Edgar Filing: PENNYMAC FINANCIAL SERVICES, INC.

Quarter ended March 31,

(in thousands)

Base management

pfsi_Current_Folio_10Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)

☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2018

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-35916

PennyMac Financial Services, Inc.

(Exact name of registrant as specified in its charter)


Delaware		80-0882793
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)


3043 Townsgate Road, Westlake Village, California		91361
(Address of principal executive offices)		(Zip Code)

(818) 224-7442

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer ☐		Accelerated filer ☒

Non-accelerated filer ☐ (Do not check if a smaller reporting company)		Smaller reporting company ☐
Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.


Class		Outstanding at May 3, 2018
Class A Common Stock, $0.0001 par value		25,094,668
Class B Common Stock, $0.0001 par value		45

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PENNYMAC FINANCIAL SERVICES, INC.

FORM 10-Q

March 31, 2018

TABLE OF CONTENTS


		Page
	Special Note Regarding Forward-Looking Statements	3

PART I. FINANCIAL INFORMATION		5

Item 1.	Financial Statements (Unaudited):	5
	Consolidated Balance Sheets	5
	Consolidated Statements of Income	6
	Consolidated Statements of Changes in Stockholders’ Equity	7
	Consolidated Statements of Cash Flows	8
	Notes to Consolidated Financial Statements	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	58
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	72
Item 4.	Controls and Procedures	74

PART II. OTHER INFORMATION		75

Item 1.	Legal Proceedings	75
Item 1A.	Risk Factors	75
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	75
Item 3.	Defaults Upon Senior Securities	75
Item 4.	Mine Safety Disclosures	75
Item 5.	Other Information	75
Item 6.	Exhibits	76

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SPECIAL NOTE REGARDING FORWARD‑LOOKING STATEMENTS

This Quarterly Report on Form 10-Q (“Report”) contains certain forward‑looking statements that are subject to various risks and uncertainties. Forward‑looking statements are generally identifiable by use of forward‑looking terminology such as “may,” “will,” “should,” “potential,” “intend,” “expect,” “seek,” “anticipate,” “estimate,” “approximately,” “believe,” “could,” “project,” “predict,” “continue,” “plan” or other similar words or expressions.

Forward‑looking statements are based on certain assumptions, discuss future expectations, describe future plans and strategies, contain financial and operating projections or state other forward‑looking information. Examples of forward‑looking statements include the following:

projections of our revenues, income, earnings per share, capital structure or other financial items;

descriptions of our plans or objectives for future operations, products or services;

forecasts of our future economic performance, interest rates, profit margins and our share of future markets; and

descriptions of assumptions underlying or relating to any of the foregoing expectations regarding the timing of generating any revenues.

Our ability to predict results or the actual effect of future events, actions, plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward‑looking statements are based on reasonable assumptions, our actual results and performance could differ materially from those set forth in the forward‑looking statements. There are a number of factors, many of which are beyond our control that could cause actual results to differ significantly from management’s expectations. Some of these factors are discussed below.

You should not place undue reliance on any forward‑looking statement and should consider the following uncertainties and risks, as well as the risks and uncertainties discussed elsewhere in this Report and the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission (“SEC”) on March 9, 2018.

Factors that could cause actual results to differ materially from historical results or those anticipated include, but are not limited to:

the continually changing federal, state and local laws and regulations applicable to the highly regulated industry in which we operate;

lawsuits or governmental actions if we do not comply with the laws and regulations applicable to our businesses;

the mortgage lending and servicing-related regulations promulgated by the Consumer Financial Protection Bureau (“CFPB”) and its enforcement of these regulations;

our dependence on U.S. government‑sponsored entities and changes in their current roles or their guarantees or guidelines;

changes to government mortgage modification programs;

certain banking regulations that may limit our business activities;

foreclosure delays and changes in foreclosure practices;

the licensing and operational requirements of states and other jurisdictions applicable to our businesses, to which our bank competitors are not subject;

changes in macroeconomic and U.S. real estate market conditions;

difficulties inherent in growing loan production volume;

difficulties inherent in adjusting the size of our operations to reflect changes in business levels;

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any required additional capital and liquidity to support business growth that may not be available on acceptable terms, if at all;

changes in prevailing interest rates;

increases in loan delinquencies and defaults;

our dependence on the success of the multifamily market for future originations of commercial mortgage loans and other commercial real estate-related loans;

our reliance on PennyMac Mortgage Investment Trust (“PMT”) as a significant source of financing for, and revenue related to, our mortgage banking business;

our obligation to indemnify third‑party purchasers or repurchase loans if loans that we originate, acquire, service or assist in the fulfillment of, fail to meet certain criteria or characteristics or under other circumstances;

our ability to realize the anticipated benefit of potential future acquisitions of mortgage servicing rights (“MSRs”);

our obligation to indemnify PMT and the Investment Funds if our services fail to meet certain criteria or characteristics or under other circumstances;

decreases in the returns on the assets that we select and manage for our clients, and our resulting management and incentive fees;

the extensive amount of regulation applicable to our investment management segment;

conflicts of interest in allocating our services and investment opportunities among ourselves and our Advised Entities;

the effect of public opinion on our reputation;

our recent growth;

our ability to effectively identify, manage, monitor and mitigate financial risks;

our initiation of new business activities or expansion of existing business activities;

our ability to detect misconduct and fraud;

our ability to mitigate cybersecurity risks and cyber incidents;

our exposure to risks of loss resulting from adverse weather conditions and man-made or natural disasters; and

our organizational structure and certain requirements in our charter documents.

Other factors that could also cause results to differ from our expectations may not be described in this Report or any other document. Each of these factors could by itself, or together with one or more other factors, adversely affect our business, results of operations and/or financial condition.

Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update any forward-looking statement to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PENNYMAC FINANCIAL SERVICES, INC.

CONSOLIDATED BALANCE SHEETS (UNAUDITED)


	March 31,		December 31,
	2018		2017
	(in thousands, except share amounts)
ASSETS
Cash (includes $116,570 and $20,765 pledged to creditors)	$	137,863	$	37,725
Short-term investments at fair value		105,890		170,080
Mortgage loans held for sale at fair value (includes $2,569,189 and $3,081,987 pledged to creditors)		2,584,236		3,099,103
Derivative assets		89,469		78,179
Servicing advances, net (includes valuation allowance of $61,670 and $59,958; $104,685 and $114,643 pledged to creditors)		284,145		318,066
Carried Interest due from Investment Funds pledged to creditors		538		8,552
Investment in PennyMac Mortgage Investment Trust at fair value		1,352		1,205
Mortgage servicing rights (includes $2,354,489 and $638,010 at fair value; $2,178,536 and $2,098,067 pledged to creditors)		2,354,489		2,119,588
Real estate acquired in settlement of loans		2,338		2,447
Furniture, fixtures, equipment and building improvements, net (includes $22,250 and $23,915 pledged to creditors)		30,172		29,453
Capitalized software, net (includes $1,457 and $1,568 pledged to creditors)		28,919		25,729
Assets purchased from PennyMac Mortgage Investment Trust under agreements to resell pledged to creditors		142,938		144,128
Receivable from PennyMac Mortgage Investment Trust		27,356		27,119
Receivable from Investment Funds		460		417
Mortgage loans eligible for repurchase		1,018,488		1,208,195
Other		94,238		98,107
Total assets	$	6,902,891	$	7,368,093
LIABILITIES
Assets sold under agreements to repurchase	$	1,814,282	$	2,381,538
Mortgage loan participation purchase and sale agreements		510,443		527,395
Notes payable		1,140,022		891,505
Obligations under capital lease		16,435		20,971
Excess servicing spread financing payable to PennyMac Mortgage Investment Trust at fair value		236,002		236,534
Derivative liabilities		4,476		5,796
Accounts payable and accrued expenses		113,046		106,716
Mortgage servicing liabilities at fair value		12,063		14,120
Payable to Investment Funds		26		2,427
Payable to PennyMac Mortgage Investment Trust		117,987		136,998
Payable to exchanged Private National Mortgage Acceptance Company, LLC unitholders under tax receivable agreement		46,037		44,011
Income taxes payable		58,956		52,160
Liability for mortgage loans eligible for repurchase		1,018,488		1,208,195
Liability for losses under representations and warranties		20,429		20,053
Total liabilities		5,108,692		5,648,419

Commitments and contingencies – Note 14

STOCKHOLDERS’ EQUITY
Class A common stock—authorized 200,000,000 shares of $0.0001 par value; issued and outstanding, 24,277,768 and 23,529,970 shares, respectively		2		2
Class B common stock—authorized 1,000 shares of $0.0001 par value; issued and outstanding, 45 and 46 shares, respectively		—		—
Additional paid-in capital		221,495		204,103
Retained earnings		282,114		265,306
Total stockholders' equity attributable to PennyMac Financial Services, Inc. common stockholders		503,611		469,411
Noncontrolling interest in Private National Mortgage Acceptance Company, LLC		1,290,588		1,250,263
Total stockholders' equity		1,794,199		1,719,674
Total liabilities and stockholders’ equity	$	6,902,891	$	7,368,093

The accompanying notes are an integral part of these consolidated financial statements.

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PENNYMAC FINANCIAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)


	Quarter ended March 31,
	2018		2017
	(in thousands, except earnings per share)
Revenues
Net gains on mortgage loans held for sale at fair value:
From non-affiliates	$	59,028	$	88,651
From PennyMac Mortgage Investment Trust		12,386		(1,695)
		71,414		86,956
Mortgage loan origination fees:
From non-affiliates		23,355		24,195
From PennyMac Mortgage Investment Trust		1,208		1,379
		24,563		25,574
Fulfillment fees from PennyMac Mortgage Investment Trust		11,944		16,570
Net mortgage loan servicing fees:
Mortgage loan servicing fees:
From non-affiliates		135,483		106,467
From PennyMac Mortgage Investment Trust		11,019		10,486
From Investment Funds		—		496
Ancillary and other fees		14,171		11,866
		160,673		129,315
Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities		(36,963)		(57,925)
Change in fair value of excess servicing spread payable to PennyMac Mortgage Investment Trust		(6,921)		2,773
		(43,884)		(55,152)
Net mortgage loan servicing fees		116,789		74,163
Management fees:
From PennyMac Mortgage Investment Trust		5,696		5,008
From Investment Funds		79		366
		5,775		5,374
Carried Interest from Investment Funds		(180)		(128)
Net interest income (expense):
Interest income:
From non-affiliates		40,639		22,054
From PennyMac Mortgage Investment Trust		1,976		1,805
		42,615		23,859
Interest expense:
To non-affiliates		32,811		24,827
To PennyMac Mortgage Investment Trust		3,934		4,647
		36,745		29,474
Net interest income (expense)		5,870		(5,615)
Change in fair value of investment in and dividends received from PennyMac Mortgage Investment Trust		182		139
Results of real estate acquired in settlement of loans		(28)		(25)
Other		1,872		1,465
Total net revenues		238,201		204,473
Expenses
Compensation		102,013		85,240
Servicing		26,299		26,843
Technology		14,620		11,356
Occupancy and equipment		6,377		5,042
Professional services		5,738		3,818
Marketing		2,161		1,736
Loan origination		2,115		4,133
Other		5,882		4,273
Total expenses		165,205		142,441
Income before provision for income taxes		72,996		62,032
Provision for income taxes		6,070		7,646
Net income		66,926		54,386
Less: Net income attributable to noncontrolling interest		50,307		43,507
Net income attributable to PennyMac Financial Services, Inc. common stockholders	$	16,619	$	10,879

Earnings per share
Basic	$	0.70	$	0.48
Diluted	$	0.67	$	0.47
Weighted average shares outstanding
Basic		23,832		22,619
Diluted		79,461		77,143

The accompanying notes are an integral part of these consolidated financial statements.

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PENNYMAC FINANCIAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)


	Class A Common Stock								Noncontrolling
								interest in Private
				Additional				National Mortgage				Total
	Number of	Par		paid-in		Retained		Acceptance				stockholders'
	shares	value		capital		earnings		Company, LLC				equity
	(in thousands)

Balance at December 31, 2016	22,427	$	2	$	182,772	$	164,549	$		1,052,033	$		1,399,356
Net income	—		—		—		10,879			43,507			54,386
Stock and unit-based compensation	157		—		1,903		—			3,874			5,777
Issuance of Class A common stock in settlement of directors' fees	5		—		84		—			—			84
Exchange of Class A units of Private National Mortgage Acceptance Company, LLC to Class A common stock of PennyMac Financial Services, Inc.	329		—		8,763		—			(8,763)			—
Tax effect of exchange of Class A units of Private National Mortgage Acceptance Company, LLC to Class A common stock of PennyMac Financial Services, Inc.	—		—		(2,008)		—			—			(2,008)
Balance at March 31, 2017	22,918	$	2	$	191,514	$	175,428	$		1,090,651	$		1,457,595

Balance at December 31, 2017	23,530	$	2	$	204,103	$	265,306	$		1,250,263	$		1,719,674
Cumulative effect of change in accounting principle – accounting for all existing classes of mortgage servicing rights at fair value	—		—		—		189			587			776
Balance at January 1, 2018	23,530		2		204,103		265,495			1,250,850			1,720,450
Net income	—		—		—		16,619			50,307			66,926
Stock and unit-based compensation	—		—		5,191		—			4,235			9,426
Issuance of Class A common stock in settlement of directors' fees	—		—		24		—			55			79
Exchange of Class A units of Private National Mortgage Acceptance Company, LLC to Class A common stock of PennyMac Financial Services, Inc. by noncontrolling interest unitholders and issued as equity compensation	748		—		14,859		—			(14,859)			—
Tax effect of exchange and repurchases of Class A units of Private National Mortgage Acceptance Company, LLC to Class A common stock of PennyMac Financial Services, Inc., net	—		—		(2,682)		—			—			(2,682)
Balance at March 31, 2018	24,278	$	2	$	221,495	$	282,114	$		1,290,588	$		1,794,199

The accompanying notes are an integral part of these consolidated financial statements.

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PENNYMAC FINANCIAL SERVICES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)


	Quarter ended March 31,
	2018		2017
	(in thousands)
Cash flow from operating activities
Net income	$	66,926	$	54,386
Adjustments to reconcile net income to net cash used in operating activities:
Net gains on mortgage loans held for sale at fair value		(71,414)		(86,956)
Accrual of servicing rebate payable to Investment Funds		—		45
Amortization, impairment and change in fair value of mortgage servicing rights, mortgage servicing liabilities and excess servicing spread		43,884		55,152
Carried Interest from Investment Funds		180		128
Capitalization of interest on mortgage loans held for sale at fair value		(14,467)		(8,900)
Accrual of interest on excess servicing spread financing		3,934		4,647
Amortization of debt issuance costs and premiums		(3,600)		3,269
Change in fair value of investment in common shares of PennyMac Mortgage Investment Trust		(147)		(103)
Results of real estate acquired in settlement in loans		28		25
Stock-based compensation expense		6,171		5,525
Provision for servicing advance losses		6,787		9,921
Depreciation and amortization		2,592		1,952
Purchase of mortgage loans held for sale from PennyMac Mortgage Investment Trust		(9,212,188)		(10,016,788)
Originations of mortgage loans held for sale		(1,281,302)		(1,061,212)
Purchase of mortgage loans from Ginnie Mae securities and early buyout investors for modification and subsequent sale		(911,585)		(936,948)
Sale and principal payments of mortgage loans held for sale to non-affiliates		11,103,785		11,860,133
Sale of mortgage loans held for sale to PennyMac Mortgage Investment Trust		781,326		21,530
Repurchase of mortgage loans subject to representations and warranties		(6,309)		(5,303)
Decrease in servicing advances		27,450		21,251
Collection of Carried Interest		7,834		—
Sale of real estate acquired in settlement of loans		1,230		—
Increase in receivable from PennyMac Mortgage Investment Trust		(955)		(4,206)
(Increase) decrease in receivable from Investment Funds		(43)		176
Increase in other assets		(1,593)		(966)
Increase (decrease) in accounts payable and accrued expenses		4,745		(28,163)
Decrease in payable to Investment Funds		(2,401)		(2,037)
Decrease in payable to PennyMac Mortgage Investment Trust		(19,544)		(5,480)
Increase in income taxes payable		6,068		7,630
Net cash provided by (used in) operating activities		537,392		(111,292)
Cash flow from investing activities
Decrease (increase) in short-term investments		64,190		(30,370)
Net settlement of derivative financial instruments used for hedging		(128,099)		(20,492)
Purchase of mortgage servicing rights		(27,544)		(203)
Purchase of furniture, fixtures, equipment and leasehold improvements		(2,779)		(2,329)
Acquisition of capitalized software		(3,722)		(4,526)
Sale of assets purchased from PMT under agreement to resell		1,190		—
Decrease (increase) in margin deposits		15,501		(2,434)
Net cash used in investing activities		(81,263)		(60,354)
Cash flow from financing activities
Sale of assets under agreements to repurchase		9,771,234		5,815,923
Repurchase of assets sold under agreements to repurchase		(10,338,629)		(5,516,480)
Issuance of mortgage loan participation certificates		6,155,178		5,302,595
Repayment of mortgage loan participation certificates		(6,172,301)		(5,732,434)
Advances on notes payable		650,000		400,000
Repayment of notes payable		(400,000)		(110,633)
Advances of obligations under capital lease		—		10,298
Repayment of obligations under capital lease		(4,536)		(2,544)
Repayment of excess servicing spread financing		(12,291)		(14,632)
Payment of debt issuance costs		(7,891)		(7,246)
Issuance of common stock pursuant to exercise of options		3,255		252
Net cash (used in) provided by financing activities		(355,981)		145,099
Net increase (decrease) in cash and restricted cash		100,148		(26,547)
Cash and restricted cash at beginning of quarter		38,173		99,642
Cash and restricted cash at end of quarter	$	138,321	$	73,095
Cash and restricted cash at end of period are comprised of the following:
Cash	$	137,863	$	72,767
Restricted cash included in Other assets		458		328
	$	138,321	$	73,095

The accompanying notes are an integral part of these consolidated financial statements.

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PENNYMAC FINANCIAL SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1—Organization

PennyMac Financial Services, Inc. (“PFSI” or the “Company”) was formed as a Delaware corporation on December 31, 2012. Pursuant to a reorganization, the Company became a holding corporation and its primary asset is an equity interest in Private National Mortgage Acceptance Company, LLC (“PennyMac”). The Company is the managing member of PennyMac and operates and controls all of the businesses and affairs of PennyMac subject to the consent rights of other members under certain circumstances, and consolidates the financial results of PennyMac and its subsidiaries.

PennyMac is a Delaware limited liability company which, through its subsidiaries, engages in mortgage banking and investment management activities. PennyMac’s mortgage banking activities consist of residential mortgage loan production and mortgage loan servicing. PennyMac’s investment management activities and a portion of its mortgage loan servicing activities are conducted on behalf of investment vehicles that invest in residential mortgage loans and related assets. PennyMac’s primary wholly owned subsidiaries are:

PNMAC Capital Management, LLC (“PCM”)—a Delaware limited liability company registered with the Securities and Exchange Commission (“SEC”) as an investment adviser under the Investment Advisers Act of 1940, as amended. PCM enters into investment management agreements with entities that invest in residential mortgage loans and related assets.

Presently, PCM has management agreements with PNMAC Mortgage Opportunity Fund, LLC and PNMAC Mortgage Opportunity Fund, L.P., (the “Master Fund”), both registered under the Investment Company Act of 1940, as amended, an affiliate of these registered funds, PNMAC Mortgage Opportunity Fund Investors, LLC (collectively, the “Investment Funds”), and PennyMac Mortgage Investment Trust (“PMT”), a publicly held real estate investment trust (“REIT”). Together, the Investment Funds and PMT are referred to as the “Advised Entities.” In 2017 and through the quarter ended March 31, 2018, the Investment Funds sold or liquidated all of their remaining investments. PCM expects to complete liquidation of the Investment Funds during 2018.

PennyMac Loan Services, LLC (“PLS”)— a Delaware limited liability company that services portfolios of residential mortgage loans on behalf of non-affiliates and the Advised Entities, purchases, originates and sells new prime credit quality residential mortgage loans and engages in other mortgage banking activities for its own account and the account of PMT.

PLS is approved as a seller/servicer of mortgage loans by the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and as an issuer of securities guaranteed by the Government National Mortgage Association (“Ginnie Mae”). PLS is a licensed Federal Housing Administration Nonsupervised Title II Lender with the U.S. Department of Housing and Urban Development (“HUD”) and a lender/servicer with the Veterans Administration (“VA”) and U.S. Department of Agriculture (“USDA”) (each an “Agency” and collectively the “Agencies”).

PNMAC Opportunity Fund Associates, LLC (“PMOFA”)—a Delaware limited liability company and the general partner of the Master Fund. PMOFA is entitled to incentive fees representing allocations of profits (“Carried Interest”) from the Master Fund.

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Note 2—Basis of Presentation and Accounting Changes

Basis of Presentation

The accompanying consolidated financial statements have been prepared in compliance with accounting principles generally accepted in the United States (“GAAP”) as codified in the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) for interim financial information and with the SEC’s instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these financial statements and notes do not include all of the information required by GAAP for complete financial statements. This interim consolidated information should be read together with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

The accompanying unaudited consolidated financial statements reflect all normal recurring adjustments necessary to present fairly the financial position, income, and cash flows for the interim periods, but are not necessarily indicative of income to be anticipated for the full year ending December 31, 2018. Intercompany accounts and transactions have been eliminated.

Preparation of financial statements in compliance with GAAP requires management to make judgments and estimates that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Actual results will likely differ from those estimates.

Accounting Changes

During the quarter ended March 31, 2018, the Company adopted changes to the accounting principles used in the preparation of its financial statements summarized below.

Mortgage Servicing Rights

Effective January 1, 2018, the Company has elected to change the accounting for the classes of mortgage servicing rights (“MSRs”) it had accounted for using the amortization method through December 31, 2017, to the fair value method as allowed in the Transfers and Servicing topic of the FASB’s ASC. The Company determined that a single accounting treatment across all MSRs is consistent with lender valuation under its financing arrangements and simplifies the Company’s hedging activities. As the result of this change, the Company recorded an adjustment to increase its investment in MSRs by $848,000, an increase in its liability for income taxes payable of $72,000 and in increase in stockholders’ equity of $776,000.

Revenue Recognition

In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Subtopic 606) (“ASU 2014-09”), which supersedes the guidance in the Revenue Recognition topic of the ASC. Effective January 1, 2018, the Company adopted ASU 2014-09 as amended using the modified retrospective method. The adoption of ASU 2014-09 did not require the Company to record a cumulative effect adjustment to its beginning retained earnings.

The Company’s revenues from contracts with customers that are subject to ASU 2014-09 include fulfillment fees, management fees, Carried Interest and certain reimbursed overhead costs. Other revenue and income streams are not subject to ASU 2014-09 as they are financial instruments or other contractual rights and obligations accounted for under the Receivables, Investments and Debt and Equity Securities, Topics of the ASC Transfers and Servicing, Topic 825 Financial Instruments and Derivatives and Hedging.

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Fulfillment Fees

Fulfillment fees represent fees the Company collects for services it performs on behalf of PMT in connection with the acquisition, packaging and sale of mortgage loans. Fulfillment fee amounts are based upon a negotiated fee schedule and the unpaid principal balance of the mortgage loans purchased by PMT. The Company’s obligation under the agreement is fulfilled when PMT completes the sale or securitization of a mortgage loan it purchases. Fulfillment fees are generally collected within 30 days of purchase by PMT, although a portion of the fulfillment fees may not be collected until 30 days following sale or securitization to the extent such sale or securitization does not occur in the month of purchase. Fulfillment fee revenue is recognized in the month the fee is earned. Fulfillment fees receivable contract assets are disclosed in Note 4—Transactions with Affiliates.

Management fees

Management fees represent compensation to the Company for its management services provided to the Advised Entities. Management fees are earned based on the Investment Funds’ net assets and PMT’s shareholders’ equity amounts and profitability in excess of specified thresholds, and are recognized as services are provided and are paid to the Company on a quarterly basis within 30 days of the end of the quarter. Management fees receivable contract assets are disclosed in Note 4—Transactions with Affiliates.

Carried Interest

The Company’s Carried Interest arrangements with the Investment Funds represent capital allocations to the Company. As a result, the Company has concluded as part of its assessment of the effect of the adoption of ASU 2014-09 that its Carried Interest represents an equity method investment subject to the Investments – Equity Method and Joint Ventures topic of the ASC. Therefore, effective January 1, 2018, the Company recharacterized its Carried Interest as financial instruments under the equity method of accounting. Carried Interest balances are disclosed in Note 9—Carried Interest Due from Investment Funds.

Expense reimbursements

Under the Company’s management agreement with PMT, PMT is required to pay its pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of the Company and its affiliates required for PMT’s and its subsidiaries’ operations. These expenses are allocated based on the ratio of PMT’s proportion of gross assets compared to all remaining gross assets managed by the Company as calculated at each fiscal quarter end. Before the adoption of ASU 2014-09, the Company accounted for such reimbursements as reductions to expenses. With the adoption of ASU 2014-09, the Company is required to include such expense reimbursements in its net revenues. As a result of the adoption of ASU 2014-09, certain overhead reimbursement amounts were reclassified from the following expense line items to Other revenue as summarized below:


	Quarter ended
Income statement line	March 31, 2018
	(in thousands)
Compensation	$	120
Occupancy and equipment		589
Technology		220
Other		192
Total expense reimbursements included in Other revenue	$	1,121

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Cash Flows

During the quarter ended March 31, 2018, the Company adopted ASU 2016-18, Statement of Cash Flows (Topic 230) – Restricted Cash (“ASU 2016-18”). ASU 2016-18 requires that a statement of cash flows explain the change during the reporting period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the consolidated statement of cash flows. Accordingly, the Company retrospectively changed the presentation of its consolidated statements of cash flows to conform to the requirements of ASU 2016-18. For the purpose of reporting statement of cash flows, the Company has identified tenant security deposits relating to rental properties owned by PMT and managed by the Company as restricted cash, which are included in Other asset on the Company’s consolidated balance sheets. As the result of adoption of ASU 2016-18, the Company’s consolidated statements of cash flows for the quarter ended March 31, 2017 changed as follows:


		As previously		Effect of adoption
		reported		of ASU 2016-18		As reported
	(in thousands)
Cash flow from operating activities	$	(111,345)	$	53	$	(111,292)
Cash and restricted cash at quarter end	$	72,767	$	328	$	73,095

Note 3—Concentration of Risk

A substantial portion of the Company’s activities relate to the Advised Entities. Revenues generated from these entities (generally comprised of gains on mortgage loans held for sale, mortgage loan origination fees, fulfillment fees, mortgage loan servicing fees, change in fair value of excess servicing spread financing (“ESS”), management fees, Carried Interest, and net interest charged to these entities) totaled 15% and 16% of total net revenue for the quarters ended March 31, 2018 and 2017, respectively.

Note 4—Transactions with Affiliates

Transactions with PMT

Operating Activities

Mortgage Loan Production Activities and Mortgage Servicing Rights (“MSR”) Recapture

The Company provides fulfillment and other services to PMT under an amended and restated mortgage banking services agreement for which it receives a fulfillment fee. Pursuant to the terms of mortgage banking services agreement, the monthly fulfillment fee is an amount that shall equal (a) no greater than the product of (i) 0.35% and (ii) the aggregate initial unpaid principal balance (the “Initial UPB”) of all mortgage loans purchased in such month, plus (b) in the case of all mortgage loans other than mortgage loans sold to or securitized through Fannie Mae or Freddie Mac, no greater than the product of (i) 0.50% and (ii) the aggregate Initial UPB of all such mortgage loans sold and securitized in such month; provided, however, that no fulfillment fee shall be due or payable to the Company with respect to any mortgage loans underwritten to the Ginnie Mae Mortgage‑Backed Securities (“MBS”) Guide. PMT does not hold the Ginnie Mae approval required to issue Ginnie Mae MBS and act as a servicer. Accordingly, under the agreement, the Company currently purchases mortgage loans underwritten in accordance with the Ginnie Mae MBS Guide “as is” and without recourse of any kind from PMT at PMT’s cost less an administrative fee plus accrued interest and a sourcing fee ranging from two to three and one-half basis points, generally based on the average number of calendar days mortgage loans are held by PMT before being purchased by the Company.

In consideration for the mortgage banking services provided by the Company with respect to PMT’s acquisition of mortgage loans under the Company’s early purchase program, the Company is entitled to fees accruing (i) at a rate equal to $1,500 per year per early purchase facility administered by the Company, and (ii) in the amount of $35 for each mortgage loan that PMT acquires thereunder. The mortgage banking services agreement expires, unless terminated earlier in accordance with the agreement, on September 12, 2020, subject to automatic renewal for additional 18-month periods.

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The Company sells newly originated loans to PMT under a mortgage loan purchase agreement and a flow commercial mortgage loan purchase agreement. Historically, the Company has used the mortgage loan purchase agreement for the purpose of selling to PMT prime jumbo residential mortgage loans. Beginning in the quarter ended September 30, 2017, the Company also sells non-government insured or guaranteed mortgage loans to PMT under the mortgage loan purchase agreement. The Company sells to PMT small balance commercial mortgage loans, including multifamily mortgage loans, originated as part of its commercial lending activities using the flow commercial mortgage loan purchase agreement.

Pursuant to the terms of an amended and restated MSR recapture agreement, effective September 12, 2016, if the Company refinances mortgage loans for which PMT previously held the MSRs, the Company is generally required to transfer and convey cash in an amount equal to 30% of the fair market value of the MSRs related to all the mortgage loans so originated. The MSR recapture agreement expires, unless terminated earlier in accordance with the agreement, on September 12, 2020, subject to automatic renewal for additional 18-month periods, unless terminated earlier in accordance with the terms of the agreement.

Following is a summary of mortgage loan production activities and MSR recapture between the Company and PMT:


	Quarter ended March 31,
	2018		2017
	(in thousands)
Net gain (loss) on mortgage loans held for sale at fair value:
Net gain on mortgage loans held for sale to PMT	$	13,811	$	—
Mortgage servicing rights and excess servicing spread recapture incurred		(1,425)		(1,695)
	$	12,386	$	(1,695)
Sale of mortgage loans held for sale to PMT	$	781,326		21,530

Fulfillment fee revenue	$	11,944	$	16,570
Unpaid principal balance of mortgage loans fulfilled for PMT subject to fulfillment fees	$	4,225,631	$	4,631,906

Sourcing fees paid to PMT	$	2,641	$	2,871
Unpaid principal balance of mortgage loans purchased from PMT	$	8,847,873	$	9,574,717

Tax service fees received from PMT included in Mortgage loan origination fees	$	1,208	$	1,379
Property management fees received from PMT included in Other income	$	99	$	71
Early purchase program fees earned from PMT included in Mortgage loan servicing fees	$	—	$	5

Mortgage Loan Servicing

The Company has a mortgage loan servicing agreement with PMT (“Servicing Agreement”). The Servicing Agreement provides for servicing fees of per‑loan monthly amounts based on the delinquency, bankruptcy and/or foreclosure status of the serviced mortgage loan or the REO. The Company also remains entitled to customary ancillary income and market-based fees and charges relating to mortgage loans it services for PMT. These include boarding and deboarding fees, liquidation and disposition fees, assumption, modification and origination fees and a percentage of late charges.

The base servicing fee rates for distressed whole mortgage loans range from $30 per month for current loans up to $85 per month for loans where the borrower has declared bankruptcy. The base servicing fee rate for REO is $75 per month.

To the extent the Company facilitates rentals of PMT's REO under its REO rental program, the Company collects an REO rental fee of $30 per month per REO, an REO property lease renewal fee of $100 per lease renewal, and a property management fee in an amount equal to the Company’s cost if property management services and/or any related software costs are outsourced to a third-party property

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management firm or 9% of gross rental income if the Company provides property management services directly. The Company is also entitled to retain any tenant paid application fees and late rent fees and seek reimbursement for certain third-party vendor fees.

Except as otherwise provided in the MSR recapture agreement, when the Company effects a refinancing of a mortgage loan on behalf of PMT and not through a third-party lender and the resulting mortgage loan is readily saleable, or the Company originates a loan to facilitate the disposition of a REO, the Company is entitled to receive from PMT market-based fees and compensation consistent with pricing and terms the Company offers unaffiliated parties on a retail basis.

Because PMT has a small number of employees and limited infrastructure, the Company is required to provide a range of services and activities significantly greater in scope than the services provided in connection with a customary servicing arrangement. For these services, the Company receives a supplemental servicing fee of $25 per month for each distressed mortgage loan. The Company is entitled to reimbursement for all customary, good faith reasonable and necessary out-of-pocket expenses incurred by the Company in performance of its servicing obligations.

The Company is entitled to retain any incentive payments made to it and to which it is entitled under the U.S. Department of Treasury’s Home Affordable Modification Plan; provided, however, that with respect to any such incentive payments paid to the Company in connection with a mortgage loan modification for which PMT previously paid the Company a modification fee, the Company is required to reimburse PMT an amount equal to the incentive payments.

The Company is also entitled to certain activity-based fees for distressed whole mortgage loans that are charged based on the achievement of certain events. These fees range from $750 for a streamline modification to $1,750 for a liquidation and $500 for a deed-in-lieu of foreclosure. The Company is not entitled to earn more than one liquidation fee, reperformance fee or modification fee per mortgage loan in any 18-month period.

The base servicing fees for non-distressed mortgage loans are calculated through a monthly per-loan dollar amount, with the actual dollar amount for each loan based on whether the mortgage loan is a fixed-rate or adjustable-rate loan. The base servicing fee rates are $7.50 per month and $8.50 per month for fixed-rate loans and adjustable-rate loans, respectively.

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The Servicing Agreement expires on September 12, 2020, subject to automatic renewal for additional 18-month periods, unless terminated earlier in accordance with the terms of the agreement.

Following is a summary of mortgage loan servicing fees earned from PMT:


	Quarter ended March 31,
	2018		2017
	(in thousands)
Mortgage loans acquired for sale at fair value:
Base and supplemental	$	56	$	65
Activity-based		122		143
		178		208
Mortgage loans at fair value:
Base and supplemental		1,005		1,958
Activity-based		2,080		2,390
		3,085		4,348
Mortgage servicing rights:
Base and supplemental		7,649		5,837
Activity-based		107		93
		7,756		5,930
	$	11,019	$	10,486

Investment Management Activities

The Company has a management agreement with PMT (“Management Agreement”). The Management Agreement provides that:

The base management fee is calculated quarterly and is equal to the sum of (i) 1.5% per year of PMT’s average shareholders’ equity up to $2 billion, (ii) 1.375% per year of PMT’s average shareholders’ equity in excess of $2 billion and up to $5 billion, and (iii) 1.25% per year of PMT’s average shareholders’ equity in excess of $5 billion.

The performance incentive fee is calculated quarterly at a defined annualized percentage of the amount by which PMT’s “net income,” on a rolling four‑quarter basis and before deducting the incentive fee, exceeds certain levels of return on “equity.”

The performance incentive fee is equal to the sum of: (a) 10% of the amount by which PMT’s net income for the quarter exceeds (i) an 8% return on equity plus the “high watermark,” up to (ii) a 12% return on PMT’s equity; plus (b) 15% of the amount by which PMT’s net income for the quarter exceeds (i) a 12% return on PMT’s equity plus the “high watermark,” up to (ii) a 16% return on PMT’s equity; plus (c) 20% of the amount by which PMT’s net income for the quarter exceeds a 16% return on equity plus the “high watermark.”

For the purpose of determining the amount of the performance incentive fee:

“Net income” is defined as net income or loss attributable to its common shares of beneficial interest computed in accordance with GAAP adjusted for certain other non‑cash charges determined after discussions between the Company and PMT’s independent trustees and approval by a majority of PMT’s independent trustees.

“Equity” is the weighted average of the issue price per common share of all of PMT’s public offerings, multiplied by the weighted average number of common shares outstanding (including restricted share units) in the rolling four‑quarter period.

The “high watermark” is the quarterly adjustment that reflects the amount by which the net income (stated as a percentage of return on equity) in that quarter exceeds or falls short of the lesser of 8% and the average Fannie Mae 30‑year MBS yield (the “Target Yield”) for the four quarters then ended. If the net income is

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lower than the Target Yield, the high watermark is increased by the difference. If the net income is higher than the Target Yield, the high watermark is reduced by the difference. Each time a performance incentive fee is earned, the high watermark returns to zero. As a result, the threshold amounts required for the Company to earn a performance incentive fee are adjusted cumulatively based on the performance of PMT’s net income over (or under) the Target Yield, until the net income in excess of the Target Yield exceeds the then‑current cumulative high watermark amount, and a performance incentive fee is earned.

The base management fee and the performance incentive fee are both receivable quarterly in arrears. The performance incentive fee may be paid in cash or a combination of cash and PMT’s common shares (subject to a limit of no more than 50% paid in common shares), at PMT’s option.

The Management Agreement expires on September 12, 2020, subject to automatic renewal for additional 18-month periods, unless terminated earlier in accordance with the terms of the agreement. In the event of termination of the Management Agreement between PMT and the Company, the Company may be entitled to a termination fee in certain circumstances. The termination fee is equal to three times the sum of (a) the average annual base management fee, and (b) the average annual performance incentive fee earned by the Company, in each case during the 24-month period immediately preceding the date of termination.

Following is a summary of the base management and performance incentive fees earned from PMT: