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PennyMac Mortgage: Asymmetrical Compensation (PMT)

July 08, 2011 | About:
PennyMac Mortgage (PMT) is a REIT that invests primarily in residential mortgage loans. The company buys so-called “scratch-and-dent” mortgages, where the homeowner has missed payments, or the mortgage was approved with missing documentation. Many of these mortgages exist in a grey area between sub-prime and prime mortgages, and so there are very few companies willing to take these on and service them. This has allows PMT to purchase large amounts of these mortgages at around 52 cents on the dollar. This discount allows the company to work with homeowners to reduce the interest rates in order to become affordable once again, while still earning a good return.

It is worth noting that the company was started in 2009 by Stanford Kurland, who was the former #2 at Countrywide, one of the biggest parties in originating the types of loans currently being purchased by PMT. The media have tended to portray this fact in a negative light, some analysts suggest this means Kurland and his team (comprised mainly of other ex-Countrywide execs) should be able to use their connections and experience in the industry to their advantage, reducing the risk of the venture.

I think those analysts are correct; the team has reduced the riskiness of the venture, but mainly for themselves in terms of their own compensation. First, let’s look at how the company works. PMT, like many REITs, has a convoluted organization structure. From the company’s Form S-11 dated May 22, 2009 (click for full size):

g68030.jpgTo make this a bit more clear and figure out how the different parties are compensated:

  • PCM manages PMT, and receives a base management fee of 1.5% per annum of Shareholders’ Equity + 20% of Core Earnings (which removed noncash equity compensation and any unrealized gains/losses) that exceed an 8% return on the weighted average share price of all their public offerings.
  • PLS services the investment portfolio on behalf of PMT, and receives servicing fees of 30 to 100bp, fulfillment fees of 50bp and a sourcing fee of 3bp (all of which are multiplied by the unpaid principal portion of the mortgages)
  • Both parties are reimbursed for most operating expenses.
This structure makes it somewhat difficult to determine exactly what expenses are really compensation in disguise, as the company does not break out the financial statements of PCM or PLS.

Ok, so let’s look at how these fees added up in 2010. According to the company’s 2010 10-K, management fees totaled $4.878M to PCM, loan servicing and fulfillment fees of $2.833M to PLS, reimbursement of $1.418M of overhead to PCM, and compensation of $2.627M. The grand total flowing out to PCM, PLS and employees (more on the latter soon) is $11.756M. From the same 10-K:

We have no employees, and we do not pay our officers any cash compensation.
So the $2.627M in compensation went to the executives, of which there are seven listed in the Definitive Proxy Statement. A review of the same document shows how these executives also run PCM and PLS. So really, the $11.756M went to seven people, or ~$1.7M per person as compensation for arranging financing and sourcing the assets (note that this includes reimbursement for overhead, which is not broken out for greater clarity). Now, it is likely that the portion of PLS’ fees that are servicing fees (rather than fulfillment and sourcing) probably go to third parties (the call centers that make contact with the homeowners). So, we would have to reduce this figure by some amount for that (unfortunately, this too is not broken out in the financial statements).

I think it is safe to say that these seven executives would be walking away with compensation in excess of $1.2M last year (average). This does not, at first glance, appear to be excessive given the assets under management, which averaged $457M (book value, which is about 1/2 the original loan value, which should be less than the value of the homes that could be repossessed) throughout the year (We’ve seen some companies where executives receive a far higher proportion of the company’s earnings), but the key issue here is that compensation should only increase from this level. The company did not achieve its 8% hurdle in 2010, so the 20% fee above that is not included, and the company is only beginning to ramp up its assets under management (assets increased over 2010 by 81%).

This appears to be a real asymmetry in terms of compensation. In years of poor performance, executives still walk away with high compensation packages. In good years, we can expect these figures to balloon. Combined with the fact that insiders own just 1.17% of the company, and it certainly seems like shareholders take the brunt of poor performance (earnings per share declined to $0.35 this last quarter, which is 23% below the trailing three quarter average – however, the company has yet to reduce the dividend accordingly), and receive a relatively smaller portion of strong performance.

Author Disclosure: No position

Talk to Frank about PennyMac

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

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