flow from operations, thereby reducing funds available for our operations, future business opportunities, cash distributions to our shareholders and other purposes.
During March 2017, we issued 4.6 million of 8.125% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares and, in July 2017, we also issued 7.8 million of 8.00% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares. Our outstanding preferred shares have preferences on distribution payments, including liquidating distributions, which could limit our ability to make distributions, including liquidating distributions, to holders of our common shares.
During November 2019, our wholly-owned subsidiary, PMC, issued $210 million of exchangeable senior notes, the 2024 Notes, that are exchangeable under certain circumstances for our common shares. Upon liquidation, holders of our debt securities and other loans would receive a distribution of our available assets before holders of our common shares and holders of the 2024 Notes could receive a distribution of PMC’s available assets before holders of our common shares. We also issued a total of 33.5 million common shares pursuant to underwritten equity offerings during fiscal year 2019.
Subject to applicable law, our board of trustees has the authority, without further shareholder approval, to issue additional debt, common shares and preferred shares on the terms and for the consideration it deems appropriate. We have issued, and/or intend to issue, additional common shares and securities convertible into, or exchangeable or exercisable for, common shares under our equity incentive plan. We have also filed a shelf registration statement, from which we have issued and may in the future issue additional common shares, including, without limitation, through our “at-the-market” equity program and as of December 31, 2020 we have approximately $74.4 million of common shares available for issuance under that program.
We also may issue from time to time additional common shares in connection with portfolio or business acquisitions and may grant demand or piggyback registration rights in connection with such issuances. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict the effect, if any, of future issuances of our common shares, preferred shares or other equity-based securities or the prospect of such issuances on the market price of our common shares. Issuances of a substantial amount of such securities, or the perception that such issuances might occur, could depress the market price of our common shares.
Thus, holders of our common shares bear the risk that our future issuances of debt or equity securities or other borrowings will reduce the market price of our common shares and dilute their ownership in us.
Initiating new business activities or investment strategies, developing new products or significantly expanding existing business activities or investment strategies may expose us to new risks and increase our cost of doing business.
Initiating new business activities or investment strategies, developing new products, or significantly expanding existing business activities or investment strategies, are ways to grow our businesses and respond to changing circumstances in our industry; however, they may expose us to new risks and regulatory compliance requirements. We cannot be certain that we will be able to manage these risks and compliance requirements effectively. Furthermore, our efforts may not succeed and any revenues we earn from any new or expanded business initiative or investment strategy may not be sufficient to offset the initial and ongoing costs of that initiative, which would result in a loss with respect to that initiative or strategy.
We may not be able to successfully operate our business or generate sufficient operating cash flows to make or sustain distributions to our shareholders.
There can be no assurance that we will be able to generate sufficient cash to pay our operating expenses and make distributions to our shareholders. The results of our operations and our ability to make or sustain distributions to our shareholders depends on many factors, including the availability of attractive risk-adjusted investment opportunities that satisfy our investment strategies and our success in identifying and consummating them on favorable terms, the level and expected movement of home prices, the level and volatility of interest rates, readily accessible short-term and long-term financing on favorable terms, and conditions in the financial markets, real estate market and the economy, as to which no assurance can be given.
We also face substantial competition in acquiring attractive investments, both in our investment activities and correspondent production activities. While we try to diversify our investments among various types of mortgages and mortgage-related assets, the
competition for such assets may compress margins and reduce yields, making it difficult for us to make investments with attractive risk-adjusted returns. There can be no assurance that we will be able to successfully transition out of investments producing lower returns into investments that produce better returns, or that we will not seek investments with greater risk to obtain the same level of returns. Any or all of these factors could cause the fair value of our investments to decline substantially and have a material adverse effect on our business, financial condition, liquidity, results of operations and ability to make distributions to our shareholders.

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ITEM 1B. UNRESOLVED STAFF COMMENTS
Item 1B.
Unresolved Staff Comments
None.

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ITEM 2. PROPERTIES
Item 2.
Properties
We do not own or lease any property. Our operations are carried out on our behalf at the principal executive offices of PennyMac, at 3043 Townsgate Road, Westlake Village, California, 91361.

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ITEM 3. LEGAL PROCEEDINGS
Item 3.
Legal Proceedings
From time to time, we may be involved in various legal actions, claims and proceedings arising in the ordinary course of business. As of December 31, 2020, we were not involved in any material legal actions, claims or proceedings.

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ITEM 4. MINE SAFETY DISCLOSURE
Item 4.
Mine Safety Disclosures
Not applicable.
PART II

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ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
Item 5.
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common shares are listed on the New York Stock Exchange (Symbol: PMT). As of February 19, 2021, our common shares were held by 90 registered holders.
We intend to pay quarterly dividends and to distribute to our shareholders at least 90% of our taxable income in each year (subject to certain adjustments). This is one requirement to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described in Part I, Item 1A of this Report in section entitled “Risk Factors”. All distributions are made at the discretion of our board of trustees and depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of trustees may deem relevant from time to time.
Unregistered Sales of Equity Securities and Use of Proceeds
There were no sales of unregistered equity securities during the quarter ended December 31, 2020.
Repurchase of our Common Stock
The following table summarized the stock repurchase activity for the quarter ended December 31, 2020:
Period
Total
number of
shares
purchased
Average
price paid
per share
Total number of
shares
purchased as
part of publicly
announced plans
or programs (1)
Amount
available for
future share
repurchases
under the
plans or
programs (1)
(in thousands)
October 1, 2020 - October 31, 2020
-
$
-
-
$
61,755
November 1, 2020 - November 30, 2020
$
16.81
$
47,989
December 1, 2020 - December 31, 2020
$
17.43
$
46,107
(1)
During 2015, our board of trustees authorized a common share repurchase program. Under the program, as amended, we may repurchase up to $300 million of our outstanding common shares. Under the program, we have discretion to determine the dollar amount of common shares to be repurchased and the timing of any repurchases in compliance with applicable law and regulation. The program does not have an expiration date. Amounts presented reflect balances as of the end of the applicable period.

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ITEM 6. SELECTED FINANCIAL DATA
Item 6.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
We are a specialty finance company that invests primarily in mortgage-related assets. Our objective is to provide attractive risk-adjusted returns to our investors over the long-term, primarily through dividends and secondarily through capital appreciation. Our investment focus is on the mortgage-related assets that we create through our correspondent production activities, including mortgage servicing rights (“MSRs”) and credit risk transfer (“CRT”) arrangements, which include CRT Agreements and CRT strips that absorb credit losses on certain of the loans we sell. We also invest in mortgage-backed securities (“MBS”), and hold excess servicing spread (“ESS”) on MSRs acquired by PennyMac Loan Services, LLC (“PLS”). We have also historically invested in distressed mortgage assets (loans and real estate acquired in settlement of loans (“REO”)) as well as other credit sensitive assets, including loans that finance multifamily and other commercial real estate. We have substantially liquidated our holdings of distressed, multifamily and commercial real estate loans and continue to reduce our holdings of REO.
We are externally managed by PNMAC Capital Management, LLC (“PCM”), an investment adviser that specializes in and focuses on U.S. mortgage assets. Our loan portfolio and MSRs are serviced by PLS.
During the year ended December 31, 2020, we purchased newly originated prime credit quality residential loans with fair values totaling $170.0 billion, as compared to $114.5 billion for the year ended December 31, 2019, in furtherance of our correspondent production business. To the extent that we purchase loans that are insured by the U.S. Department of Housing and Urban Development (“HUD”) through the Federal Housing Administration (the “FHA”), or insured or guaranteed by the Veterans Administration (the “VA”) or U.S. Department of Agriculture, we and PLS have agreed that PLS will fulfill and purchase such loans, as PLS is a Government National Mortgage Association (“Ginnie Mae”) approved issuer and we are not. This arrangement has enabled us to compete with other correspondent aggregators that purchase both government and conventional loans. We receive a sourcing fee from PLS based on the unpaid principal balance (“UPB”) of each loan that we sell to PLS under such arrangement, and earn interest income on the loan for the period we hold it before the sale to PLS. During the year ended December 31, 2020, we received sourcing fees totaling $11.0 million, relating to $60.5 billion in UPB of loans that we sold to PLS.
Credit Sensitive Investments
CRT Arrangements
The Federal Housing Finance Agency (“FHFA”) instructed the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) to gradually wind down new front-end lender risk share transactions such as CRT investments by the end of 2020. At present, we are no longer creating new CRT investments. During the year ended December 31, 2020, we recognized investment losses of $145.9 million relating to our holdings of CRT securities and losses of $159.2 million related to the firm commitments to purchase the CRT securities. We held net CRT-related investments (comprised of deposits securing CRT arrangements, CRT derivatives, CRT strips and interest-only security payable) totaling $2.6 billion at December 31, 2020.
Interest Rate Sensitive Investments
Our interest rate sensitive investments include:
•
Mortgage servicing rights. During the year ended December 31, 2020, we received $1.2 billion of MSRs as proceeds from sales of loans acquired for sale. We held $1.8 billion of MSRs at fair value at December 31, 2020.
•
REIT-eligible mortgage-backed or mortgage-related securities. We purchased $2.3 billion and sold $2.0 billion of MBS during the year ended December 31, 2020. We held MBS with fair values totaling $2.2 billion at December 31, 2020. The purchases and sales during the year reflect a restructuring of our investment in MBS aimed at reducing prepayment and price risk relating to these assets.
•
ESS relating to MSRs held by PFSI. We received ESS with fair value totaling $2.1 million during the year ended December 31, 2020, pursuant to a spread acquisition agreement with PLS. We held ESS with a fair value totaling $131.8 million at December 31, 2020.
Correspondent Production
Our correspondent production activities involve the acquisition and sale of newly originated prime credit quality residential loans. Correspondent production serves as the source of our investments in MSRs and CRT arrangements and are summarized below:
Year ended December 31,
(in thousands)
Sales of loans acquired for sale:
To nonaffiliates
$
106,306,805
$
61,128,081
$
29,369,656
To PennyMac Financial Services, Inc.
63,618,185
50,110,085
37,967,724
$
169,924,990
$
111,238,166
$
67,337,380
Net gain on loans acquired for sale
$
379,922
$
170,164
$
59,185
Investment activities resulting from correspondent production:
Receipt of MSRs as proceeds from sales of loans
$
1,158,475
$
837,706
$
356,755
Investments in CRT arrangements:
Deposits securing CRT arrangements
1,700,000
933,370
596,626
Recognition of firm commitment to purchase CRT securities (1)
(38,161
)
99,305
30,595
Change in face amount of firm commitment to
purchase CRT securities and commitment
to fund Deposits securing CRT arrangements
(1,502,203
)
897,151
122,581
Total investments in CRT arrangements
159,636
1,929,826
749,802
Total investments resulting from correspondent activities
$
1,318,111
$
2,767,532
$
1,106,557
(1)
Initial recognition of firm commitment upon sale of loans.
Common Shares of Beneficial Interest
Underwritten Equity Offerings
During 2019, we completed the following underwritten offerings of our common shares:
Year ended December 31, 2019
(in thousands)
Number of common shares issued
33,527
Gross proceeds
$
719,777
Net proceeds
$
710,752
“At-the-Market” (ATM) Equity Offering Program
On March 14, 2019, we entered into equity distribution agreements to sell from time to time, through an ATM equity offering program under which the Agents will act as sales agent and /or principal, our common shares having an aggregate offering price of up to $200 million. Following is a summary of the activities under the ATM equity offering program:
Year ended December 31,
(in thousands)
Number of common shares issued
5,463
Gross proceeds
$
5,654
$
119,905
Net proceeds
$
5,597
$
118,705
Taxation
We believe that we qualify to be taxed as a REIT and as such will not be subject to federal income tax on that portion of our income that is distributed to shareholders as long as we meet applicable REIT asset, income and share ownership tests. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, our profits will be subject to income taxes and we may be precluded from qualifying as a REIT for the four tax years following the year we lose our REIT qualification. A portion of our activities, including our correspondent production business, is conducted in our taxable REIT subsidiary (“TRS”), which is subject to
corporate federal and state income taxes. Accordingly, we have made a provision for income taxes with respect to the operations of our TRS. We expect that the effective rate for the provision for income taxes may be volatile in future periods. Our goal is to manage the business to take full advantage of the tax benefits afforded to us as a REIT.
We evaluate our deferred tax assets quarterly to determine if valuation allowances are required based on the consideration of all available positive and negative evidence using a “more-likely-than-not” standard with respect to whether deferred tax assets will be realized. Our evaluation considers, among other factors, taxable loss carryback availability, expectations of sufficient future taxable income, trends in earnings, existence of taxable income in recent years, the future reversal of temporary differences, and available tax planning strategies that could be implemented, if required. The ultimate realization of our deferred tax assets depends primarily on our ability to generate future taxable income during the periods in which the related deferred tax assets become deductible.
Critical Accounting Policies
Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates.
Fair value
Our consolidated balance sheet is substantially comprised of assets that are measured at or based on their fair values. Measurement at fair value may be on a recurring or nonrecurring basis depending on the accounting principles applicable to the specific asset or liability and whether we have elected to carry them at fair value. We group financial statement items measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value.
The fair value level assigned to an asset or liability is identified based on the lowest level of inputs that are significant to determining the respective asset or liability’s fair value. These levels are:
December 31, 2020
Percentage of
Level
Description
Carrying value
of assets
measured (1)
Total
assets
Total
shareholders'
equity
(in thousands)
Level 1:
Prices determined using quoted prices in active markets for identical assets or liabilities.
$
135,107
%
%
Level 2:
Prices determined using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing an asset or liability and are developed based on market data obtained from sources independent of the Company.
5,959,987
%
%
Level 3:
Prices determined using significant unobservable inputs. Unobservable inputs reflect our judgments about the factors that market participants use in pricing an asset or liability, and are based on the best information available in the circumstances. (2)
4,888,353
%
%
Total assets measured at or based on fair value
$
10,983,447
%
%
Total assets
$
11,492,011
Total shareholders’ equity
$
2,296,859
(1)
Includes assets measured on both a recurring and nonrecurring basis based on the accounting principles applicable to the specific asset or liability and whether we have elected to carry the item at its fair value.
(2)
For purposes of this discussion, includes Deposits securing credit risk transfer arrangements which are carried at amortized cost. These deposits along with the related CRT derivatives and CRT strips are held in the form of securities which are the basis for valuation of the CRT derivatives and strips.
At December 31, 2020, $11.0 billion, or 95%, of our total assets were carried at fair value on a recurring basis and $28.7 million, or less than 1% (consisting of REO), were carried based on fair value on a non-recurring basis when fair value indicates evidence of impairment. Of these assets, $4.9 billion, or 42%, of total assets are measured using “Level 3” fair value inputs, which are difficult to observe and require significant management judgment.
Changes in inputs to measurement of “level 3” fair value financial statement items have a significant effect on the amounts reported for these items including their reported balances and their effects on our net income as summarized below:
Year ended
December 31,
Loans at
fair value (1)
Excess
servicing
spread
Interest
rate lock
commitments
CRT Assets
Mortgage
servicing
rights (2)
Total
$
(1,578
)
$
(24,970
)
$
536,943
$
(281,957
)
$
(706,107
)
$
(451,121
)
$
(6,099
)
$
(9,256
)
$
80,133
$
161,317
$
(262,031
)
$
(20,581
)
$
(15,213
)
$
8,500
$
(14,016
)
$
119,674
$
60,772
$
166,430
(1)
Includes loans held for sale and loans at fair value.
(2)
Excluding changes in fair value attributable to realization of cash flows.
As a result of the difficulty in observing certain significant valuation inputs affecting “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in estimating the fair value of these fair value assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these fair value assets and liabilities, subsequent transactions may be at values significantly different from those reported.
Because the fair value of “Level 3” fair value assets and liabilities is difficult to estimate, our valuation process is conducted by specialized staff and receives significant executive management oversight. We have assigned the responsibility for estimating the fair values of our “Level 3” fair value assets and liabilities, except for interest rate lock commitments (“IRLCs”), to PFSI’s Financial Analysis and Valuation group (the “FAV group”). With respect to those valuations, PFSI’s FAV group reports to PFSI’s valuation committee, which oversees the valuations. PFSI’s valuation committee includes the Company’s chief financial, chief investment and risk officers as well as other senior members of the Company’s finance, capital markets and risk management staffs.
The fair value of our IRLCs is developed by our Manager’s Capital Markets Risk Management staff and is reviewed by our Manager’s Capital Markets Operations group in the exercise of their internal control activities.
Following is a discussion relating to our approach to measuring the assets and liabilities that are most affected by “Level 3” fair value estimates.
Loans
We carry loans at their fair values. We recognize changes in the fair value of loans in current period income as a component of either Net gain on loans acquired for sale or Net (loss) gain on investments. We estimate fair value of loans based on whether the loans are saleable into active markets with observable pricing.
•
We categorize loans that are saleable into active markets as “Level 2” fair value assets. Such loans include substantially all of our loans acquired for sale and our loans held in a VIE. We estimate such loans’ fair values using their quoted market price or market price equivalent. We held $3.5 billion of such loans at fair value at December 31, 2020.
•
We categorize loans that are not saleable into active markets as “Level 3” fair value assets. Such loans include substantially all of our investments in distressed loans, home equity and commercial loans held for sale and certain of the loans acquired for sale which we subsequently repurchased pursuant to representations and warranties or that we identified as non-salable to the Agencies. We held $33.9 million of such loans at fair value at December 31, 2020.
We estimate the fair value of our “Level 3” fair value loans using a discounted cash flow valuation model. Inputs to the model include current interest rates, loan amount, payment status and property type, and forecasts of future interest rates, home prices, prepayment speeds, defaults and loss severities.
Excess Servicing Spread
We acquire the right to receive the ESS cash flows relating to certain MSRs over the life of the underlying loans. We carry our investment in ESS at fair value. We record changes in the fair value of ESS in Net (loss) gain on investments.
Because ESS is a claim to a portion of the cash flows from MSRs, its valuation process is similar to that of MSRs discussed below. We use the same discounted cash flow approach to measuring the ESS as we use to value the related MSRs except that certain inputs relating to the cost to service the loans underlying the MSRs and certain ancillary income are not included as these cash flows do not accrue to the holder of the ESS.
A shift in the market for ESS or a change in our assessment of an input to the valuation of ESS can have a significant effect on the fair value of ESS and in our income for the period. We believe that the most significant “Level 3” fair value inputs to the valuation of ESS are the pricing spread (discount rate) and prepayment speed. We held $131.8 million of ESS at December 31, 2020. Following is a summary of the effect on fair value of various changes to these inputs on our fair value estimates as of December 31, 2020:
Effect on fair value of a change in input
Change in input
Pricing spread
Prepayment speed
(in thousands)
(20%)
$
5,766
$
13,977
(10%)
$
2,824
$
6,701
(5%)
$
1,397
$
3,282
5%
$
(1,369
)
$
(3,154
)
10%
$
(2,711
)
$
(6,185
)
20%
$
(5,316
)
$
(11,907
)
Derivative Assets
Interest Rate Lock Commitments
Our net gain on loans acquired for sale includes our estimates of gains or losses we expect to realize upon the sale of loans we have committed to purchase but have not yet purchased or sold. Therefore, we recognize a substantial portion of our net gain on loans acquired for sale at fair value before we purchase the loan. In the course of our correspondent production activities, we make contractual commitments to correspondent sellers to purchase loans at specified terms. We call these commitments IRLCs. We recognize the fair value of IRLCs at the time we make the commitment to the correspondent seller and adjust the fair value of such IRLCs during the time the commitment is outstanding.
We carry IRLCs as either derivative assets or derivative liabilities on our consolidated balance sheet. The fair value of an IRLC is transferred to the fair value of loans acquired for sale at fair value when the loan is funded.
An active, observable market for IRLCs does not exist. Therefore, we measure the fair value of IRLCs using methods and inputs we believe that market participants use in pricing IRLCs. We estimate the fair value of an IRLC based on quoted Agency MBS prices, our estimates of the fair value of the MSRs we expect to receive in the sale of the loans and the probability that the loan will be purchased as a percentage of the commitment we have made (the “pull-through rate”).
Pull-through rates and MSR fair values are based on our estimates as these inputs are difficult to observe in the mortgage marketplace. Changes in our estimate of the probability that a loan will fund and changes in mortgage market interest rates are recognized as IRLCs move through the purchase process and may result in significant changes in the estimates of the fair value of the IRLCs. Such changes are reflected in the change in fair value of IRLCs which is a component of our Net gain on loans acquired for sale and may be included in Net loan servicing fees - from nonaffiliates - Hedging results when we include the IRLCs in our MSR hedging activities in the period of the change. The financial effects of changes in the pull-through rates and MSR fair values generally move in different directions. Increasing interest rates have a positive effect on the fair value of the MSR component of IRLC fair value but increase the pull-through rate for the principal and interest payment portion of the loans that decrease in fair value.
A shift in the market for IRLCs or a change in our assessment of an input to the valuation of IRLCs can have an effect on the amount of gain on sale of loans acquired for sale for the period. We believe that the fair value of IRLCs is most sensitive to changes in
pull-through rate inputs. We held $72.4 million of net IRLC assets at December 31, 2020. Following is a quantitative summary of the effect of changes in pull-through inputs on the fair value of IRLCs at December 31, 2020:
Effect on fair value of a change in pull-through rate
Change in input (1)
Effect on fair value
(in thousands)
(20%)
$
(5,094
)
(10%)
$
3,934
(5%)
$
8,448
5%
$
15,882
10%
$
18,462
20%
$
23,576
(1)
Pull-through rate adjustments for individual loans are limited to adjustments that will increase the individual loan’s pull-through rate to 100%.
Credit Risk Transfer Arrangements
Through late 2020, we had CRT arrangements with Fannie Mae, pursuant to which we sold pools of loans into Fannie Mae-guaranteed securitizations while retaining recourse obligations as part of the retention of an interest-only ownership interest in such loans. We carry the strip or derivative asset or liability relating to these transactions at fair value and recognize changes in the respective assets’ or liability’s fair values in Net (loss) gain on investments in the consolidated statements of income.
A shift in the market for CRT arrangements or a change in our assessment of an input to the valuation of CRT arrangements can have a significant effect on the fair value of CRT arrangements and in our income for the period. We believe that the most significant “Level 3” fair value inputs to the valuation of CRT arrangements are the pricing spread (discount rate) and the remaining loss expectation, which is influenced by the changes in the fair value of the properties securing the loans in the reference pool.
We held $2.6 billion of net CRT arrangements assets at December 31, 2020. Following is a summary of the effect on fair value of various changes to the pricing spread input used to estimate the fair value of our CRT arrangements as of December 31, 2020:
Effect on fair value of a change in pricing spread input
Effect on fair value of a shift in property value
Change in input
(in basis points)
Effect on fair value
Property value shift
Effect on fair value
(in thousands)
(in thousands)
(100)
$
72,070
(15%)
$
(145,221
)
(50)
$
35,522
(10%)
$
(85,621
)
(25)
$
17,634
(5%)
$
(35,451
)
$
(17,392
)
5%
$
28,619
$
(34,540
)
10%
$
51,509
$
(68,135
)
15%
$
70,024
Mortgage Servicing Rights
MSRs represent the value of a contract that obligates us to service the loans on behalf of the owner of the loan in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We carry all of our investments in MSRs at fair value and recognize changes in fair value in current period income. Changes in fair value of MSRs are recognized as a component of Net loan servicing fees-from nonaffiliates-Change in fair value of mortgage servicing rights.
A shift in the market for MSRs or a change in our assessment of an input to the valuation of MSRs can have a significant effect on the fair value of MSRs and in our income for the period. We believe the most significant “Level 3” fair value inputs to the valuation of MSRs are the pricing spread (discount rate), prepayment speed and annual per-loan cost of servicing. We held
$1.8 billion of MSRs at December 31, 2020. Following is a summary of the effect on fair value of various changes to these key inputs that we use in making our fair value estimates as of December 31, 2020:
Effect on fair value of a change in input
Change in input
Pricing spread
Prepayment speed
Servicing cost
(in thousands)
(20%)
$
137,547
$
215,420
$
47,385
(10%)
$
66,266
$
102,856
$
23,692
(5%)
$
32,536
$
50,287
$
11,846
5%
$
(31,400
)
$
(48,136
)
$
(11,846
)
10%
$
(61,718
)
$
(94,244
)
$
(23,692
)
20%
$
(119,305
)
$
(180,820
)
$
(47,385
)
The preceding asset analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in a specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections.
Critical Accounting Policies Not Tied to Fair Value
Consolidation-Variable Interest Entities
We enter into various types of transactions with special purpose entities (“SPEs”), which are trusts that are established for limited purposes. Generally, SPEs are formed in connection with securitization transactions. In a securitization transaction, we transfer loans on our balance sheet to an SPE, which then issues various forms of interests in those assets to investors. In a securitization transaction, we typically receive cash and/or beneficial interests in an SPE in exchange for the assets we transfer.
SPEs are generally considered variable interest entities (“VIEs”). A VIE is an entity having either a total equity investment that is insufficient to finance its activities without additional subordinated financial support or whose equity investors lack the ability to control the entity’s activities. Variable interests are investments or other interests that will absorb portions of a VIE’s expected losses or receive portions of the VIE’s expected residual returns. Expected residual returns represent the expected positive variability in the fair value of a VIE’s net assets.
When an SPE is a VIE, holders of variable interests in that entity must evaluate whether they are the VIE’s primary beneficiary. The primary beneficiary of a VIE is the party that has both the power to direct the activities that most significantly impact the VIE and a variable interest that could potentially be significant to the VIE. The primary beneficiary of a VIE must include the assets and liabilities of the VIE on its consolidated balance sheet. Therefore, our evaluation of a securitization as a VIE and our status as the VIE’s primary beneficiary can have a significant effect on our consolidated balance sheet.
We evaluate the securitization trust into which assets are transferred to determine whether the entity is a VIE. To determine whether a variable interest we hold could potentially be significant to the VIE, we consider both qualitative and quantitative factors regarding the nature, size and form of our involvement with the VIE. We assess whether we are the primary beneficiary of a VIE on an ongoing basis.
For our financial reporting purposes, the underlying assets owned by the securitization VIEs that we presently consolidate are shown under Loans at fair value, Derivative and credit risk transfer strip assets and liabilities and Deposits securing credit risk transfer agreements on our consolidated balance sheets:
•
The VIEs that hold assets relating to our CRT arrangements are shown as their constituent assets and liabilities - the Deposit securing credit risk transfer agreements, Derivative and credit risk transfer strip assets and liabilities which represent our Interest-only (“IO”) ownership interest and Recourse Obligation, and Interest-only security payable at fair value. We include the income we receive from the IO ownership interests and changes in fair value of the Derivative credit risk transfer strip assets and liabilities and Interest-only security payable at fair value in Net (loss) gain on investments in our consolidated income statements.
•
The VIE that holds loans we have securitized is also shown as its constituent assets and liabilities- Loans at fair value, and the securities issued to third parties by the consolidated VIE are shown as Asset-backed financing of a variable interest entity at fair value on our consolidated balance sheets. We include the interest earned on the loans held by the VIE in Interest income and interest attributable to the asset-backed securities issued by the VIE in Interest expense in our
consolidated income statements. Changes in the fair value of loans held in the VIE and the associated asset-backed financing are included in Net (loss) gain on investments in our consolidated income statements.
Income Taxes
We have elected to be taxed as a REIT and believe we comply with the provisions of the Internal Revenue Code applicable to REITs. Accordingly, we believe that we will not be subject to federal income tax on that portion of our REIT taxable income that is distributed to shareholders as long as we meet the requirements of certain asset, income and share ownership tests. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, we will be subject to income taxes and may be precluded from qualifying as a REIT for the four tax years following the year of loss of our REIT qualification.
Our TRS is subject to federal and state income taxes. We provide for income taxes using the asset and liability method. We recognize deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We measure deferred tax assets and liabilities using enacted rates expected to apply to taxable income in the years in which we expect those temporary differences to be recovered or settled.
We recognize the effect on deferred taxes of a change in tax rates in income in the period in which the change occurs. We establish a valuation allowance if, in our judgment, realization of deferred tax assets is not more likely than not.
We recognize tax benefits relating to tax positions we take only if it is more likely than not that the position will be sustained upon examination by the appropriate taxing authority. We recognize a tax position that meets this standard as the largest amount that in our judgment exceeds 50 percent likelihood of being realized upon settlement. We will classify any penalties and interest as a component of income tax expense.
Accounting Developments
Refer to Note 3 - Significant Accounting Policies - Recently Issued Accounting Pronouncement to our consolidated financial statements for a discussion of recent accounting developments and the expected effect of these developments on us.
Non-Cash Income
A substantial portion of our net investment income is comprised of non-cash items, including fair value adjustments, recognition of the fair value of assets created and liabilities incurred in loan sale transactions and the capitalization and amortization of certain assets and liabilities. Because we have elected, or are required by generally accepted accounting principles, to record certain of our financial assets (comprised of MBS, loans acquired for sale at fair value, loans at fair value and ESS), our firm commitment to purchase CRT securities, our derivatives, our MSRs, and our asset-backed financing and interest-only security payable at fair value, a substantial portion of the income or loss we record with respect to such assets and liabilities results from non-cash changes in fair value.
The amounts of net non-cash (loss) income items included in net investment income are as follows:
Year ended December 31,
(dollars in thousands)
Net (loss) gain on investments:
Mortgage-backed securities
$
87,852
$
77,283
$
(11,262
)
Loans:
Held in a variable interest entity
(6,617
)
7,883
(8,499
)
Distressed
(87
)
(7,169
)
(11,514
)
ESS
(22,729
)
(7,530
)
11,084
CRT arrangements
(161,854
)
(11,445
)
6,015
Firm commitment to purchase CRT securities
(121,067
)
60,943
7,399
Interest-only security payable at fair value
14,952
10,302
(19,332
)
Asset-backed financing of a VIE
5,519
(7,553
)
9,610
(204,031
)
122,714
(16,499
)
Net gain on loans acquired for sale (1)
1,199,605
931,733
402,359
Net loan servicing fees-MSR valuation adjustments
(938,937
)
(464,353
)
(58,780
)
Net interest income-Capitalization of interest
pursuant to loan modifications
-
2,318
7,439
$
56,637
$
592,412
$
334,519
Net investment income
$
469,351
$
488,815
$
351,067
Non-cash items as a percentage of net investment income
%
%
%
(1)
Amount represents MSRs received, fair value of firm commitment to purchase CRT securities recognized, representations and warranties incurred in loan sales transactions and changes in fair value of loans, IRLCs and hedging derivatives held at year end.
We receive or pay cash relating to:
•
Our investments in mortgage-backed securities through monthly principal and interest payments from the issuer of such securities;
•
Loan investments when the investments are paid down, paid off or sold, when payments of principal and interest occur on such loans or when the property securing the loan has been sold;
•
ESS investments through a portion of the monthly interest payments collected on the loans in the ESS reference pool;
•
CRT arrangements through a portion of both the interest payments collected on loans in the CRT arrangements’ reference pools and the release to us of the deposits securing the arrangements as principal on such loans is repaid;
•
Hedging instruments when we receive or make margin deposits as the fair value of respective instrument changes, when the instruments mature or when we effectively cancel the transactions through offsetting trades;
•
Our liability for representations and warranties when we repurchase loans or settle loss claims from investors; and
•
MSRs in the form of loan servicing fees and placement fees on the deposits we manage on behalf of the borrowers and investors in the loans we service.
Results of Operations
The following is a summary of our key performance measures:
Year ended December 31,
(dollar amounts in thousands, except per common share amounts)
Net investment income
$
469,351
$
488,815
$
351,067
Expenses
389,621
298,174
193,079
Pretax income
79,730
190,641
157,988
Provision for (benefit from) income taxes
27,357
(35,716
)
5,190
Net income
52,373
226,357
152,798
Dividends on preferred shares
24,938
24,938
24,938
Net income attributable to common shareholders
$
27,435
$
201,419
$
127,860
Pretax income by segment:
Credit sensitive strategies
$
(317,143
)
$
182,176
$
87,251
Interest rate sensitive strategies
105,697
1,148
98,432
Correspondent production
344,639
64,593
16,472
Corporate
(53,463
)
(57,276
)
(44,167
)
$
79,730
$
190,641
$
157,988
Annualized return on average common
shareholder's equity
1.4
%
12.0
%
10.2
%
Earnings per common share:
Basic
$
0.27
$
2.54
$
2.09
Diluted
$
0.27
$
2.42
$
1.99
Dividends per common share
$
1.52
$
1.88
$
1.88
At year end:
Total assets
$
11,492,011
$
11,771,351
$
7,813,361
Book value per common share
$
20.30
$
21.37
$
20.61
Closing price per common share
$
17.47
$
22.29
$
18.62
During the year ended December 31, 2020, the United States was significantly impacted by the effects of the COVID-19 coronavirus pandemic (the “Pandemic” or “COVID-19”) and the effects of market and government responses to the COVID-19 pandemic. These developments have triggered an economic recession in the United States.
The national unemployment rate increased to 14.9% as of April 30, 2020 but has subsequently decreased to 6.7% as of December 31, 2020. The ongoing uncertainty caused by the COVID-19 pandemic has created financial hardships for many existing borrowers. As part of its response to the COVID-19 pandemic, the federal government included requirements in the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) that we provide borrowers with loans we service subject to Agency securitizations with substantial payment forbearance. As a result of this requirement, we have seen a large increase in delinquencies in our servicing portfolio which has increased our cost to service those loans and may require us to finance substantial amounts of advances of principal and interest payments to the holders of the securities holding those loans, as well as property tax and insurance costs to protect investor’s interest in the properties collateralizing the loans. As of December 31, 2020, 2.3% of the loans in our MSR portfolio were in COVID-19 related forbearance provided for under the CARES Act.
The emergence of the COVID-19 pandemic created significant disruption in the financial markets as well as changing market perceptions of future credit losses to be incurred on investments in mortgage loans. The primary effect of this disruption on the Company has been on our credit sensitive strategies. During the year ended December 31, 2020, we recognized $267.0 million in fair value losses on our CRT arrangements and $38.2 million of losses on the initial recognition of firm commitments to purchase CRT securities in our credit sensitive strategies segment. We believe these fair value losses reflect increases both in expectations of future credit losses to be incurred as well as the return demanded by market participants due to the uncertainty surrounding such expectations. While the credit markets have recovered somewhat since the beginning of the COVID-19 pandemic, the recovery has not been complete as the economy remains weak and uncertainty about future mortgage loan credit performance persists.
Before the onset of the COVID-19 pandemic, the mortgage origination market was experiencing healthy demand owing to historically low interest rates in the United States. The government’s response to the onset of the COVID-19 pandemic, including fiscal stimulus and infusions of additional liquidity by the Federal Reserve into financial markets, acted to further lower market
mortgage interest rates. These developments have acted to sustain demand for new mortgage loans despite the slowdown in overall economic activity. The mortgage origination market for 2019 was estimated at $2.3 trillion. Current forecasts estimate the origination market to approximate $4.0 trillion for 2020 and $3.3 trillion for 2021. The uncertainties and strains on many mortgage lenders induced by the COVID-19 pandemic and resulting disruptions in the financial markets caused some market participants to scale back or exit mortgage loan production activities early in the course of the COVID-19 pandemic, which, combined with constraints on mortgage industry origination capacity that existed before the COVID-19 pandemic, allowed us to realize higher gain-on sale margins in our correspondent production activities. With the return of other market participants, our gain-on-sale margins in our correspondent production activities have moderated.
We expect the COVID-19 pandemic to have a negative effect on the future earnings of our interest rate sensitive strategies segment by reducing the income collected from our servicing portfolio, reducing the amount of placement fees we earn on custodial deposits related to the loans in our servicing portfolio, and increasing servicing expenses due to increasing delinquencies. Increasing delinquencies or deteriorating economic conditions may also continue to have a negative effect on the fair value of our MSRs that may not be offset by our hedging activities, which typically seek to moderate changes in fair value due to changes in interest rates. We expect these negative effects to be partially offset by increases in servicing fees arising from growth in our loan servicing portfolio.
The current environment caused by the COVID-19 pandemic in the United States is historically unprecedented and the source of much uncertainty surrounding future economic and market prospects and the ongoing effects of this continuing situation on our future prospects are difficult to anticipate. For further discussion of the potential impacts of the COVID-19 pandemic please also see “Risk Factors” in Part II. Item 1A.
Our consolidated net income during the year ended December 31, 2020 decreased by $174.0 million, reflecting the effect of the COVID-19 pandemic on the fair value of our CRT-related investments and a $63.1 million increase in provision for income taxes, partially offset by gains in our correspondent production and interest rate sensitive strategies segments during the year ended December 31, 2020, as compared to the same period in 2019.
Our consolidated net income during the year ended December 31, 2020 decreased by $174.0 million, reflecting the effect of the Pandemic on the fair value of our CRT-related investments and a $63.1 million increase in provision for income taxes, partially offset by gains in our correspondent production and interest rate sensitive strategies segments during the year ended December 31, 2020, as compared to the same period in 2019.
The increase in pretax results is summarized below:
•
Our credit sensitive strategies segment reflects the severe impact of the market conditions on our investments in CRT arrangements; we recognized a $438.6 million reduction in the net investment gains on our CRT arrangements and initial recognition of firm commitment to purchase CRT securities.
•
Our interest rate sensitive strategies segment was positively affected by growth in its servicing portfolio and performance of its interest rate hedges. We recognized a $212.6 million increase in net servicing fees caused by growth in servicing fees due to an increase in our servicing portfolio and improved hedging performance in relation to MSR fair value changes.
•
Our correspondent production segment benefited from increases in loan production volume and gain on sale margins due to the increase in loan demand resulting from historically low interest rates that prevailed throughout 2020, compounded by existing mortgage industry capacity constraints, resulting in a $280.0 million increase in our pretax income.
Our consolidated net income during the year ended December 31, 2019 increased by $73.6 million, reflecting the growth of our CRT-related investments and the effects of decreasing mortgage interest rates in our interest rate sensitive strategies segment, as compared to the same period in 2018. These results were supplemented by a $40.9 million decrease in provision for income taxes. Our provision for income taxes reflects the fair value impairment we recognized on our investment in MSRs in our TRS, resulting in an income tax benefit for the year ended December 31, 2019.
•
Our credit sensitive strategies segment benefitted from growth in our investments in CRT arrangements as well as from the decrease in our investment in distressed loans compared to 2018; we recognized a $71.3 million increase in gains on CRT arrangements as well as an $8.0 million decrease in losses on loans at fair value.
•
During the year ended December 31, 2019, our interest rate sensitive strategies segment was also affected by the decrease in interest rates. We recognized a $121.5 million increase in valuation gains on our investment in MBS and hedging gains which was offset by a $179.5 million decrease in net servicing fees caused by fair value adjustments to our investment in
MSRs, and a $5.4 million decrease in net interest income resulting from the expiration of a master repurchase agreement that provided us with incentives to finance loans satisfying certain consumer debt relief characteristics.
•
Our correspondent production segment benefitted from increases in loan production volume and gain on sale margins due to the increase in loan demand resulting from decreasing interest rates that prevailed throughout 2019, compared to 2018, resulting in a $48.1 million increase in our pretax income.
Net Investment Income
Our net investment income is summarized below:
Year ended December 31,
(in thousands)
Net gain on loans acquired for sale
$
379,922
$
170,164
$
59,185
Net loan origination fees
147,272
87,997
43,321
Net (loss) gain on investments
(170,885
)
263,318
81,926
Net loan servicing fees
153,696
(58,918
)
120,587
Net interest (expense) income
(48,635
)
20,439
47,601
Other
7,981
5,815
(1,553
)
$
469,351
$
488,815
$
351,067
Net Gain on Loans Acquired for Sale
Our net gain on loans acquired for sale is summarized below:
Year ended December 31,
(in thousands)
From non-affiliates:
Cash loss:
Loans
$
(326,214
)
$
(687,317
)
$
(363,271
)
Hedging activities
(504,506
)
(88,633
)
9,172
(830,720
)
(775,950
)
(354,099
)
Non-cash gain:
Receipt of MSRs in loan sale transactions
1,158,475
837,706
356,755
Provision for losses relating to representations
and warranties provided in loan sales:
Pursuant to loan sales
(19,316
)
(3,778
)
(2,531
)
Reduction in liability due to change in estimate
4,457
3,550
3,707
(14,859
)
(228
)
1,176
Recognition of fair value of commitment to purchase
credit risk transfer securities relating to loans sold
(38,161
)
99,305
30,595
Change in fair value during the year of
financial instruments held at year end:
IRLCs
61,232
(834
)
7,356
Loans
(12,279
)
(1,765
)
(9,685
)
Hedging derivatives
45,197
(2,451
)
16,162
94,150
(5,050
)
13,833
1,199,605
931,733
402,359
Total from nonaffiliates
368,885
155,783
48,260
From PFSI-cash
11,037
14,381
10,925
$
379,922
$
170,164
$
59,185
Interest rate lock commitments issued on loans
acquired for sale to nonaffiliates
$
117,727,579
$
63,323,599
$
29,341,579
Acquisition of loans for sale:
To nonaffiliates
$
106,898,339
$
57,396,037
$
26,438,464
To PFSI
62,413,089
49,116,781
36,366,180
$
169,311,428
$
106,512,818
$
62,804,644
The changes in net gain on loans acquired for sale during the year ended December 31, 2020, as compared to 2019, reflect both the effects of increasing demand in the mortgage market on our loan sales volume and of constraints in mortgage industry capacity on our gain on sale margins, partially offset by losses on the fair value of our commitment to invest in the CRT assets created through our current loan sales. We incurred $38.2 million in fair value losses related to our firm commitment to purchase CRT securities arising from loan sales during the year ended December 31, 2020, as compared to $99.3 million in gain on such loan sales in 2019. The changes in net gain on loans acquired for sale during the year ended December 31, 2019, as compared to 2018, reflects both the effects of increasing demand in the mortgage market on our loan sales volume and gain on sale margins and the fair value of our commitment to invest in the credit risk assets arising from our loan production.
Non-cash elements of gain on sale of loans
Our net gain on sale of loans includes our estimates of gains or losses we expect to realize upon the sale of mortgage loans we have committed to purchase but have not yet purchased or sold. Therefore, we recognize a substantial portion of our net gain on sale before we purchase the loans. This gain is reflected on our balance sheet as IRLC derivative asset and liabilities. We adjust the fair value of our IRLCs as the loan acquisition process progresses until we complete the acquisition or the commitment is canceled. Such adjustments are included in our gain on sale of loans. The fair value of our IRLCs become part of the carrying value of our loans when we complete the purchase of the loans.
The MSRs and liability for representations and warranties we recognize represent our estimate of the fair value of future benefits and costs we will realize for years in the future. These estimates represented approximately 301% of our gain on sale of loans at fair value for the year ended December 31, 2020, as compared to 492% and 605% for the year ended December 31, 2019 and December 31, 2018, respectively. These estimates change as circumstances change, and changes in these estimates are recognized in our results of operations in subsequent periods. Subsequent changes in the fair value of our MSRs significantly affect our results of operations. During the time we were selling loans into CRT arrangements we recognized the fair value of our commitment to purchase CRT securities when we sold loans subject to CRT arrangements. This fair value represents the difference between the expected fair value of the CRT securities we committed to purchase and their contractual purchase price. How we measure and update our measurements of our firm commitment to purchase CRT securities and MSRs is detailed in Note 7 - Fair value - Valuation Techniques and Inputs to the consolidated financial statements included in this Report.
We recognize a liability for losses we expect to incur relating to the representations and warranties we provide to purchasers in our loan sales transactions. The representations and warranties require adherence to purchaser and insurer origination and underwriting guidelines, including but not limited to the validity of the lien securing the loan, property eligibility, borrower credit, income and asset requirements, and compliance with applicable federal, state and local law.
We recorded provisions for losses relating to representations and warranties relating to current loan sales of $19.3 million, $3.8 million and $2.5 million as part of our loan sales in each of the years ended December 31, 2020, 2019 and 2018, respectively. The increase in the provision relating to current loan sales reflects the increase on our loan sales volume as well as fewer loans being subject to credit risk transfer arrangements.
In the event of a breach of our representations and warranties, we may be required to either repurchase the loans with the identified defects or indemnify the investor or insurer against credit losses attributable to the loans with indemnified defects. In such cases, we bear any subsequent credit loss on the loans. Our credit loss may be reduced by any recourse we have to correspondent sellers that, in turn, had sold such loans to us and breached similar or other representations and warranties. In such event, we have the right to seek a recovery of those repurchase losses from that correspondent seller.
Following is a summary of the indemnification and repurchase activity and loans subject to representations and warranties:
Year ended December 31,
(in thousands)
Indemnification activity (UPB):
Loans indemnified at beginning of year
$
5,697
$
7,075
$
5,926
New indemnifications
1,937
Less: Indemnified loans repaid or refinanced
1,564
1,961
Loans indemnified at end of year
$
4,583
$
5,697
$
7,075
UPB of loans with deposits received from correspondent
sellers collateralizing prospective indemnification
losses at end of year
$
$
$
Repurchase activity (UPB):
Loans repurchased
$
72,535
$
22,648
$
12,208
Less:
Loans repurchased by correspondent sellers
31,306
13,745
8,455
Loans resold or repaid by borrowers
24,837
4,830
2,713
Net loans repurchased
$
16,392
$
4,073
$
1,040
Net losses charged to liability for representations and warranties
$
$
$
(12
)
At end of year:
Loans subject to representations and warranties
$
163,592,788
$
122,163,186
$
90,427,100
Liability for representations and warranties
$
21,893
$
7,614
$
7,514
The losses on representations and warranties we have recorded to date have been moderated by our ability to recover most of the losses inherent in the repurchased loans from the correspondent sellers. As the outstanding balance of loans we purchase and sell subject to representations and warranties increases, as the loans sold season, as our investors’ and guarantors’ loss mitigation strategies change and as our correspondent sellers’ ability and willingness to repurchase loans change, we expect that the level of repurchase activity and associated losses may increase.
The method we use to estimate the liability for representations and warranties is a function of our estimates of future defaults, loan repurchase rates, severity of loss in the event of default and the probability of reimbursement by the correspondent loan seller. We establish a liability at the time loans are sold and review our liability estimate on a periodic basis.
The amount of the liability for representations and warranties is difficult to estimate and requires considerable judgment. The level of loan repurchase losses is dependent on economic factors, investor loss mitigation strategies, our ability to recover any losses inherent in the repurchased loan from the correspondent seller and other external conditions that change over the lives of the underlying loans. We may be required to incur losses related to such representations and warranties for several periods after the loans are sold or liquidated.
We record adjustments to our liability for losses on representations and warranties as economic fundamentals change, as investor and Agency evaluations of their loss mitigation strategies (including claims under representations and warranties) change and as economic conditions affect our correspondent sellers’ ability or willingness to fulfill their recourse obligations to us. Such adjustments may be material to our financial position and income in future periods.
Adjustments to our liability for representations and warranties are included as a component of our Net gains on loans acquired for sale at fair value. We recorded reductions in liabilities for representations and warranties for previously sold loans totaling $4.5 million, $3.6 million and $3.7 million during each of the years ended December 31, 2020, 2019 and 2018, respectively, due to the effects of certain loans reaching specified performance histories identified by the Agencies as sufficient to limit repurchase claims relating to such loans.
Loan Origination Fees
Loan origination fees represent fees we charge correspondent sellers relating to our purchase of loans from those sellers. The increase in fees during 2020, as compared to 2019 and 2018, reflects an increase in our purchases of loans with delivery fees.
Net (Loss) Gain on Investments
Net (loss) gain on investments is summarized below:
Year ended December 31,
(in thousands)
From nonaffiliates:
Mortgage-backed securities
$
87,852
$
77,283
$
(11,262
)
Loans at fair value:
Held in a VIE
(6,617
)
7,883
(8,499
)
Distressed
(837
)
(7,169
)
(15,197
)
CRT arrangements
(145,938
)
110,676
92,943
Firm commitment to purchase CRT securities
(121,067
)
60,943
7,399
Asset-backed financings of a VIE at fair value
5,519
(7,553
)
9,610
Hedging derivatives
32,932
28,785
(4,152
)
(148,156
)
270,848
70,842
From PFSI-ESS
(22,729
)
(7,530
)
11,084
$
(170,885
)
$
263,318
$
81,926
The shift in net gain on investments to a net loss for the year ended December 31, 2020, as compared to 2019, reflects the effect of the disruption in the credit markets during the year ended December 31, 2020 on our CRT investments including expectations for increased losses to be absorbed by those investments as a result of the COVID-19 pandemic.
The increase in net gain on investments during 2019, as compared to 2018, was caused primarily by increased gains from our investments in MBS and CRT commitments, partially offset by the ESS losses. These changes reflect the benefit of generally decreasing interest rates on MBS fair value and of decreasing credit spreads during most of 2019, compared to 2018, on the fair value of existing firm commitments to purchase CRT securities.
Mortgage-Backed Securities
During 2020, we recognized net valuation gains on MBS of $87.9 million, as compared to net valuation gains of $77.3 million during 2019. The gains recognized during the years ended December 31, 2020 and 2019, reflect the significant interest rate declines that were experienced during those years. The losses we recognized during the year ended December 31, 2018, reflect rising interest rates during 2018.
Loans at fair value - Held in a VIE
Loans at fair value held in a VIE incurred a loss of $6.6 million during the year ended December 31, 2020, as compared to 2019. The change from 2019 is attributable to the effect of uncertainties surrounding borrower credit performance experienced in the mortgage market as the result of the COVID-19 pandemic discussed above. Unlike our investments in MBS which carry Agency guarantees of security payment performance, the loans held in a VIE are the sole source of repayment of the securities. Therefore, uncertainties about borrower performance are more directly reflected in the fair value of these loans and more than offset the positive effect of decreasing interest rates for the year ended December 31, 2020.
Loans at Fair Value - Distressed
The results on our investment in distressed loans increased by $6.3 million for the year ended December 31, 2020, as compared to 2019. The increase in results reflects the substantial liquidation of our remaining investment in distressed loans. During 2019, we substantially liquidated our remaining investment in distressed loans through sales to nonaffiliates. Our investment in distressed loans was $8.0 million as of December 31, 2020.
.
CRT Arrangements
The activity in and balances relating to our CRT arrangements and firm commitments to purchase CRT securities are summarized below:
Year ended December 31,
(in thousands)
UPB of loans sold
$
18,277,263
$
47,748,300
$
21,939,277
Investments:
Deposits securing CRT arrangements
$
1,700,000
$
933,370
$
596,626
Change in expected face amount of firm
commitment to purchase CRT securities
(1,502,203
)
897,151
122,581
$
197,797
$
1,830,521
$
719,207
Investment (loss) income:
Net (loss) gain on loans acquired for sale - Fair value
of firm commitment to purchase CRT
securities recognized upon sale of loans
$
(38,161
)
$
99,305
$
30,595
Net (loss) gain on investments:
Derivative and CRT strips:
CRT derivatives
Realized
(53,965
)
79,619
86,928
Valuation changes
(82,633
)
(9,571
)
25,347
(136,598
)
70,048
112,275
CRT strips
Realized
54,929
32,200
-
Valuation changes
(79,221
)
(1,874
)
-
(24,292
)
30,326
-
Interest-only security payable at fair value
14,952
10,302
(19,332
)
(145,938
)
110,676
92,943
Firm commitments to purchase CRT securities
(121,067
)
60,943
7,399
(267,005
)
171,619
100,342
Interest income - Deposits securing CRT
arrangements
7,012
34,229
15,441
$
(298,154
)
$
305,153
$
146,378
Payments made to settle losses on CRT arrangements
$
115,475
$
5,165
$
2,133
December 31, 2020
December 31, 2019
(in thousands)
Carrying value of CRT arrangements:
Derivative and credit risk transfer strip assets (liabilities), net
CRT derivatives
$
31,795
$
115,863
CRT strips
(202,792
)
54,930
$
(170,997
)
$
170,793
Firm commitment to purchase credit risk transfer
securities at fair value
$
-
$
109,513
Deposits securing CRT arrangements
$
2,799,263
$
1,969,784
Interest-only security payable at fair value
$
10,757
$
25,709
CRT arrangement assets pledged to secure borrowings:
Derivative and credit risk transfer strip assets
$
58,699
$
142,183
Deposits securing CRT arrangements (1)
$
2,799,263
$
1,969,784
Face amount of firm commitment to purchase CRT
securities
$
1,502,203
UPB of loans - funded CRT arrangements
$
58,697,942
$
41,944,117
Collection status (UPB):
Delinquency (2)
Current
$
54,990,381
$
41,355,622
30-89 days delinquent
$
710,872
$
463,331
90-180 days delinquent
$
693,315
$
106,234
180 or more days delinquent
$
2,297,365
$
8,802
Foreclosure
$
6,009
$
10,128
Bankruptcy
$
75,700
$
55,452
UPB of loans - firm commitment to purchase CRT
securities
$
38,738,396
Collection status (UPB):
Delinquency
Current
$
38,581,080
30-89 days delinquent
$
146,256
90-180 days delinquent
$
9,109
180 or more days delinquent
$
-
Foreclosure
$
1,951
Bankruptcy
$
2,980
(1)
Deposits securing credit risk transfer strip liabilities also secure $229.7 million in CRT strip and CRT derivative liabilities at December 31, 2020.
(2)
At December 31, 2020, delinquent loans include loans subject to forbearance agreements entered into under the CARES Act with UPBs totaling $383.0 million in the 30-89 days delinquent category; $548.0 million in the 90-180 days delinquent category; and $1.9 billion in the 180 or more days delinquent not in foreclosure category.
The performance of our investments in CRT arrangements during the year ended December 31, 2020 reflects increased loss expectations on the loans underlying the arrangements as compared to the year ended December 31, 2019. Specifically, the performance of our CRT investments for the year ended December 31, 2020 reflects the effects of the emergence of the COVID-19 pandemic during the period on perceptions of and prospects for the future performance of the loans in the reference pools that underlie the investments’ fair values as well as increased returns required for CRT investments in the marketplace.
The increase in gains recognized on CRT arrangements during the year ended December 31, 2019 is due to growth in such investments which increased realized gains in the form of interest on our IO interest, on our investments, partially offset by valuation
losses which reflect increases in both credit spreads and prepayment expectations for certain of our CRT investments during the year ended December 31, 2019, compared to 2018.
ESS Purchased from PFSI
We recognized losses relating to our investment in ESS totaling $22.7 million for the year ended December 31, 2020, as compared to gains of $7.5 million during 2019. The change in valuation results during 2020, as compared to 2019, resulted from increased prepayment experience and expectations for the loans underlying the ESS and the effect of uncertainties surrounding future cash flows on the discount rate used to develop the assets’ fair value. The change in valuation results during 2019 as compared to 2018 reflects the different interest rate environments that prevailed between the periods.
Net Loan Servicing Fees
Our correspondent production activity is the source of our loan servicing portfolio. When we sell loans, we generally enter into a contract to service those loans and we recognize the fair value of such contracts as MSRs. Under these contracts, we are required to perform loan servicing functions in exchange for fees and the right to other compensation.
The servicing functions, which are performed on our behalf by PLS, typically include, among other responsibilities, collecting and remitting loan payments; responding to borrower inquiries; accounting for the loan; holding and remitting custodial (impound) funds for payment of property taxes and insurance premiums; counseling delinquent mortgagors; and supervising foreclosures and property dispositions.
Net loan servicing fees are summarized below:
Year ended December 31,
(in thousands)
From nonaffiliates:
Contractually specified (1)
$
406,060
$
295,390
$
204,663
Other
56,457
24,099
8,062
Effect of MSRs fair value changes:
Realization of cashflows
(232,830
)
(202,322
)
(119,552
)
Market and other changes
(706,107
)
(262,031
)
60,772
(938,937
)
(464,353
)
(58,780
)
Gain (loss) on hedging derivatives
601,743
80,622
(35,550
)
(337,194
)
(383,731
)
(94,330
)
Net servicing fees from non-affiliates
125,323
(64,242
)
118,395
From PFSI-MSR recapture income
28,373
5,324
2,192
Net loan servicing fees
$
153,696
$
(58,918
)
$
120,587
Average servicing portfolio UPB
$
147,832,880
$
110,075,179
$
80,500,212
(1)
Includes contractually specified servicing fees, net of guarantee fees.
Net loan servicing fees increased by $212.6 million during the year ended December 31, 2020 as compared to 2019 due primarily to increased servicing fees resulting from the growth in our loan servicing portfolio during the year ended December 31, 2020. The decrease in net loan servicing fees during 2019, as compared to 2018, was primarily attributable to the negative effect of the decrease in fair value of our MSRs, net of hedging derivative gains, resulting from decreasing interest rates during 2019 compared to 2018. This negative effect was partially offset by growth in our loan servicing portfolio resulting from our correspondent production activities which included retention of a higher servicing fee rate relating to loans sold during 2019 as compared to 2018.
The fair value of our investment in MSRs was affected by increased prepayment experience and expectations as a result of the decrease in interest rates during the year ended December 31, 2020, as well as increased market discount rates and servicing costs, which reflect projected impacts and investor uncertainties surrounding the cash flows to be generated by this asset as the result of the emergence of the COVID-19 pandemic and the related loan servicing requirements imposed by the CARES Act.
Loan servicing fees (including ancillary and other fees) increased by $106.8 million during the year ended December 31, 2019, reflecting the growth of our servicing portfolio and retention of a higher servicing fee rate relating to loans sold during 2019, as
compared to 2018. This increase was offset by increases in realization of cash flows of $82.8 million during the year ended December 31, 2019. Realization of cash flows increased disproportionately to the increase in servicing fees due to acceleration of the rate of realization caused by the increased prepayment experience and expectations that accompany lower interest rates.
Net Interest (Expense) Income
Net interest income is summarized below:
Year ended December 31, 2020
Year ended December 31, 2019
Year ended December 31, 2018
Interest
Interest
Interest
Interest
Interest
Interest
income/
Average
yield/
income/
Average
yield/
income/
Average
yield/
expense
balance
cost %
expense
balance
cost %
expense
balance
cost %
(dollars in thousands)
Assets:
Cash and short-term investments
$
3,804
$
650,630
0.58
%
$
4,559
$
164,577
2.73
%
$
$
37,939
2.25
%
Mortgage-backed securities
59,461
2,921,879
2.00
%
78,450
2,591,828
2.99
%
55,487
1,669,373
3.33
%
Loans acquired for sale at
fair value
103,221
3,469,392
2.93
%
121,387
2,754,955
4.35
%
75,610
1,577,395
4.81
%
Loans at fair value:
Held by variable interest entity
10,609
214,596
4.86
%
11,734
281,449
4.11
%
11,813
301,398
3.93
%
Distressed
9,032
5.37
%
3,848
75,251
5.04
%
21,666
473,458
4.59
%
11,102
223,628
4.88
%
15,582
356,700
4.31
%
33,479
774,856
4.33
%
ESS from PFSI
8,418
153,768
5.38
%
10,291
197,273
5.15
%
15,138
231,448
6.56
%
Deposits securing CRT arrangements
7,012
1,772,762
0.39
%
34,229
1,639,885
2.06
%
15,441
751,593
2.06
%
193,018
9,192,059
2.07
%
264,498
7,705,218
3.39
%
196,007
5,042,604
3.90
%
Placement fees relating to
custodial funds
28,804
52,587
26,065
Other
222,135
$
9,192,059
2.38
%
317,885
$
7,705,218
4.07
%
222,772
$
5,042,604
4.43
%
Liabilities:
Assets sold under agreements
to repurchase (1)
$
102,131
$
5,508,147
1.82
%
178,211
$
5,600,469
3.14
%
115,383
$
3,901,772
2.97
%
Mortgage loan participation
purchase and sale
agreements
44,432
2.00
%
1,570
40,036
3.87
%
2,422
64,512
3.76
%
Notes payable secured by credit
risk transfer and mortgage
servicing assets
59,261
1,771,370
3.29
%
53,968
1,101,501
4.83
%
14,623
300,035
4.89
%
Exchangeable senior notes
18,847
269,247
6.89
%
17,037
279,207
6.02
%
14,601
250,000
5.86
%
Asset-backed financings of a
variable interest entity
at fair value
10,971
203,795
5.30
%
11,324
267,539
4.17
%
10,821
288,244
3.76
%
Assets sold to PFSI under
agreement to repurchase
3,325
93,264
3.56
%
6,302
118,264
5.33
%
7,462
138,155
5.42
%
195,437
7,890,255
2.44
%
268,412
7,407,016
3.57
%
165,312
4,942,718
3.35
%
Interest shortfall on repayments of
loans serviced for Agency
securitizations
71,516
25,776
7,324
Interest on loan impound deposits
3,817
3,258
2,535
270,770
$
7,890,255
3.38
%
297,446
$
7,407,016
3.96
%
175,171
$
4,942,718
3.55
%
Net interest (expense) income
$
(48,635
)
$
20,439
$
47,601
Net interest margin
-0.52
%
0.26
%
0.94
%
Net interest spread
-1.00
%
0.11
%
0.88
%
(1)
In 2017, we entered into a master repurchase agreement that provided us with incentives to finance loans approved for satisfying certain consumer relief characteristics as provided in the agreement. During the years ended December 31, 2019 and 2018, we included $10.8 million and $19.7 million, respectively, of such incentives as a reduction to Interest expense. The master repurchase agreement expired on August 21, 2019.
The effects of changes in the yields and costs and composition of our investments on our interest income are summarized below:
Year ended December 31, 2020
Year ended December 31, 2019
vs.
vs.
Year ended December 31, 2019
Year ended December 31, 2018
Increase (decrease)
due to changes in
Increase (decrease)
due to changes in
Total
Total
Rate
Volume
change
Rate
Volume
change
(in thousands)
Assets:
Cash and short-term investments
$
(5,855
)
$
5,100
$
(755
)
$
$
3,465
$
3,707
Mortgage-backed securities
(28,146
)
9,157
(18,989
)
(5,339
)
28,302
22,963
Loans acquired for sale at fair value
(45,316
)
27,150
(18,166
)
(6,553
)
52,330
45,777
Loans at fair value:
Held by variable interest entity
1,940
(3,065
)
(1,125
)
(807
)
(79
)
Distressed
(3,590
)
(3,355
)
2,282
(20,100
)
(17,818
)
2,175
(6,655
)
(4,480
)
3,010
(20,907
)
(17,897
)
ESS from PFSI
(2,340
)
(1,873
)
(2,803
)
(2,044
)
(4,847
)
Deposits securing CRT
arrangements
(29,802
)
2,585
(27,217
)
18,537
18,788
(106,477
)
34,997
(71,480
)
(11,192
)
79,683
68,491
Placement fees relating to custodial
funds
-
(23,783
)
(23,783
)
-
26,522
26,522
Other
-
(487
)
(487
)
-
(106,477
)
10,727
(95,750
)
(11,192
)
106,305
95,113
Liabilities:
Assets sold under agreements to
repurchase
(73,199
)
(2,881
)
(76,080
)
9,342
53,486
62,828
Mortgage loan participation
purchase and sale agreement
(826
)
(668
)
(956
)
(852
)
Notes payable secured by credit risk
transfer and mortgage servicing
assets
(20,827
)
26,120
5,293
39,267
39,345
Exchangeable senior notes
2,428
(618
)
1,810
1,761
2,436
Asset-backed financings of a
variable interest entity at fair value
2,679
(3,032
)
(353
)
1,316
(813
)
Assets sold to PFSI under
agreement to repurchase
(1,821
)
(1,156
)
(2,977
)
(99
)
(1,061
)
(1,160
)
(91,566
)
18,591
(72,975
)
11,416
91,684
103,100
Interest shortfall on repayments of
loans serviced for Agency
securitizations
-
45,740
45,740
-
18,452
18,452
Interest on loan impound deposits
-
-
(91,566
)
64,890
(26,676
)
11,416
110,859
122,275
Net interest expense
$
(14,911
)
$
(54,163
)
$
(69,074
)
$
(22,608
)
$
(4,554
)
$
(27,162
)
The decrease in net interest income during the year ended December 31, 2020, as compared to 2019, is due to:
•
An increase in interest shortfall on repayments of loans serviced for Agency securitizations resulting from the increased levels of prepayment activity in our MSR portfolio. In many cases, when a borrower repays its loan, we are responsible
for paying the full month’s interest to the holders of the Agency securities that are backed by the loan regardless of when in the month the borrower repays the loan.
•
A decrease in earnings from placement fees relating to custodial funds managed for borrowers and investors and deposits securing CRT arrangements which reflect the effect of decreasing interest rates we earn on these assets.
•
Included in net interest income for the year ended December 31, 2019 was $10.8 million of incentives we recognized relating to a master repurchase agreement that provided us with incentives to finance loans approved for satisfying certain consumer characteristics. The master repurchase agreement expired on August 21, 2019.
The decrease in net interest income during the year ended December 31, 2019, as compared to the year ended December 31, 2018, reflects increased financing of non-interest earning assets such as MSRs, CRT derivatives and CRT strips, along with a shift in our interest-earning investments toward MBS and away from distressed assets and the expiration of a master repurchase agreement that provided us with incentives to finance loans approved for satisfying certain consumer relief characteristics.
During 2019, we issued approximately $1.3 billion of term notes secured by our investments in CRT arrangements. While we earn interest on the Deposits securing credit risk transfer arrangements, most of the net investment income we earn relating to these arrangements is included in Net (loss) gain on investments. Our production of loans for sale increased significantly due to decreases in market mortgage interest rates as borrowers refinanced their existing loans. The increase in refinancing activity in our MSR portfolio caused an $18.5 million increase in the interest shortfall on payments of Agency securitizations as compared to the amount we incurred in 2018.
Included in net interest income as a reduction of interest expense relating to Assets sold under agreements to repurchase for the year ended December 31, 2019 are $10.8 million, compared to $19.7 million during the year ended December 31, 2018, of incentives we recognized relating to a master repurchase agreement. This master repurchase agreement expired on August 21, 2019.
These reductions in net interest income were partially offset by an increase in placement fees relating to custodial funds, which reflects the growth in our MSR portfolio from 2018 to 2019, net of reductions in the placement fee rates we are able to obtain from the banks where we place the custodial funds and an increase in net interest income from increases in our investment in MBS and loans acquired for sale. Our average investment in MBS increased by approximately $922.5 million, or 55%, during 2019, as compared to 2018, and our average investment in loans held for sale increased by approximately $1.2 billion, or 75%, during 2019, as compared to 2018.
Expenses
Our expenses are summarized below:
Year ended December 31,
(in thousands)
Earned by PennyMac Financial Services, Inc.:
Loan fulfillment fees
$
222,200
$
160,610
$
81,350
Loan servicing fees
67,181
48,797
42,045
Management fees
34,538
36,492
24,465
Loan origination
26,437
15,105
6,562
Loan collection and liquidation
10,363
4,600
7,852
Safekeeping
7,090
5,097
1,805
Professional services
6,405
5,556
6,380
Compensation
3,890
6,897
6,781
Other
11,517
15,020
15,839
$
389,621
$
298,174
$
193,079
Expenses increased $91.4 million, or 31%, during the year ended December 31, 2020, as compared to 2019, primarily due to increased loan fulfillment fees attributable to increases in our production volume and to increased loan servicing fees, reflecting both the growth of our loan servicing portfolio and the fees we incur relating to CARES Act forbearance and modification activities. Expenses increased $105.1 million, or 54%, during 2019, as compared to the same period in 2018, due primarily to increased loan fulfillment fees attributable to increases in our production volume, partially offset by a reduction in the average fulfillment fee rate we incurred during 2019, as well as an increase in the management fee we incurred, reflecting both the growth in our shareholders’ equity and profitability, which are the basis for our fees.
Loan Fulfillment Fees
Loan fulfillment fees represent fees we pay to PLS for the services it performs on our behalf in connection with our acquisition, packaging and sale of loans. The increase in loan fulfillment fees of $61.6 million during 2020, as compared to 2019 and 2018, is primarily due to an increase in the volume of loans fulfilled for us by PFSI, partially offset by a change in the fulfillment fee structure described in Note 4 - Transactions with Affiliates to the consolidated financial statements included in this Report.
Loan Servicing Fees
Loan servicing fees payable to PLS are summarized below:
Year ended December 31,
(in thousands)
Loan servicing fees:
Loans acquired for sale at fair value
$
2,067
$
1,772
$
1,037
Loans at fair value
2,207
7,555
MSRs
64,307
44,818
33,453
$
67,181
$
48,797
$
42,045
Average investment in:
Loans acquired for sale at fair value
$
3,469,392
$
2,754,955
$
1,577,395
Loans at fair value:
Distressed
$
9,032
$
75,251
$
473,458
Held in a VIE
$
214,596
$
281,449
$
301,398
Average MSR portfolio UPB
$
147,832,880
$
110,075,179
$
80,500,212
Loan servicing fees increased by $18.4 million during the year ended December 31, 2020, as compared to 2019 and $6.8 million during the year ended December 31, 2019 as compared to 2018. We incur loan servicing fees primarily in support of our MSR portfolio. The increase in loan servicing fees during the year ended December 31, 2020 as compared to 2019, was due to the growth in our portfolio of MSRs and the fees we incur relating to CARES Act loan forbearance and modification activities. The increase in loan servicing fees during the year ended December 31, 2019, as compared to 2018, was due to growth in our portfolio of MSRs, partially offset by the effect of the continuing liquidation of the investment in distressed mortgage assets.
Management Fees
Management fees payable to PCM are summarized below:
Year ended December 31,
(in thousands)
Base
$
34,538
$
29,303
$
23,033
Performance incentive
-
7,189
1,432
$
34,538
$
36,492
$
24,465
Average shareholders' equity amounts used
to calculate base management fee expense
$
2,330,154
$
1,958,970
$
1,535,590
Management fees decreased by $2.0 million during the year ended December 31, 2020, as compared to 2019, due to the offsetting effects of an increase in base management fees and the recognition of no performance incentive fees during 2020 as compared to 2019. The increase in base management fees during the year ended December 31, 2020, as compared to 2019, reflects an increase in average shareholder’ equity in 2020 as a result of common shares issuances through 2019. The elimination of the performance incentive fee during 2020, as compared to 2019, reflects the negative effects on our earnings from COVID-19 pandemic-related losses incurred from our investment in CRT arrangements.
Management fees increased by $12.0 million during the year ended December 31, 2019, as compared to 2018, due to increases in both the base management and performance incentive fees. Performance incentive fees are based on our profitability in relation to our common shareholders’ equity. The increase in the base management fee is due to increases in our average shareholders’ equity as the result of common share issuances during the year ended December 31, 2019. The increases in performance incentive fees also
reflects the increase in average shareholders’ equity and the increases in our return on common shareholders’ equity from 10.2% during 2018 to 12.0% during 2019.
Loan origination
Loan origination expenses increased $11.3 million or 75% during 2020, as compared to 2019, and $19.9 million during 2019 as compared to 2018, reflecting the increases in our loan originations produced through our correspondent production activities.
Loan collection and liquidation
Loan collection and liquidation expenses increased $5.8 million during 2020, as compared to 2019, due to borrower assistance expenses we incurred relating to loans in our CRT reference pools. We incurred this expense to assist certain borrowers in mitigating loan delinquencies they incurred as a result of dislocations arising from the COVID-19 pandemic as an alternative to incurring losses in the CRT arrangements. Loan collection and liquidation expenses decreased $3.3 million during 2019 as compared to 2018, due to our continuing collection and liquidation efforts relating to our portfolio of nonperforming mortgage loans.
Compensation
Compensation expense decreased $3.0 million during the year ended December 31, 2020, as compared to 2019, primarily due to a decrease in expected future vesting of equity awards as a result of our projected earnings performance not achieving the targets included in the outstanding performance-based awards. Compensation expense increased $116,000 during the year ended December 31, 2019 as compared to 2018, primarily due to an increase in performance expectations relating to outstanding awards of performance-restricted share units.
Other Expenses
Other expenses are summarized below:
Year ended December 31,
(in thousands)
Common overhead allocation from PFSI
$
5,172
$
5,340
$
4,640
Bank service charges
1,924
2,552
1,522
Technology
1,440
1,616
1,408
Insurance
1,351
1,239
1,193
Other
1,630
4,273
7,076
$
11,517
$
15,020
$
15,839
Income Taxes
We have elected to treat PMC as a taxable REIT subsidiary (“TRS”). Income from a TRS is only included as a component of REIT taxable income to the extent that the TRS makes dividend distributions of income to us. A TRS is subject to corporate federal and state income tax. Accordingly, a provision for income taxes for PMC is included in the accompanying consolidated statements of income.
Our effective tax rates were 34.3% for the year ended December 31, 2020 and (18.8)% for the year ended December 31, 2019. Our TRS recognized a tax expense of $27.3 million on pretax income of $151.5 million while our consolidated pretax income was $79.7 million for the year ended December 31, 2020. For 2019, the TRS recognized tax benefit of $36.4 million on a pretax loss of $187.8 million while our consolidated pretax income was $190.6 million. The relative values between the tax benefit or expense at the TRS and our consolidated pretax income drive the fluctuation in the effective tax rate. The primary difference between our effective tax rate and the statutory tax rate is due to nontaxable REIT income resulting from the dividends paid deduction.
We evaluated the net deferred tax asset of our TRS and established a deferred tax valuation allowance in the amount of $110,000. In our evaluation, we consider, among other things, taxable loss carryback availability, expectations of sufficient future taxable income, trends in earnings, existence of taxable income in recent years, the future reversal of temporary differences, and available tax planning strategies that could be implemented, if required. We establish valuation allowances based on the consideration of all available evidence using a more-likely-than-not standard.
In general, cash dividends declared by the Company will be considered ordinary income to the shareholders for income tax purposes. Some portion of the dividends may be characterized as capital gain distributions or a return of capital. For tax years beginning after December 31, 2017, the 2017 Tax Cuts and Jobs Act (the “Tax Act”) (subject to certain limitations) provides a 20% deduction from taxable income for ordinary REIT dividends.
Below is a reconciliation of GAAP year to date net income to taxable income (loss) and the allocation of taxable income (loss) between the TRS and the REIT:
Taxable income (loss)
GAAP
net income
GAAP/tax
differences
Total taxable
income (loss)
Taxable
subsidiaries
REIT
Year ended December 31, 2020
(in thousands)
Net investment income
Net loan servicing fees/ESS transactions
$
153,696
$
1,058,016
$
1,211,512
$
1,211,512
$
-
Net gain (loss) on mortgage loans acquired for sale
379,922
(1,106,036
)
(725,913
)
(725,913
)
-
Loan origination fees
147,272
-
147,272
147,272
-
Net (loss) gain on investments
(170,885
)
169,670
(1,215
)
(88,444
)
87,229
Net interest (expense) income
(48,635
)
84,125
35,490
(124,824
)
160,314
Results of real estate acquired in settlement of loans
5,465
(2,178
)
3,287
3,287
-
Other
2,516
(1
)
2,516
2,458
Net investment income
469,351
203,596
672,949
425,348
247,601
Expenses
389,621
4,545
394,167
359,093
35,074
REIT dividend deduction
-
212,514
212,514
-
212,514
Total expenses and dividend deduction
389,621
217,059
606,681
359,093
247,588
Income (loss) before provision for (benefit from) income taxes
79,730
(13,463
)
66,268
66,255
Provision for (benefit from) income taxes
27,357
(27,344
)
-
Net income
$
52,373
$
13,881
$
66,255
$
66,255
$
-
Balance Sheet Analysis
Following is a summary of key balance sheet items as of the dates presented:
December 31,
December 31,
(in thousands)
Assets
Cash
$
57,704
$
104,056
Investments:
Short-term
127,295
90,836
Mortgage-backed securities at fair value
2,213,922
2,839,633
Loans acquired for sale at fair value
3,551,890
4,148,425
Loans at fair value
151,734
270,793
ESS
131,750
178,586
Derivative and credit risk transfer strip assets
164,318
202,318
Firm commitment to purchase CRT securities
-
109,513
Deposits securing credit risk transfer arrangements
2,799,263
1,969,784
MSRs
1,755,236
1,535,705
REO
28,709
65,583
10,924,117
11,411,176
Other
510,190
256,119
Total assets
$
11,492,011
$
11,771,351
Liabilities
Debt:
Short-term
$
6,407,131
$
7,005,986
Long-term
2,267,278
2,159,286
8,674,409
9,165,272
Other
520,743
155,164
Total liabilities
9,195,152
9,320,436
Shareholders’ equity
2,296,859
2,450,915
Total liabilities and shareholders’ equity
$
11,492,011
$
11,771,351
Total assets decreased by approximately $279.3 million, or 2%, from December 31, 2019 to December 31, 2020, primarily due to a decrease of $625.7 million in MBS, a $596.5 million decrease in loans acquired for sale at fair value, and a decrease of $109.5 million in Firm commitment to purchase CRT securities offset by an $829.5 million increase in Deposits securing credit risk transfer arrangements and an increase of $219.5 million of MSRs. The decrease in Loans acquired for sale reflects our efforts aimed at accelerating the settlement of our loan sales. The change in the composition of our CRT assets reflects the completion of our loan sales into CRT arrangements and funding of our remaining commitment to purchase CRT securities. The growth in our investment in MSRs reflects the growth in our servicing portfolio from our correspondent lending activities.
Asset Acquisitions
Our asset acquisitions are summarized below.
Correspondent Production
Following is a summary of our correspondent production acquisitions at fair value:
Year ended December 31,
(in thousands)
Correspondent loan purchases:
Agency-eligible
$
106,472,654
$
63,989,938
$
30,221,732
Government-insured or guaranteed-for sale to PLS
63,574,547
50,499,641
37,718,502
Jumbo
-
12,839
67,501
Home equity lines of credit
2,569
5,182
-
Commercial loans
-
-
7,263
$
170,049,770
$
114,507,600
$
68,014,998
During 2020, we purchased for sale $170.0 billion in fair value of correspondent production loans as compared to $114.5 billion during 2019 and $68.0 billion during 2018. Our ability to increase the level of correspondent production during the three-year period ended December 31, 2020 reflects the continuing decrease in mortgage market interest rates to historic lows, which has increased demand in the mortgage origination market.
Other Investment Activities
Following is a summary of our acquisitions of mortgage-related investments held in our credit sensitive strategies and interest rate sensitive strategies segments:
Year ended December 31,
(in thousands)
Credit sensitive assets:
Credit risk transfer strips
$
(178,501
)
$
56,804
$
-
Deposits and commitments to fund deposits
relating to CRT arrangements
1,700,000
933,370
596,626
Change in firm commitment to purchase
CRT securities
Fair value
(159,228
)
160,248
37,994
Expected face amount
(1,502,203
)
897,151
122,581
(1,661,431
)
1,057,399
160,575
(139,932
)
2,047,573
757,201
Interest rate sensitive assets:
MSRs received in loan sales and purchased
1,158,475
837,706
356,755
MBS (net of sales)
352,307
546,111
1,810,877
ESS received pursuant to a recapture agreement
2,093
1,757
2,688
1,512,875
1,385,574
2,170,320
$
1,372,943
$
3,433,147
$
2,927,521
Our acquisitions during the three years ended December 31, 2020 were financed through the use of a combination of proceeds from borrowings, liquidations of existing investments and proceeds from equity issuances. We continue to identify additional means of increasing our investment portfolio through cash flow from our business activities, existing investments, borrowings, and transactions that minimize current cash outlays. However, we expect that, over time, our ability to continue our investment portfolio growth will depend on our ability to raise additional equity capital.
Investment Portfolio Composition
Mortgage-Backed Securities
Following is a summary of our MBS holdings:
December 31, 2020
December 31, 2019
Average
Average
Fair
Life
Fair
Life
value
Principal
(in years)
Coupon
value
Principal
(in years)
Coupon
(dollars in thousands)
Agency:
Freddie Mac
$
1,311,036
$
1,253,755
4.4
2.7
%
$
830,540
$
809,595
5.3
3.2
%
Fannie Mae
902,886
863,758
5.3
2.5
%
2,009,093
1,946,203
5.0
3.4
%
$
2,213,922
$
2,117,513
$
2,839,633
$
2,755,798
Credit Risk Transfer Transactions
Following is a summary of the composition of the loans underlying our investment in funded CRT arrangements and our firm commitment to purchase CRT securities.
CRT Arrangements
Following is a summary of our holding of CRT arrangements:
December 31, 2020
December 31, 2019
(in thousands)
Carrying value of CRT arrangements:
Derivative and credit risk transfer strip assets (liabilities), net
CRT strips
$
(202,792
)
$
54,930
CRT derivatives
31,795
115,863
(170,997
)
170,793
Deposits securing CRT arrangements
2,799,263
1,969,784
Interest-only security payable at fair value
(10,757
)
(25,709
)
$
2,617,509
$
2,114,868
UPB of loans subject to credit guarantee obligations
$
58,697,942
$
41,944,117
Following is a summary of the composition of the loans underlying our investment in CRT arrangements as of December 31, 2020:
Year of origination
Total
(in millions)
UPB:
Outstanding
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Cumulative defaults
$
-
$
$
$
$
$
$
Cumulative losses
$
-
$
-
$
$
$
$
$
Year of origination
Original debt-to income ratio
Total
(in millions)
<25%
$
1,884
$
3,988
$
$
$
$
$
8,238
25 - 30%
1,598
3,691
7,537
30 - 35%
1,786
4,502
1,003
9,293
35 - 40%
1,800
5,155
1,352
1,165
10,705
40 - 45%
1,773
6,156
1,860
1,568
1,244
13,041
>45%
1,114
4,912
2,362
9,884
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Weighted average
33.8
%
35.9
%
38.6
%
36.3
%
35.1
%
35.5
%
35.9
%
Year of origination
Origination FICO credit score
Total
(in millions)
600 - 649
$
$
$
$
$
$
$
650 - 699
2,658
1,500
6,453
700 - 749
2,525
8,637
2,885
2,136
1,523
18,196
750 or greater
6,816
16,665
3,477
3,035
2,534
33,214
Not available
-
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Weighted average
Year of origination
Origination loan-to value ratio
Total
(in millions)
<80%
$
4,581
$
9,653
$
2,525
$
1,908
$
1,818
$
$
21,054
80-85%
1,621
5,340
1,918
1,706
1,237
12,200
85-90%
1,757
3,484
90-95%
3,086
6,451
95-100%
2,141
8,568
2,257
1,454
15,509
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Weighted average
81.1
%
83.7
%
83.6
%
82.9
%
81.2
%
81.5
%
82.9
%
Year of origination
Current loan-to value ratio (1)
Total
(in millions)
<80%
$
6,716
$
18,895
$
6,721
$
5,903
$
4,630
$
1,467
$
44,332
80-85%
1,298
5,131
7,593
85-90%
1,432
3,622
5,428
90-95%
1,220
95-100%
-
-
>100%
-
-
-
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Weighted average
74.3
%
73.8
%
69.5
%
64.0
%
58.5
%
55.4
%
70.6
%
(1)
Based on current UPB compared to estimated fair value of the property securing the loan.
Year of origination
Geographic distribution
Total
(in millions)
CA
$
1,266
$
3,156
$
$
$
$
$
7,317
FL
2,551
5,691
TX
1,130
2,236
5,250
VA
1,302
2,914
MD
1,147
2,612
Other
5,716
18,012
4,848
3,677
2,038
34,914
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Year of origination
Regional geographic
distribution (1)
Total
(in millions)
Northeast
$
$
2,887
$
$
$
$
$
6,061
Southeast
3,166
9,538
2,898
2,147
1,469
19,665
Midwest
2,610
5,145
Southwest
2,706
6,568
1,584
1,183
13,236
West
2,470
6,801
2,104
1,461
1,363
14,591
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
(1)
Northeast consists of CT, DE, MA, ME, NH, NJ, NY, PA, PR, RI, VT, VI;
Southeast consists of AL, DC, FL, GA, KY, MD, MS, NC, SC, TN, VA, WV;
Midwest consists of IA, IL, IN, MI, MN, NE, ND, OH, SD, WI;
Southwest consists of AR, AZ, CO, KS, LA, MO, NM, OK, TX, UT; and
West consists of AK, CA, GU, HI, ID, MT, NV, OR, WA and WY.
Year of origination
Collection status
Total
(in millions)
Delinquency
Current - 89 Days
$
9,731
$
26,936
$
7,344
$
5,807
$
4,471
$
1,412
$
55,701
90 - 179 Days
180+ Days
1,200
2,297
Foreclosure
-
-
-
$
9,955
$
28,404
$
8,034
$
6,156
$
4,675
$
1,474
$
58,698
Bankruptcy
$
-
$
$
$
$
$
$
Cash Flows
Our cash flows for the years ended December 31, 2020, 2019, and 2018 are summarized below:
Year ended December 31,
(in thousands)
Operating activities
$
671,656
$
(2,985,074
)
$
(573,752
)
Investing activities
(15,367
)
(704,677
)
(1,424,292
)
Financing activities
(702,641
)
3,733,962
1,980,242
Net cash flows
$
(46,352
)
$
44,211
$
(17,802
)
Our cash flows resulted in a net decrease in cash of $46.4 million during 2020, as discussed below.
Operating activities
Cash provided by operating activities totaled $671.7 million during 2020, as compared to cash used in operating activities of $3.0 billion during 2019 and $573.8 million during 2018. Cash flows from operating activities are most influenced by cash flows from loans acquired for sale as shown below:
Year ended December 31,
(in thousands)
Operating cash flows from:
Loans acquired for sale
$
(165,398
)
$
(3,291,371
)
$
(689,826
)
Other
837,054
306,297
116,074
$
671,656
$
(2,985,074
)
$
(573,752
)
Cash flows from loans acquired for sale primarily reflect changes in the level of production inventory from the beginning to end of the years presented as well as cash flows relating to related hedging activities. The negative cash flows relating to loans acquired for sale during 2020 reflect the significant cash hedging costs that reduced cash inflows from loan sales by more than the decrease in our inventory of loans held for sale. Our inventory of loans acquired for sale increased during both 2019 and 2018, resulting in the cash outflow relating to loans acquired for sale.
Investing activities
Net cash used in our investing activities was $15.4 million during 2020, as compared to cash used in investing activities of $704.7 million and $1.4 billion during 2019 and 2018, respectively, due primarily to the $871.5 million of distributions from CRT arrangements along with sales and repayments of our investments in MBS in excess of purchases of such assets. We did not increase our investment in MBS as significantly during 2019 as compared to 2018. However, reduced growth in investment in MBS was partially offset by increased investments in CRT arrangements.
Financing activities
Net cash used in our financing activities was $702.6 million during 2020, as compared to net cash provided by financing activities of $3.7 billion and $2.0 billion during 2019 and 2018, respectively. This change reflects the repayment of borrowings relating to reduced levels of inventory of loans held for sale. Cash provided by financing activities during 2019 and 2018, reflects the increased borrowings and the equity issuances made to finance growth in investments in MBS, CRT arrangements and growth in our inventory of loans held for sale.
As discussed below in Liquidity and Capital Resources, our Manager continually evaluates and pursues additional sources of financing to provide us with future investing capacity. We do not raise equity or enter into borrowings for the purpose of financing the payment of dividends. We believe that the cash flows from the liquidation of our investments, which include accumulated gains recorded during the periods we hold those investments, along with our cash earnings, are adequate to fund our operating expenses and dividend payment requirements. However, we manage our liquidity in the aggregate and are reinvesting our cash flows in new investments as well as using such cash to fund our dividend requirements.
Liquidity and Capital Resources
Our liquidity reflects our ability to meet our current obligations (including the purchase of loans from correspondent sellers, our operating expenses and, when applicable, retirement of, and margin calls relating to, our debt and derivatives positions), make investments as our Manager identifies them, pursue our share repurchase program and make distributions to our shareholders. We generally need to distribute at least 90% of our taxable income each year (subject to certain adjustments) to our shareholders to qualify as a REIT under the Internal Revenue Code. This distribution requirement limits our ability to retain earnings and thereby replenish or increase capital to support our activities.
We expect our primary sources of liquidity to be cash flows from our investment portfolio, including cash earnings on our investments, cash flows from business activities, liquidation of existing investments and proceeds from borrowings and/or additional equity offerings. When we finance a particular asset, the amount borrowed is less than the asset’s fair value and we must provide the cash in the amount of such difference. Our ability to continue making investments is dependent on our ability to invest the cash representing such difference.
The impact of the COVID-19 pandemic on our operations, liquidity and capital resources remains uncertain and difficult to predict, For further discussion of the potential impacts of the COVID-19 pandemic please also see “Risk Factors” in Part I, Item 1A.
Our current debt financing strategy is to finance our assets where we believe such borrowing is prudent, appropriate and available. We make collateralized borrowings in the form of sales of assets under agreements to repurchase, loan participation purchase and sale agreements and notes payable, including secured term financing for our MSRs and our CRT arrangements which has allowed us to more closely match the term of our borrowings to the expected lives of the assets securing those borrowings. Our leverage ratio, defined as all borrowings divided by shareholders’ equity at the date presented, was 3.78 and 3.75 at December 31, 2020 and December 31, 2019, respectively.
Our repurchase agreements represent the sales of assets together with agreements for us to buy back the assets at a later date. Following is a summary of the activities in our repurchase agreements financing:
Year ended December 31,
Assets sold under agreements to repurchase
(in thousands)
Average balance outstanding
$
5,508,147
$
5,600,469
$
3,901,772
Maximum daily balance outstanding
$
10,433,609
$
8,577,065
$
6,665,118
Ending balance
$
6,309,418
$
6,648,890
$
4,777,027
The difference between the maximum and average daily amounts outstanding is primarily due to timing of loan purchases and sales in our correspondent production business. The total facility size of our assets sold under agreements to repurchase was approximately $10.9 billion at December 31, 2020.
Because a significant portion of our current debt facilities consists of short-term borrowings, we expect to either renew these facilities in advance of maturity in order to ensure our ongoing liquidity and access to capital or otherwise allow ourselves sufficient time to replace any necessary financing.
As discussed above, all of our repurchase agreements, and mortgage loan participation purchase and sale agreements have short-term maturities:
•
The transactions relating to loans and REO under agreements to repurchase generally provide for terms of approximately one to two years;
•
The transactions relating to loans under mortgage loan participation purchase and sale agreements provide for terms of approximately one year; and
•
The transactions relating to assets under notes payable provide for terms ranging from two to five years.
Our debt financing agreements require us and certain of our subsidiaries to comply with various financial covenants. As of the filing of this Report, these financial covenants include the following:
•
profitability at the Company for at least one (1) of the previous two consecutive fiscal quarters;
•
a minimum of $40 million in unrestricted cash and cash equivalents among the Company and/or our subsidiaries; a minimum of $40 million in unrestricted cash and cash equivalents among our Operating Partnership and its consolidated subsidiaries; a minimum of $25 million in unrestricted cash and cash equivalents between PMC and PMH; a minimum of $25 million in unrestricted cash and cash equivalents at PMC; and a minimum of $10 million in unrestricted cash and cash equivalents;
•
a minimum tangible net worth for the Company of $1.25 billion; a minimum tangible net worth for our Operating Partnership of $1.25 billion; a minimum tangible net worth for PMH of $250 million; and a minimum tangible net worth for PMC of $300 million;
•
a maximum ratio of total liabilities to tangible net worth of less than 10:1 for PMC and PMH and 5:1 for the Company and our Operating Partnership; and
•
at least two warehouse or repurchase facilities that finance amounts and assets similar to those being financed under our existing debt financing agreements.
Although these financial covenants limit the amount of indebtedness we may incur and impact our liquidity through minimum cash reserve requirements, we believe that these covenants currently provide us with sufficient flexibility to successfully operate our business and obtain the financing necessary to achieve that purpose.
PLS is also subject to various financial covenants, both as a borrower under its own financing arrangements and as our servicer under certain of our debt financing agreements. The most significant of these financial covenants currently include the following:
•
positive net income for at least one (1) of the previous two consecutive fiscal quarters;
•
a minimum in unrestricted cash and cash equivalents of $40 million;
•
a minimum tangible net worth of $1.25 billion;
•
a maximum ratio of total liabilities to tangible net worth of 10:1; and
•
at least one other warehouse or repurchase facility that finances amounts and assets that are similar to those being financed under certain of our existing secured financing agreements.
In addition to the financial covenants imposed upon us and PLS under our debt financing agreements, we and/or PLS, as applicable, are also subject to liquidity and net worth requirements established by FHFA for Agency sellers/servicers and Ginnie Mae for single-family issuers. FHFA and Ginnie Mae have established minimum liquidity and net worth requirements for approved non-depository single-family sellers/servicers in the case of FHFA, and for approved single-family issuers in the case of Ginnie Mae, as summarized below:
•
A minimum net worth of a base of $2.5 million plus 25 basis points of UPB for total 1-4 unit residential loans serviced;
•
A tangible net worth/total assets ratio greater than or equal to 6%;
•
Effective June 30, 2020, FHFA liquidity requirement is equal to 0.035% (3.5 basis points) of total Agency servicing UPB plus an incremental 200 basis points of the amount by which total nonperforming Agency servicing UPB (reduced by 70% of the UPB of nonperforming Agency loans that are in COVID-19 payment forbearance and were current when they entered such forbearance) exceeds 6% of the applicable Agency servicing UPB; allowable assets to satisfy liquidity requirement include cash and cash equivalents (unrestricted), certain investment-grade securities that are available for sale or held for trading including Agency mortgage-backed securities, obligations of Fannie Mae or Freddie Mac, and U.S. Treasury obligations, and unused and available portions of committed servicing advance lines;
•
In the case of PLS, liquidity equal to the greater of $1.0 million or 0.10% (10 basis points) of its outstanding Ginnie Mae single-family securities, which must be met with cash and cash equivalents; and
•
In the case of PLS, net worth equal to $2.5 million plus 0.35% (35 basis points) of its outstanding Ginnie Mae single-family obligations.
On January 31, 2020, FHFA proposed changes to the eligibility requirements:
•
A tangible net worth requirement of a base of $2.5 million plus 35 basis points of the UPB of loans serviced for Ginnie Mae and 25 basis points of the UPB of all other 1-4 unit loans serviced;
•
Liquidity equal to or exceeding four basis points multiplied by the aggregate UPB of mortgages serviced for Fannie Mae and Freddie Mac plus 10 basis points multiplied by the aggregate UPB of mortgages serviced for Ginnie Mae plus 300 basis points multiplied by the sum of nonperforming Agency Mortgage Servicing that exceeds 4% of the UPB of total Agency Mortgage Servicing; and
•
On June 15, 2020, FHFA announced that it will be re-proposing changes to these requirements.
Our debt financing agreements also contain margin call provisions that, upon notice from the applicable lender at its option, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. A margin deficit will generally result from any decline in the market value (as determined by the applicable lender) of the assets subject to the related financing agreement, although in some instances we may agree with the lender upon certain thresholds (in dollar amounts or percentages based on the market value of the assets) that must be exceeded before a margin deficit will arise. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice.
On August 7, 2020, PMC entered into a master repurchase agreement with Credit Suisse First Boston Mortgage Capital LLC, and Credit Suisse AG, Cayman Islands Branch providing PMC with the ability to finance servicing advances made to support monthly
principal and interest to mortgage-backed securities holders as well as other corporate and escrow advances related to servicing delinquent loans. The committed amount available to PMC under the master repurchase agreement is $100 million.
Our Manager continues to explore a variety of additional means of financing our growth, including debt financing through bank warehouse lines of credit, repurchase agreements, term financing, securitization transactions and additional equity offerings. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or that such efforts will be successful.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
Off-Balance Sheet Arrangements
As of December 31, 2020, we have not entered into any off-balance sheet arrangements.
All debt financing arrangements that matured between December 31, 2020 and the date of this Report have been renewed, extended or replaced.
The amount at risk (the fair value of the assets pledged plus the related margin deposit, less the amount advanced by the counterparty and accrued interest) relating to our assets sold under agreements to repurchase is summarized by counterparty below as of December 31, 2020:
Counterparty
Amount at risk
(in thousands)
Citibank, N.A.
$
144,566
Credit Suisse First Boston Mortgage Capital LLC
88,921
Morgan Stanley Bank, N.A.
75,720
Goldman Sachs & Co. LLC
59,654
Royal Bank of Canada
55,831
Barclays Capital Inc.
33,917
Bank of America, N.A.
25,746
Daiwa Capital Markets America Inc.
22,714
JPMorgan Chase & Co.
19,749
Mizuho Securities
13,041
BNP Paribas Corporate & Institutional Banking
11,197
Wells Fargo Securities, LLC
9,996
Amherst Pierpont Securities LLC
7,161
$
568,213
Management Agreement. We are externally managed and advised by our Manager pursuant to a management agreement, which requires our Manager to oversee our business affairs in conformity with the investment policies that are approved and monitored by our board of trustees. Our Manager is responsible for our day-to-day management and will perform such services and activities related to our assets and operations as may be appropriate.
Pursuant to our management agreement, our Manager collects a base management fee and may collect a performance incentive fee, both payable quarterly and in arrears. The management agreement, as amended, expires on June 30, 2025 subject to automatic renewal for additional 18-month periods, unless terminated earlier in accordance with the terms of the servicing agreement.
The base management fee is calculated at a defined annualized percentage of “shareholders’ equity.” Our “shareholders’ equity” is defined as the sum of the net proceeds from any issuances of our equity securities since our inception (weighted for the time outstanding during the measurement period); plus our retained earnings at the end of the quarter; less any amount that we pay for repurchases of our common shares (weighted for the time held during the measurement period); and excluding one-time events pursuant to changes in GAAP and certain other non-cash charges after discussions between our Manager and our independent trustees and approval by a majority of our independent trustees.
Pursuant to the terms of our management agreement, the base management fee is equal to the sum of (i) 1.5% per year of average shareholders’ equity up to $2 billion, (ii) 1.375% per year of average shareholders’ equity in excess of $2 billion and up to $5 billion, and (iii) 1.25% per year of average shareholders’ equity in excess of $5 billion.
The performance incentive fee is calculated at a defined annualized percentage of the amount by which “net income,” on a rolling four-quarter basis and before deducting the incentive fee, exceeds certain levels of annualized return on our “equity.” For the purpose of determining the amount of the performance incentive fee, “net income” is defined as net income attributable to common shares or loss computed in accordance with GAAP and adjusted to exclude one-time events pursuant to changes in GAAP and certain other non-cash charges determined after discussions between PCM and our independent trustees and approval by a majority of our independent trustees. For this purpose, “equity” is the weighted average of the issue price per common share of all of our public offerings of common shares, multiplied by the weighted average number of common shares outstanding (including restricted share units issued under our equity incentive plans) in the four-quarter period.
The performance incentive fee is calculated quarterly and is equal to: (a) 10% of the amount by which net income attributable to common shares of beneficial interest for the quarter exceeds (i) an 8% return on equity plus the high watermark, up to (ii) a 12% return on equity; plus (b) 15% of the amount by which net income for the quarter exceeds (i) a 12% return on equity plus the high watermark, up to (ii) a 16% return on equity; plus (c) 20% of the amount by which net income for the quarter exceeds a 16% return on equity plus the high watermark.
The “high watermark” is the quarterly adjustment that reflects the amount by which the net income (stated as a percentage of return on equity) in that quarter exceeds or falls short of the lesser of 8% and the Fannie Mae MBS yield (the target yield) for such quarter. The “high watermark” starts at zero and is adjusted quarterly. If the net income is lower than the target yield, the high watermark is increased by the difference. If the net income is higher than the target yield, the high watermark is reduced by the difference. Each time a performance incentive fee is earned, the high watermark returns to zero. As a result, the threshold amounts required for PCM to earn a performance incentive fee are adjusted cumulatively based on the performance of our net income over (or under) the target yield, until the net income in excess of the target yield exceeds the then-current cumulative high watermark amount, and a performance incentive fee is earned.
Under the management agreement, PCM is entitled to reimbursement of its organizational and operating expenses, including third-party expenses, incurred on our behalf, it being understood that PCM and its affiliates shall allocate a portion of their personnel’s time to provide certain legal, tax and investor relations services for our direct benefit. With respect to the allocation of PCM’s and its affiliates’ personnel, PCM was reimbursed $120,000 per fiscal quarter through June 30, 2020 and is reimbursed $165,000 per fiscal quarter from and after July 1, 2020, such amount to be reviewed annually and to not preclude reimbursement for any other services performed by PCM or its affiliates.
We are required to pay PCM and its affiliates a pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of PCM and its affiliates required for our and our subsidiaries’ operations. These expenses will be allocated based on the ratio of our and our subsidiaries’ proportion of gross assets compared to all remaining gross assets managed by PCM as calculated at each fiscal quarter end.
PCM may also be entitled to a termination fee under certain circumstances. Specifically, the termination fee is payable for (1) our termination of our management agreement without cause, (2) PCM’s termination of our management agreement upon a default by us in the performance of any material term of the agreement that has continued uncured for a period of 30 days after receipt of written notice thereof or (3) PCM’s termination of the agreement after the termination by us without cause (excluding a non-renewal) of our MBS agreement, our MSR recapture agreement or our servicing agreement (each as described and/or defined below). The termination fee is equal to three times the sum of (a) the average annual base management fee and (b) the average annual (or, if the period is less than 24 months, annualized) performance incentive fee earned by our Manager during the 24-month period immediately preceding the date of termination.
We may terminate the management agreement without the payment of any termination fee under certain circumstances, including, among other circumstances, uncured material breaches by our Manager of the management agreement, upon a change in control of our Manager (defined to include a 50% change in the shareholding of our Manager in a single transaction or related series of transactions).
Our management agreement also provides that, prior to the undertaking by PCM or its affiliates of any new investment opportunity or any other business opportunity requiring a source of capital with respect to which PCM or its affiliates will earn a management, advisory, consulting or similar fee, PCM shall present to us such new opportunity and the material terms on which PCM proposes to provide services to us before pursuing such opportunity with third parties.
Servicing Agreement. We have entered into a loan servicing agreement with PLS, pursuant to which PLS provides servicing for our portfolio of residential loans and subservicing for our portfolio of MSRs. Such servicing and subservicing provided by PLS include collecting principal, interest and escrow account payments, if any, with respect to loans, as well as managing loss mitigation, which may include, among other things, collection activities, loan workouts, modifications, foreclosures and short sales. PLS also engages in certain loan origination activities that include refinancing loans and financings that facilitate sales of real estate owned properties, or REOs.
The base servicing fee rates for distressed whole loans are charged based on a monthly per-loan dollar amount, with the actual dollar amount for each loan based on the delinquency, bankruptcy and/or foreclosure status of such loan or whether the underlying mortgage property has become REO. The base servicing fee rates for distressed whole loans range from $30 per month for current loans up to $85 per month for loans where the borrower has declared bankruptcy. The base servicing fee rate for REO is $75 per month. To the extent that we rent our REO under our REO rental program, we pay PLS an REO rental fee of $30 per month per REO, an REO property lease renewal fee of $100 per lease renewal, and a property management fee in an amount equal to PLS’ cost if property management services and/or any related software costs are outsourced to a third-party property management firm or 9% of gross rental income if PLS provides property management services directly. PLS is also entitled to retain any tenant paid application fees and late rent fees and seek reimbursement for certain third-party vendor fees.
PLS is also entitled to certain activity-based fees for distressed whole loans that are charged based on the achievement of certain events. These fees range from $750 for a streamline modification to $1,750 for a full modification or liquidation and $500 for a deed-in-lieu of foreclosure. PLS is not entitled to earn more than one liquidation fee, re-performance fee or modification fee per loan in any 18-month period.
The base servicing fee rates for non-distressed loans subserviced by PLS on our behalf are also calculated through a monthly per-loan dollar amount, with the actual dollar amount for each loan based on whether the loan is a fixed-rate or adjustable-rate loan. The base servicing fee rates for loans subserviced on our behalf are $7.50 per month for fixed-rate loans and $8.50 per month for adjustable-rate loans. To the extent that these loans become delinquent, PLS is entitled to an additional servicing fee per loan falling within a range of $10 to $55 per month and based on the delinquency, bankruptcy and foreclosure status of the loan or $75 per month if the underlying mortgaged property becomes REO. PLS is also entitled to customary ancillary income and certain market-based fees and charges, including boarding and deboarding fees, liquidation and disposition fees, and assumption, modification and origination fees, as well as certain fees for COVID-19 related forbearance and modification activities provided for under the CARES Act.
In addition, because we have limited employees and infrastructure, PLS is required to provide a range of services and activities significantly greater in scope than the services provided in connection with a customary servicing arrangement. For these services, PLS receives a supplemental servicing fee of $25 per month for each distressed whole loan. PLS is entitled to reimbursement for all customary, good faith reasonable and necessary out-of-pocket expenses incurred by PLS in the performance of its servicing obligations.
Except as otherwise provided in our MSR recapture agreement, when PLS effects a refinancing of a loan on our behalf and not through a third-party lender and the resulting loan is readily saleable, or PLS originates a loan to facilitate the disposition of the real estate acquired by us in settlement of a loan, PLS is entitled to receive from us market-based fees and compensation consistent with pricing and terms PLS offers unaffiliated third parties on a retail basis.
We currently participate in HAMP (or other similar loan modification programs). HAMP establishes standard loan modification guidelines for “at risk” homeowners and provides incentive payments to certain participants, including loan servicers, for achieving modifications and successfully remaining in the program. The loan servicing agreement entitles PLS to retain any incentive payments made to it and to which it is entitled under HAMP; provided, however, that with respect to any such incentive payments paid to PLS in connection with a loan modification for which we previously paid PLS a modification fee, PLS is required to reimburse us an amount equal to the incentive payments.
PLS continues to be entitled to reimbursement for all customary, bona fide reasonable and necessary out-of-pocket expenses incurred by PLS in connection with the performance of its servicing obligations.
Mortgage Banking Services Agreement. Pursuant to a mortgage banking services agreement (the “MBS agreement”), PLS provides us with certain mortgage banking services, including fulfillment and disposition-related services, with respect to loans acquired by us from correspondent sellers.
Pursuant to the MBS agreement, PLS has agreed to provide such services exclusively for our benefit, and PLS and its affiliates are prohibited from providing such services for any other third party. However, such exclusivity and prohibition shall not apply, and
certain other duties instead will be imposed upon PLS, if we are unable to purchase or finance loans as contemplated under our MBS agreement for any reason.
In consideration for the mortgage banking services provided by PLS with respect to our acquisition of loans, through June 30, 2020, PLS was entitled to a monthly fulfillment fee that shall equal (a) no greater than the product of (i) 0.35% and (ii) the aggregate initial unpaid principal balance (the “Initial UPB”) of all loans purchased in such month, plus (b) in the case of all loans other than loans sold to or securitized through Fannie Mae or Freddie Mac, no greater than the product of (i) 0.50% and (ii) the aggregate Initial UPB of all such loans sold and securitized in such month; provided however, that no fulfillment fee shall be due or payable to PLS with respect to any Ginnie Mae loans. We do not hold the Ginnie Mae approval required to issue Ginnie Mae MBS and act as a servicer. Accordingly, under the MBS agreement, PLS currently purchases loans underwritten in accordance with the Ginnie Mae Mortgage-Backed Securities Guide “as is” and without recourse of any kind from us at our cost less an administrative fee plus accrued interest and a sourcing fee ranging from two to three and one-half basis points, generally based on the average number of calendar days that loans are held by us prior to purchase by PLS.
Effective July 1, 2020, the fulfillment fees and sourcing fees were revised as follows:
•
Fulfillment fees shall not exceed the following:
(i)
the number of loan commitments multiplied by a pull-through factor of either .99 or .80 depending on whether the loan commitments are subject to a “mandatory trade confirmation” or a “best efforts lock confirmation”, respectively, and then multiplied by $585 for each pull-through adjusted loan commitment up to and including 16,500 per quarter and $355 for each pull-through adjusted loan commitment in excess of 16,500 per quarter, plus
(ii)
$315 multiplied by the number of purchased loans up to and including 16,500 per quarter and $195 multiplied by the number of purchased loans in excess of 16,500 per quarter, plus
(iii)
$750 multiplied by the number of all purchased loans that are sold or securitized to parties other than Fannie Mae and Freddie Mac; provided, however, that no fulfillment fee shall be due or payable to PLS with respect to any Ginnie Mae loans.
•
Sourcing fees charged to PLS range from one to two basis points, generally based on the average number of calendar days the loans are held by us before purchase by PLS.
In consideration for the mortgage banking services provided by PLS with respect to our acquisition of loans under PLS’ early purchase program, PLS is entitled to fees accruing (i) at a rate equal to $1,500 per year per early purchase facility administered by PLS, and (ii) in the amount of $35 for each loan that we acquire thereunder.
Notwithstanding any provision of the MBS agreement to the contrary, if it becomes reasonably necessary or advisable for PLS to engage in additional services in connection with post-breach or post-default resolution activities for the purposes of a correspondent agreement, then we have generally agreed with PLS to negotiate in good faith for additional compensation and reimbursement of expenses to be paid to PLS for the performance of such additional services.
MSR Recapture Agreement. Through June 30, 2020, pursuant to the terms of the MSR recapture agreement entered into by PMC with PLS, if PLS refinanced through its consumer direct lending business loans for which we previously held the MSRs, PLS was generally required to transfer and convey to PMC, cash in an amount equal to 30% of the fair market value of the MSRs related to all such loans so originated.
Effective July 1, 2020, the 2020 MSR recapture agreement changes the recapture fee payable by PLS to a tiered amount equal to:
•
40% of the fair market value of the MSRs relating to the recaptured loans subject to the first 15% of the “recapture rate”;
•
35% of the fair market value of the MSRs relating to the recaptured loans subject to the recapture rate in excess of 15% and up to 30%; and
•
30% of the fair market value of the MSRs relating to the recaptured loans subject to the recapture rate in excess of 30%.
The “recapture rate” means, during each month, the ratio of (i) the aggregate unpaid principal balance of all recaptured loans, to (ii) the aggregate unpaid principal balance of all mortgage loans for which the Company held the MSRs and that were refinanced or otherwise paid off in such month. The Company has further agreed to allocate sufficient resources to target a recapture rate of 15%.
Spread Acquisition and MSR Servicing Agreement. On December 19, 2016, we amended and restated a master spread acquisition and MSR servicing agreement with PLS (the “12/19/16 Spread Acquisition Agreement”). Pursuant to the 12/19/16 Spread Acquisition Agreement, we may acquire from PLS, from time to time, the right to receive participation certificates representing
beneficial ownership in ESS arising from Ginnie Mae MSRs acquired by PLS, in which case PLS generally would be required to service or subservice the related loans for Ginnie Mae. The primary purpose of the amendment and restatement was to facilitate the continued financing of the ESS owned by us in connection with the parties’ participation in the GNMA MSR Facility (as defined below).
To the extent PLS refinances any of the loans relating to the ESS we have acquired, the 12/19/16 Spread Acquisition Agreement also contains recapture provisions requiring that PLS transfer to us, at no cost, the ESS relating to a certain percentage of the unpaid principal balance of the newly originated loans. However, under the 12/19/16 Spread Acquisition Agreement, in any month where the transferred ESS relating to newly originated Ginnie Mae loans is not equivalent to at least 90% of the product of the excess servicing fee rate and the unpaid principal balance of the refinanced loans, PLS is also required to transfer additional ESS or cash in the amount of such shortfall. Similarly, in any month where the transferred ESS relating to modified Ginnie Mae loans is not equivalent to at least 90% of the product of the excess servicing fee rate and the unpaid principal balance of the modified loans, the 12/19/16 Spread Acquisition Agreement contains provisions that require PLS to transfer additional ESS or cash in the amount of such shortfall. To the extent the fair market value of the aggregate ESS to be transferred for the applicable month is less than $200,000, PLS may, at its option, wire cash to us in an amount equal to such fair market value in lieu of transferring such ESS.
Master Repurchase Agreement with PLS. On December 19, 2016, we, through PMH, entered into a master repurchase agreement with PLS (the “PMH Repurchase Agreement”), pursuant to which PMH may borrow from PLS for the purpose of financing PMH’s participation certificates representing beneficial ownership in ESS acquired from PLS under the 12/19/16 Spread Acquisition Agreement. PLS then re-pledges such participation certificates to PNMAC GMSR ISSUER TRUST (the “Issuer Trust”) under a master repurchase agreement by and among PLS, the Issuer Trust and Private National Mortgage Acceptance Company, LLC, as guarantor (the “PC Repurchase Agreement”). The Issuer Trust was formed for the purpose of allowing PLS to finance MSRs and ESS relating to such MSRs (the “GNMA MSR Facility”).
In connection with the GNMA MSR Facility, PLS pledges and/or sells to the Issuer Trust participation certificates representing beneficial interests in MSRs and ESS pursuant to the terms of the PC Repurchase Agreement. In return, the Issuer Trust (a) has issued to PLS, pursuant to the terms of an indenture, the Series 2016-MSRVF1 Variable Funding Note, dated December 19, 2016, known as the “PNMAC GMSR ISSUER TRUST MSR Collateralized Notes, Series 2016-MSRVF1” (the “VFN”), and (b) has issued and may, from time to time pursuant to the terms of any supplemental indenture, issue to institutional investors additional term notes (“Term Notes”), in each case secured on a pari passu basis by the participation certificates relating to the MSRs and ESS. The maximum principal balance of the VFN is $1,000,000,000.
The principal amount paid by PLS for the participation certificates under the PMH Repurchase Agreement is based upon a percentage of the market value of the underlying ESS. Upon PMH’s repurchase of the participation certificates, PMH is required to repay PLS the principal amount relating thereto plus accrued interest (at a rate reflective of the current market and consistent with the weighted average note rate of the VFN and any outstanding Term Notes) to the date of such repurchase. PLS is then required to repay the Issuer Trust the corresponding amount under the PC Repurchase Agreement.
As a condition to our entry into the 12/19/16 Spread Acquisition Agreement and our participation in the GNMA MSR Facility, we were also required to enter into a subordination, acknowledgement and pledge agreement (the “Subordination Agreement”). Under the terms of the Subordination Agreement, we pledged to the Issuer Trust our rights under the 12/19/16 Spread Acquisition Agreement and our interest in any ESS purchased thereunder.
The Subordination Agreement contains representations, warranties and covenants by us that are substantially similar to those contained in our other financing arrangements. To the extent there exists an event of default under the PC Repurchase Agreement or a “trigger event” (as defined in the Subordination Agreement), the Issuer Trust would be entitled to liquidate any and all of the collateral securing the PC Repurchase Agreement, including the ESS subject to the PMH Repurchase Agreement.
Loan Purchase Agreement. We have entered into a loan purchase agreement with our Servicer. Currently, we use the loan purchase agreement for the purpose of acquiring prime jumbo and Agency-eligible residential loans originated by our Servicer through its consumer direct lending channel. The loan purchase agreement contains customary terms and provisions, including representations and warranties, covenants, repurchase remedies and indemnities. The purchase prices we pay our Servicer for such loans are market-based.
Reimbursement Agreement. In connection with the initial public offering of our common shares on August 4, 2009 (the “IPO”), we entered into an agreement with PCM pursuant to which we agreed to reimburse PCM for the $2.9 million payment that it made to the underwriters for the IPO (the “Conditional Reimbursement”) if we satisfied certain performance measures over a specified period of time. Effective February 1, 2013, we amended the terms of the reimbursement agreement to provide for the reimbursement of PCM
of the Conditional Reimbursement if we are required to pay PCM performance incentive fees under our management agreement at a rate of $10 in reimbursement for every $100 of performance incentive fees earned. The reimbursement of the Conditional Reimbursement is subject to a maximum reimbursement in any particular 12-month period of $1.0 million and the maximum amount that may be reimbursed under the agreement is $2.9 million. The reimbursement agreement also provides for the payment to the IPO underwriters of the payment that we agreed to make to them at the time of the IPO if we satisfied certain performance measures over a specified period of time. As PCM earns performance incentive fees under our management agreement, the IPO underwriters will be paid at a rate of $20 of payments for every $100 of performance incentive fees earned by PCM. The payment to the underwriters is subject to a maximum reimbursement in any particular 12-month period of $2.0 million and the maximum amount that may be paid under the agreement is $5.9 million.
In the event the termination fee is payable to our Manager under our management agreement and our Manager and the underwriters have not received the full amount of the reimbursements and payments under the reimbursement agreement, such amount will be paid in full. On February 1, 2019, the term of the reimbursement agreement was extended, and it now expires on February 1, 2023.
Item 6A.
Quantitative and Qualitative Disclosures About Market Risk
Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices, real estate values and other market-based risks. The primary market risks that we are exposed to are real estate risk, credit risk, interest rate risk, prepayment risk, inflation risk and market value risk. Our primary trading asset is our inventory of loans acquired for sale. We believe that such assets’ fair values respond primarily to changes in the market interest rates for comparable recently-originated loans. Our other market-risk assets are a substantial portion of our investments and are primarily comprised of MSRs, ESS, CRT arrangements and MBS. We believe that the fair values of MSRs, ESS and MBS also respond primarily to changes in the market interest rates for comparable loans or yields on MBS. Changes in interest rates are reflected in the prepayment speeds underlying these investments and in the pricing spread (an element of the discount rate) used in their valuation. We believe that the primary market risks to the fair values of our investment in CRT arrangements are changes in market credit spreads and the fair value of the real estate securing the loans underlying such arrangements.
Real Estate Risk
Residential property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions (such as an oversupply of housing); construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. Decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay loans, which could cause us to suffer losses.
Credit Risk
We are subject to credit risk in connection with our investments. A significant portion of our assets is comprised of residential loans. The credit risk related to these investments pertains to the ability and willingness of the borrowers to pay, which is assessed before credit is granted. We believe that residual loan credit quality is primarily determined by the borrowers’ credit profiles and loan characteristics. We have entered into CRT arrangements which involve the absorption on our part of losses relating to certain loans we sell that subsequently default. The fair value of the assets we carry related to these arrangements are sensitive to credit market conditions generally, perceptions of the performance of the loans in our CRT arrangements’ reference pools specifically and to the actual performance of such loans.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in interest rates affect the fair value of interest income and net servicing income we earn from our mortgage-related investments. This effect is most pronounced with fixed-rate investments, MSRs and ESS. Changes in interest rates significantly influence the prepayment speed of the loans underlying our investment in MSRs and ESS which affects those assets’ estimated lives. In general, rising interest rates negatively affect the fair value of our investments in MBS and loans, while decreasing market interest rates negatively affect the fair value of our MSRs and ESS.
Our operating results will depend, in part, on differences between the income from our investments and our financing costs. Presently much of our debt financing is based on a floating rate of interest calculated on a fixed spread over the relevant index, as determined by the particular financing arrangement.
In the event of a significant rising interest rate environment and/or economic downturn, defaults could increase and result in credit losses to us, which could materially and adversely affect our business, financial condition, liquidity, results of operations and prospects. Furthermore, such defaults could have an adverse effect on the spread between our interest earning assets and interest bearing liabilities.
We engage in interest rate risk management activities in an effort to reduce the variability of earnings caused by changes in interest rates. To manage this price risk resulting from interest rate risk, we use derivative financial instruments acquired with the intention of moderating the risk that changes in market interest rates will result in unfavorable changes in the value of our interest rate lock commitments, inventory of loans acquired for sale, MBS, ESS, loans and MSRs. We do not use derivative financial instruments for purposes other than in support of our risk management activities.
Prepayment Risk
To the extent that the actual prepayment rate on our mortgage-based investments differs from what we projected when we purchased the loans and when we measured fair value as of the end of each reporting period, our unrealized gain or loss will be affected. As we receive prepayments of principal on our MBS investments, any premiums paid for such investments will be amortized against interest income using the interest method through the expected maturity dates of the investments. In general, an increase in prepayment rates will accelerate the amortization of purchase premiums, thereby reducing the interest income earned on such MBS investments and will accelerate the fair value decline of MSRs and ESS thereby reducing net servicing income. Conversely, as we receive prepayments of principal on our investments, any discounts realized on the purchase of such investments will be accrued into interest income using the interest method through the expected maturity dates of the investments. In general, an increase in prepayment rates will accelerate the accrual of purchase discounts, thereby increasing the interest income earned on such MBS investments.
Inflation Risk
Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors will influence our performance more so than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Furthermore, our consolidated financial statements are prepared in accordance with GAAP and any distributions we may make to our shareholders will be determined by our board of trustees based primarily on our taxable income and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair value without considering inflation.
Risk Management Activities
We engage in risk management activities primarily in an effort to mitigate the effect of changes in interest rates on the fair value of our assets. To manage this price risk, we use derivative financial instruments acquired with the intention of moderating the risk that changes in market interest rates will result in unfavorable changes in the fair value of our assets, primarily on our MSR investments as well as IRLCs and our inventory of loans held for sale. Our objective is to minimize our hedging expense and maximize our loss coverage based on a given hedge expense target. We do not use derivative financial instruments other than IRLCs and repurchase agreement derivatives (both of which arise from our operations) for purposes other than in support of our risk management activities.
Our strategies are reviewed daily within a disciplined risk management framework. We use a variety of interest rate and spread shifts and scenarios and define target limits for market value and liquidity loss in those scenarios. With respect to our IRLCs and inventory of loans held for sale, we use MBS forward sale contracts to lock in the price at which we will sell the mortgage loans or resulting MBS, and further use MBS put options to mitigate the risk of our IRLCs not closing at the rate we expect. With respect to our MSRs and other interest rate sensitive assets and liabilities, we seek to mitigate mortgage-based loss exposure utilizing MBS forward purchase and sale contracts, address exposures to smaller interest rate shifts with Treasury and interest rate swap futures, and use options and swaptions to achieve target coverage levels for larger interest rate shocks.
Fair Value Risk
Our loans, MBS, MSRs, ESS and CRT arrangements are reported at their fair values. The fair value of these assets fluctuates primarily based on the exposure of the underlying investment. Performing prime loans (along with any related recognized IRLCs), MBS, MSRs and ESS are more sensitive to changes in market interest rates, while CRT arrangements are more sensitive to changes in the market credit spreads, underlying real estate values relating to the loans underlying our investments, and other factors such as the effectiveness and servicing practices of the servicers associated with the properties securing such investment.
Generally, in an interest rate market where interest rates are rising or are expected to rise, the fair value of our loans and MBS would be expected to decrease, whereas in an interest rate market where interest rates are generally decreasing or are expected to
decrease, loan and MBS values would be expected to increase. The fair value of MSRs and ESS, on the other hand, tends to respond generally in an opposite manner to that of loans acquired for sale and MBS.
Generally, in a real estate market where values are rising or are expected to rise, the fair value of our investment in distressed loans and CRT arrangements would be expected to appreciate, whereas in a real estate market where values are generally dropping or are expected to drop, the fair values of distressed loans and CRT arrangements would be expected to decrease.
The following sensitivity analyses are limited in that they were performed at a particular point in time; only contemplate the movements in the indicated variables; do not incorporate changes to other variables; are subject to the accuracy of various models and inputs used; and do not incorporate other factors that would affect our overall financial performance in such scenarios, including operational adjustments made by management to account for changing circumstances. For these reasons, the following estimates should not be viewed as earnings forecasts.
Mortgage-backed securities at fair value
The following table summarizes the estimated change in fair value of our mortgage-backed securities as of December 31, 2020, given several hypothetical (instantaneous) changes in interest rates and parallel shifts in the yield curve:
Interest rate shift in basis points
(dollar in thousands)
Change in fair value
$
(29,276
)
$
18,083
$
15,781
$
(30,047
)
$
(51,977
)
$
(199,724
)
Mortgage Servicing Rights
The following tables summarize the estimated change in fair value of MSRs as of December 31, 2020, given several shifts in pricing spread, prepayment speeds and annual per-loan cost of servicing:
Change in fair value attributable to shift in:
-20%
-10%
-5%
+5%
+10%
+20%
(dollars in thousands)
Pricing spread
$
137,547
$
66,266
$
32,536
$
(31,400
)
$
(61,718
)
$
(119,305
)
Prepayment speed
$
215,420
$
102,856
$
50,287
$
(48,136
)
$
(94,244
)
$
(180,820
)
Annual per-loan cost of servicing
$
47,385
$
23,692
$
11,846
$
(11,846
)
$
(23,692
)
$
(47,385
)
Excess servicing spread
The following tables summarize the estimated change in fair value of our ESS as of December 31, 2020, given several shifts in pricing spread and prepayment speed:
Change in fair value attributable to shift in:
-20%
-10%
-5%
+5%
+10%
+20%
(dollars in thousands)
Pricing spread
$
5,766
$
2,824
$
1,397
$
(1,369
)
$
(2,711
)
$
(5,316
)
Prepayment speed
$
13,977
$
6,701
$
3,282
$
(3,154
)
$
(6,185
)
$
(11,907
)
CRT arrangements
Following is a summary of the effect on fair value of various changes to the pricing spread input used to estimate the fair value of our CRT arrangements given several shifts in pricing spread:
Pricing spread shift in basis points
(dollars in thousands)
Change in fair value
$
72,070
$
35,522
$
17,634
$
(17,392
)
$
(34,540
)
$
(68,135
)
Following is a summary of the effect on fair value of various instantaneous changes in home values from those used to estimate the fair value of our CRT arrangements given several shifts:
Property value shift in %
-15%
-10%
-5%
5%
10%
15%
(dollars in thousands)
Change in fair value
$
(145,221
)
$
(85,621
)
$
(35,451
)
$
28,619
$
51,509
$
70,024
Loans at Fair Value
The following table summarizes the estimated change in fair value of our loans at fair value held by VIE as of December 31, 2020, net of the effect of changes in fair value of the related asset-backed financing of the VIE at fair value, given several hypothetical (instantaneous) changes in interest rates and parallel shifts in the yield curve:
Interest rate shift in basis points
(dollar in thousands)
Change in fair value
$
(155
)
$
$
$
(102
)
$
(191
)
$
(891
)

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Item 8.
Financial Statements and Supplementary Data
The information called for by this Item 8 is hereby incorporated by reference from our Financial Statements and Auditors’ Report beginning at page of this Report.

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None

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ITEM 9A. CONTROLS AND PROCEDURES
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. However, no matter how well a control system is designed and operated, it can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in our periodic reports.
Our management has conducted an evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act. Based on our evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective, as of the end of the period covered by this Report, to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Exchange Act Rule 13a-15(f). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of its internal control over financial reporting based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on those criteria, management concluded that our internal control over financial reporting was effective as of December 31, 2020.
The effectiveness of our internal control over financial reporting as of December 31, 2020 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Trustees of
PennyMac Mortgage Investment Trust
Opinion on Internal Control over Financial Reporting
We have audited the internal control over financial reporting of PennyMac Mortgage Investment Trust and subsidiaries (the “Company”) as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control-Integrated Framework (2013) issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2020, of the Company and our report dated February 26, 2021, expressed an unqualified opinion on those financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Los Angeles, California
February 26, 2021
Changes in Internal Control over Financial Reporting
There have been no changes in internal control over financial reporting during the quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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ITEM 9B. OTHER INFORMATION
Item 9B.
Other Information
None.
PART III

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ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Item 10.
Directors, Executive Officers and Corporate Governance
The information required by this Item 10 is hereby incorporated by reference from our definitive proxy statement, or will be contained in an amendment to this Report, in either case to be filed by April 30, 2021, which is within 120 days after the end of fiscal year 2020.

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ITEM 11. EXECUTIVE COMPENSATION
Item 11.
Executive Compensation
The information required by this Item 11 is hereby incorporated by reference from our definitive proxy statement, or will be contained in an amendment to this Report, in either case to be filed by April 30, 2021, which is within 120 days after the end of fiscal year 2020.

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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Equity Compensation Plan Information
The PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan (the “2019 Plan”) was adopted and approved by the Company’s shareholders in June 2019. The PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan (the “2009 Plan”) expired on July 24, 2019; however, there are outstanding equity awards under the 2009 Plan that remain subject to the terms of such plan. The 2019 Plan provides for the issuance of equity based awards, including share options, restricted shares, restricted share units, unrestricted common share awards, LTIP units (a special class of partnership interests in our Operating Partnership) and other awards based on our shares that may be awarded by us to our officers and trustees, and the members, officers, trustees, directors and employees of PFSI and its subsidiaries or other entities that provide services to us and the employees of such other entities. The 2019 Plan is administered by our compensation committee, pursuant to authority delegated by our board of trustees, which has the authority to make awards to the eligible participants referenced above, and to determine what form the awards will take, and the terms and conditions of the awards. The 2019 Plan allows for grants of equity-based awards up to an aggregate of 8% of our issued and outstanding common shares on a diluted basis at the time of the award. However, the total number of shares available for issuance under the 2019 Plan cannot exceed 40 million.
The following table provides information as of December 31, 2020 concerning our common shares authorized for issuance under our equity incentive plan.
(a)
(b)
(c)
Plan category
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
Weighted average
exercise price of
outstanding options,
warrants and rights
Number of securities
remaining available for
future issuance under
equity compensation
plans excluding
securities reflected
in column(a))
Equity compensation plans approved by
security holders (1)
392,459
$
-
8,008,082
Equity compensation plans not approved
by security holders (2)
-
-
-
Total
392,459
-
8,008,082
(1)
Represents equity awards outstanding under the 2009 Plan and the 2019 Plan.
(2)
We do not have any equity plans that have not been approved by our shareholders.
The information otherwise required by this Item 12 is hereby incorporated by reference from our definitive proxy statement, or will be contained in an amendment to this Report, in either case to be filed by April 30, 2021, which is within 120 days after the end of fiscal year 2020.

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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by this Item 13 is hereby incorporated by reference from our definitive proxy statement, or will be contained in an amendment to this Report, in either case to be filed by April 30, 2021, which is within 120 days after the end of fiscal year 2020.

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ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Item 14.
Principal Accounting Fees and Services
The information required by this Item 14 is hereby incorporated by reference from our definitive proxy statement, or will be contained in an amendment to this Report, in either case to be filed by April 30, 2021, which is within 120 days after the end of fiscal year 2020.
PART IV

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ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Item 15.
Exhibits and Financial Statement Schedules
Incorporated by Reference from the Below-Listed Form (Each Filed under SEC File Number 14-64423)
Exhibit
No.
Exhibit Description
Form
Filing Date
3.1
Declaration of Trust of PennyMac Mortgage Investment Trust, as amended and restated.
10-Q
November 6, 2009
3.2
Second Amended and Restated Bylaws of PennyMac Mortgage Investment Trust.
8-K
March 16, 2018
3.3
Articles Supplementary classifying and designating the 8.125% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest.
8-A
March 7, 2017
3.4
Articles Supplementary classifying and designating the 8.00% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest.
8-A
June 30, 2017
4.1
Specimen Common Share Certificate of PennyMac Mortgage Investment Trust.
10-Q
November 6, 2009
4.2
Specimen Certificate for 8.125% Series A Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest.
8-A
March 7, 2017
4.3
Specimen Certificate for 8.00% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Shares of Beneficial Interest.
8-A
June 30, 2017
4.4
Indenture for Senior Debt Securities, dated as of April 30, 2013, among PennyMac Corp., PennyMac Mortgage Investment Trust and The Bank of New York Mellon Trust Company, N.A.
8-K
April 30, 2013
4.5
Second Supplemental Indenture, dated as of November 7, 2019, among PennyMac Corp., PennyMac Mortgage Investment Trust and The Bank of New York Mellon Trust Company, N.A.
8-K
November 8, 2019
4.6
Form of 5.50% Exchangeable Senior Notes due 2024 (included in Exhibit 4.5).
8-K
November 8, 2019
4.7
Description of Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934.
10-K
February 21, 2020
10.1
Amended and Restated Limited Partnership Agreement of PennyMac Operating Partnership, L.P.
10-Q
November 6, 2009
10.2
First Amendment to the Amended and Restated Limited Partnership Agreement of PennyMac Operating Partnership, L.P., dated as of March 9, 2017.
8-K
March 9, 2017
10.3
Second Amendment to the Amended and Restated Limited Partnership Agreement of PennyMac Operating Partnership, L.P., dated as of July 5, 2017.
8-K
July 6, 2017
10.4
Registration Rights Agreement, dated as of August 4, 2009, among PennyMac Mortgage Investment Trust, Stanford L. Kurland, David A. Spector, BlackRock Holdco 2, Inc., Highfields Capital Investments LLC and Private National Mortgage Acceptance Company, LLC.
10-Q
November 6, 2009
10.5
Second Amended and Restated Underwriting Fee Reimbursement Agreement, dated as of February 1, 2019, by and among PennyMac Mortgage Investment Trust, PennyMac Operating Partnership, L.P. and PNMAC Capital Management, LLC.
10-K
February 26, 2019
10.6
Third Amended and Restated Management Agreement, dated as of June 30, 2020, by and among PennyMac Mortgage Investment Trust, PennyMac Operating Partnership, L.P. and PNMAC Capital Management, LLC.
8-K
July 2, 2020
10.7
Fourth Amended and Restated Flow Servicing Agreement, dated as of June 30, 2020, between PennyMac Operating Partnership, L.P. and PennyMac Loan Services, LLC.
10-Q
July 2, 2020
10.8
Second Amended and Restated Mortgage Banking Services Agreement, dated as of June 30, 2020, between PennyMac Loan Services, LLC and PennyMac Corp.
8-K
July 2, 2020
10.9
Amendment No. 1 to Second Amended and Restated Mortgage Banking Services Agreement, dated as of December 8, 2020, between PennyMac Loan Services, LLC and PennyMac Corp.
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10.10
Second Amended and Restated MSR Recapture Agreement, dated as of June 30, 2020, between PennyMac Loan Services, LLC and PennyMac Corp.
8-K
July 2, 2020
10.11
Amendment No. 1 to Second Amended and Restated MSR Recapture Agreement, dated as of December 8, 2020, between PennyMac Loan Services, LLC and PennyMac Corp.
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10.12
Mortgage Loan Purchase Agreement, dated as of September 25, 2012, by and between PennyMac Loan Services, LLC and PennyMac Corp.
10-K
February 29, 2016
10.13
Flow Sale Agreement, dated as of June 16, 2015, by and between PennyMac Corp. and PennyMac Loan Services, LLC.
10-Q
August 10, 2015
10.14
HELOC Flow Purchase and Servicing Agreement, dated as of February 25, 2019, by and between PennyMac Loan Services, LLC and PennyMac Corp.
10-Q
May 5, 2019
10.15†
PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan.
10-Q
November 6, 2009
10.16†
First Amendment to the PennyMac Mortgage Investment Trust Equity Incentive Plan.
10-Q
November 8, 2017
10.17†
Second Amendment to the PennyMac Mortgage Investment Trust Equity Incentive Plan.
10-K
March 1, 2018
10.18†
PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan.
DEF 14A
April 22, 2019
10.19†
Form of Performance Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan (2018).
10-Q
August 7, 2018
10.20†
Form of Restricted Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan (2019).
10-Q
February 26, 2019
10.21†
Form of Performance Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan (2019).
10-Q
February 26, 2019
10.22†
Form of Restricted Share Unit Award Agreement for Non-Employee Trustee under the PennyMac Mortgage Investment Trust 2009 Equity Incentive Plan (2019).
10-Q
May 3, 2019
10.23†
Form of Performance Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan (2020 MBOs).
10-Q
May 8, 2020
10. 24†
Form of Performance Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan (Net Share Withholding) (2020).
10-Q
May 8, 2020
10.25†
Form of Restricted Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan (Net Share Withholding) (2020).
10-Q
May 8, 2020
10.26†
Form of Restricted Share Unit Award Agreement under the PennyMac Mortgage Investment Trust 2019 Equity Incentive Plan (Non Employee Trustee) (2020).
10-Q
May 8, 2020
10.27
Second Amended and Restated Master Spread Acquisition and MSR Servicing Agreement, dated as of December 19, 2016, between PennyMac Loan Services, LLC and PennyMac Holdings, LLC.
8-K
December 21, 2016
10.28
Master Repurchase Agreement, dated as of December 19, 2016, by and among PennyMac Holdings, LLC, as Seller, PennyMac Loan Services, LLC, as Buyer, and PennyMac Mortgage Investment Trust, as Guarantor.
8-K
December 21, 2016
10.29
Guaranty, dated as of December 19, 2016, by PennyMac Mortgage Investment Trust, in favor of PennyMac Loan Services, LLC.
8-K
December 21, 2016
10.30
Subordination, Acknowledgment and Pledge Agreement, dated as of December 19, 2016, between PNMAC GMSR ISSUER TRUST, as Buyer, and PennyMac Holdings, LLC, as Pledgor.
8-K
December 21, 2016
10.31
Base Indenture, dated as of December 20, 2017, by and among PMT ISSUER TRUST-FMSR, Citibank, N.A., PennyMac Corp. and Credit Suisse First Boston Mortgage Capital LLC.
8-K
December 27, 2017
10.32
Amendment No. 1, dated as of April 25, 2018, to the Base Indenture dated as of December 20, 2017, by and among PMT ISSUER TRUST - FMSR, Citibank, N.A., PennyMac Corp., and Credit Suisse First Boston Mortgage Capital LLC
8-K
April 30, 2018
10.33
Amendment No. 2, dated as of July 31, 2020 to the Base Indenture dated as of December 20, 2017, by and among PMT ISSUER TRUST - FMSR, Citibank, N.A., PennyMac Corp., and Credit Suisse First Boston Mortgage Capital LLC.
10-Q
August 7, 2020
10.34
Amendment No. 3, dated as of October 20, 2020 to the Base Indenture dated as of December 20, 2017, by and among PMT ISSUER TRUST - FMSR, Citibank, N.A., PennyMac Corp., and Credit Suisse First Boston Mortgage Capital LLC.
10-Q
November 6, 2020
10.35
Series 2017-VF1 Indenture Supplement, dated as of December 20, 2017, by and among PMT ISSUER TRUST-FMSR, Citibank, N.A., PennyMac Corp. and Credit Suisse First Boston Mortgage Capital LLC.
10-K
March 1, 2018
10.36
Amendment No. 1 to the Series 2017-VF1 Indenture Supplement, dated as of June 29, 2018, by and among PMT ISSUER TRUST-FMSR, Citibank, N.A., PennyMac Corp. and Credit Suisse First Boston Mortgage Capital LLC.
8-K
July 6, 2018
10.37
Amendment No. 2 to the Series 2017-VF1 Indenture Supplement, dated as of August 4, 2020, among PMT ISSUER TRUST - FMSR, Citibank, N.A., PennyMac Corp. and Credit Suisse First Boston Mortgage Capital LLC.
8-K
August 10, 2020
10.38
Series 2018-FT1 Indenture Supplement, dated as of April 25, 2018 to Base Indenture dated as of December 20, 2017, by and among PMT ISSUER TRUST - FMSR, Citibank, N.A., PennyMac Corp., and Credit Suisse First Boston Mortgage Capital LLC.
8-K
April 30, 2018
10.39
Master Repurchase Agreement, dated as of December 20, 2017, by and among PennyMac Corp., PMT ISSUER TRUST-FMSR and PennyMac Mortgage Investment Trust.
8-K
December 27, 2017
10.40
Guaranty, dated as of December 20, 2017, by PennyMac Mortgage Investment Trust in favor of PMT ISSUER TRUST - FMSR.
8-K
December 27, 2017
10.41
Master Repurchase Agreement, dated as of December 20, 2017, by and among PennyMac Holdings, LLC, PennyMac Corp. and PennyMac Mortgage Investment Trust.
8-K
December 27, 2017
10.42
Guaranty, dated as of December 20, 2017, by PennyMac Mortgage Investment Trust in favor of PennyMac Corp.
8-K
December 27, 2017
10.43
Subordination, Acknowledgement and Pledge Agreement, dated as of December 20, 2017, between PMT ISSUER TRUST - FMSR and PennyMac Holdings, LLC.
8-K
December 27, 2017
10.44
Amended and Restated Master Repurchase Agreement, dated as of June 29, 2018, by and among Credit Suisse First Boston Mortgage Capital LLC and PennyMac Corp.
8-K
July 6, 2018
10.45
Joint Amendment No. 1 to the Series 2017-VF1 Repurchase Agreement and Amendment No. 2 to the Pricing Side Letter, dated as of August 4, 2020, among PennyMac Mortgage Investment Trust, PennyMac Corp., Credit Suisse First Boston Mortgage Capital LLC, and Credit Suisse AG, Cayman Islands Branch and Citibank, N.A.
8-K
August 10, 2020
10.46
Amended and Restated Guaranty, dated as of June 29, 2018 by PennyMac Mortgage Investment Trust in favor of Credit Suisse AG, Cayman Island Branch and Citibank, N.A.
8-K
July 6, 2018
21.1
Subsidiaries of PennyMac Mortgage Investment Trust.
*
23.1
Consent of Deloitte & Touche LLP.
*
31.1
Certification of David A. Spector pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*
31.2
Certification of Daniel S. Perotti pursuant to Rule 13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*
32.1**
Certification of David A. Spector pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
**
32.2**
Certification of Daniel S. Perotti pursuant to Rule 13a-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
**
Interactive data files pursuant to Rule 405 of Regulation S-T, formatted in Inline XBRL: (i) the Consolidated Balance Sheets as of December 31, 2020 and December 31, 2019 (ii) the Consolidated Statements of Income for the years ended December 31, 2020 and December 31, 2019, (iii) the Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2020 and December 31, 2019, (iv) the Consolidated Statements of Cash Flows for the years ended December 31, 2020 and December 31, 2019 and (v) the Notes to the Consolidated Financial Statements.
101.INS
Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document.
101.SCH
Inline XBRL Taxonomy Extension Schema Document
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
101.LAB
101.PRE
Inline XBRL Taxonomy Extension Definition Linkbase Document
Inline XBRL Taxonomy Extension Label Linkbase Document
Inline XBRL Taxonomy Extension Presentation Linkbase Document
Cover Page Interactive Data File (embedded within the Inline XBRL document)
*
Filed herewith
**
The certifications attached hereto as Exhibits 32.1 and 32.2 are furnished to the SEC pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.
†
Indicates management contract or compensatory plan or arrangement.