PennyMac Financial Services, Inc. Class A Aktie

Good afternoon, and welcome to PennyMac Financial Services, Incorporated's Third Quarter 2026 Earnings Call.

Additional earnings materials, including presentation slides that will be referred to in this call as well as an Excel file with supplemental information are available on PennyMac Financial's website at pfsi.pennymac.com.

Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.

Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer. Please go ahead.

Thank you, operator. Good afternoon. And thank you to everyone for participating in our third quarter 2026 earnings call.

Before discussing our financial results, I want to take a few moments to address the important leadership transitions we announced earlier today. First, after a historic career in the mortgage banking industry spanning several decades, including more than 15 years of exceptional leadership at PennyMac, Doug Jones, our President and Chief Mortgage Banking Officer, has made the decision to retire on June 30, 2027. Doug has been an integral partner to me and a cornerstone of PennyMac since its early days. Over the next several months, Doug's roles and responsibilities will transition smoothly to other senior leaders across our organization.

Second, effective January 1, 2027, Kevin Ryan, currently our Chief Strategy Officer, will assume the role of Chief Financial Officer. Dan Perotti, our current CFO, will remain in his current role through the end of this year and will continue supporting the company in an advisory role through the first quarter of 2027. Kevin will continue to lead our strategy and business development teams in addition to his financial leadership responsibilities.

I want to express my extraordinary gratitude to both Doug and Dan for their long service to PennyMac, their relentless dedication and their enduring passion for our business. Both served in critical leadership positions, guiding PennyMac through dynamic market cycles and helping transform our organization into the premier mortgage company it is today. Their countless contributions have shaped our foundation, and they will be greatly missed.

Having said that, we have an exceptional leadership team and a deep bench of talent that is fully prepared to lead PennyMac into its next chapter. I have absolute confidence in this management team's ability to carry our strategy forward seamlessly while driving long-term value for our stockholders.

Turning now to our third quarter results on Slide 3. PennyMac Financial generated $29 million of net income or $0.54 in diluted earnings per share, representing a 3% annualized return on equity. Adjusted net income was $56 million or $1.05 per share for a 5% adjusted return on equity, down slightly from the prior quarter.

Our production segment recorded a pretax loss in the third quarter, driven by 3 primary factors. First, revenues declined significantly as fallout adjusted lock volumes were down across each of our channels in response to higher mortgage rates.

Second, while production expenses came down, they declined at a slower rate than revenues. Production expenses are largely driven by funded unit volume rather than locks. And throughout the quarter, we were still processing and funding higher volume loan pipelines established under the prior more favorable interest rate environment.

And third, we have not yet fully realized the full impact of previously announced cost reductions.

Servicing segment pretax income in the third quarter was $99 million. Excluding MSR fair value changes net of hedging, Servicing segment pretax income was $132 million, up from $99 million in the prior quarter, primarily driven by lower realization of MSR cash flows and an increase in loan servicing fees, partially offset by lower interest income from custodial balances and EBO loan-related income.

Slide 4 illustrates the constrained origination environment we are currently operating in. The primary 30-year fixed rate mortgage rose more than 90 basis points from June 30, ending the quarter at approximately 7.4%. This sharp increase in mortgage rates has impacted the housing market and has driven significantly lower origination demand, particularly for borrowers looking to refinance into a lower rate.

According to secondary market data, industry-wide rate and term agency deliveries have declined approximately 80% from the first quarter of this year. And as you can see by the current distribution by agency mortgages by coupon, less than 1% of homeowners currently possess an incentive greater than 50 basis points to refinance. All of this has created one of the most constrained origination environments our industry has seen since 2023 when rates sharply increased in response to high inflation as we emerge from COVID.

Although the origination market remains challenging, higher rates have driven prepayment speeds down to very low levels. This has caused our servicing business to continue to produce strong operating profitability as amortization has declined and fee income has increased. This dynamic highlights the natural hedge embedded in our balanced business model and the power of our large servicing portfolio.

Turning now to Slide 5 for key business updates. First, we continue to make progress on the acquisition of Cenlar's subservicing business and now expect the transition to close in the first quarter of 2027.

Second, given a smaller projected origination market and the realization of efficiencies due to technology, we are completing additional aggressive and proactive expense reduction initiatives, which we project will result in $160 million of annualized expense reductions from the second quarter of 2026 to the first quarter of 2027. We expect a modest sequential reduction from the third to the fourth quarter of this year, followed by a much more pronounced step down in the first quarter of 2027 as these initiatives fully run rate.

While these actions reflect necessary staffing and operational reductions in response to the low to a smaller origination market, significant process improvements driven by our continued technology enhancements have given us confidence in our ability to address our customers' needs even if rates were to meaningfully decline.

And after quarter-end, we entered into an agreement to sell $29 billion in UPB of low-coupon MSRs with an expected close in the fourth quarter.

Net proceeds of approximately $490 million will primarily be used to pay down outstanding debt, lowering financing costs.

I would also note we maintain an active share repurchase authorization from our Board of Directors. Given where our common shares have traded relative to book value and as we've done historically, we will continue to opportunistically utilize our share repurchase authorization to create long-term value for our stockholders.

Turning to Slide 6 and looking ahead, while the near term presents cyclical origination market headwinds, we are aggressively executing on structural initiatives to permanently lower our cost structure and position PennyMac appropriately for the size of the market we're currently operating in. Given the smaller origination market and the ongoing execution of our expense adjustments through year-end, fourth quarter adjusted ROE is expected to remain near current levels.

Turning to Slide 7. We continue to rapidly accelerate AI automation across our origination business. Across our production workflows, process automation has progressed meaningfully with 37% live in production and the remaining 28% currently in development expected to be completed by year-end. Our automation efforts will continue into 2027, focused primarily on advancing our AI voice agent capabilities and deploying AI agents into our broker direct channel once live on our next-generation loan origination system.

We have already developed 22 proprietary AI agents that are live in production, which have completed more than 205,000 automated agent executions and over 200,000 automated document reviews with an additional 17 agents currently in the development pipeline. Our proprietary AI voice agent is already driving meaningful origination volume. In the third quarter alone, it supported more than 15,000 transfers and contributed to over 1,600 rate locks. Just as importantly, this voice agent provides us the ability to rapidly add capacity to meet the demand generated by a market rally, enabling borrower self-service and thereby reducing hold times and lost sales opportunities.

By automating labor-intensive fulfillment workflows, we are permanently lowering our cost to produce and uncoupling platform capacity from staffing requirements. This will allow us to maintain lean operation in today's constrained environment while ensuring substantial operating leverage when origination volumes normalize.

Turning to Slide 8. This highlights the opportunity in our consumer direct channel when interest rates decline as well as the meaningful improvement in our first lien refinance recapture rates in recent periods. As of September 30, we serviced a combined $355 billion in UPB of loans with note rates above 5%, of which more than 60% or approximately $220 billion in UPB had note rates above 6%.

As shown on the right, our first lien recapture rate remained near record highs at 44%, up 9 percentage points from the prior year. The slight decline from the prior quarter reflects a broader market shift towards more credit-sensitive cash outs versus rate and term refinances where we traditionally see our highest conversion rates. Given the size of our servicing portfolio, our technology foundation and our accelerating recapture trends, we are highly convinced in our ability to execute on this opportunity, driving towards our long-term ROE targets when interest rates do decline.

Now I'd like to introduce our current Chief Strategy Officer and incoming CFO, Kevin Ryan.

Thank you, David. I am honored and excited to assume the CFO role here at PennyMac, and I want to thank David and the Board for their trust and confidence.

I also want to express my sincere gratitude to Dan. Over his years of leadership, Dan has built an exceptional, world-class finance organization and established a remarkably resilient balance sheet. He and I will be working closely together over the coming months to ensure continuity and a seamless operational handoff. Having spent the past year leading our corporate strategy and business development initiatives, I've had the privilege of working alongside our leaders in production, servicing and technology. Bringing finance, strategy and business development together under one umbrella allows us to tightly integrate our long-term vision with real-time capital allocation and financial execution.

In challenging environments like the one we are navigating today, our priorities are clear: maintain rigorous cost discipline across the enterprise, allocate capital dynamically to the highest risk-adjusted return opportunities and leverage our scale and proprietary technology to permanently drive down unit costs across our platform. I look forward to engaging directly with our stockholders and the broader investment community in the months ahead.

And with that, I will now turn the call over to Dan, who will review the drivers of PFSI's third quarter financial performance.

Thank you, Kevin. PFSI reported net income of $29 million in the third quarter or $0.54 in earnings per share for an annualized ROE of 3%. Adjusted net income was $56 million or $1.05 in adjusted earnings per share for an annualized adjusted ROE of 5%. The $0.51 difference between our GAAP and adjusted EPS was driven by $34 million of fair value declines on MSRs net of hedges and costs and $2 million of expenses related to our pending acquisition of Cenlar's subservicing business.

PFSI's Board of Directors declared a third quarter common share dividend of $0.30 per share.

On Slides 10 and 11, beginning with our production segment, pretax loss was $7 million compared to pretax income of $38 million in the prior quarter and $123 million in the third quarter of 2025.

Total acquisition and origination volumes were $24 billion in unpaid principal balance, down 30% from the prior quarter and 33% from the third quarter of last year. The revenue contribution from the correspondent channel was down $6 million from the prior quarter. This decline was driven by lower production volume as the origination market was impacted by higher interest rates.

In addition, we have maintained our pricing discipline, not chasing loan volume priced around aggressive recapture assumptions that we don't feel comfortable underwriting.

Also, correspondent lending remains competitive with the GSEs remaining active through their cash window alongside other industry participants competing aggressively on price. Our priority remains allocating capital prudently and preserving margin discipline. In October, correspondent volumes are expected to be in line with average third quarter levels.

In broker direct, revenue contribution was down $23 million from the prior quarter. The channel remains competitive with fallout adjusted locks down 28% and margins down 12 basis points from the prior quarter.

Volumes in October are down slightly from the average third quarter levels as a result of higher mortgage rates.

The revenue contribution from our consumer direct channel declined $40 million from the prior quarter as higher interest rates resulted in lower refinance demand. Fallout adjusted lock volumes were down 37% from the prior quarter due to the sharp increase in mortgage rates.

Margins were up to 335 basis points from 300 basis points in the prior quarter, reflecting a higher proportion of closed-end second lien production versus first lien.

Secondary market impacts across the channels resulted in a $5 million pretax loss compared to $7 million of pretax loss in the prior quarter. Of note, on Slide 11, prior period amounts have been recast to conform to our current period presentation.

The line previously titled, post-lock impacts and other, has been changed to secondary market impacts to isolate pure pipeline hedging valuation changes and secondary execution items. As part of this presentation update, certain execution items previously captured in this line item have now been attributed directly to each respective channel. While this recast historical channel margins, our total production revenues, expenses and pretax income remain unchanged.

Production expenses net of loan origination expense decreased 11% from the prior quarter due to previously announced reductions in capacity and lower volumes.

Turning to the Servicing segment on Slides 12 and 13, our total servicing portfolio UPB ended the quarter at $737 billion, up slightly from the end of the prior quarter. The Servicing segment recorded pretax income of $99 million. Excluding MSR fair value changes net of hedging, pretax income was $132 million or 7.3 basis points of average servicing portfolio UPB, up from $99 million or 5.5 basis points in the prior quarter.

Servicing fees were up from the prior quarter, primarily due to growth in the MSR portfolio.

Realized prepayment fees were 8.1%, down from 11.6% in the prior quarter. This decline resulted in a 15% reduction in the realization of MSR cash flows and also drove lower average custodial balances and related earnings.

Income from EBO activities was down $20 million from the prior quarter due to higher rates and recent changes to FHA and VA loss mitigation programs, which changed the timing and volume of buyout and redelivery options.

Operating expenses in the quarter were 4.4 basis points of average servicing portfolio UPB, or $80 million, up slightly from the prior quarter.

On Slide 14, including the provision for losses on active loans, the fair value of PFSI's MSR increased by $930 million. An increase of $951 million was due to changes in market interest rates and $21 million of declines was due to other model and performance-related impacts.

Hedge fair value losses, including principal-only bond accretion changes were $964 million. Rate impact accounted for $946 million of losses, while hedge costs were $18 million, down from $52 million last quarter and more in line with our long-term targets.

Corporate and other items recorded a pretax loss of $49 million compared to $29 million in the prior quarter. The prior quarter included $9 million of valuation-related gains related to our minority interest in Vesta.

On Slide 15, total debt-to-equity at quarter-end was 3.5x, down slightly from the end of the prior quarter and non-funding debt-to-equity was 1.9x, up from 1.8x at the end of the prior quarter. The increase in non-funding leverage was driven by higher interest rates, which increased the utilization of our secured MSR facilities.

To provide some context on how this dynamic operates, our MSR portfolio is financed through secured bank facilities where our borrowing base is driven by the collateral value of the underlying asset. When interest rates rise sharply, as they did throughout the third quarter, the fair value of our MSR increases, which expands our available borrowing capacity with our banking partners. At the same time, because we maintain a disciplined near 100% hedge, our derivative hedge positions decline in value, requiring cash variation margin and rebalancing. We utilize the expanded collateral capacity on our MSR facilities to fund those hedge requirements.

This creates a self-funding mechanism that protects stockholder equity and book value while mechanically resulting in higher facility draws and non-funding leverage during periods of rising rates. Holding interest rates constant through a combination of earnings and utilizing the approximately $490 million in proceeds from our planned MSR sale to pay down outstanding debt, we expect non-funding leverage at year-end to be lower.

Finally, we ended the quarter with $3.5 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledge.

On a more personal note, I want to take a moment to express my sincere gratitude to David, our Board of Directors and my colleagues for their trust, partnership and shared dedication throughout my time at PennyMac. I'm extraordinarily proud of what we've accomplished in my 18 years with the company and my 6 years in the CFO role. And in particular, I'm proud of the world-class finance organization and the resilient balance sheet we have built.

Having worked alongside Kevin for the past year, I have the utmost confidence in his leadership and vision to steer our financial and strategic execution going forward as he assumes the CFO role.

And finally, to our shareholders and the investment community, thank you for your thoughtful engagement, rigorous questions and constructive partnership over the years. It's been a privilege working with you.

And now we'll open it up for questions. Operator?

We will now begin the Question-And-Answer Session. [Operator Instructions] Your first question comes from the line of Crispin Love with Piper Sandler.

Your next question comes from the line of Doug Harter with BTIG.

Hoping you could talk a little bit more about the MSR sale and kind of how you're thinking about what is the target level for leverage. And I guess, on that MSR sale, are you retaining subservicing on that?

Sure, Doug. This is Dan. Thanks for the question. In terms of the MSR sale, as we mentioned, we're expecting to utilize the majority of the proceeds to pay down our outstanding MSR or some of our outstanding MSR debt. With respect to overall leverage, as we've talked about before, non-funding leverage generally have targeted being closer to 1.5x. We expect to move toward that level over time, not necessarily all in one chunk. The paydown of this debt will contribute to moving our leverage lower. And as we said on the call, we expect our leverage to move lower quarter-over-quarter.

The other factor, as we talked about on the call, is that our non-funding leverage will fluctuate up and down initially as we see interest rates move up and down due to the dynamic of our hedge and utilizing our funding facilities to fund any cash requirements that we have due to changes in interest rates. We saw interest rates increase really sharply at the end of Q4, and that helped to drive up our leverage ratio slightly. We've seen a rally since then, and that is moving our leverage ratio in the opposite direction.

So overall, over the next few quarters, we expect to bring down our leverage ratio from the levels that it is at today through a combination of the MSR sale and deploying some of that cash as well as we see interest rates decline somewhat and utilizing the earnings from our business to bring overall leverage down.

And then I guess just are you retaining subservicing on the sale? And how do you think about additional sales?

We're not retaining subservicing on this sale. That is an opportunity that we see potentially in future sales, but not with this particular sale. As we are looking at the market overall and our capital position as well as opportunities, we'll continue to look at potential opportunities for MSR sales, but it's not necessarily something that is -- we expect to be a consistent strategy. It's our evaluation of our capital position versus opportunities that we see as well as our overall leverage level and our trajectory with respect to.

And Doug, this is David. I just want to add, this is one of the benefits that we get from the Cenlar acquisition in the fact that we have obvious scale on the platform. And by adding the Cenlar portfolio, we'll be increasing that scale, which gives us flexibility to strategically sell MSRs when the opportunity presents itself and the market environment necessitates in my mind, an MSR sale.

So this is the flexibility that we're excited about, and we're going to continue to strategically look at the market in terms of looking at MSRs and perhaps these are low-rate MSRs. They don't exactly fit what we want in terms of the flywheel and the future opportunity, and there's an active market for these. So it was a good transaction all the way around.

Your next question comes from the line of Trevor Cranston with Citizens JMP.

Congratulations to everyone on the career transitions. Looking at the consumer direct channel specifically, I was wondering if you could provide a little color on within 3Q numbers, kind of how much of the volume there came from second lien volume in 3Q and kind of where you expect overall volume within the consumer direct channel to kind of stabilize, assuming rates stay around the current level?

So obviously, we had more of a proportion of our production coming in second lien volume. The fundings in Q3 in consumer direct were approximately $3.3 billion, of which approximately $700 million of it was closed-end seconds. And that number is staying pretty consistent in the market today.

Year-over-year, we were up in consumer direct. But right now, the focus on consumer direct is on cash outs and closed-end seconds, given the fact that rates are at the level where rate and term refinance is not really in the money.

In addition, we added the HELOC product into our consumer direct channel. We launched that over the past couple of weeks. And so that's something that we're looking forward to being able to offer to our consumers as well.

And then in your commentary, it sounded like you guys were seeing some competitive pressure on margins in the broker direct channel. Can you maybe provide an update on what you're seeing in the early part of 4Q and how you expect that to evolve given the increased competition for loans?

We maintain a really disciplined approach to pricing. And as it pertains to where we value MSRs in our pricing model, obviously, it involves the valuation process of looking loan level characteristics, looking at FICO, LTV, prepayment speeds, there's a recapture component to it. And we're just seeing some valuations in terms of competitors that don't meet our return targets.

And so we want to be market leaders. We want to stay disciplined in our pricing and how we price. And in particular, we want to be on the government side, really mindful of the fact that -- there's a lot of -- there's a few executions out there that require a very large servicing investment on strip sizes north of 50 basis points that, again, don't really pan out when you look at the recapture opportunity. So I think that's the story on the government side.

On the conventional side, we're seeing a little bit -- we're seeing more than a little bit, we're seeing a good amount of pressure from the GSE cash window, execution being offered to smaller broker originators.

And so we're staying very competitive with the top 2 in the industry, and they're in various ways, staying aggressive as well. But we're picking and choosing our spots, and while maintaining market share and not really getting too caught up in market share at levels that are just not sustainable or that one can rationalize.

Your next question comes from the line of Bose George with KBW.

Dan, it's been a pleasure working with you over the years.

First question, just on the guidance that you guys gave. So just to clarify, so that's a 5% expectation for 4Q? And then where do you see that trending in 2027, assuming the market remains flat?

I'll lead off with this, and I'm sure Dan and Kevin will comment afterwards. But look, we're in a very challenging origination market with higher interest rates. And I think right now we are rightsizing our production channel and trying to maintain a level of profitability in Q4. Obviously, we're able to offset that with the continued decline in amortization. And so many of the actions we're taking this quarter won't run rate until early next year.

And with respect to 2027, obviously, the origination market is expected to decline. We're seeing forecast from the MBA and Fannie Mae bringing it down to $1.9 trillion. Right now, we're running a little bit lighter than that in terms of the run rate.

We have taken aggressive actions to right-size the business appropriately from Q2 of '26 to January 1 of '27 will be $160 million of annualized reductions. And most of that is going to come through in Q4. The tech spend is coming off of peak levels, we're reducing our tech spend, and we're continuing to see further efficiency gains because of the investments we're making.

And so as I think about the bridge from Q4 '26 to Q4 '27, I'm expecting us to be at low double digits by Q4 '27. And if you start out the 5% level we're at today, there's about 3.5 points that are going to come out of servicing, primarily at these levels because of the reduction in speeds and the lower amortization, the increase in net interest income and then bringing on Cenlar in the back half of the year.

We're expecting another 2 points to come from the OpEx reductions that we've made in the second half of '26 and getting a full run rate of those. And then there's going to be another one to two points coming out of our production channels, primarily coming out of the implementation of Vesta in broker direct, the deployment of the AI agents in consumer direct that will be replicated in broker direct.

And just some increase in pricing strategies and executions that we have been identifying in this period of time as we're seeing a very healthy bid for conventional production away from the GSEs into the whole of market. So all that adds up when you bridge it to the low double digits. And that's at current market levels. Obviously, if rates decline, you'd see a different market where production volume increases would yield greater profitability and production offset to some extent to a little bit with an increase in amortization.

Yes, Bose, it's Kevin. I'll add to that quickly, which is, as David said, we're assuming a mortgage market next year that's smaller than $1.9 trillion, certainly smaller than 2026 is likely to finish up. And we're focused on the things we can control. Most of what David went through was Cenlar, NII expense reductions, and we're already at $160 million, and we're not done yet on expense reductions.

And so we're not bullish on the market. We are bullish on self-help and what we can do to drive down costs and get ourselves back to those types of returns.

Your next question comes from the line of Don Fandetti with Wells Fargo.

Look, it's a tough mortgage market. It's a scale business. I'm just curious as you look out over the landscape and all the tech investment, do you feel like you guys have the right scale? Or do you need to consider some strategic alternatives maybe that are a little more dramatic? Or do you feel like you can kind of compete with the likes of maybe some of the larger players in the business?

Look, I feel really good about what we have here in the organization. We're about to complete our 19th year. I think our track record is well known and our ability to adapt in the cyclical market that you rightfully talk about today is something that is a trademark of the organization. I think what I'm really excited about is the fact that as rates do come down, and they will come down, I feel really good about the position we're in being able to attack the demand that's going to come about without having to scurry about to add people or other infrastructure.

And so we're really taking advantage of this period of time where rates are at these elevated levels to move quickly to complete the work on the loan origination side to be able to deal with any increase in production.

Look, I think that the market is a tough one. I think you're going to continue to see consolidation in the market. But I think we have -- if you think about capital position, you think about what we built here with the leading correspondent aggregator, we're the #3 broker direct lender, our recap numbers are above 40% at levels that we have not seen in the history of the company. We're really positioned really well to take advantage of any decrease in rates that come about on the production side.

And likewise, on the servicing side, we're just continuing to get more and more efficient. And that scale is going to be a real benefit to us as we strategically address what the portfolio is.

Yes. Remember, Don, we're going to be over $1 trillion in servicing when we close Cenlar. We're at scale.

Your next question comes from the line of Crispin Love with Piper Sandler.

David, on capacity on the comment that you just made, it seems like you wouldn't need to add significant capacity if rates did rally. Is that fair? And is that because of the tech initiatives that you're taking right now? Just curious if I'm thinking about that correctly.

Yes. Look, I'm not going to say -- we're going to have -- we'll be at zero because there's always a client who wants a human in the loop. Having said that, the human in the loop becomes less and less prevalent in terms of the refinancing of a mortgage. And even more importantly, on the processing side, the human in the loop has been greatly reduced. And so from my perspective, the amount of ads we're going to have to do, and I was looking at were looking yesterday like 100 basis point rally. It's less than 100 people across the consumer direct channel when historically, that number would have been multiples. And so I feel really good about what we're building.

And look, the longer rates stay where they are and you have capacity to leave the system, that's going to further lend itself for greater margin increases as well in a rally. And so I think we're positioned really well to be able to deal with anything that comes our way.

And then on the Cenlar deal, can you talk about plans for the bank charter once the deal closes? Is that something that you're able to sell? Because I don't believe you're retaining it. Just if you can provide any color for the bank charter and just what's possible with that that would be great.

Yes, Crispin, it's Kevin. I think we've talked about this in previous calls. We've done a lot of work on retaining it. I think a combination of Basel III has been slow to get implemented, although we're supportive of the likely changes in MSRs. And they've got 100 clients that are great clients, and we've got the lowest cost of service in the industry. So we want to get those loans on our platform as quickly as possible.

So our plan is to close the deal in Q1 ex the bank charter we're working -- Dan is really leading an effort to work with Cenlar's management to dispose of the deposits at that bank charter and that bank charter will just relinquish and we'll close the deal.

Congratulations on the new role, Kevin.

Your next question comes from the line of Ryan Shelley with Bank of America.

Just following up on the Cenlar acquisition, it looks like timing has slipped a bit into 1Q of next year. Could you just give everyone a reminder on what approvals you still need and if there's any customer transfer.

Ryan, can you start from the top and speak up, please?

Yes, just on Cenlar, just a quick follow-up. It looks like the timing has slipped a little bit into early next year. Can you just remind us of what approvals are still needed and if there's any potential that you could see that slip further?

Yes. Ryan, it's Kevin. We heard you this time. We have basically all approvals, except for one state. You can likely guess which state that is, is generally slow in almost every transaction. We feel very good about where we are as far as getting that approval. And then we're just working with the OCC, as we said to the last question, on getting the deposits transferred. So we feel very comfortable in that Q1 timing.

We took more time to study the bank, right? So part of the slowdown was self-imposed.

Understood. And then just one more on leverage. It sounds like you should expect leverage to tick down next quarter, especially after this MSR sale. Given the environment, can we generally expect next year, you guys aim to operate closer to that 1.5 target? And to get there, could we see future sales potentially of MSRs in the book?

Yes. Look, I'll start and Dan may want to jump in. As David mentioned, this is opportunistic. We're going to be over $1 trillion of servicing post-Cenlar. We're clearly at scale. there's a strong bid in the market, particularly amongst banks for low note rate servicing where there's not a big recapture opportunity and the portfolio we're selling looks a bit like that.

And so we can sell MSRs and look at leverage. Leverage has come down, as Dan mentioned before, just organically over the last 2 weeks as the 10-year is sitting at rates lower than where we closed the quarter. So we have levers to pull. We have a lot of liquidity, and we certainly have levers to pull as it relates to leverage.

Consistent with what I talked about earlier, we continue to evaluate potential MSR sales. But as Kevin said, there's nothing necessarily in the pipeline in terms of sales currently, and it's something that we continue to evaluate in terms of our capital options as to what can optimize both leverage as well as returns.

Your next question comes from the line of Shanna Qiu with Barclays.

I know on the call, Dan mentioned that the MSR facility commitments increased with the improvement in the MSR fair value that was offset by the debt increase to fund the hedge requirement. It's like overall, it looks like net liquidity declined by $500 million to $3.5 billion, which I think is on the lower end of where you guys have run at in the past few years. Is this something that we should think of as a minimal level of liquidity? And are you guys thinking about any kind of liquidity risk that might materialize for the industry, maybe beyond just servicing advances?

So our liquidity planning process and scenario planning process around liquidity is very robust. We have a weekly discipline where we are looking out at over a 12-month horizon that includes shocks to both interest rates and the potential impact of liquidity from that as we discussed on the call and how that can impact liquidity with respect to hedges as well as a potential significant delinquency shock as we saw in the shock that we use is similar to what we saw during COVID and what the impact of that would be if prepayments in a slower prepayment speed environment, so where P&I advances are also significantly impacted.

And as we're looking at the sizing of our facilities and our available liquidity, even in those scenarios, we still have excess liquidity for the combination of those 2 types of shocks. The overall liquidity level that we're looking at, as you said, is on the lower end of where we've been historically. Obviously, that has expanded -- or not obviously, but that has expanded as we've rallied down a little bit and we had a reversal of what we saw in Q3 or at the end of Q3 with respect to interest rates.

To the extent that we needed additional -- as we're looking at our liquidity planning, needed additional facility availability, we have very significant amounts of MSR collateral to be able to borrow against that is in excess of our current commitments. In other words, the liquidity that we show there is with relation to the current sizes of our facilities and to the extent that we saw liquidity or potential liquidity decline further below the thresholds that we would need to be able to fund advances in a shock scenario or combined with a significant interest rate shock, we would look to expand our liquidity further.

So that overall, with respect to the current levels, as you said, we generally would expect that to be on the lower end of what we would see given our overall liquidity planning or at least given the current size of the portfolio. But to the extent that we needed to increase that or saw a different shock, we have plenty of collateral to be able to expand our facilities further.

And then I know you mentioned you guys were opportunistically selling MSRs. So I'm assuming that we should expect to book a gain on MSR sales in the fourth quarter.

We are not expecting to book a gain. We sold the MSR portfolio near inconsistent with our mark. When you see the results in the fourth quarter, it will come through as normal fair value changes, not something that's a specific gain on sale, but the sale was consistent with where we have the portfolio mark.

There are no further questions at this time. I will now turn the call back to David Spector for closing remarks.

Thank you, operator. And thank you all for joining us this afternoon. I encourage investors with additional questions to contact our Investor Relations team by e-mail or phone. And thanks again for the time and the good questions today.

This concludes today's call. Thank you for attending. You may now disconnect.

All right. So we'll get started. I'm very pleased to have PennyMac Financial Services join me on stage. With me today, I have David Spector, Chairman and Chief Executive Officer. Welcome, David.

Thank you, Terry. Great to be here, and thank you all for joining us.

All right. So we'll get right into it. You guys filed a quarter-to-date update yesterday. Maybe just give us some color around that. What are you seeing around third quarter trends?

Yes. So clearly, as we sit here today, we're seeing rates at a much higher level than we saw at the beginning of the quarter. Mortgage rates are up about 50 basis points. And so like you would expect in a rising rate environment, we're seeing production taper off as a result of that. And that's leading to some, obviously, reductions in our forecast for originations on our -- in all 3 channels. In our consumer direct channel, we're seeing margins hold in, which is good news. Obviously, with the increase in rates, we'll see a higher percentage of closed-end seconds getting originated. So the weighted average margin out of consumer could go up in the second quarter. But with originations down, the overall revenues will be down.

Similarly, in our broker direct channel, we're seeing a little bit of margin pressure there with production going down, and we'll be talking a little bit more about broker in a few minutes. And in the correspondent channel, we're seeing, again, production down a bit there. Margins are holding in really nicely there. So there's good news there.

On the servicing side, look, we continue to see a great story out of servicing. Our servicing portfolio continues to run at very low delinquency levels. It's a portfolio that has close to $530 million of revenue or servicing fees every quarter, and we're seeing good results there. And on the corporate side, we had some headwinds in Q2 from credits from AWS and some revaluation of incentive compensation, but we should run flat to a year ago. And so it's a story, I think given the increase in rates, we're again going to be at what I call a post-COVID trough level in operating ROE. But again, it's going to be -- it will be in the kind of in that single -- mid- to high-single digits, probably mid in Q3.

Got it. That's helpful color. Forgot to mention we're going to be mostly discussing PFSI on this chat, and then we'll address PMT a little bit at the end.

Right.

So again, like helpful color, lots of impact there. But maybe, like, just taking a step back, the macro has been tough this year. Mortgage activity has remained pressured for most of this year. As you look across the balance of 2026 and 2027, what are your expectations for industry volumes? And what do you see as the biggest drivers of upside or downside from here?

Yes. So as I mentioned earlier, being that with the higher rates, I think volumes are going to come in on the kind of the lower end of forecast. I think that we -- from an internal point of view, I think there's tremendous opportunity within the company. We're seeing a lot of good results coming out of our consumer direct channel on the deployment of our new technology, but more exciting about that is the fact that we're really beginning to see the benefit of having legacy free technology and being able to build AI agents on top of it. And so on the mortgage fulfillment side, which is our processing group, we're seeing processing costs down approximately 50% on a marginal loan basis. And on the loan origination side, we're seeing loan officer efficiencies up about 20%, and that's only going to grow.

And so today, as we sit here at the higher rates, you have the benefit on what you're originating. But in many ways, what's more exciting to me is the fact that we've been carrying a lot of excess capacity over the last few years to be able to really seize on an opportunity of lower rates. And what we're seeing with the technology is the need to maintain the levels of excess capacity that we've been holding have been greatly, if not eliminating -- greatly diminished, if not eliminated. And that's what led to our reduction of production expenses of $60 million that took place in July. And so we really reduced the capacity, and that should reduce the volatility of the earnings in our consumer direct channel.

In our broker direct channel, we're doing the work rather quickly to use the technology that we deployed in our consumer direct channel to deploy it in our broker direct channel. Now there's a little bit more work on top of that, that we need to do and the fact that when you run a broker direct business, there's a broker portal that has to go along with that, that's being built. But that's something that I think is going to be a real exciting opportunity for our brokers. And the brokers that we deal with typically deal with the #1 in the market or the #2 in the market. And I think as we continue to be competitive with price while be offered to be -- being able to offer a better product, that's going to lead to share growth within our broker direct channel.

In our correspondent channel, we've been the leading correspondent aggregator for many years. That lead has shrunk a bit. We're going to get into the reasons why momentarily. But we're going to continue to be the leading correspondent aggregator. And so there, it's just a matter of when you're in the correspondent business, you're in it to buy servicing to really support the flywheel that we've created. And so as we see opportunities to participate in that market and we like the servicing values that we're seeing in that market and how those are being constructed, we're going to continue to see growth on the correspondent side.

On the servicing side, it's with great pride, I'd say there's not a lower cost servicer than us. And I think that's with our servicing portfolio at $700 billion and the cost-to-service that we have for that. With the technology that we have in place and the work we're doing with our technology called place, we're going to continue to drive down the cost-to-service. And that's something that I'm really excited about. And then with the Cenlar acquisition, look, we're going to add scale to our portfolio, and that's only going to help us drive down costs further while equally as important, grow the capital-light part of our business model. And that's something we're very focused on as we look out into the future.

And then finally, across what I call our shared services groups, technology, finance and capital markets, the benefits we're getting from AI and AI tools like Claude and Cursor and others are meaningful. And so the technology investments that we're making within the company, which I expect to crest in the third quarter, are really going to start coming down as we finish a lot of the work that we undertook at the beginning of the year.

So for all things considered, if you think about the beginning of the year, we walked in expecting 3 interest rate cuts. As we sit here today, we're expecting 3 interest rate increases. But by and large, I'm really happy and excited about what I'm seeing in the organization.

Got it. Super helpful. So I want to talk about returns. Last quarter, you revised your operating ROE target to mid-teens by year-end 2027. You maybe just walk us through the glide path from here and the major building blocks required to achieve that outcome. Maybe just more specifically, how should investors think about the relative contributions from technology-driven cost saves, just overall operating leverage and then the market recovery piece?

So look, the glide path is, I think, one that we believe is very much achievable and it is going to be achieved. With the increase in rates, that could get pushed out a quarter, but let's not get into the quarter-by-quarter gyrations. From where we started, if you look at the Q2 results, number one, you had this issue with the mortgage pipeline that has about a $20 million, $25 million loss that's not going to be repeated because as you start to see changes we've made along with some normalization that's taken place in the MBS market will eliminate that. But more importantly, in mortgage banking, you have this phenomenon when you take an interest rate lock, you recognize the revenue, but the expense associated with that lock gets recognized at the time that loans close.

So as you see rates generally increasing, what happens is, number one, you -- as I mentioned, you recognized your lock earlier, and so you have your expense later. But more importantly, as production slows down, your revenues are slowing down while you're incurring the expense. And then furthermore, your amortization is running higher than the current run rate that you're seeing from your locks. And so as you get a normalization or more of a true-up of revenue and expenses happening roughly at the same time, you're going to see an increase in ROE of a couple of points. And so right off the bat, you're going to get the benefit, you're going to get the benefit of the increase there.

Then as we start to see -- as we see the continued improvement of efficiencies in our consumer direct channel and our broker direct channel, our broker direct channel, we forecast to continue to see growth. Our market share is going to continue to grow there, then you can start to see a couple of points of ROE coming out of that. Then you layer in the fact that our technology expense right now is running at elevated levels because of the work we're doing in our production channel and our servicing channel and our Drive to 55 as we'll be talking about shortly, working on the Cenlar acquisition and really taking advantage of the -- of all of the AI tools that, that cost is going to come down meaningfully. And so you can start -- you can see a couple of points taking place there in improvement in ROE.

And then finally, as you start to see a normalization of the mortgage market, that's going to -- that will get it from the mid-teens to 20% and above just based on the size of the market. I believe that you're going to continue to see this company get more and more efficient and you'll continue to see our costs, whether it's in production or servicing or everything that an organization of the complexity of ours is required to run as efficiently as it runs, you'll see the costs come down in a very meaningful way.

Got it. That's helpful. Maybe just drilling down to the channel aspect. You've spoken in the past about being more selective in correspondent, just given the competitive pressures and elevated GSE activity. Can you provide an update on how you're approaching the channel today and what the optimal channel mix looks like just given the current macro?

Yes. So look, I think as you all know, correspondent is the key strategic initiative we have to really load the flywheel up when rates decline, we have loans that we can refinance into our portfolio. The issue around correspondent is that there are certain parts of the market that we believe are a little bit too aggressive in how they're viewing recapture and the recapture opportunity in MSRs. And so we saw this especially take place at the end of last year. And so we've made the strategic decision that we want to be very precise as we have a reputation for being in terms of how we look at loans in the correspondent market, okay? Are these loans coming from correspondents that have slow prepayment speeds or maybe perhaps we recapture better out of brokers or loan characteristics surrounding the loan.

And so we've just been a little bit more particular and been much more focused in our capital allocation views in terms of bringing on new MSRs. And so that's what's led to the market share dip that you've seen. Having said that, we see in correspondent and certain market participants following our lead in terms of how we view servicing and how we view, in particular, the value of recapture of certain loans. And I expect the market to follow suit very clearly by the end of the year. And all it's going to take is one little rally and people see how quickly certain loans run off that they're going to wake up and they're going to understand how they should be viewing the loans.

Having said that, we are a leading government correspondent aggregator. We're growing our non-QM aggregation business. We're growing our jumbo business. And even on the GSE front, we're making a lot of inroads in terms of the loans that the GSEs don't want to buy. And so we are an active buyer of loans that are typically executing better outside the GSE footprint, and that's business that we're continuing to grow and accelerate in our correspondent channel.

Got it. That's helpful. Turning to broker. That continues to be a focus and the eventual transition on to Vesta remains an important milestone.

Absolutely.

How should investors think about the market share opportunities and competitive positioning in that channel?

Yes. So look, I think that in the broker channel, we all understand what's happening in the channel today. But it's very early to tell what effect that's going to have come 3 and 6 months from now. I do think that we've established ourselves as a clear #2 to the 2 market leaders in the broker channel. And that channel is an interesting one because as a broker, you have to choose which one of those leaders you want to deliver to or you want to originate your loans. And so we're in a very good unique position to be able to really have an opportunity to do business with all of our brokers.

We have great technology that will be fully deployed by the middle of next year to the broker channel that is going to give brokers the opportunity to achieve the efficiencies that we ourselves are seeing in our consumer direct channel. And that's something that's going to be a meaningful effect. And as I talked about on the glide path, we expect to continue to grow share over the next 2 to 3 years in a very, very meaningful way. I think the broker direct channel is one that has been a little bit under a little bit of stress at the moment. But I think that it's too early to tell in terms of what that's going to mean. I believe that margins are going to have to come up in broker, and that's something that we'll see over time.

I also think that some of the phenomenon that we saw in broker that we saw in correspondent with how people were thinking about MSR values and recapture, we're starting to find their ways into the broker channel. And I think that, that's getting mitigated rather quickly. But by and large, we're really bullish on the broker channel. And I think it's something that you're going to see us play a more meaningful role in as time goes on.

Got it. And just to be clear, 10% market share is still the goalpost?

Well, yes, it is. I don't think we'll -- I think suffice it to say, we have 4 months left in this year, so we're not going to get there this year. But we're not going to -- look, market share from my perspective is a guidepost for all of you to think about as you're building your models, where we're going to be. I will tell you, internally, for me, the most important and only driving factor is return on equity and the amount of return we're achieving. And so I think that we're going to get to 10% share. I know that it's just going to -- we've got to get through this little blip here.

Got it. So you've been reporting improving recapture rates across conventional and also government. How much of that improvement is being driven by tech? And are you seeing any early impacts from the Trigger Lead bill?

Yes. So the recapture numbers are really good. They're the best I've ever seen in my career. And under the leadership team that we have in our consumer direct channel, they're hyper focused on recapping the portfolio. We're seeing conventional recapture rates approaching 30%, which I've never seen in my career. And on the government side, we're north of 50%. And so the recapture numbers are really strong. I think it starts with leadership. And then it starts with the workflows that we have in place and the marketing initiatives you have in place to get the recapture.

Then you layer in what's happening with the technology. And as I pointed out earlier, you -- just being able to be more efficient as a loan officer allows you to be able to go after more loans. And so that's the benefit of Vesta and the loan-origination technology that we have in place. Then we've introduced our Natural Language Virtual Assistant or NLVA, that's allowing borrowers to self-serve, and that's leading to increased activity in nights and weekends and holidays. And that's something that we introduced in our consumer direct channel just 60 days ago, and that's something that we're already seeing some exciting results. And look, the goal and we're going to get there is to be able to have what we call the driverless mortgage where borrowers can just self-serve and be able to originate a loan without dealing with a loan officer. And that's something that is going to be more and more prevalent throughout the industry. But I think -- look, I think there is something that we have in the fact that our technology that we're using is legacy free, and it was built to allow for quick adoption of AI.

And most importantly, that AI is being built and driven by the business. And that's something that throughout my 20 years, close to 20 years at PennyMac, I've always felt that the business should drive technology and they should own the building of it. And this is AI is allowing us to do it. And so there, we're seeing real good results. And look, the Trigger Lead bill has helped, okay? We shouldn't ignore that. And it's given us a little bit more value in terms of owning an MSR as opposed to when you pull credit, you have 60 different lenders calling the borrowers and hassling them. And so we're seeing good results coming out of that. And look, that's contributed to these historically high recapture rates.

Got it. Just turning to technology. You've highlighted significant improvement in cycle times, also targeted 80% automation by year-end 2027. What are the most important benefits investors should expect as these initiatives scale, both from cost and a growth perspective?

Look, I think from your position out there, the exciting part should be the volatility associated with the staffing up and laying off of human capital is getting greatly reduced and very quickly. And that should lead to more stable earnings in the company, okay? And reduce some of the volatility around the move in interest rates. And so as I talked about earlier, we were keeping excess capacity for potential rallies and the need for holding that has been greatly, greatly diminished. And so as we look at what our needs are going to be for a 50 basis point rally and 100 basis points rally, it's come down, a big, big number.

So right off the bat, I think that's the -- that, to me, is one of the most exciting parts about the technology that we're building in the organization. I think that, look, from a technology expense standpoint, I talked about, we walked into the year with a lot of initiatives. And I think as we see those initiatives complete, we're going to get real benefits as a company. Obviously, we'll be spending less on technology. But more importantly, we're going to be getting the benefits of the technology that's being built that will lead to greater profitability in the company.

Got it. So you targeted a reduction in servicing costs to $55 per loan from north of $80 today. Where are you today relative to that goal? And also, what are the most important drivers remaining?

Yes. So we started the year at $89 a loan. We expect to finish the year at $80. I expect to be at $70 by the end of 2027. And so sometime by the, call it, end of '28, beginning of '29, I'm really hopeful that we'll be at the $55 a loan. And look, when you have a portfolio of 4 million loans, you can do the simple math for every dollar we save, it's really meaningful to the company.

The drivers of the $80 to $55 are really around a few things. Number one, there's a heavy focus on default. And so there's a lot of work being done on the AI front to give the distressed borrower the opportunity to get solutions, to get questions answered and to help deal with their default in a much faster, more efficient way. I believe that there's many cases where a borrower in distress would rather deal with a Natural Language Virtual Assistant or deal with something AI related as opposed to dealing with a human. And I think that there are opportunities. We saw during COVID, 90% of our borrowers took forbearances without speaking to a customer service representative.

And so building technology solutions and building the alternatives is something that we're very focused on. And the Natural Language Virtual Assistant is, in many ways, more powerful in servicing, but it's very prescriptive what you need to do in servicing. And so if you get into a period of high distress, the need to add more people or the distress that puts on our servicing people are going to be greatly diminished.

Furthermore, I expect the technology that we're built -- the AI that we're deploying on our own technology is going to benefit our customer-service representatives. So whether it's the in-line QC when they're on the phone with the borrower or whether it's just the ability for the borrower to self-serve is going to allow the more simple issues to be dealt with through automated means and allow our customer-service representatives to deal with the more complex issues in a faster, more efficient way.

And then finally, there's a lot of work that goes into investor accounting function, the compliance function, the complaint functions that have a lot of people decked against it that we're quickly deploying AI that will help drive down cost as well.

Got it. That's helpful. Just maybe switching to credit. There's been some headlines regarding government loan delinquencies trending upward this year. What's your outlook on government loans and the broader mortgage credit? And anything PFSI is doing on the servicing side to help performance?

Yes. So our -- look, our delinquency numbers are continuing to hold in really nicely. And on the government side, the government servicing is naturally going to print higher delinquency numbers. We have always taken the position that we want to price servicing at the loan level. And what that means is that we've had a tendency to lean in correspondent more in the direction of higher FICO, a little lower DTIs, a little lower LTVs and really try to focus on giving attribution on what we perceive is going to be the better performing servicing.

As a result, we have a servicing portfolio that is a little bit less credit sensitive than the market as a whole. And so that leads to better delinquency numbers coming out of our government servicing portfolio. On the conventional side, that portfolio continues to operate very strongly. We're seeing delinquency numbers pretty low there. And it's something we're very focused on, but I'm not, as I sit here today, really, really concerned about a credit event as we sit here today. Now if you see unemployment increase or you see other things take place in the market, that could change. But as I sit here today, the portfolio continues to perform strongly. And as I said, at $530 million a quarter of servicing fees, it really speaks to the value of the balanced business model that from when we started this company in 2008, we've set out to create what I think is today the gold standard of the balanced business model.

Got it. So at this point, we'll switch to PMT for a few minutes. Can you just talk in general around the strategy there and what excites you about what PMT is doing?

Yes. So PMT, as many of you know, is a really unique REIT that has been set up to really take advantage of the synergistic relationship it has with PFSI. And so over the years, we've been able to use that synergistic relationship to create really unique mortgage-related investments. As we started the year, we looked at PMT and we said, okay, a couple of things. Number one, PMT has a lot of mortgage-servicing rights. And the returns that they were achieving on the mortgage-servicing rights, when you looked at it versus returns of securitizations of owner-occupied loans or securitizations of agency-eligible investor loans and second home loans or even securitization of jumbo loans, those latter investments look to provide better returns than investments in mortgage-servicing rights.

And so what we've done in PMT is deemphasize the creation of new MSRs, and we've actually sold some MSRs. We had a $13 billion sale that closed this quarter. And we are taking the capital and we're redeploying it into credit investments. And the credit investments that we're creating in PFSI are mid-teens returns in the base case. In a stress case, they're still high single digits. And we believe that as we repurpose capital out of what was going to go into MSRs into credit-related investments, we'll continue to see the returns in PMT go up. And that's something that we're really excited about. And look, there are things we can do to speed that along. There are things we can do to continue to look to grow the returns in PMT. But suffice it to say, we are moving with great urgency to get the returns in PMT back up to double digits.

Got it. How do you view the current dividend of $0.40? And how should investors think about dividend coverage gap over the past few quarters?

Yes. So look, as a REIT, we have to pay out taxable income. And so a lot of times, you'll have a mismatch of source between taxable income and GAAP income. It has been our dividend policy since we started the REIT to try to hold the dividend as close to GAAP income as we can, giving consideration to the requirement to pay out taxable income. And so we've had this issue over the past few quarters where the dividend has been higher than GAAP income. I -- we were -- we continue to look at this, and it is my stated goal to get the GAAP income and the dividend closer to one another. And then -- so as we work through this period where the taxable income gets paid out as a dividend, the dividend itself should migrate closer to GAAP income.

Now that doesn't necessarily mean the dividend is coming down, okay? Or if it does, it's not going to come down to where the GAAP income has been to the last quarter or 2 because at the same time, as we redeploy our capital into mortgage-servicing rights, we're starting to see the GAAP income go back up. And so I think that the final thing that I'm really mindful of is we like to maintain a stable dividend. So as we look out over the next 4 quarters, we're going to look to really establish a dividend that we -- as I said, is reflective of GAAP income that we believe can be a stable dividend, and it's something that's reflective of the performance of the company.

Got it. That's helpful. At this point, we'll just pivot back to PFSI. I just want to get your thoughts on just capital allocation priorities, how you're thinking about capital allocation, whether or not you can do a buyback.

Yes. So look, I think that we have a robust capital allocation framework within the company. Buybacks are on the menu of capital allocation. But having said that, we're very focused on our non-funding debt leverage. And we're sitting today at 1.8x, and I'd like to get that number down a bit. There's natural ways, obviously, that will come down with increased profitability or in a rally, it will naturally come down because of the way we run the servicing hedge. But I don't want to see the leverage go up. And by the way, we -- I would expect that leverage number to come down over the next 12 months just based on what I'm seeing from our financial forecast.

But leverage is at the top of my list. I then say, okay, from a capital allocation standpoint, and we're seeing it in our -- in how we think about correspondent, do we want to invest in the MSRs? Do we want -- do we believe the MSRs can give us the returns, the mid-teens returns that we've been very vocal in saying is our cost of capital? And so even if it's at the risk of foregoing a little bit of gain on sale, we're going to be very focused on making sure that we run this company with a culture and a desire and a need to deliver mid-teens returns to investors. And that's something that is a part of our capital allocation methodology.

And then finally, the investments in technology plays into it as well. And so as we look at where we started the year, as I talked about, we had a lot of technology initiatives that just from a return standpoint made a lot of sense that we opted to sign up for, and we did so with very clear view that we felt production was going to stay strong. We expected, if you think about it, an element of rate cuts to come into play, and we felt that we could get through the year in '27 and be able to afford the technology while reaping the benefits. And as we sit here today, we're already seeing the benefits of it. And as that technology investment comes down, that should give us even more capital to invest in the company.

That's super helpful. We have a few minutes left. I'll open it up for any questions. Okay. I'll just repeat the question. What's the primary method for increasing recapture rates?

So there's a few things. Number one, it's how do you market to the consumer, okay? And you need to be really careful that you're not inundating them with e-mails and phone calls and you're just -- and you're creating a negative experience for that borrower. Secondly, you have to create a user experience for the borrower that comes to you that meets their needs.

So what is that? Do they want to speak to a loan officer? Do they want to originate the refinance through chat? Do they want to come online and be able to do it without a human in the loop? Do you offer them one -- kind of a single thread user experience, whether they're in the servicing, whether they're coming in through servicing or through consumer direct? So if you call in to find out if your taxes have been paid and you can refinance your loan and save $300 a month, I want to be able to make it a seamless experience for you. And then if you want to do it with a human out of the loop or with a human, then you have that opportunity.

Mortgage banking historically has been very siloed between production and servicing. And further to that point, we run 2 call centers. There's no reason for that. And so as we merge kind of -- or we've not merge as we blur the lines between are you a servicing customer or are you a production customer, that's going to lead to higher recapture rates.

And then finally, I think that you want to market the company to your servicing portfolio to help them understand that, although they may have originated their loan with a correspondent or a broker, that you are a top producer that you offer refinance capabilities and you can close a closed-end second within 7 days, you can close a rate and term refinance within 10 to 14 days. And so the marketing of that is vitally important. And those are the marketing initiatives that we speak about.

I got one question over here.

Yes. So that's been the benefit -- look, I think that historically, mortgage banking, in particular, has struggled with the variable cost structure. And in particular, when you see rates come down, there's a lot of time and effort that goes into hiring people and getting more space and having to deal with the infrastructure you need to meet the demands of the market. The really exciting part of what we have done in our consumer direct channel is created a cost structure that we can staff up very quickly through just increasing the amount of AI agents that we need to meet the demands of the borrower, okay? And those AI agents, both are on the front end and on the fulfillment side.

And so just to give you some round numbers, we -- on a 100 basis point rally, we were forecasting we would need 450 LOs. That number is down to 280 right now. And that's not because we're going to do less recapture or less loans. We're just going to become that much more efficient. And that's what we're seeing out of our technology, okay? Similarly, on the mortgage fulfillment side, the amount of people we needed to process a loan is coming down materially, okay, in a 100 basis point rally because of the AI agents that are getting developed on the technology. And so what that means is you just have just a lot more efficient operation that is going to reduce the earnings volatility of the company.

Okay. I think we're out of time, and we'll just end it there. Thank you very much.

Thank you, Terry. Thank you all for your time today.

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Second Quarter 2026 Earnings Call. [Operator Instructions] Additional earnings materials, including presentation slides that will be referred to in this call as well as an Excel file with supplemental information are available on PennyMac Financial's website at pfsi.pennymac.com.

Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.

I'd now like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer. Please go ahead.

Thank you, operator. Good afternoon, and thank you to everyone for participating in our second quarter 2026 earnings call. As shown on Slide 3, PennyMac Financial generated net income of $22 million in the second quarter or $0.41 in earnings per diluted share, representing a 2% annualized return on equity. While interest rate volatility during the quarter created noncash MSR valuation headwinds that impacted our GAAP results, our underlying adjusted earnings per share came in at $1.39 or 7% annualized adjusted return on equity. Although our operational execution remains solid, these results fell short of our expectations as interest rates increased and origination demand declined.

To address these rate headwinds, we have already taken proactive steps to align our cost structure with current market conditions and the operational capabilities provided by recent enhancements to our technology platform. Our results were also impacted by our current funding of major technology initiatives in AI and automation that will structurally lower our cost to produce and cost to service while enhancing the customer experience and expanding our origination servicing capacity. At the same time, I'm particularly encouraged by the strong underlying operational momentum across our platform, highlighted by the meaningful increase in our recapture rates.

Turning to Slide 4. Let's review several key business updates. First, the transition to our new consumer direct loan origination system has helped to facilitate our rapid deployment and development of process automating AI agents. Another example of our technology transformation is the recent launch of our proprietary Natural Language Virtual Agent or NLVA, which handles 24/7 conversational voice interactions across both inbound and outbound customer calls. This technology deployment is already directly benefiting customer engagement and retention.

Conventional first lien refinance recapture rates increased 7 percentage points from the prior quarter to 29%, while government first-lien refinance recapture rates increased 9 percentage points to 59%. Third, we continue to make excellent progress toward onboarding Cenlar's subservicing portfolio with the transaction on track to close in the fourth quarter. And finally, we expanded our strategic partnership with Amazon Web Services to further bolster our transformation as an AI-driven mortgage technology leader.

Turning to Slide 5, I want to address our financial outlook and the steps we are taking to rightsize our cost structure. With a smaller projected origination market due to higher interest rates, we expect adjusted ROEs to remain in the high single digits through 2026 as we reduce our expense base. Earlier this month, we took targeted actions to reduce our production footprint and adjust staffing levels to better align with the smaller market. And because of our investments in technology, we are able to execute these expense reductions while preserving operational capacity when mortgage demand increases. With exciting new technology fully deployed in our consumer direct channel and our AI agents expanding rapidly, we are laying the foundation for unprecedented operational capacity and long-term ROE expansion.

Turning to Slide 6. While our near-term outlook reflects high single-digit adjusted ROEs in the back half of this year, we see a well-defined and visible path back to mid-teens ROEs. The cost realignments we executed this month are expected to generate approximately $60 million of annualized cost savings, which will begin to be realized in the third quarter. We believe expansion in our ROEs will be driven by the structural operating leverage we are creating across the enterprise. Our proprietary AI agents and workflow automation are permanently lowering both our cost to produce and cost to service, expanding our operating margins without adding fixed overhead.

Our trajectory towards higher returns is also based on the operational momentum we are building today with continued growth in broker direct and in consumer direct, where the meaningful increase in our recapture rates positions us to capture upside as the origination market normalizes. And while we are currently running at a higher expense base to fund our tech transformation, these technology expenses have begun to decline, and we expect they will continue trending lower. As we pair this technology foundation with the capital-light scale of Cenlar's subservicing portfolio in the coming months, we expect to realize significant operating leverage.

Slide 7 highlights the opportunity in our consumer direct channel if interest rates decline as well as our first lien refinance recapture rates over the 5 most recent quarters. As of June 30, we serviced a combined $343 billion in UPB of loans with note rates above 5%, of which more than half had note rates above 6%. As you can see on the charts in the middle of the page, government refinance originations from our portfolio in the consumer direct channel have more than doubled from the second quarter of 2025 as our refinance recapture rates have grown to 59% from 44%.

We are seeing even more success in conventional loans, where volumes are up nearly threefold from levels reported in the second quarter of 2025, driven by a significant improvement in recapture rates to 29% from 17%. Given the size of our servicing portfolio, our technology foundation and our accelerating recapture trends, we feel a high level of conviction in our ability to execute on this opportunity as refinance demand grows.

Turning to Slide 8. Our servicing segment continues to demonstrate the power of scale combined with our advanced technology, otherwise known as Place. According to the latest MBA study, PennyMac's direct servicing expense per loan was $89 in 2025, down 8% from 2024 and far below both the large IMB average of $133 and the overall industry average of $185. And we've achieved these low costs despite our higher concentration of government loans, which are inherently more complex and costly to service.

As you can see, our operating expenses remain extremely low at 4.5 basis points of average servicing UPB. The combination of our proven low cost to service and AI capabilities gives me confidence that we will continue to drive down unit costs and expand platform efficiencies as we prepare to onboard Cenlar's subservicing portfolio.

Slide 9 details the transformative operational gains we are realizing in production. Consumer Direct has facilitated a rapid implementation of process automated and AI agents, and we are now beginning the transition of Vesta into our broker direct channel to deliver these same structural efficiencies and automation gains to our broker partners. Across our production workflows, we have mapped and standardized 150 discrete origination tasks. Today, approximately 25% of these tasks are being completed by automated logic or AI agents, and we are targeting 80% by year-end 2027. This technology is delivering immediate measurable benefits. We have already seen a significant reduction in our processing cost to produce a loan, and we are targeting an additional 20% or more by the end of the third quarter.

Similarly, we've seen dramatic cycle time reductions of 40% to 80% across major loan programs, specifically from application to conditional approval on files where our autonomous AI agents are deployed. Speed is a direct cost saver and closing loans faster allows us to price more profitably through shorter lock windows, drastically reduces fallout while delivering a best-in-class experience for our borrowers. And I believe we are still in the early stages of this transformation.

As we scale AI automation, onboard Cenlar's capital-light subservicing portfolio and capitalize on our consumer direct recapture momentum, we are establishing a permanent structural advantage that will compound across our platform for years to come. We have the right strategy, the scale and the technology to navigate current market headwinds while driving a clear return to mid-teens ROEs and delivering compelling long-term value for our stockholders.

I will now turn it over to Dan, who will review the drivers of PFSI's second quarter financial performance.

Thank you, David. PFSI reported net income of $22 million in the second quarter or $0.41 in earnings per share for an annualized ROE of 2%. Adjusted net income was $74 million or $1.39 in adjusted earnings per share for an annualized adjusted ROE of 7%. The $0.98 difference between our GAAP and adjusted EPS was driven by $77 million of fair value declines on MSRs net of hedges and costs, a $9 million valuation gain related to our minority interest in Vesta and $1 million of expenses related to our acquisition of Cenlar's subservicing business. PFSI's Board of Directors declared a second quarter common share dividend of $0.30 per share.

On Slides 11 and 12, beginning with our Production segment, pretax income was $38 million, down from $134 million in the prior quarter and $58 million in the second quarter of 2025. Total acquisition and origination volumes were $35 billion in unpaid principal balance, down 6% from the prior quarter and 8% from the second quarter of last year. Of this, $32 billion was for PFSI's own account and $3 billion was fee-based fulfillment activity for PMT. PennyMac maintained its leading position in correspondent lending. The revenue contribution from the channel was down $9 million from the prior quarter. Fallout adjusted lock volumes were down compared to previous periods due to higher rates in a highly competitive environment, which includes the GSEs.

Correspondent margins were 29 basis points, up from 28 basis points in the prior quarter due to a shift in mix towards higher-margin government loans. Under its fulfillment agreement, PMT retains the right to purchase all nongovernment correspondent loan production from PFSI. However, in June, PMT elected to stop acquiring agency-eligible conventional loans through correspondent production, but will continue acquiring 100% of all non-agency loans. In July, correspondent volumes were down versus the second quarter versus second quarter levels, reflecting our pricing discipline in a competitive environment and our continued focus on allocating capital to drive optimal returns.

In Broker Direct, we continue to see strong momentum despite increasing levels of competition, and the number of brokers approved to do business with us continues to grow, reflecting brokers who are increasingly leveraging our distinct value proposition. Broker Direct's revenue contribution was down $3 million from the prior quarter. Fallout adjusted lock volumes were down 8%, but were up 21% from the second quarter of 2025, driven by market share gains in a larger origination market. Margins increased to 104 basis points from 99 basis points in the prior quarter. Non-QM locks in our broker channel more than tripled from the prior quarter to $515 million in UPB, underscoring the positive reception and rapid market adoption of our expanding product menu.

The revenue contribution from our consumer direct channel declined $36 million from the prior quarter as higher interest rates resulted in lower refinance demand. Fallout adjusted lock volumes were down 32% from the prior quarter. And margins were up to 317 basis points from 267 basis points in the prior quarter, reflecting an increase in closed-end second lien production as refinance volumes declined. Post-lock impacts across the channels resulted in a $23 million pretax loss compared to $13 million of pretax income in the prior quarter. This $36 million shift was driven by adverse market price changes on specialized pools and other cross-channel impacts.

Production expenses net of loan origination expense increased 6% from the prior quarter due to increased capacity and funded unit volume in the consumer direct lending channel. As David mentioned, the cost realignments we executed in July are expected to be reflected in our third quarter results.

Turning to the Servicing segment on Slides 13 and 14. Our total servicing portfolio UPB ended the quarter at $731 billion, up 1% from the end of the prior quarter and 4% from June 30, 2025, as production volumes more than offset runoff due to prepayments. The Servicing segment recorded pretax income of $22 million. Excluding valuation-related changes, pretax income was $99 million or 5.5 basis points of average servicing portfolio UPB, up from $57 million or 3.1 basis points in the prior quarter.

Average custodial deposit balances increased 7% from seasonal lows in the prior quarter, driving a $14 million increase in earnings on custodial balances and deposits. Realized prepayment speeds were 11.6%, down from 13.7% in the prior quarter. Realization of cash flows declined 9% as prepayment speeds declined. Operating expenses in the quarter were 4.2 basis points of average servicing portfolio UPB or $76 million, both lower than prior quarters. Income from EBO activities was higher as buyout and redelivery volumes increased from the prior quarter. Including the provision for losses on active loans, the fair value of PFSI's MSR increased by $110 million. An increase of $96 million was due to changes in market interest rates and another $13 million was due to other model and performance-related impacts.

Hedge fair value losses, including principal-only bond accretion changes were $135 million. Hedge costs were $52 million, up from $14 million last quarter, reflecting elevated option pricing due to heightened interest rate volatility. While rate movements created some adverse impacts in May, our hedging strategy was highly effective for the remainder of the quarter. Our hedge ratio remains near 100% to proactively manage prepayment risk.

Coming out of the quarter, hedge costs have moderated significantly, trending in the mid-single-digit millions of dollars. Maintaining a disciplined continuous hedge is central to how we manage risk. Rather than leaving our balance sheet exposed to directional rate impacts, we prioritize book value preservation to protect stockholder capital across all market environments.

Corporate and other items recorded a pretax loss of $29 million, down from $42 million in the prior quarter as the prior quarter's expenses included elevated marketing expense related to the Olympic and Paralympic winter games. PFSI recorded a provision for tax expense of $10 million, resulting in an effective tax rate of 31%. Total debt to equity at quarter end was 3.6x, down from 4x at the end of the prior quarter and nonfunding debt to equity was 1.8x, up slightly from the end of the prior quarter.

The decrease in total leverage from the prior quarter was driven by a decline in funded debt, reflecting lower overall production. The increase in nonfunding leverage from the prior quarter was driven by higher interest rates, which drove increased utilization of our MSR credit facilities. We expect these leverage ratios to remain near these levels as interest rates remain high. Finally, we ended the quarter with $4 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledge.

We'll now open it up for questions. Operator?

[Operator Instructions] Your first question comes from the line of Doug Harter with BTIG.

Can you just talk about how you're balancing kind of trying to take costs out that you mentioned with also kind of being prepared if we ultimately do get a reversal in rates to not kind of be caught short in capacity like you were late last year?

Yes. Doug, thanks so much for the question. So look, as you know, we've always been disciplined in how we think about expenses and capacity. And look, I think that one of the things that we did at the end of last year, and we talked about was adding capacity in the event that the market did decline. What's really exciting for me is that in the technology work that we've been doing on the new loan origination platform, we're creating that excess capacity. And so there's -- it's going to lead to really a meaningful reduction in costs. And really what the cost reduction that we're talking about is $60 million annually. And it's really coming about as a result of, one, rates being higher, but also as we've gotten more and more confident with the technology, we feel very comfortable and convicted that the excess capacity that we brought on at the end of last year is no longer needed.

And the -- as we sit here today, that as we talked about, there's a lot of work that we're doing to continue to chip away at that. But I think where also, I think we've really shined these last few quarters is just the continued growth of recapture. And so when you look at the recapture rates that we're getting on both the government and the conventional servicing portfolios, they're very, very good. And so I think -- I believe that as we get a normalized market, this work that we're doing, that we've done is going to allow us to maintain the recapture levels as we get into a bigger market.

Great. Appreciate that, David. And then just quickly, the ROE, as you kind of laid out the path back to mid-teens, does that require lower rates? Or do you think you can get there with the current rate environment?

Look, I think the path that we've laid out at this level, and we're at very high levels of rates. Today, I saw the 10 years at -- I'm sorry, the 30 years at a 20-year high. And so at this level of rates, I would say that the path we've laid out is more weighted to an exit of 2027. Obviously, if rates were to decline, that would accelerate getting there -- just getting there faster.

Your next question from the line of Mark DeVries with Deutsche Bank.

David, when you think about kind of getting to your objective of the drive to $55, can you just talk about how much of that is coming from added operating efficiency versus just scale? And how much does Cenlar kind of help get you there?

As we look at the drive to $55, we're really focused on cutting actual expenses without really leaning into growing the denominator as you would talk about in terms of adding Cenlar. There is a lot of AI agents being developed to be put into place for us to be able to drive down the costs. Obviously, with the scale in place, not just from Cenlar, but from our own activity, that will accelerate to get down to $55. But my feeling is that there's a lot of deeper servicing integrations that need to take place. There's a lot of additional agents that need to be built. And I think from the team standpoint, when we look at it, we look at it just in terms of the current -- the effect of the activity vis-a-vis the current expense structure, not focusing necessarily on the scale itself. because I said the scale always helps.

Okay. That's helpful. And then, Dan, I think you indicated that hedge costs have actually come down a lot since the end of the quarter, although we've had another obviously, big spike in rates and a lot of volatility. Can you just talk about how the hedge is performing so far quarter-to-date?

So fourth quarter-to-date, the hedge overall has been more stable than what we saw in the second quarter and especially with the emphasis on hedge costs given what we saw in the second quarter. We've adjusted -- some of our practices in terms of readjusting our hedges, that was part of what contributed to our overall -- the overall cost during the quarter was given the volatility and the overall realized volatility during the quarter and the impact that, that has on the MSR adjusting fairly frequently.

We've sort of calibrated our practices to minimize that the amount of impact that has. And that has been despite the fact that we've had a little bit of uptick of volatility here in the last couple of days has been beneficial, and we've been able to maintain a lower run rate of hedge costs going here into the third quarter. So overall, tracking much better, especially on the hedge cost side than what we saw in the second quarter.

Your next question comes from the line of Crispin Love with Piper Sandler.

Just on the ROE outlook, how would you frame 2027 based on what you know today? Previously, you were expecting getting back to that low to mid-teens by the end of '26, but that's pushed out now. So would you expect ROE to grind higher from the end of the year into 2027, so looking at a low to mid-double digits in '27? Or could there be a step function higher just based on the environment? Just curious on how you're thinking about this.

Yes. Look, I think, Crispin, you have it identified correctly. I think as we look at where we are in rates today, combined with the fact that we're going to be reducing expenses throughout the year, I view us leaving 2026 kind of in the lower part of that range, call it, high single digits to low double digits. I generally think that throughout the year, '27, that's when you'll see the step up to the mid-teens level that we spoke about. I think there's going to be real benefit to some of the key initiatives we're working on in 2027, including things like getting our broker direct channel on to Vesta. That's going to be a key component that we should have them on by the middle of 2027.

I think we'll begin the work in terms of transitioning Cenlar onto the servicing portfolio and achieving some of the efficiencies there. And I think that we're going to continue to focus on driving down the cost to originate in our consumer direct channel. But I think that, obviously, as you on the call is aware of, the path to how quickly we get that, there is an interest rate component to that. But even without interest rates moving, I feel good about exiting '27 at these levels at the mid-teens levels that we talk about.

All right. Great, David. I appreciate the color there. And then just on the broker channel, you discussed elevated competition. Looking in your deck, your market share over the past year or so is about 6%. Can you remind us of your targets here? Was it getting to 10% by the end of '26. First, is that still attainable? Is there investment needed there that may be now on hold just given the plans? And what would you need to do to get there?

Yes. So look, I think that our view in terms of share growth in broker direct or TPO is number one, we want to do it profitably. And we're being disciplined in how we approach that. Obviously, that part of the market, there's -- it's been a little bit more volatile with some of the market participants. I will tell you that given the work we're doing in terms of getting broker on to Vesta, I don't see us getting to that 10% market share by the end of '26. But I can tell you that the brokers, I think are going to be really enthusiastic about what they're going to see when we get broker on there in mid-'27. So we don't want to do anything irrational or do anything that's not disciplined. And so that's how we're thinking about the broker channel.

Your next question from the line of Terry Ma with Barclays.

I guess maybe just on the ROE guide. Is it still a target that high teens to low 20s is the kind of right normalized ROE for the business going forward? And then as we kind of think about it, any reason why it can't be higher than that with all the enhanced efficiencies from tech investments that you're making?

Yes. So look, the mid -- the high teens to low 20s is a guiding principle of this company, and it will be -- continue to be a guiding principle of this company. I think that what we're in the midst of now is, one, we're at the higher rates. Two, we're investing a lot in technology. And that's an investment for the long term to create a consistent high teens to low 20 operating company. And so I think that it's going to continue to grind up there. And I see that we are going to be one of a few winners because we can afford to make the investment in the technology and to build something clearly unique in the market. And when you combine what we're doing on the production side to what we're doing on the servicing side, that's something to me that is truly, truly unique.

Our servicing technology is something that has, I think, served us really well. As you can -- as we talked about, we are the low-cost servicer by a meaningful, meaningful amount. Industry parties see the low cost, they see the scale benefits. It doesn't go unnoticed. And I think as we think about continuing to drive down costs, I think we are really the only ones who can get down to $55 a loan. And that's, by the way, with a heavy government portfolio. And so what we're in the midst of right now is a perfect storm of negatively of where the fact that we are investing a lot in the future and in technology, combined with the fact that we see rates at high levels as it pertains to this cycle. And so I think that you're going to see a company coming out of this. I truly believe that we are going to live by the high teens to low 20 North Star that we've run this company on for the last 18 years.

Got it. That's helpful. And then on the recapture rates you guys show on Slide 7, it's good to see the consistent improvement as you embark on this tech journey. I guess, is there a target or a goal in mind that you have like after you kind of run rate all these improvements? Just trying to figure out what the upside is.

Yes. So look, the target for us is we want to recapture every possible loan that we can. And the work that the team is doing, both operationally and analytically using AI is allowing us to meaningfully grow our recapture levels. And I think that as we deploy the work in Vesta to close loans faster, to close loans cheaper, those recapture rates are going to be growing even more. The idea that you can close a VA IRRRL in 14 days when the rest of the market is taking 34 days is a meaningful competitive advantage. And that's something that we're guiding towards. And so I think it's more -- we're looking at it as ways to drive down the cost to originate, drive down the days to close. And then the investment in the technology and the consumer experience, I believe we'll continue to see those recapture rates grow.

Your next question comes from the line of Bose George with KBW.

Your volume in the correspondent channel looks like it declined again or at least the share probably declined a little bit again. Can you just talk about the competitive dynamics there? Is it still the cash window? Are there other factors? And then when we just think about the share, do you think it kind of stays at this level for the foreseeable future until something changes?

Look, I think that in correspondent, we have a combination of factors taking place. As you point out, we're seeing the GSEs continue to be aggressive and on some days, they are even more aggressive through the cash window. And so that's a meaningful change from even Q4 of last year. We are maintaining our pricing discipline. We have a very large servicing portfolio with a lot of loans that would become refinanceable in the event of an interest rate decline. And I think we want to maintain our dry powder should perhaps rates move higher and we need more leads or we want to do more activity.

And likewise, I think that we want to do so at adhering to our margin discipline. I do think that there are market participants at the time to time that perhaps are being a bit irrational. But I wouldn't read too much into the correspondent decline. I think it's more, again, a combination of the GSEs and from time to time other participants. But we're still the leaders in this space, and we'll continue to be the leaders in the space.

Okay. That's helpful. And then actually, just looking at the difference between GAAP and operating results, I mean, is there something structural that maybe Ginnie Mae convexity, which just makes it harder to hedge that asset? And I mean, are you comfortable that, that gap will close in the mid-teens next year is both a GAAP and an operating ROE?

Yes. Look, let me talk about the results and the hedge and where we sit today. As everyone knows, the hedge we have in place protect MSR values against interest rate moves. And I think -- and I know in this quarter, we did that. The MSR rose by $110 million and the hedge offset as intended. We had $135 million loss on rate moves. What we had was $52 million of hedge costs. And so that's what -- so those 2 components are what resulted in our $77 million loss. Putting aside the $52 million of hedge costs for a minute, the underlying protection worked well. And rather than an intentional attempt to perhaps hedge out sell-off gains or this was driven by a somewhat conservative positioning for an interest rate rally that ultimately didn't materialize, which naturally neutralize our sensitivity as rates moved higher.

And I say interest rate rally not that we're making necessarily market calls. It's just we were running a hedge coverage ratio of close to 100%. And so really, what the net result really came down to this perfect storm and unusual volatility disconnect and really some specific headwinds. And that was really a few things. One was volatility. In Q2, volatility traded in a tight 40 basis point range, primarily on the geopolitical tension and the widening distribution of monetary policy outcomes, and we saw a sharp diversion between implied and realized volatility. As a matter of fact, in the second quarter, this is a quarter that had the largest quarterly drop in short-dated implied volatility in 15 years, where realized volatility didn't decline. And so this -- that drove a loss on the option holdings that we have.

And furthermore, as we had to rebalance as rates went up, the rebalancing costs were elevated. At the same time, we had this kind of weird phenomenon where Agency MBS spreads widened as rates moved higher, which further magnified our MSRs negative convexity. And to manage that, we had to reduce our positive carrying MBS holdings, which pushed hedge costs higher. And so really, I think what we've done is we've seen -- we've maintained our discipline.

We're hedging the MSR. As Dan pointed out, hedge costs this quarter are down to the mid-single-digit millions, and we're keeping the book positioned for a wide range of rate and economic outcomes. And I think the hedging story is one that is not going to be unique to us. And I think when we see how everyone else has done, I think you're going to see that we actually did a very good job and just the hedge cost that really in this perfect storm that led to the $77 million loss.

Your next question from the line of Don Fandetti with Wells Fargo.

Can you talk about Q2 margins for broker and consumer direct if you kind of strip out some of the non-QM and second lien just sort of directionally and where you think those could be going near term, just given a smaller market?

So look, I think that as we see in Broker Direct, margins have been pretty steady. I think we have broker direct margins running roughly 100 basis points and I think that there's still -- from time to time, you see some pressures from other larger market participants. They were up in Q2 from 99 bps to 104 bps. But I generally think that we're going to see rational pricing taking place. Obviously, the non-QM, as you well pointed out, and jumbo margins are higher, and that leads to higher reported margins. But I would say, generally speaking, that the margin story in broker direct as well as correspondent consumer direct are staying very steady.

Got it. And back to the ROE commentary, thanks for all the detail and covered a lot of angles. I guess I'm just trying to understand the sort of path to the increasing ROE. Can you do that in this type of rate market, let's say, the 10-year goes up a little bit. Can you sort of still hit that upward slope through some of the efficiencies and things of that nature?

I believe so. And I truly believe that. I think, number one, you take, for example, the $60 million cost reductions that we just announced. And look, there's going to be additional efficiencies that we're going to see both in our consumer direct channel and in our broker direct channels, we get broker direct on to Vesta. And so this is going to have a meaningful effect in terms of the cost to originate. I also believe that we're going to continue to grow share profitably in broker direct and I think as we grow our servicing portfolio, you can't help but grow share a bit in the consumer direct channel while having a very -- being able to compete in a meaningful way and being the low-cost producer will allow us to grow profitability.

In addition, I think there's -- I don't want to say that there's a finite amount of tech initiatives. What I will say is we have a lot of tech initiatives taking place at the moment. And as we wind those down, of course, there will be others that arise. But I think generally speaking, our tech spend is going to come down in a meaningful way, not just from the number of tech initiatives, but also the cost to develop AI agents, the cost for developers to do their work is dramatically decreasing as they use AI tools like Claude Code and Cursor. And so I think you'll see tech expense coming down in a meaningful way.

And then this is even before we start bringing on the benefits coming out of the Cenlar transaction. And that's going to have a meaningful effect. And what's exciting about that is it capital-light fee growth, which is an area of our company that has real potential to continue to grow. Cenlar is going to continue to add clients. We've been in the subservicing business for now 4 years. We added a couple of clients ourselves this quarter. Obviously, it's going to come together as one platform. But I think we'll get real benefits there. And as we bring the Cenlar clients onto our platform, we're going to get the efficiencies that come from being a higher cost platform to a lower cost platform.

And I think just to add on to that, in terms of a lot of these initiatives, as David mentioned, in particular, in servicing, reducing the cost to service, adding the equity-like flows are not rate dependent and bringing down the technology expense are not rate dependent at all. Expanding our presence in the direct lending channels from the base that we are today is also not rate dependent, but will expand our overall earnings. And I'd say if you look at our historical operating ROEs going back to the first half of last year, where we were in the mid-teens returns, it's -- we've shown that we can reach those levels even at these higher interest rate levels. We were at around the same level of rates at the beginning half of last year, and that's before we add some of these other additional drivers.

Your next question comes from the line of Trevor Cranston with Citizens JMP.

One more question on the expense side of things, and I appreciate all the color you've given there and the expectation for near-term savings levels. Looking at Slide 9, you have the target there for the year-end '27 of getting up to kind of 80% of the workflow automated. Is there a way to sort of translate that goal of moving from 25% to 80% into kind of expense savings in terms of the cost to produce per loan sort of beyond the kind of 20% near-term target you guys have shown there on the top right.

Yes. I think that as we sit here today, I think the 25% is what I would call more low-hanging fruit. We're seeing the expense reduction coming in about 25%, 30%. I think it's -- that 80% number, I would be remiss if I had a ballpark number. I think, look, a lot of it is going to depend on the scale of the organization, and it's going to further, I think, depend on volumes to some degree. But suffice it to say that should come down -- look, the cost to originate should come down by more than 50%, okay? That's a given. Whether it's 60%, 65%, I don't -- I think that we'll have a better sense of that in the coming quarters.

Your next question comes from the line of Kyle Joseph with Stephens.

Just kind of wanted to refresh going over to the balance sheet. You guys have been drawing down a little bit more on your bank lines. It looks like you're up to $1.5 billion. Just kind of what's driving that? And then kind of refresh us how the balance sheet looks after when Cenlar closes?

Sure. So Overall, as we've mentioned in some of the commentary, as interest rates increase, everything else being equal, we have a couple of impacts to the balance sheet. Overall, as the production environment shrinks and production volumes decline a bit, our overall leverage declined. So it went from 4x to 3.6x last quarter to 3.6x this quarter. We have a bit -- if you look at the nonfunding leverage of sort of the opposite movement where as interest rates increase, that drives an increase in our overall MSR valuation and a decline in our hedge. The decline in our hedge generally leads to a margin call, which needs to be funded. And so we draw on our bank lines to fund those amounts that are driven by the increase in the MSR value. And of course, we have more collateral in terms of our MSR to draw against. But it does lead to upward pressure in terms of our nonfunding leverage ratio. So it picked up slightly from 1.7 to 1.8. But in the context of the overall balance sheet and leverage on the balance sheet, that declines.

And so we look at those 2 things in conjunction or in balance and are comfortable at the levels that we're at today and expect our overall leverage to remain in that area to the extent that overall -- to the extent that rates remain in this vicinity. In terms of the impact of Cenlar, when we close the Cenlar transaction versus tangible equity, we would expect a slight increase in terms of our terms of leverage, given that the Cenlar transaction will include a bit of goodwill and intangibles, so around $230 million to $240 million of goodwill and intangibles, we would expect to recognize on the balance sheet as a -- in conjunction with the transaction. And so that overall will have the effect looking at tangible equity of slightly increasing the reported leverage ratios. That, of course, will be offset by the increased cash flow and earnings from the Cenlar transaction, and we'd expect that to both contribute positively to the ROE over time and also help to reduce the leverage ratio as we move forward from that point.

Your next question from the line of Ryan Shelley with Bank of America.

Number one, on Cenlar, there's a comment here about expanding B2B relationships and potential for additional product offerings post close there. Obviously, that hasn't closed yet, but could you just provide us any insight on potential areas you might like to expand with the capabilities of Cenlar?

Ryan, can you speak up a bit?

Yes. Sorry, is that better?

Yes.

Yes. Sorry. Just a quickly recap. On the Cenlar, there's a comment in the deck around potential additional product offerings. Obviously, it's early, hasn't closed yet. But could you just give us some color on what potential additional products you might like to build using the capabilities you get with Cenlar?

Yes. Look, I think that we have some ancillary businesses and title and appraisal that I think can lead to some additional ancillary income. I think that there's other things we can do vis-a-vis our technology to be able to offer technology solutions to reduce the cost to the 100 Cenlar clients that they're incurring because they have to do certain middle office work and other reconciliations that through AI and other tools, we can help to reduce the cost. I do think that there's other product offerings that as we think about subservicing and when we started subservicing, we thought of things that we can bring to our subservicing clients, including potential warehouse financing or servicing advance financing. But that's down the road. There's a good amount of that available in the market today. But I think there is real opportunity to work with our business partners that we're going to have once we close the Cenlar transaction.

Got it. And then just one more quick one, if I may. So EBO loan volume was up sequentially about $600 million. Could you give us some color on how that's trended post quarter? And then just any color on if there's any particular drivers to call out there?

With respect to EBO volume. Overall, EBO volume is -- as we're moving into the next quarter, we are seeing that slow slightly. But a couple of factors there. One, at higher levels of rates, the overall sort of modifications that can be done at market rates are slightly higher and so somewhat similar to -- and the gains related to redelivery of that are potentially lower for lower level of rate, however you want to think about that. And so that is a bit of a dampening effect in terms of the EBO gains and activity.

We've also seen a little bit of slowing in terms of modification volume driven by some of the changes in the FHA, some of the changes that we previously discussed around FHA modifications and the fact that they now require trial payments and that they are -- there's lower ability to remodify loans also has a bit of a dampening effect in terms -- or we're expecting a bit of a dampening effect of modifications in EBOs as we go into the second half of the year.

There are no further questions at this time. I will now turn the call back to David Spector for closing remarks.

I just want to take these last few minutes and thank you all for joining us. And to remind you, if you have any additional questions, please reach out to our Investor Relations team. And again, thank you so much for the time.

This concludes today's call. Thank you for attending. You may now disconnect.

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s First Quarter 2026 Earnings Call. Additional earnings materials, including presentation slides that will be referred to in this call as well as an Excel file with supplemental information are available on PennyMac Financial's website at pfsi.pennymac.com.

Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.

Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer.

Thank you, operator. Good afternoon, and thank you to everyone for participating in our first quarter 2026 earnings call. As shown on Slide 3, PennyMac Financial generated net income of $82 million in the first quarter or $1.53 in earnings per diluted share or an 8% annualized return on equity. Excluding the impact of valuation-related changes and transaction expenses related to our acquisition of Cenlar's subservicing business, adjusted EPS was $2.19 per diluted share or an 11% annualized adjusted return on equity.

As Dan will expand upon, we continue to optimize our hedging strategies to converge GAAP and adjusted ROEs. While our adjusted return on equity this quarter remained below our longer-term expectations, we remain intensely focused on maximizing returns on invested capital over the near and long term.

I am also optimistic regarding the underlying trends in our business, particularly higher recapture rates in consumer direct channel, coupled with increasing revenue per loan. In addition to these positive trends, I will also address initiatives we currently have underway later in this call.

Our optimism is most evident in the production segment, where we are strategically growing in areas that will optimize returns on capital in what remains a dynamic and fragmented market. Specifically in the correspondent channel, we are leveraging our leadership position to exercise rigorous pricing discipline on the related MSRs while driving an increase in margins across various products. This pricing discipline, combined with continued growth in our consumer and broker direct channels led to production segment generating its highest level of pretax income in nearly 5 years.

In addition, we have 3 distinct production channels: correspondent, broker direct and consumer direct, all of which are operating at significant scale. This diversified platform provides us with multiple complementary avenues for sustainable growth and a unique ability to shift our focus and resources to the channel that offers the most attractive risk-adjusted returns.

Turning to Slide 4. Let's review a few additional business updates. During the quarter, we repurchased 560,000 shares or 1% of our outstanding stock for $50 million at a weighted average price of $89.28 per share as we saw tremendous value in the stock at these price levels. I am also pleased to report that we remain on track to close the acquisition of Cenlar's subservicing business in the second half of the year. Our teams are collaborating effectively to ensure a seamless integration of Cenlar's subservicing business into our operations. As outlined in our investor update presentation in February, once fully integrated, we expect strong returns from this acquisition, and we are excited about the increase in scale and diversification that this transaction will provide.

Turning to our consumer direct origination channel. The deployment of Vesta has been complete for new loan originations and has begun to drive operating efficiencies through the introduction of AI agents and the resulting reduction in previously manual tasks. On recapture, I am also pleased with the meaningful progress we have already achieved with consumer direct origination volumes up meaningfully from recent periods and conventional first lien refinance recapture rates up 5 percentage points from the prior quarter to 22%. This momentum has continued into the second quarter with conventional first lien refinance recapture rates running near 30% in the month of April.

Turning to Slide 6. Our mortgage banking operating pretax income was $190 million for the quarter, up from $173 million in the fourth quarter. As we look ahead, we expect adjusted ROEs to remain near current levels in the second quarter before increasing to the low to mid-teens in the second half of 2026 as we realize the benefits of technology and efficiency enhancements.

As just mentioned, we have lowered our ROE guidance from the mid- to high teens to low to mid-teens in the second half of the year due to 2 main factors. First, we have decided to meaningfully accelerate our technology investments to drive significant operational efficiencies in both production and servicing. And second, we expect less origination demand with interest rates at current levels. Over the medium to long term, we continue to expect PFSI to achieve ROEs in the high teens to low 20% range, which we expect to achieve through the realization of these technology investments and increasing scale.

On Slide 7, we highlight the future opportunity within our consumer direct channel when rates do decline as well as our first lien refinance recapture rates over the 5 most recent quarters. As of March 31, we serviced a combined $320 billion in UPB of loans with note rates above 5%, of which more than half had note rates above 6%. As you can see on the charts in the middle of the page, government refinance originations from our portfolio in the consumer direct channel are nearly double first quarter 2025 loans and our first lien refinance recapture rates remain strong in the 50% range.

We are seeing even more success in conventional loans, where volumes are up more than fivefold from levels reported in the first quarter of 2025, driven by the previously noted improvement in first lien recapture rates to 22% from 17% in the prior quarter. And as I mentioned earlier, in April, we achieved conventional first lien refinance recapture rates of nearly 30%.

We also completed the transition to Vesta, our new consumer direct loan origination system during the first quarter, and we are in the process of working through the pipeline of loans originated on the old system, which we expect to have completed in the second quarter. This new system has already substantially improved the customer experience. I am very pleased with these initial results and expect to realize material benefits of our new platform in the second half of this year. The early success we are seeing is a direct byproduct of our ability to reduce cost per loan and the days to close as well as leverage real-time data to engage borrowers more effectively.

We have also started the successful release of AI agents within our fulfillment process across multiple products. We are rapidly moving towards a model with exceptionally low manual intervention and in some cases, we will have removed human touch points entirely, thereby improving the customer experience, further increasing recapture rates and driving higher operating margins. Furthermore, we are focused on the implementation of additional specific tech-enabled solutions, ranging from AI-driven lead prioritization to enhanced digital self-service.

Turning to Slide 8. You can see how our state-of-the-art technology platform is driving significant operating leverage and superior unit economics across the entire enterprise. By combining our technology foundation with our scale advantages, we are driving unit costs to historic lows. As noted on the chart, our direct expenses within the consumer direct channel dropped 26% compared to 2022 levels. Similarly, in our servicing segment, our operating expenses as a percentage of total servicing UPB have dropped 24% to 4.5 basis points as we continued to enhance workforce productivity and automate complex tasks through the deployment of sophisticated technology. In our corporate and other segment, we are clearly achieving more results.

By leaning into a unified technology foundation, we have reduced compensation as a percentage of adjusted revenue to 3.7% from 6.5% in 2022, a decrease of 44%. While these results are compelling, we are in a new stage of transformation and AI implementation with significant runway ahead to further optimize our platform, reduce unit costs and capture additional economies of scale. By combining our pricing and capital allocation disciplines with a best-in-class technology infrastructure that is already delivering record low unit costs, we are building a more resilient and profitable enterprise. We have the team, the technology and the scale necessary to drive toward our long-term target of high teens to low 20% ROEs.

I will now turn it over to Dan, who will review the drivers of PFSI's first quarter financial performance.

Thank you, David. PFSI reported net income of $82 million in the first quarter or $1.53 in earnings per share for an annualized ROE of 8%. Adjusted net income was $118 million or $2.19 in adjusted earnings per share for an annualized adjusted ROE of 11%.

The $0.66 difference between our GAAP and adjusted EPS was driven by 2 items. First, $44 million of fair value declines on MSRs net of hedges and costs. This includes principal-only stripped MBS valuation-related accretion changes and provision for losses on active loans. And second, $3 million of expenses related to our acquisition of Cenlar.

PFSI's Board of Directors declared a first quarter common share dividend of $0.30 per share. And as David mentioned, we repurchased 560,000 shares of common stock for $50 million.

On Slides 10 and 11, beginning with our production segment, pretax income was $134 million, more than double from the same quarter a year ago and up 5% from the prior quarter. As David mentioned, the increase from the prior quarter was driven primarily by strong execution in consumer and broker direct, which combined represented 75% of PFSI's account revenues.

Total acquisition and origination volumes were $37 billion in unpaid principal balance, down 12% from the prior quarter. Of this, $34 billion was for PFSI's own accounts and $3 billion was fee-based fulfillment activity for PMT. Total lock volumes were $44 billion in UPB, down 4% from the prior quarter.

PennyMac maintained its leading position in correspondent lending. Correspondent acquisitions were $24 billion in the first quarter, down 20% from the prior quarter. While our platform continues to drive profitable and sustainable growth, we are refining our production mix to better withstand market volatility and maximize the long-term value of our servicing portfolio.

Correspondent channel margins were 28 basis points, up from 25 basis points in the prior quarter due to a shift in mix towards higher-margin government loans given the increased levels of competition from the GSE cash window, combined with a meaningful increase in average revenue per loan. Under its fulfillment agreement, PMT retains the right to purchase all nongovernment correspondent loan production from PFSI.

In the first quarter, PMT purchased 18% of total conventional conforming correspondent production and 100% of nonconforming correspondent production, both percentages essentially unchanged from the prior quarter. In broker direct, we continued to see momentum as we position PennyMac as a strong alternative to channel leaders. Originations were up 3% and locks were up 26% from the prior quarter. The number of brokers approved to do business with us continues to grow, up 12% from the same time a year ago, reflecting the growing number of brokers who are increasingly leveraging our distinct value proposition. The revenue contribution from broker direct was up from the prior quarter due to higher volumes. Though margins were down slightly, revenue per loan increased, reflecting an increase in our average loan balances.

Additionally, we recently launched the non-QM product within our broker direct channel and are already seeing strong initial take-up and positive traction from our broker partners as they leverage our expanded product suite. Lots of non-QM loans in our broker channel were $151 million in UPB during the first quarter, and momentum continued in April with $157 million in UPB of blocks.

In consumer direct, volumes were up with originations up 15% and locked up 24% from the prior quarter, driving revenue contribution 30% higher than in the prior quarter. While margins were down slightly, revenue per loan increased sequentially across our conventional jumbo and closed-end second products, indicating higher average loan balances for those loan types.

Post-lock activities across the channels contributed $13 million to pretax income, down from $34 million in the prior quarter, which benefited from strong secondary market execution relative to initial pricing. Production expenses net of loan origination expense increased 11% from the prior quarter due to higher volumes in direct lending.

Turning to servicing on Slides 12 and 13. Our total servicing portfolio UPB ended the quarter at $720 billion, down only 2% from the prior quarter end despite runoff in MSR sales, which were largely mitigated by additions from new production. The servicing segment recorded pretax income of $13 million. Excluding valuation-related changes, pretax income was $57 million or 3.1 basis points of average servicing portfolio UPB, up from $45 million or 2.5 basis points in the prior quarter.

Earnings from custodial balances were down from the prior quarter, primarily due to lower short-term interest rates. Though realized prepayment fees increased slightly from the prior quarter, realization of MSR cash flows was down 7% due to the expectation of lower prepayment fees in future periods resulting from portfolio burnout.

Operating expenses remained low at 4.5 basis points of average servicing portfolio UPB or $81 million in the quarter. EBO revenue increased due to higher initiation of modifications and redelivery margins as a result of lower rates in the beginning of the quarter. Including the provision for losses on active loans, the fair value of PFSI's MSR increased by $177 million. An increase of $201 million was due to changes in market interest rates and was partially offset by $24 million in declines from other model and performance-related impacts. Hedge fair value losses, including principal-only stripped MBS valuation-related accretion changes and hedge costs were $221 million.

As we talked about last quarter, we increased our hedge ratio to near 100% to proactively manage prepayment risk. While agency MBS spread volatility and tightening of the primary/secondary spread drove a net fair value decline this quarter, our positioning reflects our disciplined approach to maintaining book value stability across a volatile interest rate environment.

Corporate and other items recorded a pretax loss of $42 million, up from $30 million in the prior quarter, primarily driven by $9 million in marketing activations related to the Olympic and Paralympic Winter Games, which are not expected to recur in upcoming quarters as well as $3 million of transaction expenses related to our acquisition of Cenlar's subservicing business. The prior quarter also included reduced expenses related to technology accruals.

PFSI recorded a provision for tax expense of $22 million, resulting in an effective tax rate of 21.4%. Total debt to equity at quarter end was 4x and nonfunding debt to equity at the end of the quarter was 1.7x. The increase in total leverage was driven by higher direct lending production and the increase in nonfunding leverage was driven by higher interest rates, which drove increased utilization for our MSR credit facilities in addition to share repurchases. We expect these leverage ratios to remain near these levels as interest rates remain at current levels.

Finally, we ended the quarter with $4.2 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledged.

We'll now open it up for questions. Operator?

I would like to remind everyone we will only take questions related to PennyMac Financial Services, Inc. or PFSI. [Operator Instructions] Our first question comes from the line of Doug Harter with BTIG.

Hoping you could talk about any impact the volatility had on revenue margins in the quarter whether it was increased hedging costs or less effective execution.

Congrats on the new role.

Thank you, David.

So on the production side, I am really encouraged by what I saw take place in the first quarter. On the correspondent side, we saw margins up quarter-over-quarter from the fourth quarter, and we're seeing a continuation of that as we start the second quarter.

In GPO, we're seeing margins currently holding near to the levels we saw in the first quarter. They're actually up a bit, and they're up from the fourth quarter. In our consumer direct channel we're seeing a consistent margin story there, while the mix is going to -- the mix in the second quarter will probably warrant a higher margin of course.

But I'll tell you that just the focus that we're seeing in the company in driving up the revenue per loan is really showing in our results that we saw in Q1. It's going to continue to be a focus of the company.

On the hedge side, Dan, do you want to answer on the hedge side?

Sure. With respect to hedging, as we talked about in the call there was a fair amount of interest rate volatility during the first quarter as you saw in terms of the results and how we laid it out. We think we navigated that volatility well overall with respect to our rate impacts, fairly minimal impact, just $7 million difference between the MSR and hedge versus our rate impacts.

Hedge costs, we did see as a little bit elevated, particularly related to the increase in volatility toward the end of the quarter, drove up our hedge costs in March, and that contributed the majority of the hedge costs that we saw, the $14 million in hedge costs that we saw during the quarter. But overall, pleased with our results and our navigation through what was a fairly volatile period in terms of interest rates during Q1.

Your next question comes from Kyle Joseph with Stephens.

I guess, yes, as it pertains to hedging, I'd start, and I did hear the operator's warning, but just pending the acquisition how are you thinking about balancing hedging with how the business looks on a pro forma basis? Like, any changes we should expect there?

No real changes expected to our hedging strategy as we get through the acquisition. Just to refresh, the business that we're acquiring from Cenlar, their subservicing business is not the MSRs. They have -- it's really a fee-for-service business and so equity light. They don't have any MSRs in particular to speak of.

And so our overall strategy in terms of hedging the MSR, we expect to be consistent with how we've operated to date and not really change with respect to the additional subservicing business that we're bringing on.

Got it. And then just to follow up, just been getting more and more questions on the Homebuyers Privacy Protection Act and how you're thinking about any potential changes to position the business to best address that?

Are you referring to the trigger leads, Kyle?

Yes. Exactly. Yes.

Yes. It's really early. The law went into effect on March 5, and we're just starting to see loans come through that funded that locked at or after that date. We'll have a much better look through in the second quarter. But from the little that we've seen, it's generally positive.

Your next question comes from the line of Bose George with [ KBW ].

Actually, just in terms of your guidance, it looks like you removed the high teens part of the guidance. Now it seems like it's the mid-teens. Is that a reflection of the smaller -- the mortgage market that's expected this year with the move up in rates?

We are -- I will tell you, I've not removed the high teens from the long-term ROE guidance of this company. We believe we're a high teens to low 20% ROE company.

In the short to medium term, there's really 2 factors that led us to just kind of slow down the return to the historic levels that we've seen. One is the technology spend, and we are investing across -- both across our production channel and our servicing channel.

On the production side we've deployed our new technology into our consumer direct channel. And now we are very busy introducing and implementing AI agents to help reduce not only the cost to fulfill, but also to continue to grow the efficiencies that we're seeing on Vesta for our sales associates.

And so based on the early results that we're seeing from both, we feel it's incumbent upon us to really move quickly to take humans out of the loop and to be able to close loans faster and cheaper. And so that's going to lead to just growing scale within our consumer direct platform.

Similarly based on the results we're seeing in our consumer direct channel, we are moving quickly to move our broker direct channel onto the same platform. There's work that needs to be done to be able to build a broker portal that is very similar in experience and feel to the portal that our brokers experience today. And so that work will be done in the second and third quarters.

We expect to see the first broker loans coming on at the end of the year with the full migration taking place in 2027. But the exciting part about the move in broker is that the work we're doing on AI agents for our consumer direct channel are very relevant for our broker partners. And so I feel it's incumbent upon us to deliver the same experience for our brokers that we're seeing within our consumer direct channel.

Similarly, on the consumer direct channel, we're doing work to create a human-out-of-the-loop mortgage origination process that I'm excited about that I'm hopeful -- not hopeful, I know we'll see in the second half of this year. And then we're always looking to reduce costs in our correspondent channel and our shared service groups.

But other than the technology shared service groups, the cost -- the technology costs with those are pretty minimal with what I'm seeing out of Gemini and Claude and the add-ins that they have to Excel, there's a lot of great work being done around the organization.

On the servicing side, there's similar work we're doing to drive down the cost to service., okay? And we have a long term -- not long term, a medium-term goal to bring that cost down to $55 a loan a year. It's what we call the drive to $55. And we believe we can get there in 24 to 36 months. And so the benefit there is not only to our own servicing portfolio, but as we add capacity and scale to our servicing platform, we're going to get the benefits with the Cenlar loans.

And so it's just -- it's a lot of good exciting investment that I expect is going to really deliver returns starting in the second half of this year, but into '27 and '28. And I feel it's incumbent upon us to make these investments to continue to retain our competitive advantage in the industry and hopefully widen the moat.

On the origination side, I think to the point you raised there the Fannie MBA average for 2026 is at $2.3 trillion. But given where we're seeing rates today and given where it looks like they're going to be for the future, I suspect and I believe they will be lower. And so that will lead to lower production volumes.

Some of that will be offset by lower amortization on the portfolio. But I think given the results we're seeing out of our production units, when rates do decline, I expect to see very good recapture coming out of our consumer direct channel. I expect to see broker direct continue to grow share while growing revenues.

And in our correspondent channel, they had a great first quarter. And when you consider with the GSEs being more aggressive through the cash window and conventional, they really did a nice job at increasing margins, increasing revenue per loan, maintaining the leadership in the correspondent channel and I would expect that to continue for 2026.

Okay. Great. That's great color. And just a quick follow-up. The mix in the -- the product mix, just given what you noted in terms of the GSEs continuing to be competitive, do you feel like the mix is going to be similar where there's -- you're leaning more into the broker and direct-to-consumer?

I think, look, we lean into all 3 channels, but we do so to do it profitably, okay? We -- I often tell people around here since 2023, we, as an industry, have underexecuted to our cost of capital. And we, as an industry, have to make our cost of capital.

We have to do what we need to do to increase margins, increase our returns and to do so without being concerned about market share or being concerned about what the GSEs are doing. Obviously, market share leads to scale and it's something -- is a byproduct of our leadership position.

But I think that suffice it to say that what we're seeing in broker direct and consumer direct and with that representing 75% of our loan production in Q1, I would expect to see something similar in Q2 for sure, and then we'll see what happens after that.

Your next question comes from the line of Mark DeVries with Deutsche Bank.

David, I was wondering if you could help us understand on that revised ROE guidance for the end of the year, kind of the high teens going down to the maybe low to mid-teens. How much of that is that pulling forward of the investment in technology versus just kind of the smaller market size?

I would say it's about 2/3 technology, 1/3 smaller origination market. I think that the returns we're seeing from the investment are really compelling. And so I think that to wait to invest one versus the other, I don't think -- it doesn't warrant waiting given the returns.

And so I think that we feel very strongly and convicted that we want -- that we're going to make the investment. And I think, as I said, we'll see tech at near peak levels. And believe me, starting in the second half of this year, we're going to see the returns from this spend as well as the decline of technology spend over the following 12 to 18 months.

I know many people say tech spend doesn't go down, but we reduced our tech spend from '22 to '24, and we will reduce it here as we deploy the finite amount of AI agents that we need to in our production and servicing divisions.

Okay. That's helpful context. And that may help answer the second part of my question. But when I just look back to -- excluding the last 2 quarters, the annualized operating ROE had been kind of more like the mid- to high teens, and we're kind of guiding even in the back half of the year to kind of below that. Is that -- is kind of -- despite the market size, it probably wasn't any bigger then than what we're projecting now. Is this just kind of a -- given this -- maybe this investment imperative in tech, we're looking at some intermediate term lower ROEs as you make these kind of essential investments with hopefully a much more significant longer-term payoffs?

I think that's right. Look, I'm always going to present to you what we think is the base case. Everyone on this call knows me well enough that if we can deliver the results faster, we're going to, and you'll see the results sooner. But I think it's going to be, as I said, in the second half of '26, we'll begin to see the results. And I think we will get into that mid- to high teens in the back half -- I'm sorry, the mid-teens in the back half of the year. But I just think that we want to be very enthusiastic about the technology investments that we're making here. They're very meaningful. And that's something that we want to see implemented, given the fact that we work in a competitive environment and others are doing similar.

I think we're ahead of most, if not all of them. And I think it's something that we want to continue to maintain our competitive advantage.

Your next question comes from Don Fandetti with Wells Fargo.

Yes, David, I guess you talked a lot about the ROE and tech investments. I mean, if you look at the industry, there are some large players, a lot of investment going on. Like, what gives you the confidence that this is sort of a 4-quarter kind of situation? Why not take that longer-term ROE down? And I guess this incremental spend, it sounds like it's more offensive. I guess you've had some good improvement, looking at the conventional loan, consumer direct recapture up to almost 30%. Like, is this offensive or defensive type incremental investment?

I believe it's offensive, Don. And I'll tell you, where we get our confidence from is first, if you just started servicing and what we've done with our servicing technology and driving down our cost to service to industry-leading lows, and I'm not talking by a few dollars here, I'm talking by a lot, and our ability to be able to serve our customers and be able to react to market anomalies.

And what we've done in servicing gives me great confidence that we have the culture to be able to identify what the business opportunities and needs are and the technology leadership to be able to deliver those on a low-cost basis.

Similarly, with AI, what we're seeing is a lot of ability for our business leaders to take ownership and control of developing and building and implementing the AI agents. And they have a staff in place that requires augmentation by moving people out of technology into the business units to build those agents. Now over time, the demand for the agents and the other AI tools is going to lessen. But I believe our business leaders who are -- who have been very tech-focused since we started the company understand what needs to be done. And so that's a factor in my decision-making here.

And then finally, with what I'm seeing on Vesta in the platform and the way it's built and the ease to which we can deploy the agents into our workflow is very meaningful. And that's work that is -- that has to be done by the team here as well. And so I just -- I generally believe that we're at a point in the market where we have to go on offense. And we're going to do it as we always do. We're rows and columns folks. We're going to do it responsibly. We're watching the investment. But as I said, I believe we're at or near peak levels.

And given with what I'm seeing in the revenue per loan increasing, gives me great confidence in terms of our ability to pay for some of it. But also what I really expect to see in terms of the cost reduction is going to be very meaningful.

Your next question comes from the line of Trevor Cranston with Citizens JMP.

A bit of a follow-up on that last question. When you think about companies across the industry investing pretty aggressively in AI and new tech with the goal of making it cheaper to originate loans and faster, how do you guys think about the long-term impact of that in terms of -- do you think that ends up resulting in companies just sort of structurally competing down gain on sale margins to a lower level than they've been historically?

I'm curious kind of how you guys think about that dynamic when you think about kind of the long-term ROE guidance for the company.

Look, I think that we have to compete based on cost to originate and ultimately on price, especially in our consumer direct channel. I think on broker direct I think that if you look at what's taken place in the marketplace and you look at the Q1 results we didn't see the perhaps margin expansion that others may have expected to see.

But at the same time, I think that we're investing in AI because we believe here at the company that to increase the profitability and to consistently get to ROEs above 20%, we have to be the low-cost provider. And to be the low-cost provider, we have to make the investments in technology to reduce the cost to originate and also to reduce the days to close.

And as an industry, we haven't seen as much movement on that as well. And so I just think that we're going to be competing on -- whether you want to call it gain on sale margins or net margins, we're going to be competing on profitability. But that profitability is going to be more heavily weighted to what the cost is to produce the mortgage and how quickly can you close the loan, especially on the refinance. And so that's where I see really the industry headed.

And I think we're just in a really unique position to be able to be a first mover on this, just given the fact that we have scale in all 3 channels, and we can quickly deploy technologies we created and to see meaningful results.

[Operator Instructions]

Our next question comes from Shanna Qiu with Barclays.

Leverage is at 1.7x, which I think is above historical target of 1.5x. I know you mentioned that your ROE guide is somewhat predicated on the 2/3 technology and 1/3 smaller market. How should we think about where you guys would let leverage run to as you're making these investments if we do perhaps see a smaller market than you currently are anticipating?

Overall, we're very focused on leverage. As going back historically, we've maintained our leverage at very responsible levels. And the 1.7x, as you mentioned, is a bit above our historical target or historical run rate.

We -- as we talked about in the earnings deck, we do expect to maintain our leverage at these levels. We are very focused on maintaining prudent levels of leverage in the business and we do have the ability to adjust and reallocate our capital in order to maintain our leverage ratios as we've shown in the past few quarters around optimizing our MSR portfolio and selling certain portfolios to ensure that we stay within leverage bound.

And so despite the increases or the -- our -- what we projected for leverage or what we put out as our projection for leverage at the 1.7x contemplates the increase or the elevated technology spend that David went through. And it's also contemplating the lower levels of activity with the smaller market. So it contemplates both of those factors already. But it is an element in our capital structure and maintaining prudent levels of leverage is something that we are very focused on and will continue to maintain in the business.

I'm focused on this every day. And I think we're at the -- I know we're at the upper bounds of where we're comfortable running the company. And so we're going to do what we need to do to try to get that down more towards the historic levels that we've seen in the company.

Great. And then just a follow-up on the accounting. Can you comment on kind of what drove the changes in the breakout of the principal-only stripped MBS valuation related to accretion? I don't believe that was in prior quarters. So any comments on that?

Sure. That -- we did make a change there or shift some of that geography, and that really relates to the placement of some of the impacts to accounting from the principal-only bonds versus changes in value during the period. So not to get too far into the details, but a piece of the principal-only bonds change in value is captured in the changes in cash flows relating to interest rates is captured in interest income with changes in accretion.

If you look in our 10-Q for this quarter, which was released this afternoon, you can see there was actually a negative impact to interest income due to basically changes in projected cash flows and sort of a reversal of the accretion.

Those changes in accretion relating to future projected cash flows and the projected life of the bonds, we really view as being associated with changes in fair value during the period due to changes in interest rates, which obviously is also what impacts MSR fair value. The change is typically, if you look at the past couple of quarters that are presented there on Page 13 of the earnings deck has typically been fairly small.

But given the change in the volatility of interest rates during the quarter, and some of the sell-off, it was a bit larger this quarter, and we thought that it made sense and was more appropriate to present associated with changes in fair value of the MSR as opposed to -- and it is noncash and based on future expected projected cash flows as opposed to in the pretax income, excluding the valuation-related changes. And so we've made that change for this period and going back historically.

We have no further questions at this time. I'll now turn it back to David Spector for closing remarks.

Well, I want to thank everyone for joining us on the call today, and thank you for taking the time to ask your thoughtful questions. If you have any follow-up questions, I can make myself available, IR is available, and I look forward to ongoing results and good discussions taking place. Thank you very much.

That concludes today's call. You may now disconnect.

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Fourth Quarter and Full Year 2025 Earnings Call. Additional earnings materials, including presentation slides that will be referred to in this call are available on PennyMac Financial's website at pfsi.pennymac.com.

Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.

Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer.

Thank you, operator. Good afternoon, and thank you to everyone for participating in our fourth quarter and full year 2025 earnings call.

As shown on Slide 3, PFSI finished the year with a solid fourth quarter, generating net income of $107 million or $1.97 per share. To refresh, in the third quarter, we capitalized on higher lock volumes driven by an initial decline in interest rates to generate an 18% annualized return on equity. While our previous guidance was for annualized operating ROEs in the high teens to low 20s, the sustained rally continued into the fourth quarter and drove market prepayment speeds significantly higher than what both we and the market expected. This activity resulted in a meaningful increase in realization of MSR cash flows and accelerated runoff of our servicing asset.

While we generally expect production income to act as a natural hedge to this runoff, the benefit in the fourth quarter was impacted by competitive dynamics. Many industry participants have also added significant capacity in anticipation of lower rates, and this excess capacity has created a more competitive origination market, limiting expected production margin increases and revenues typically associated with an interest rate rally. As a result, the growth in our production segment income did not fully offset the higher level of runoff in our MSR portfolio, leading us to generate a 10% annualized return on equity in the fourth quarter. I will speak to the strategic actions we are taking to improve overall production income later in my presentation.

Turning to Slide 4. You can see that for the full year 2025, our results were very strong. Pretax income was up 38% and net income was up 61% from their respective 2024 levels. We generated a 12% return on equity and grew book value per share by 11%. These results highlight our ability to consistently deliver stockholder value through disciplined execution, driven primarily by the strong operational performance of both segments, which you can see on the right side of the slide. In our Production segment, total volumes increased 25%, driving a 19% increase in pretax income. Similarly, in our Servicing segment, we grew the total unpaid principal balance of our portfolio by 10%, which, along with improved MSR hedging results helped drive a 58% increase in pretax income from the prior year.

Turning to Slide 6. You can see the financial impacts of the dynamics I described earlier. While production segment income was approximately double the levels reported in the first two quarters of this year, the growth from the third quarter to the fourth quarter did not offset the runoff of the portfolio's prepayment speeds increase. However, we've taken strategic and targeted actions to drive improvements over the course of this year. By accelerating the deployment of new technologies such as Vesta, quickly ramping our capacity and continuing to enhance efficiencies, we are positioning ourselves to better capture the significant opportunities presented by lower mortgage rates and further increase production income in comparison to MSR runoff. In January, total volumes have been consistent with those reported in the fourth quarter, but with a mix shift towards the higher-margin direct lending channels. This is driving our expectations for production segment income in the first quarter to be higher. Channel margins remain at similar levels.

On Slide 7, we highlight the significant opportunity for our consumer direct channel as mortgage rates decline. As of year-end, we serviced a combined $312 billion in UPB of loans with note rates above 5%, of which $209 billion in UPB of loans had a note rate above 6%. As rates decline, these borrowers tend to benefit financially by refinancing their loans. While our recapture rates have improved, we see significant upside potential from current levels. To that end, we are making targeted investments in AI and other technologies to drive these recapture rates higher and ensure we capture the value embedded in our portfolio.

The cornerstone of our technological investment is shown on Slide 8. We previously discussed the early stages of our transition to Vesta, the modern and next-generation loan origination system we invested in to improve and grow our consumer direct lending operations. We are on track to have Vesta fully implemented across our consumer direct channel in the fourth quarter and completing this migration on time -- excuse me, in the first quarter. And completing this migration on time is a key driver of our 2026 outlook, ensuring that for the bulk of the year, we are operating on our most efficient AI-enabled platform in order to capture the production income improvements we expect.

We are already seeing the power of this technology transform our workflow. By deploying AI-driven automation for tasks that were previously performed manually, we are experiencing an immediate impact, unlocking efficiency gains of approximately 50% for our loan officers. Walking a loan with a borrower on the phone, which took over an hour on our legacy system has been cut to just 30 minutes with Vesta.

The impact also extends to our fulfillment operations, where intelligent workflows are streamlining the loan manufacturing process. We are seeing a reduction in the average end-to-end loan processing time by approximately 25%. When multiplying the sales and fulfillment time savings across the number of loans originated on our consumer direct channel in 2025, it represents approximately 240,000 hours of time saved.

This operational velocity has a direct financial impact with a corresponding 25% decrease in our operational cost to originate, creating another lever in our pricing strategy and giving us the flexibility to be even more competitive in the market. It represents a transformative shift in our unit economics, increases our capacity without substantially increasing operational costs and unlocks new levels of scalability. This enhanced operational scale will be a huge benefit in an interest rate rally. If we see a continuation of the rate decline and volume increase, this AI forward infrastructure will allow us to rapidly scale in order to absorb an increase in recapture volume. Looking ahead, this modern architecture allows for rapid iteration and integration of new AI processes and technologies to deliver meaningful improvements in the customer experience while unlocking significantly more efficiency gains throughout 2026 and beyond.

Finally, on Slide 9, you can see how Vesta fits into our broader customer retention strategy. Our customer relationships are our most important asset, and we are driving strategies to retain those customers for life. A faster and more efficient origination and processing workflow is just a part of our synchronized effort. We are beginning to utilize artificial intelligence to drive greater customer service and using deeper servicing integrations to anticipate borrower needs with real-time data.

By combining this technology with our growing brand presence, we are transforming single transactions into lifetime partnerships. We believe these investments will allow us to achieve greater efficiencies and drive recapture to new heights. And we expect PFSI's operating return on equity to move into the mid- to high teens later in the year.

As we look ahead, PennyMac is uniquely positioned to continue leading the mortgage industry. Our balanced business model and cutting-edge technology provide a powerful foundation for our continued growth, and we remain focused on the continued advancement of our strategies to drive sustained long-term value for our stockholders.

I will now turn it over to Dan, who will review the drivers of PFSI's fourth quarter financial performance.

Thank you, David. PFSI reported net income of $107 million in the fourth quarter or $1.97 in earnings per share for an annualized ROE of 10%. These results included $1 million of fair value gains on MSRs net of hedges and costs, and the contribution from these items to diluted earnings per share was $0.01. PFSI's Board of Directors declared a fourth quarter common share dividend of $0.30 per share.

On Slides 11 through 13, beginning with our production segment, pretax income was $127 million, up slightly from $123 million in the prior quarter. Total acquisition and origination volumes were $42 billion in unpaid principal balance, up 16% from the prior quarter. Of this, $38 billion was for PFSI's own account and $4 billion was fee-based fulfillment activity for PMT. Total lock volumes were $47 billion in UPB, up 8% from the prior quarter. PennyMac maintained its dominant position in correspondent lending with total acquisitions of over $30 billion in the fourth quarter, up 10% from the prior quarter.

Correspondent channel margins were 25 basis points, down from 30 basis points in the third quarter due to increased levels of competition. Under its fulfillment agreement, PMT retains the right to purchase all nongovernment correspondent loan production from PFSI. In the fourth quarter, PMT purchased 17% of total conventional conforming correspondent production and 100% of non-agency eligible correspondent production, both percentages unchanged from the prior quarter.

In the first quarter of 2026, we expect PMT to purchase 15% to 25% of total conventional conforming correspondent production and 100% of non-agency eligible correspondent production, consistent with levels in the recent quarters. In broker direct, we continue to see momentum as we position PennyMac as a strong alternative to channel leaders. Originations were up 16% from the prior quarter. However, locks were down 5% as we maintained our pricing discipline in highly competitive segments of the channel.

The number of brokers approved to do business with us continues to grow, reaching nearly 5,300 at year-end, up 17% from year-end 2024, reflecting the growing number of brokers who are increasingly recognizing and leveraging our distinct value proposition. The revenue contribution from Broker Direct was essentially unchanged from the prior quarter as the impact from lower fallout adjusted lock volume was offset by higher margins.

Consumer direct volumes were up with originations up 68% and locks up 25% from the prior quarter. However, the contribution from higher volumes in the channel was largely offset by lower margins from increased competition as well as a higher percentage of first lien versus closed-end second lien loans and a more focused effort on recapture of higher balance, lower-margin conventional loans.

We also benefited from a strong secondary market execution relative to initial pricing, which contributed $34 million to PFSI's account revenues during the quarter. Production expenses net of loan origination expense increased 3% from the prior quarter due to higher volumes.

Turning to Servicing on Slides 14 and 15. Our Servicing portfolio continued to grow, ending the quarter at $734 billion in unpaid principal balance. $470 billion was owned servicing, $227 billion was subserviced for PMT and $12 billion was subserviced for other non-affiliates. $24 billion was interim subservicing related to an MSR sale, which has since been transferred to a third party. The Servicing segment recorded pretax income of $37 million. Excluding valuation-related changes, pretax income was $48 million or 2.6 basis points of average servicing portfolio UPB, down from $162 million or 9.1 basis points in the prior quarter. Loan servicing fees were roughly flat to the prior quarter due to MSR sales, which offset owned portfolio growth from production.

Earnings from custodial balances were unchanged from the prior quarter as lower earnings rates offset the benefit of higher average balances. Custodial funds managed for PFSI's own portfolio averaged $9.1 billion in the fourth quarter, up from $8.5 billion in the third quarter. Realization of MSR cash flows was up 32% from the prior quarter, consistent with the increase in prepayment speeds for our owned portfolio as lower mortgage rates drove higher prepayment activity.

Operating expenses were $82 million for the quarter or 4.5 basis points of average servicing portfolio UPB, down from the prior quarter. EBO revenue decreased as the reintroduction of FHA's trial payment plans extended modification time lines and delayed redeliveries into future quarters.

Similar to the prior quarter, we saw the operating and GAAP ROEs converge as gains from changes in fair value inputs on MSRs were offset by hedging declines in costs. The fair value of PFSI's MSR increased by $40 million. $35 million was due to changes in market interest rates and $5 million was due to other assumption and performance-related impacts. Excluding costs, hedge fair value losses were $38 million and hedge costs were $2 million. As previously stated, we expect hedge costs to remain contained and that we will more consistently realize results in line with our targeted hedge ratio going forward. Our hedge ratio is currently near 100%, up from 85% to 90% last quarter.

Corporate and other items contributed a pretax loss of $30 million, down from $44 million in the prior quarter, primarily driven by reduced expenses related to technology initiatives and performance-based incentive compensation. PFSI recorded a provision for tax expense of $28 million, resulting in an effective tax rate of 20.5%. The provision for tax expense included a $4 million benefit -- tax benefit consisting of a repricing of deferred tax liabilities and an adjustment to the 2025 tax accrual. PFSI's tax provision rate in future periods is expected to be 25.1%, down slightly from 25.2% in recent quarters.

As noted earlier, we sold approximately $24 billion in UPB of low note rate government MSRs to a third party on a servicing release basis. This sale represented an opportunistic rotation of capital. By monetizing these lower-yielding assets at a strong valuation, we are unlocking capital to strategically reinvest into the continued growth of our servicing portfolio with new originations at current market rates and significantly higher recapture potential while maintaining prudent levels of leverage on our balance sheet.

Total debt to equity at year-end was 3.6x and nonfunding debt to equity at the end of the quarter was 1.5x, both within our targeted levels. Finally, we ended the quarter with $4.6 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledged, giving us significant liquidity resources to be able to deploy opportunistically or in adverse market circumstances.

We'll now open it up for questions. Operator?

I would like to remind everyone, we will only take questions related to PennyMac Financial Services, Inc. or PFSI. [Operator Instructions].

Your first question comes from the line of Terry Ma with Barclays.

So, I guess to start, so you guys have kind of talked about increasing capacity in consumer direct all year long. You guys have kind of talked about holding excess origination capacity, kind of stacked your servicing book with more current coupon. It seems like almost obviously to plan for kind of like a moment like this. So maybe kind of just talk about like what went wrong? And then on a go-forward basis, like maybe just talk about what you're doing to kind of address the issue and your level of confidence.

Yes. So, thanks for the question. So, coming out of Q3, we felt very good about our ability to attack the portfolio and be able to participate in the recapture opportunity afforded to us by the decrease in rates. But then as Q4 got underway and throughout the quarter, we saw increasing amounts of amortization that indicated to us that not only perhaps we thought we are adding capacity, but I think two things took place.

First, that the rest of the market had to add capacity in place also. And so where you would typically in a declining rate environment, see increasing margins, those also did not come into play. And so the competitive environment for refinances was quite frankly, stronger than what I've seen historically in an interest rate decline. And so we pivoted throughout the quarter and rather quickly to do a few things. One, we're accelerating our move on to Vesta, which will give us additional capacity, as I point out. Two, we are adding even more capacity to not just -- there's a -- we were -- we had capacity in place and we were continuing to build capacity, but these rallies are these flash rallies are so robust that we have to have capacity in place to deal with a 50 to 75 basis point rally in less than a week. And so we're just continuing to add more capacity.

We also changed some strategies to really help improve recapture, and we saw some of those strategies pay off nicely throughout the quarter and into January. And so I think that the -- I have a lot of confidence in the team that we're going to continue to accelerate our recapture and accelerate our growth in consumer direct. I think that this is one of the reasons why we expect to get to mid- to high mid-teen ROEs by the middle of the year. And I just think that you're going to continue to see us move into that direction.

Got it. That's helpful. Maybe just a little bit more on the ROE guide of low double digits to kind of mid- to high teens. Like any more color on kind of what's contemplated in that expansion? Like maybe just some more color on that, please.

Yes. So, look, I think we're -- remember, these forecasts that we give are based on a point in time. And so first of all, we expect an origination market to grow between $2.3 trillion and $2.4 trillion in the year. Rates -- obviously, if rates go up, that will change. We expect to grow production in consumer to grow production and recapture in consumer direct and grow share in volumes and TPO. Correspondent, we are maintaining at generally current flat levels, market share levels. A lot of that is coming out of increased competition we're seeing primarily on the conventional side through the cash windows of the two GSEs as they're looking to proceed on their path to buy more mortgages.

We expect margins to remain at levels to those we saw in the fourth quarter. And so this is -- there could be some -- in the fourth quarter, we did see a little margin compression in brokers, the top two participants were very aggressive in a race to be the #1 loan producer. But I think we're going to stay disciplined. But I think what we're not factoring in this, which is what we -- as I said, we've historically seen is margin expansion. And should that margin expansion take place, obviously, there'll be upside from there.

We expect the realization of cash flows to remain similar as a percentage of MSR values versus what we saw in the fourth quarter. And I expect that to pretty much be the story. There are some continued efficiency gains in servicing with pretax income grinding higher as a result. There will definitely be some scale benefits that we see coming out of the deployment of the Vesta technology as well as the growth in share in TPO. And there are some additional leverage outside of this that could drive it higher. But I generally believe that we've mapped out and I have the confidence that we can get back to the mid- to high operating ROEs. It's just -- it's not going to be at the pace that perhaps we all would love.

Your next question comes from Mark DeVries of Deutsche Bank.

David, I think you indicated that the prepayments you saw in your servicing book were even faster than you would have thought. Any insight as to kind of what happened there? Or is it just how rapidly the market responded to rate incentives you kind of alluded to in prior comments?

I'm sorry for interrupting. Did you want to continue?

And then just a follow-up. Did I hear you right? Do you expect realization of cash flows, at least in the guidance you kind of provided or at least the high-level guidance to be consistent with what you saw in 4Q?

In the fourth quarter, yes.

Yes.

So let me just point out that the market generally has been surprised by the increased prepayment speeds. They were forecasted, but not to the level that we've seen. And so I think that, that's something that we've heard it throughout the Street in speaking to them, and this is something that has been, I think, kind of -- you've seen it throughout the market.

I think that in terms of where we're seeing it, I generally will tell you everywhere. There is probably a little bit more -- it's a little bit more competitive on the higher balance loans, obviously, because there's just -- that's generally where we see brokers focusing on as well as some of our correspondents. Prepayment speeds on lower balance loans, while fast are a little bit slower versus the comparable high balance. On the VAs, it's pretty competitive. But we're getting the expected market share there.

The biggest issue from my perspective is you're not seeing margin expansion. And that's something that we're going to -- of course, you know us really well. In the 18 years we've been operating, we're always leaning to get more margin, and we're going to continue to test the waters on that. But it's a bit more competitive than we've historically seen when rates increase. Margins have come up a little bit, but not to the levels that we would have thought given the rally.

Okay. Got it. And are you seeing some different margins across all the channels in purchase versus refi? Or was it refi that really was under pressure? And also, any thoughts on rates really kind of the decline we've seen kind of reducing some of the lock-in effect and starting to stimulate more purchase activity as well?

I think that given the fact that everyone is stretched on capacity. We're seeing -- typically, it's on both purchase and refi that we're just -- I'm not seeing one necessarily differentiation. But I think we're focused on -- in our consumer direct channel, we have a purchase team that we continue to focus on purchase activity.

On the refi side, one of the strategies we put in place is we -- on the closed-end seconds, we took some of our focus in closed-end seconds and moved it over to conventional. And that's why you see the overall margin differential in consumer direct quarter-over-quarter. That's more of a mix issue than anything else. But I generally think that there there's a lot -- everyone is going after the loans.

The next question is from Bose George with KBW.

I just wanted to follow up on the same themes here. Is this kind of a structural change in the industry where historically runoff happens, originations pick up and margins pick up because of capacity constraints. And now with technology and is it a scenario where people can run with excess capacity, so you don't see that offset to runoffs?

I'm not ready to declare it a structural change in the industry, okay? I think that the administration and others in the industry have been warning us for well over a year that they're going to be pulling levers to reduce rates. And so I think it gave people the that they needed to have capacity in place.

I think that there is -- on the other side of it, it's going to get increasingly easier to refinance loans as you start to see technologies like we're using and others are using to reduce the amount of time to refinance a loan to get the borrower a lower payment. And so this is why I think that one of the things that we're focusing on more and more is issues like revenue per loan and net income per loan as opposed to margin. because margin as we have it is a gross number. And as we see these expenses come down, I would expect the revenue is the gross margin, but I would expect the net income per loan to go up ultimately. And so that's something that is something we're talking about internally.

But I think -- look, I think the story of this quarter, we've seen it with some of those who've already reported, volumes have been up, margins have been down. And I generally think it's just the fact that people were ready for rates to decline in this initial decline. If rates were to decline 75, 100 basis points, you definitely would see margin expansion. There's just no doubt about it.

Okay. Great. That's helpful. And then in terms of the competition in the different channels, in the correspondent channel, did you -- was it really driven by the GSE cash windows? Or how about sort of other participants?

Yes. Look, I think on the conventional side, it was generally the cash windows. And I think that's going to be the story for 2026. I think that with the announcement coming out of Washington, D.C., the GSEs are going to be very active. And so we have to -- we will -- I'm not expecting a share decline per se, but I'm not expecting us to be at 25% at the end of the year either. We're going to maintain our discipline, and we're just not going to be focused on volume and share.

I think that -- on the government side, there, it's -- we had a really good December. I would say, in October, November, we saw some of the other market participants get very aggressive. And so our market discipline there has caused us to really just wait for the market to come our way. And in fact, as I said, in December, we had a really good December.

Your next question comes from Doug Harter with UBS.

As you were talking about the benefits from Vesta, do you envision that of actually taking costs out of the origination business or just continuing to build capacity and as volume comes back, lowering the cost per loan?

The answer is both, okay? I will tell you, first off is with the deployment that will be in place in Q1, we will get the benefits of just a more modern system that will lead to just greater efficiency gains on both the sales side and the fulfillment side.

Throughout 2026, and this is what's very exciting for us. We're going to see more and more deployment of AI tools and AI agents that's really going to have a meaningful effect on our ability to originate a loan in as inexpensive as anyone else in the industry, as quickly as anyone in the industry and most importantly, to be able to close the loan when the borrower wants to close the loan. And so that's something that is very exciting to us. And I think that's something that I'm really looking forward to sharing with you all as it gets deployed.

Your next question comes from Trevor Cranston with Citizens JMP.

A follow-up on some of the earlier questions. I guess as we think forward for this year, if we were to see an additional leg down in mortgage rates, whether it's driven by reduction in G fees or some of the other things that have been discussed a little bit. How should we think about the net impact on the company if that were to happen? Would you expect to see the production offset kick in pretty well if there is an additional rally? Or how should we think about kind of the net impact on the returns of the company?

Look, we are -- there's no one driving for more capacity in this company more so than me. And so I will tell you that we want to have enough capacity to be able to withstand a ferocious rally, and that's going to come in two forms. The obvious one is we're going to need to add some headcount to deal with some of the regulatory requirements for LOs to speak to customers. But at the same time, I expect to get more and more capacity benefits coming out of our technology. And I -- it is my stated goal to not get to be in this position where we're saying to you that we had amortization that exceeded the recapture necessary to balance it. And that's something that we are going to continue to perfect. And it's not like aspirational. It's something that's going to take place this year, and it's going to be achieved long before the end of the year. So, I think, that we're going to be in a position to be able to execute on a rally.

The other thing that I'd add is that we talked about it a little bit earlier, is that we continue to increase our hedge ratio as well. So as or if interest rates decline further from here, we have even greater protection from our financial hedges that we put into place and our hedging discipline.

Got it. Okay. And I guess as a second part to that question, can you maybe talk about how you're thinking about the likelihood of something coming through like a significant reduction in G fees or a change to loan level pricing or sort of other levers that could be pulled in an attempt to lower mortgage rates?

Of course, I read everything you're reading. I don't necessarily see a reduction of guarantee fees coming. While the administration is hyper focused on affordability and doing what they can to drive down rates, I think the usage of the portfolios to buy mortgages is the logical place for them to continue to lean on. And the $200 billion number is a big number, but that's not to say it couldn't get bigger. I think that as it pertains to loan level price adjustments between the capital rule and other rules that they have, changing those would take some time. And so I generally think that they're going to continue to focus on keeping mortgage spreads tight to treasuries, and they're going to continue to try to job loan rates down.

But look, we manage the company to a range of outcomes. And so I generally believe, of course, if GPs comes down, that's better, and we'll have the capacity in place to take advantage of that. And likewise, at times we hear loan level price adjustments are going to be going up. And that speaks to the work we've done to distribute close to 15% of our agency collateral outside of the agencies to insurance companies and whole loan investors. And so managing to the range of outcomes and continuing to build and enhance the customer journey is something that we'll be able to react to.

Your next question comes from the line of Crispin Love with Piper Sandler.

Can you talk a little bit about first quarter activity thus far, what that means for near-term ROEs just you have spreads tighten and mortgage rates got pretty close to 6%. Are you experiencing an episodic rate and pickup in refis? Just kind of curious how purchase is trending and then the momentum through January, the trajectory there? And then just kind of bigger picture, how you'd expect ROEs to trend throughout the year as you add capacity and invest? Is it a ramp higher? Just curious on how you're thinking about it.

Yes. So, Dan will go over the ramp in a second. January has been a good month. For a month that historically has been very slow coming out of the holidays, we've had a good production month. We're seeing nice increases in production. Offsetting that, we're seeing increases in demand statements that I would expect to see prepayments in February kind of go back to where they were in December. January, I think, will be a little bit slower.

And so I think one of the things I'm looking at is our recapture and our recapture numbers are going up. Of course, I want more. Everyone wants more in the organization, and that kind of speaks to the ramp. But it's something that we're seeing. And margins are generally holding in. And so I think that that's something that I really am pleased to see.

And I generally think in TPO, we saw a hypercompetitive market in Q4 that I believe is starting to -- we're getting a little bit of rational pricing coming into that. And so I'm generally the belief that our growth in TPO, while perhaps was slowed a bit in Q4 due to a price war, will continue to accelerate at higher margins.

And with respect to the trajectory through the year, I think consistent with the way that David described it in our implementation of these initiatives and continued build of capacity and so forth, we are expecting basically a ramp through the year, consistent with the guidance that we gave during the prepared remarks. So starting out in the lower double digits and then ramping up to the mid- to high double digits as we get later in the year.

Great. And then just a little bit deeper into that, kind of what's baked into the ROE guide for realization of MSR cash flows and recapture beyond the first quarter? It seems that 1Q should be similar to 4Q. I think the MSR prepay rate was about 16% in the fourth quarter. So, curious on how you think about that through the year. I completely understand it's just a point in time now, very rate dependent, but just curious on that and kind of where you are on recapture today and what kind of levels you might be targeting?

So, overall, in terms of the realization of cash flows, we are expecting on a dollar basis to be at a pretty similar level in the first quarter and also as we move through the year as you have the sort of dynamics given that we did see this initial responsiveness and there will be a little bit of a pullback in terms of borrower responsiveness at these levels as we move overall through the year, but expecting overall dollar realization of cash flows to remain in a fairly similar place to what we saw in Q4 and Q1 and both -- and similarly as we move through the year.

With respect to recapture, also expect incremental gains consistent with the way that David had described it as we move through the year to facilitate the increase in production income as well as gains in our share in TPO or in broker that will further increase our production income as -- which will offset some of the declines that we've seen in the servicing segment.

Your next question comes from Shanna Qiu with Barclays.

So just looking at the FHA delinquencies, it looks like it ticked up to 7.5% this quarter from 5.9% sequentially. I think it was roughly 6% last year. So, can you comment on what you're seeing in the FHA loans? I think previously, you guys had shown some slides that showed your FHA delinquencies substantially below the industry level and it feels like quite a jump there. Any context or color there?

Sorry, we weren't able to hear your question very clearly, but I know that it was on delinquencies and specifically FHA delinquencies. So we do see delinquencies increase seasonally in the fourth quarter. We look at our overall delinquency profile or our overall delinquencies for our book increased marginally year-over-year, had a similar sort of slope in terms of delinquencies through the year.

Overall, with respect to FHA delinquencies, as we mentioned as in part of the prepared remarks, the FHA did change its policy around modifications during the latter half of the year, moving from allowing streamlined modifications that required no trial payments to requiring trial payments. And really, what that is going to result in is a bit of a lag in terms of loans that had been delinquent, getting those modifications implemented and coming back to current. And so that is generally what is driving some of those increases in delinquencies that you're seeing specifically in FHA. We do expect that, that's primarily a lag and not something that is going to dramatically change the performance overall of the FHA book.

We also saw that impact our revenue from EBO redeliveries during the quarter, that went down by about 1/3 from last quarter. Again, we expect that to be just a lag. And our current expectation is that will come back up to levels that we had seen over the past few quarters to come back up by that 1/3 as we get into the first quarter, and we see those folks move through the trial and receive those modifications and come back to current.

Okay. And then I know you guys mentioned your hedge ratio is now over around 100% and you moved it up from last quarter. I think there's a bit of rate -- there has been a bit of rate volatility in 1Q and we had heard that some -- that could cause some basis hedging issues so far in 1Q. So just any color on the rate moves and if you've seen any impacts on your hedging strategy from that?

Overall, during the first quarter thus far, as you said, there has been specifically some basis movements really related to the announcement around the GSE buying. We did see some of that volatility did have a slight impact thus far on our hedging results. Obviously, we're still early in the quarter and a lot of things can change. Overall, I would say it had a slight impact, but not anything substantial.

The hedge performed really well in the fourth quarter.

And third quarter.

In the third quarter. And I will tell you that absent this one change when they announced that the GSEs are going to be buying mortgages and everything stayed flat with the exception of mortgages, which rallied, which really had a very small effect on us. The hedge continues to perform along the lines that we've seen in the third and fourth quarters.

Your next question comes from Eric Hagen with BTIG.

A lot of good discussion here. I think I just have one. Lots of debt raised over the last couple of years, unsecured debt. I think a good portion of that has been used to pay down the secured term notes that you guys have. I mean, how do you guys think about the asset liability match on the balance sheet right now if prepayment speeds are picking up, right? And if the macro backdrop is for faster speeds, is there a limit to how much unsecured debt that you keep on the balance sheet? Or do you think there's room to raise more?

I mean, so we generally look at our overall debt with respect to the balance sheet. The main lens that we look at that through is our nonfunding debt-to-equity ratio, which we've maintained around that 1.5x basically for the past couple of years, I think, at this point.

And so as we continue to build equity in the business and retain equity and continue to build our MSR portfolio, notwithstanding runoff or sales, we do expect to continue to grow our overall MSR asset and our overall equity. And given both of those, we do think that there is potential for additional debt, including unsecured debt as we move forward.

With respect to would we -- with respect to our balance sheet, our preference is generally to deploy into unsecured debt. We think that's a stronger deployment, gives us greater liquidity flexibility with respect to our ability to draw down on facilities if we so need that are secured by our MSR as we -- as mentioned in the prepared remarks.

And so we do think that there is potential for us to issue additional unsecured debt as we move through 2026 and beyond, but will be related to what the build is like as I mentioned, in terms of our equity and our MSR asset and maintaining our leverage ratios at prudent levels.

Your next question is from Ryan Shelley with Bank of America.

Most of might have been answered. I just want to touch back on recapture. It sounds like it's going to be a theme here. So you've talked about investments you're making in AI, other technologies to improve. And then you also, in the deck here, talk about implementation of specific solutions. Can you just run through what those solutions might be? And then I might as well try for it. Anything you could do to quantify that potential upside that you see remaining?

Yes. Well, thanks, Ryan. Look, the -- I would tell you that the solutions obviously start with bringing on more capacity, bringing on additional headcount as well as getting the technology fully deployed across the organization. In the meantime, we're -- as I mentioned to you earlier, there are some strategies that we deployed in Q4, including taking some of the focus that we typically have had on closed-end seconds and moving that focus to the conventional recap efforts and the recap efforts in general. On the fulfillment side, there, we're just continuing to add capacity. And as I said, we're getting some good inroads from the technology move that we made.

And I think that generally, it's something that combined with continuing to test the waters to try to drive up margins. Those are the strategies to increase recapture in a profitable -- in the most profitable fashion, which is what I think is really, really important that we want the profitability, and we wanted to do it in the most, I would say, productive way when combined with the actual production.

Your next question comes from Bose George with KBW.

In terms of the areas where you saw the increased prepayments where the offset on the margin wasn't as expected. Was that more on the Ginnie Mae side versus the conventional? Or is that -- was that kind of across the board?

So, look, I think it's generally across the board. I will tell you, and you your question indicates you understand this, there are loans with the varying servicing strips in Ginnie servicing. And obviously, when you have 69 basis points of servicing, your basis in the loan is much greater than when you have 19. And so with the proliferation of 69 basis point strips in the market over the last three years, that's something that obviously is just provides a bit of a headwind when you're running a balanced business model.

But having said that, this is one of the reasons why we brought the hedge ratios up, and this is something that we continue to focus on getting the recapture on those loans. But obviously, I think on the Ginnie side, the fact that there's more 69 basis point strips in the portfolio just lends itself to this issue.

On the conventional side, there, I think it's really, as I mentioned, on the higher balance product. And there, we're just seeing a lot of activity, a lot of competition from those who are buying trigger leads, which, by the way, that goes away at the end of Q1. But that's something that the last her for that activity. And so I think that had a little bit of play. When we looked at our runoff that we didn't recapture at the top of the list with broker originators. And I generally think that they're going to be hard-pressed to duplicate that once this trigger law comes into play.

Your final question comes from Eric Hagen with BTIG.

The stock has done so well, but can you refresh us on how much room you have on your buyback authorization right now?

We have a little over $200 million of buyback available. And that's -- I think it's something that, as you know, historically, we've had no problems using, and it's something that I think it's something that in our culture of capital allocation and cost of capital and how we think about capital deployment, that's one of the tools that we have, and it's something that we utilized ever so briefly in Q3, and it's something that we look at on a regular basis.

We have no further questions at this time. I'll now turn it back to David Spector for closing remarks.

I just want to thank everyone for joining us on this call today. Great questions, good robust discussion. And if anyone has any follow-up questions, I'm available, Dan is available. Isaac and Kevin are available. Please don't hesitate to reach out. Thank you all for the time, and have a good day.

This concludes today's call. Thank you for attending. You may now disconnect.

Good afternoon, and welcome to PennyMac Financial Services, Inc.'s Third Quarter 2025 Earnings Call. Additional earnings materials, including presentation slides that will be referred to on this call, are available on PennyMac Financial's website at pfsi.pennymac.com.

Before we begin, let me remind you that this call may contain forward-looking statements that are subject to certain risks identified on Slide 2 of the earnings presentation that could cause the company's actual results to differ materially, as well as non-GAAP measures that have been reconciled to their GAAP equivalent in the earnings materials.

Now I'd like to introduce David Spector, PennyMac Financial's Chairman and Chief Executive Officer; and Dan Perotti, PennyMac Financial's Chief Financial Officer. You may go ahead.

Thank you, operator. Good afternoon, and thank you to everyone for participating in our third quarter earnings call.

As shown on Slide 3, PFSI delivered outstanding financial and operational results in the third quarter, with an 18% return on equity on both a GAAP and operating basis. These results highlight the strategic advantage of our balanced business model, our ability to rapidly address refinance opportunities as they arise and the success of our dynamic hedging program, which offset MSR fair value declines, thereby demonstrating the financial stability that is central to our operating model.

As you can see on Slide 5, our consistent performance demonstrates the strength of our organic and comprehensive mortgage banking platform. The chart on the left shows our annualized operating ROEs in recent quarters. The 20% operating return on equity we earned in the third quarter of 2024 was achieved when mortgage rates declined to approximately 6%. Similarly, this quarter, we achieved an 18% operating return on equity as mortgage rates move closer to that level. These 2 quarters illustrate the earnings power of our business.

A key benefit of our balanced business model has been the consistent strength of our servicing business. As you can see from the chart on the right, servicing pretax net valuation-related changes has provided the majority of our mortgage banking operating pretax income over the last several quarters.

While there can be some fluctuations in our results due to typical seasonality, if mortgage rates remain between 6% and 6.5%, while delinquency rates remain stable, we expect annualized operating returns on equity to average in the high-teens to low 20s through 2026, with potential for additional upside if origination market volumes grow further. I would like to bring your attention to the recently announced strategic transaction we completed this quarter that highlights our active capital management.

As you can see on Slide 6, we successfully completed the sale of MSRs with an unpaid principal balance of $12 billion to Annaly Capital Management with subservicing retained, accelerating the growth of our capital-light subservicing business. This transaction allowed us to monetize a mature asset with a weighted average coupon of 3.1% and projected go-forward returns at the lower end of our target range, freeing up capital to deploy into new higher coupon MSRs with greater recapture and return potential.

Importantly, we retained the core elements that drive the growth of our mortgage flywheel, the subservicing, recapture and marketing rights for closed-end seconds and other products, preserving our customers' ongoing relationship with PennyMac. This transaction is a testament to our ongoing drive to grow capital-light revenue streams that leverage our servicing expertise, operational scale and proprietary technology. It also reinforces our best-in-class servicing capabilities and signals our intent to be a dominant subservicer in the market. We view this transaction as a part of our disciplined effort to optimize our balance sheet and enhance long-term value for both our customers and stockholders, a win for all parties.

Turning to production. Our results this quarter reflect the strength of our unique multichannel production platform. On Slide 7, we proudly showcased our position as the outright leader in correspondent lending. Over the last 12 months, we have generated more than $100 billion in UPB of correspondent production, achieving an estimated market share of approximately 20% in the first 9 months of 2025. This significant volume is a direct result of our operational excellence, technology innovation and deep partnerships with many of our nearly 800 active correspondent sellers across the country. A key aspect of our leadership in this channel is our exceptional operational leverage and scale, which underscores our fundamental strength as a highly efficient, low-cost provider with a significant competitive advantage.

Similarly, you can see on Slide 8 that our broker direct business was a key contributor this quarter and represents a significant ongoing opportunity. From our entry into this business in 2018, our broker direct market share has expanded significantly, currently standing at just under 6%. We have clearly established ourselves as a trusted partner for brokers. And though we are already the third largest in the channel, we see tremendous momentum to continue our growth to more than 10% market share by the end of 2026.

Our strength in this channel is driven by our tech-enabled platform with unmatched support throughout the origination process. This advanced infrastructure and dedicated assistance assures brokers that their customers will experience a seamless and efficient origination process, empowering brokers and reinforcing their trust in us as a reliable, long-term partner.

On Slide 9, we highlight the significant opportunity for our consumer direct channel as mortgage rates decline. As a reminder, our operating ROE this quarter was 18% and a substantial portion of the increase versus the prior quarter can be directly attributed to the success of our recapture activities.

Our performance this quarter is a powerful real-time indicator that our current investments and strategy are working, and it highlights the opportunity for us in future periods as market rates decline.

As of September 30, $291 billion in UPB or 41% of the loans in our servicing portfolio have a note rate above 5%, and $201 billion in UPB or 28% of the loans in our portfolio have a note rate above 6%. This large and growing portfolio of borrowers who recently entered into mortgages at higher rates stands to significantly benefit by refinancing their loan when interest rates decline, as this refinancial potential positions are consumer direct lending divisions for stronger future growth.

Our multiyear investments in technology and process innovation, including the introduction of our new loan origination system have already driven meaningful improvements in both our overall efficiency and recapture. We expect our recapture rates to continue improving, translating directly into higher earnings potential as refinance opportunities materialize.

In conclusion, our strong quarterly results reflect our ability to rapidly address refinance demand when rates decline and the increase in sophistication introduced into the hedging of our MSRs, which demonstrated robust financial stability and risk management that underpins our system.

I am extraordinarily proud of the work and effort provided by the management team in producing these strong quarterly results, defined by outstanding execution in both production and servicing and of course, an 18% gap in operating return on equity.

Looking ahead, as we continue deploying AI throughout the organization, I am confident that our strategic positioning and our relentless focus on efficiency ensures we are well equipped to drive substantial growth, superior returns and a continued upward trajectory for PennyMac.

I will now turn it over to Dan, who will review the drivers of PFSI's third quarter financial performance.

Thank you, David. PFSI reported net income of $182 million in the third quarter or $3.37 in earnings per share for an annualized ROE of 18%. These results included $4 million of fair value declines on MSRs, net of hedges and costs. The contribution from these items to diluted earnings per share was negative $0.06. PFSI's Board of Directors declared a third quarter common share dividend of $0.30 per share.

On Slides 12 and 13, beginning with our production segment. Pretax income was $123 million, more than twice the $58 million reported in the prior quarter. Total acquisition and origination volumes were $36 billion in unpaid principal balance, down 4% from the prior quarter. Of this, $33 billion was for PFSI's own account and $3 billion was fee-based fulfillment activity for PMT.

Total lock volumes were $43 billion in UPB, essentially unchanged from the prior quarter, but with a greater mix of volume coming from our direct lending channels. PennyMac maintained its dominant position in correspondent lending in the third quarter with total acquisitions of $28 billion, down 7% from the prior quarter. Correspondent channel margins in the third quarter were 30 basis points, up from 25 basis points in the second quarter, with the revenue contribution unchanged from the prior quarter and displaying our margin discipline, driving slightly higher revenue on reduced volume.

PMT retains the right to purchase up to 100% of nongovernment correspondent loan production from PFSI's correspondent production volumes. PMT purchased 17% of PFSI's total conventional conforming correspondent production, essentially unchanged from the percentage PMT retained in the prior quarter. In the fourth quarter, we expect PMT to purchase approximately 15% to 25% of PFSI's total conventional conforming correspondent production, consistent with levels in recent quarters.

In broker direct, we continue to see strong trends and growth in market share as we position PennyMac as a strong alternative to channel leaders. Originations in the channel were up 6% and locks were up 11% from the prior quarter, driven by a growing number of approved brokers who are increasingly recognizing and leveraging our distinct value proposition.

The number of brokers approved to do business with us at quarter end was nearly 5,200, up 17% from the same time last year. In broker direct, we saw a revenue contribution $10 million higher than the prior quarter, driven by increased volumes and margins. As David mentioned, consumer direct saw positive trends with origination volumes up 12% and lock volumes up 57% from the prior quarter as rates declined late in the third quarter.

Revenue contribution from the channel increased by $29 million from the prior quarter, primarily driven by increased refinance volume. Margins were down, driven by a higher proportion of higher balance first lien refinance loans versus smaller balance second lien loans, although the refinances have lower margins on a basis point basis, revenue per loan is typically greater.

PFSI account revenues benefited from a positive contribution from post lock items such as non-agency and specified pool of spreads -- spread improvement, which contributed $30 million in the third quarter compared to a loss of $10 million in the prior quarter.

Activity across our channels in October has been strong, with increased activity across all 3 channels compared to what we reported for the third quarter with the most substantial increase in the consumer direct channel.

Production expenses net of loan origination expense increased 11% from the prior quarter. The increase from the prior quarter was due to both higher volumes and additional capacity in our direct lending channels, which is expected to drive our ability to rapidly address opportunities presented by lower mortgage rates.

Turning to servicing on Slides 14 and 15. As David mentioned, our servicing portfolio continues to grow, ending the quarter at $717 billion in unpaid principal balance. The servicing segment recorded pretax income of $158 million, nearly 3x that of the prior quarter. Excluding valuation-related changes, pretax income was $162 million or 9.1 basis points of average servicing portfolio UPB, up from $144 million or 8.3 basis points in the prior quarter.

Loan servicing fees were up from the prior quarter, primarily due to growth in PFSI's MSR portfolio. Custodial funds managed for PFSI's own portfolio averaged $8.5 billion in the third quarter, up from $7.5 billion in the second quarter due to seasonal impacts and higher prepayments. As a result, earnings on custodial balances and deposits and other income increased.

Realization of MSR cash flows increased from the prior quarter due to continued growth of the MSR asset and higher realized and projected prepayment activity due to lower mortgage rates.

Operating expenses were $85 million for the quarter or 4.8 basis points of average servicing portfolio UPB, up slightly from the prior quarter. As David mentioned, we saw the operating ROE and GAAP ROE converged this quarter with strong hedge results that offset the vast majority of MSR fair value declines. These results were a direct result of adjustments made to our hedging practices at the beginning of the quarter, more directly incorporating recapture expectations into our hedge management and thereby reducing our reliance on more expensive option positions. This, in turn, allows us to be more measured in our approach to rebalancing our hedge positions.

In addition, the environment for hedging has also improved with volatility declining, improving option pricing and short-term interest rates expected to decline in comparison to longer-term interest rates, improving the carry of our hedge positions. As a result of our hedging practice adjustments and these improving market factors, going forward, we expect hedge costs to remain contained, and we expect to realize results closer to our targeted hedge ratio, which is currently around 85% to 90%.

During the third quarter, the fair value of PFSI's MSR decreased by $102 million, $94 million was due to changes in market interest rates and $9 million was due to other assumption and performance-related impacts. Excluding costs, hedge fair value gains were $102 million. Hedge costs were $4 million, down significantly from $54 million in the second quarter.

Corporate and other items contributed a pretax loss of $44 million, up from $35 million in the prior quarter, primarily driven by expenses related to technology initiatives and increased performance-based incentive compensation. PFSI recorded a tax expense of $55 million, resulting in an effective tax rate of 23.2%.

We were also active in the management of our financing in the third quarter. In August, we successfully issued $650 million of unsecured senior notes due in 2034, furthering our objective of increasing the proportion of long-term unsecured financing in our non-funding debt. Additionally, we issued $300 million of Ginnie Mae MSR term notes due in August 2030 and paid off $200 million of the $680 million notes due in February 2028, meaningfully improving our financing cost on the secured debt.

Total debt to equity at the end of the quarter was 3.3x and non-funding debt to equity at the end of the quarter was 1.5x, both down slightly from the end of last quarter as we consistently manage to our target leverage levels.

We ended the quarter with nearly $5 billion of total liquidity, which includes cash and amounts available to draw on facilities where we have collateral pledged, giving us significant liquidity resources to be able to deploy opportunistically or in adverse market circumstances.

We'll now open it up for questions. Operator?

[Operator Instructions] Your first question comes from the line of Crispin Love with Piper Sandler.

First, on operating ROEs, definitely saw a nice bounce back in the quarter to 18%. I appreciate your high-teens to low-20s ROE guide through 2026. But just given the mortgage rate rally late in the quarter is in the September time frame and the lag in correspondent, would you expect the fourth quarter ROEs to be more towards that low-20s range, just given where rates stand today?

Overall -- so there's a couple of factors in the fourth quarter specifically. So we do -- we have had a rally recently. We've obviously seen an uptick in volumes. If we stay here, that could well drive up our volumes and our ROEs to the higher end of -- operating ROEs to the higher end of that range. Offsetting that typically in the fourth quarter with seasonality with respect to purchase, et cetera, you can see a bit of a lag there as well as with custodial balances on our servicing portfolio. So with the fourth quarter, those tend to be a little bit lower from a seasonal perspective. So overall, if we stay at these rate levels, that probably pushes our operating ROE higher -- to the higher teens to, as you said, low 20s, but we do expect some of those typical effects as we're here in the fourth quarter.

Absolutely. No, that makes sense. And then just with the government shutdown, can you discuss the implications and expected impact of PFSI to the FHA business as well as other areas, just what that has meant for you in October and then what you could expect in the fourth quarter if the shutdown continues?

Yes. So we are always prepared for a range of outcomes in the company, and we've been through this drill a few times. We are -- it starts with how we think about having enough commitment authority with Ginnie Mae to be able to continue to issue Ginnie Mae securities. And we always look out to make sure we have at least 9 months of commitment authority.

On the delinquency side, where you could see this start to show up, we have a couple of thousand borrowers in forbearance as a result of the government shutdown. We've received 2 to 2.5x that number of calls coming from the government shutdown. But I'm not expecting anything substantive. And I think it's suffice it to say that our technology and what we've built allows us to be able to adapt to something to whether it's a government shutdown or a natural disaster, which there hasn't been really any this year to something even as extreme of COVID. And so the team is always ready to be able to adapt to whatever comes its way.

Your next question comes from the line of Bose George with KBW.

Actually, the first question, can you talk about the trend in rate locks in the fourth quarter? I know it's only been a couple of weeks, but how does that compare to the third quarter?

Sure. So, so far in the fourth quarter, we've seen an uptick in volumes really across all of our channels, in particular, our direct lending and consumer direct lending, given the lower rates, we've seen a significant amount of refinance volume coming in. And so overall, as you mentioned, it's only a couple of weeks in, and things can change, but the trajectory is very positive thus far.

And Bose to the earlier point, as you see some of the August and September locks in the industry fund out, you should see an increase in bulk production and correspondent. And so I think to the point Dan raised, we're seeing a nice little uptick in consumer direct, and it's just really a function of rates, which have come down even over the last week.

Okay. Great. That makes sense. And then just in terms of the margins, can you just talk about the margins, just the different channels, the consumer direct was down, but was that really kind of a mix issue? Or yes, just color on that. And then it was up in the other channels, so just some color on trends as well.

Exactly. So as you mentioned, as I talked about a bit in my remarks, the consumer direct, it's really the mix of products. So on a basis point basis, the second lien loans tend to be higher and refinances tend to be lower. But first lien refinances are higher loan sizes generally. And so on a revenue per loan basis, we actually see higher revenues per loan despite lower basis points per UPB for those loans. And so we've seen those fluctuations in the past, but really as rates declined, it's an indicative of greater refinances, which generally is more profitable activity in the consumer direct channel on a per loan basis.

As you mentioned, in both correspondent and broker saw margins go up. With respect to correspondent really around margin discipline, you can see that our margins increased and volumes declined a bit, but we made slightly -- or had slightly greater revenues in the correspondent channel than in the prior quarter. And so that's really indicative of our margin discipline in that channel. And with broker continues to be a positive environment, we continue to gain share and gain momentum in that channel.

Your next question comes from the line of Douglas Harter with UBS.

You guys repurchased some shares in the quarter. Can you just talk about your appetite to continue to do that and how the MSR sale to Annaly might factor into that?

Sure. So with respect to all of our capital deployment, and I think both of those items are indicative of our more active stance towards allocation of capital in PFSI. With respect to the share repurchases, we really look at that as the opportunity for doing that versus what we see as other opportunities for deployment of capital, as shares got down -- in terms of the pricing of our shares got down to a level where we saw that return as being attractive to our other -- as compared to our other opportunities, we did enter into the market. Obviously, the prices have changed somewhat since then. And we do believe that as we have in the past, we have very attractive opportunities in terms of deploying capital into higher-rate MSRs with really excellent recapture potential, which is evidencing itself as we're going in lower in rates currently.

But when we see that opportunity, we've shown our willingness and ability in the past to be in the market repurchasing shares, and that will continue to be on our menu of capital allocation items to the extent that we see those opportunities.

With respect to the Annaly transaction, really there looking more toward allocating the capital that we raise from that more toward, again, those opportunities to bring on additional high note rate servicing with opportunities for recapture and believe that the returns from -- the go-forward returns from that Annaly transaction we're at the lower end of our targeted range, being able to deploy into higher note rate servicing with much greater recapture potential and reallocate that capital is a positive benefit for PFSI.

Yes, Doug, the 2 other things I'd add to that is that as we see the growth in broker, the capital needs to support that growth are going to grow, and we can be put on higher rate MSRs to continue to support that initiative. While at the same time, we saw a slight tick down in our non-funding debt to equity was down slightly from 1.6x to 1.5x. And keeping it at that 1.5x is important to us and especially as we're talking to key constituents like the rating agencies, I think that's something that we're keeping in mind as well. So all in all, a great quarter in terms of recycling out of lower returning investments to set ourselves up to redeploy in higher returning investments.

And Dan, you mentioned the tax rate, it was down a couple of hundred basis points this quarter. Anything to call out there? And how sustainable is that this quarter's level?

This quarter is a little bit lower than what we would expect on a go-forward basis. Some of that was driven by option executions during the quarter, which has the effect of creating a permanent tax difference which reduces the tax rate in the quarter. So our overall tax rate, we expect to be -- over time, we expect to be, as you mentioned, slightly higher -- a couple of hundred basis points higher, but it was a benefit that we did see in the quarter.

Your next question comes from the line of Trevor Cranston with Citizens JMP.

Okay. So I was curious about what you guys are seeing within the servicing portfolio as we get rate rallies, I was curious if you guys are seeing any difference in the responsiveness of borrowers sort of jumping on refi opportunities today versus kind of what your experience has been like in the past or what your models have projected?

And the second part of that, I was curious, I don't think I saw a recapture rate specifically for the third quarter. So I was wondering if you could also just comment specifically on the third quarter recapture performance?

Yes. Look, I'll let Dan go over the recapture rates in a minutes. I will tell you that my observation is, one, they were up for the quarter, and that is a byproduct of the work and efforts done by Doug and Abbie and Scott and the team and really honing in on perfecting recapture. And that's a byproduct of technology. We're already seeing really good results from the deployment of our new loan origination system upwards of a 50% reduction in time to complete a lock application, and that's allowing us to meet the demands driven into the call center by our marketing initiatives. And those marketing initiatives are really key to driving in leads to the call center. And so it's really in and of itself its own set of initiatives, but I'm really happy with where the recapture rates came in.

Yes. With respect to the responsiveness, I think, generally, we've seen some folks come to the table a little bit quicker than we have historically, just folks that had purchased homes at higher rates are excited to get into slightly lower rates. And so that's probably -- the responsiveness has been slightly higher than what we have seen historically.

With respect to the recapture rate, they continue to improve in the third quarter, as David mentioned. I think that as we get into the fourth quarter, that's where you're going to -- and some of the loans that we locked in the third quarter and they'll come to sort of fruition with payoffs in the fourth quarter is where you really see the benefits of the improved focus on recapture.

Your next question comes from the line of Eric Hagen with BTIG.

Hopefully, I'm coming in. Lots of renewed attention here on community banks and speculation on whether some of the credit risk that we're talking about is systemic or if it's more contained. I mean, how do you think just generally that changes their appetite for originating mortgages and their relationship back to you?

And when there's consolidation in the banking space, I mean, how do you think that generally impacts just the flow of credit and the opportunity that you guys have to encroach on market share?

Look, I think that it's a little early. I'll tell you that there's been consolidation going on for quite some time now in the industry. Our job is to continue to do the work that we do to make sure that our correspondent counterparts or counterparties have the right risks under control. The capital is reviewed on a regular basis. We have a robust underwriting and review process to really understand the manufacturing that goes into the loans that we buy. And so I think that, that's something that gives us comfort.

We just have to stay diligent and our risk management practices are well honed. And I believe that you'll see consolidation, that consolidation will benefit us in the long run. And this is why it's really important that we're in all 3 channels because whether it benefits us in correspondent or broker or our call center, we will be able to participate.

That's good color. I appreciate that. Are there any opportunities you guys feel like to reduce servicing expenses from this point forward or reduce them kind of meaningfully over the near term? I mean, is there a target rate that you have in mind for servicing expenses and does the ROE guidance that you've given include any reductions in servicing costs?

So yes, we do expect servicing costs or unit servicing costs to continue to decline, both through the use of our technology, implementation of some of our artificial intelligence initiatives. We think that there are places in parts of the operations where we can gain significant additional operational leverage and reduce costs to a greater degree.

As we're moving into 2026 and the guidance that was reflected, the guidance that was put out did reflect additional cost savings in terms of servicing on a unit basis. And as the portfolio grows, to the extent that we can move as quickly as we want to with our technology initiatives, there could be potential additional upside there. But we do think that there is continued opportunity to be able to reduce costs in a meaningful way in the servicing segment.

We had a little slight uptick in our corporate expenses because of the investments in technology to enhance our servicing system. A lot of these initiatives are AI related to help speed up the decline in expenses as well as look at other ways that we can use our technology in the marketplace.

[Operator Instructions] Your next question comes from the line of Ryan Shelley with Bank of America.

I just wanted to zone in a bit on the broker direct channel, especially after recent consolidation in this space. Have you guys seen any changes to competitive behavior, whether by the player involved in that consolidation or players not in the top 2 and not you guys? Any changes to call out there?

Look, I think our rapid ascent in broker direct is, to me, the results of the hard work and effort that the team has gone through in building technology to meet the demands and needs of the broker as well as to be able to provide a clear alternative to the top 2 brokers. And I think that's resonating with our broker partners.

I think that we are -- I know we're the only mortgage bank out there that's not distracted. And it's those distractions that's allowing -- that the other participants are having that's allowing us to focus on meeting the needs of our broker partners as well as to grow share. And that's why I'm very confident that we're going to get to the 10% market share number by the end of 2026. And I think that you're going to continue to see growth.

The nice part about the growth this quarter is you had growth in share and growth in margin. And I think that, that's really important to keep in mind. It's something that we're seeing the broker market, really having a nice increase in that margin, and it's something that is starting to have good meaningful impact on the results of the company.

And as I said earlier, being able to participate in all 3 parts of the production ecosystem allows us to not focus on just one part of the origination lead system, for example, whether it's correspondent, we're just focusing on bulk or consumer direct, just focusing on recapture of our own portfolio. By being in broker as well, we continue to have a presence with the purchase market as well as the refinance market. So it's something that I'm really bullish about and really happy to see.

Got it. Yes, definitely. And then one more quick one. So I think there's this narrative out there that you'll see further consolidation in this industry? I guess do you guys buy into that narrative? And how do you think you would fit into that?

Yes. Look, I think that there are some parts of the market where perhaps you'll see more consolidation than the other -- than others. We've been -- we're -- at the end of this year, we'll finish our 18th year. Most of -- just about everything we've done has been done organically. We're an organic management team. We've built our 3 production divisions organically. We built our servicing platform organically. And I don't foresee anything that would change that. And so it's something that we are going to continue to operate. We're going to continue to grow. And while others may be focused on consolidation or other corporate activities, that allows us to continue to grow faster and it allows us to do it profitably. And that's something that's really one of the great highlights of this quarter, for me is just the focus on capital allocation and focusing on really deploying capital and the higher returning assets and finding assets that perhaps aren't meeting our return targets and being able to find alternatives, and that's what this management team is great at, and that's something that I want to continue to focus on.

We have no further questions at this time. I'll now turn it back to David Spector for closing remarks.

Thank you, operator, and thank you all for joining us this afternoon. We really appreciate the time and the opportunity to present the quarter and answer any questions. I encourage all of you if you have any additional questions to contact our Investor Relations team by e-mail or phone. I'm going to look forward to speaking to all of you in the future. Thanks again.

This now concludes today's call. Thank you for attending. You may now disconnect.