Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies
Preparation of financial statements in compliance with accounting principles generally accepted in the United States (“GAAP”) requires us to make 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. Certain of these estimates significantly influence the portrayal of our financial condition and results, and they require us to make difficult, subjective or complex judgments. Our critical accounting policies primarily relate to our fair value estimates.
Fair Value
We group assets measured at or based on fair value in three levels based on the markets in which the assets are traded and the observability of the inputs used to determine fair value. These levels are:
Percentage of
(in thousands)
Total stockholders' equity $ 3,389,388
At December 31, 2020, $14.9 billion or 47% of our total assets were carried at fair value on a recurring basis and $12.2 million (real estate acquired in settlement of loans (“REO”)), were carried based on fair value on a non-recurring basis when fair value indicates evidence of impairment of individual properties.
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Changes in fair value of our holdings of assets carried at fair value have significant effects on our financial position and results of operations. As summarized above, changes in fair values of “Level 1” and “Level 2” fair value assets are determinable with reference to direct quotes in active markets on the measurement date in the case of “Level 1” assets, or reference to publicly available reference interest rates and credit spreads and prices of similar assets in the case of “Level 2” assets.
$7.9 billion or 25% of our total assets are measured using “Level 3” fair value inputs – significant inputs where there is difficulty in observing the inputs used by market participants in establishing fair value. Different approaches to valuing those assets or changes in inputs to measurement of these assets can have a significant effect on the amounts reported for these items including their reported balances and their effects on our income.
During the three years ended December 31, 2020, we recognized significant changes in the fair value of our holdings of “Level 3” fair value assets and liabilities as shown below:
Interest Loans held Mortgage Excess Mortgage
Year ended rate lock for sale at servicing servicing servicing
(positive (negative) effects on income in thousands)
(1) Excluding changes in fair value attributable to realization of cash flows.
The changes above primarily reflect changes attributable to our observations of changes in the markets for those assets and liabilities as opposed to changes in accounting policies or approaches to the valuation of those instruments.
As a result of the difficulty in observing certain significant valuation inputs affecting our “Level 3” fair value assets and liabilities, we are required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets, subsequent transactions may be at values significantly different from those reported.
Because the fair value of “Level 3” fair value assets and liabilities are difficult to estimate, our valuation process includes performance of these items’ fair value estimation by specialized staff with significant senior management oversight. We have assigned the responsibility for estimating the fair values of non-interest rate lock commitment (“IRLC”) “Level 3” fair value assets and liabilities to our Financial Analysis and Valuation group (the “FAV group”), which is responsible for valuing and monitoring these items and maintenance of our valuation policies and procedures for non-IRLC assets and liabilities. The FAV group submits the results of its valuations to our senior management valuation committee, which oversees the valuations. Our senior management valuation committee includes the Company’s chief financial, investment and risk officers as well as other senior members of the Company’s finance, capital markets and risk management staffs.
The fair value of our IRLCs is developed by our Capital Markets Risk Management staff and is reviewed by our Capital Markets Operations group.
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Following is a discussion of our approach to measuring the balance sheet items that are most affected by “Level 3” fair value estimates.
Loans Held for Sale
We carry loans at their fair values. We recognize changes in the fair value of loans in current period income as a component of Net gains on loans held for sale at fair value. How we estimate the fair value of loans is based on whether the loans are saleable into active markets with observable fair value inputs.
We use a discounted cash flow model to estimate the fair value of “Level 3” fair value loans. The significant unobservable inputs used in the fair value measurement of our “Level 3” fair value loans held for sale are discount rates, home price projections and prepayment speeds. Significant changes in any of those inputs in isolation could result in a significant change to the loans’ fair value measurement.
Interest Rate Lock Commitments
Our net gains on loans held for sale include our estimates of the gains or losses we expect to realize upon the sale of loans we have contractually committed to fund or purchase but have not yet funded, purchased or sold. We recognize a substantial portion of our net gains on loans held for sale at fair value before we fund or purchase the loans as the result of these commitments. We call these commitments IRLCs. We recognize the fair value of IRLCs at the time we make the commitment to the correspondent seller, broker or loan applicant and adjust the fair value of such IRLCs as the loan approaches the point of funding or purchase or the prospective transaction is canceled.
We carry IRLCs as either Derivative assets or Derivative liabilities on our consolidated balance sheet. The fair value of an IRLC is transferred to Loans held for sale at fair value when the loan is funded or purchased.
An active, observable market for IRLCs does not exist. Therefore, we measure the fair value of IRLCs using methods we believe that market participants use in pricing IRLCs. We estimate the fair value of an IRLC based on observable Agency MBS prices, our estimates of the fair value of the MSRs we expect to receive in the sale of the loans and the probability that we will fund or purchase the loan (the “pull-through rate”).
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Pull-through rates and MSR fair values are based on our estimates as these inputs are difficult to observe in the marketplace. Our estimate of the probability that a loan will be funded and market interest rates are updated as the loans move through the funding or purchase process and as market interest rates change and may result in significant changes in our estimates of the fair value of the IRLCs. Such changes are reflected in the change in fair value of IRLCs which is a component of our Net gains on loans held for sale at fair value in the period of the change. The financial effects of changes in these inputs are generally inversely correlated. Increasing interest rates have a positive effect on the fair value of the MSR component of IRLC fair value but increase the pull-through rate for the loan principal and interest payment cash flow component, which decreases in fair value.
A shift in our assessment of an input to the valuation of IRLCs can have a significant effect on the amount of Net gains on loans held for sale at fair value for the period. We believe that the most significant “Level 3” fair value input to the measurement of IRLCs is the pull-through rate. At December 31, 2020, we held $677.0 million of net IRLC assets at fair value. Following is a quantitative summary of the effect of changes in the pull-through rate input on the fair value of IRLCs at December 31, 2020:
(in thousands)
The preceding analysis holds constant all of the other inputs to show an estimate of the effect on fair value of a change in the pull-through rate. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analysis is not a projection of the effects of a shock event or a change in our estimate of an input and should not be relied upon as an earnings projection.
Mortgage Servicing Rights
MSRs represent the fair value assigned to contracts that obligate us to service the mortgage loans on behalf of the owners of the mortgage loans in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We recognize MSRs at our estimate of the fair value of the contract to service the loans.
We include changes in fair value of MSRs in current period income as a component of Net loan servicing fees—Change in fair value of mortgage servicing rights and mortgage servicing liabilities. Both our estimate of the change in fair value attributable to realization of cash flows and of the change in fair value are affected by changes in fair value inputs. During the year ended December 31, 2020, we recognized a $1.5 billion net reduction in fair value of MSRs: $431.1 million of the reduction was due to realization of cash flows underlying the fair value of MSR and $1.1 billion of the reduction was due to changes in fair value inputs.
We classify MSRs as “Level 3” fair value assets and determine their fair value using a discounted cash flow approach. We believe the most significant “Level 3” fair value inputs to the valuation of MSRs are the pricing spread (used to develop periodic discount rates), prepayment speed and annual per-loan cost of servicing.
A shift in the market for MSRs or a change in our assessment of an input to the valuation of MSRs can have a significant effect on their fair value and in our income for the period. The fair value of MSRs that we held at December 31, 2020 was $2.6 billion.
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Following is a summary of the effect on fair value of MSRs of various changes to these key inputs at December 31, 2020:
Effect on fair value of MSRs of a change in input value
Change in input Pricing spread Prepayment speed Servicing cost
(in thousands)
The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in a specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections.
Excess Servicing Spread Financing
We finance a portion of the cost of Agency MSRs that we purchase from non-affiliate sellers through the sale to PMT of the servicing spread in excess of a specified level. We carry our ESS at fair value.
Because the ESS is a claim to a portion of the cash flows from MSRs, the valuation of the ESS is similar to that of MSRs. We use the same discounted cash flow approach to measure the ESS and the related MSRs except that certain inputs relating to the cost to service the mortgage loans underlying the MSRs and certain ancillary income are not included in the ESS valuation as these cash flows do not accrue to the holder of the ESS.
A shift in the market for, or a change in our assessment of an input to, the valuation of ESS can have a significant effect on the fair value of ESS and in our income for the period. However, we believe that this change will be offset to a great extent by a change in the fair value of the MSRs that the ESS is financing. We record changes in the fair value of ESS in Net loan servicing fees—Change in fair value of excess servicing spread payable to PennyMac Mortgage Investment Trust. During the year ended December 31, 2020, we recorded $25.0 million of net gains due to changes in fair value of ESS.
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We believe that the most significant “Level 3” fair value inputs to the valuation of ESS are the pricing spread (used to develop periodic discount rates) and prepayment speed. At December 31, 2020, we carried $131.8 million of ESS at fair value. Following is a summary of the effect on fair value of various changes to these inputs at December 31, 2020:
Effect on fair value of excess servicing spread of a change in input value
Change in input Pricing spread Prepayment speed
(in thousands)
The preceding analyses hold constant all of the inputs other than the input that is being changed to show an estimate of the effect on fair value of a change in that specific input. We expect that in a market shock event, multiple inputs would be affected and the effects of these changes may compound or counteract each other. Therefore the preceding analyses are not projections of the effects of a shock event or a change in our estimate of an input and should not be relied upon as earnings projections.
Accounting Developments
Refer to Note 3 – Significant Accounting Policies ‒ Recently Issued Accounting Pronouncements to our consolidated financial statements for a discussion of recent accounting developments and the expected effect on the Company.
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Results of Operations
Our results of operations are summarized below:
Year ended December 31,
(dollars in thousands except closing prices and per share amounts)
Revenues:
Expenses:
Earnings per share
Return on average common stockholders' equity 61.4 % 21.6 % 12.7 %
Income before provision for income taxes by segment:
Mortgage banking:
Non-segment activities (1) — — 1,126
During the year:
Common stock closing prices:
At end of year:
Unpaid principal balance of loan servicing portfolio:
Owned:
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We define “Adjusted EBITDA” as net income attributable to our common stockholders before net income attributable to noncontrolling interest plus provision for income taxes, depreciation and amortization, excluding decrease (increase) in fair value of MSRs and MSLs due to changes in valuation inputs used in the valuation model, increase (decrease) in fair value of ESS payable to PMT, hedging losses (gains) associated with MSRs, stock-based compensation and interest expense on corporate debt or corporate revolving credit facilities and capital leases to the extent such items existed in the years presented.
We believe that the presentation of Adjusted EBITDA provides useful information to investors regarding our results of operations because each measure assists both investors and management in analyzing and benchmarking the performance and value of our business. However, other companies may define Adjusted EBITDA differently, and as a result, our measures of Adjusted EBITDA may not be directly comparable to those of other companies.
Adjusted EBITDA measures have limitations as analytical tools, and should not be considered in isolation or as a substitute for analysis of our results as reported under U.S. GAAP. Some of these limitations are:
Because of these limitations, Adjusted EBITDA measures are not intended as alternatives to net income as an indicator of our operating performance and should not be considered as measures of cash available to us to invest in the growth of our business or as measures of cash that will be available to us to meet our obligations.
The following table presents a reconciliation of Adjusted EBITDA to our net income, the most directly comparable financial measure calculated and presented in accordance with GAAP, for each of the years indicated:
Year ended December 31,
(in thousands)
Net income attributable to noncontrolling interest — — 156,749
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Comparison of the years ended December 31, 2020, 2019 and 2018
For the year ended December 31, 2020, we recorded income before provision for income taxes of $2.2 billion, an increase of $1.7 billion or 323% from 2019. The increase was primarily due to an increase in production income (Net gains on loans held for sale at fair value, Loan origination fees and Fulfillment fees from PennyMac Mortgage Investment Trust) which reflects higher production volume and improved margins, and an increase in Net loan servicing fees primarily due to growth in our loan servicing portfolio and an increase in income from the re-performance of loans bought out of Ginnie Mae securities for potential resecuritization, partially offset by an increase in total expenses. The increase in total expense was mainly due to increases in compensation, servicing and loan origination expenses reflecting the continuing growth of our mortgage banking activities and the impact of the COVID-19 pandemic on our servicing portfolio and operations.
During the year ended December 31, 2019, we recorded net income of $393.0 million, an increase of $148.5 million, or 61%, from 2018. The increase is due to an increase of $492.8 million in total net revenue, partially offset by an increase of $231.0 million in total expenses and $113.2 million in provision for income taxes. The increase in total expenses was primarily due to increases in compensation and loan origination expenses, reflecting the continuing growth of our mortgage banking activities. The provision for income taxes increased significantly as a result of the Reorganization which was completed in late 2018.The increase in total revenue was primarily due to an increase of $476.5 million in Net gains on loans held for sale at fair value, $79.3 million in Fulfillment fees from PennyMac Mortgage Invest Trust, and $72.5 million in Loan origination fees resulting from higher production volume and improved profit margins, which was partially offset by a decrease of $151.7 million in Net loan servicing fees primarily attributable to the effect of lower interest rates on the fair value of our MSRs that resulted in fair value losses net of hedging results compared to the year ended December 31, 2018.
Before the onset of the COVID-19 pandemic, the mortgage origination market was experiencing healthy demand owing to historically low interest rates in the United States. The government’s response to the onset of the COVID-19 pandemic, including fiscal stimulus and infusions of additional liquidity by the Federal Reserve into financial markets, acted to further lower mortgage interest rates. These developments have acted to sustain heightened demand for new mortgage loans despite the slowdown in overall economic activity. The mortgage origination market for 2019 was $2.3 trillion; for 2020, the origination market is estimated to be $4.0 trillion and for 2021, is forecasted to be $3.3 trillion. This increase in demand for mortgage loans, combined with constraints on mortgage industry origination capacity that existed before the COVID-19 pandemic, has allowed us to realize higher gain-on sale margins in our production segment. We expect our gain on sale margins to decrease to historical levels as industry capacity adjusts to demand. Furthermore, Fannie Mae and Freddie Mac added a 50 basis point adverse market refinance fee applicable to most mortgage refinances that could have a negative impact on future refinances.
During the year ended December 31, 2020, the United States was significantly impacted by the ongoing effects of the COVID-19 pandemic and the effects of market and government responses to the COVID-19 pandemic. These developments have resulted in an economic recession in the United States and increased unemployment that have created financial hardships for many existing borrowers.
As part of its response to the COVID-19 pandemic, the federal government included requirements in the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act that we as a servicer of Agency loans provide borrowers with substantial payment forbearance. As a result of this requirement, we have seen a large increase in delinquencies in our servicing portfolio which has increased our cost to service those loans and may require us to finance substantial amounts of advances of principal and interest payments to the investors holding securities backed by these loans, as well as property taxes, insurance and other costs to protect investors’ interest in the properties collateralizing the loans. As of December 31, 2020, 7.2% of loans in UPB in our predominately government-insured or guaranteed MSR portfolio were in forbearance plans and delinquent resulting in an increase in the level of servicing advances we have been required to make due to borrower delinquencies.
This development may have a negative effect on the earnings of our servicing segment before taking into account the effect of future developments on the valuation of our MSRs by, among other things, reducing servicing fee income, reducing the amount of placement fees we earn on custodial deposits related to these loans, increasing our cost
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to service due to higher delinquency and default rates, as well as increased financing costs due to the need to advance funds on behalf of delinquent borrowers. We expect these losses to be offset by growth in our loan servicing portfolio and gains on the resale of early buyout loans as those borrowers reperform.
Net gains on loans held for sale at fair value
During the year ended December 31, 2020, we recognized Net gains on loans held for sale at fair value totaling $2.7 billion, compared to $725.5 million and $249.0 million during the years ended December 31, 2019 and 2018, respectively. The increase in 2020 compared to 2019 and 2018 was primarily due to an increase in loan production volume and improved profit margins in our mortgage production business, reflecting increased demand for mortgage loans during 2020 as compared to 2019 and 2018. The increase in demand for mortgage loans during 2020 as compared to 2019 and 2018 is attributable primarily to the decrease in market interest rates that prevailed during 2020. The increase in profit margins during 2020 reflects the effects of increased loan demand on an already capacity-constrained industry and the disruptive effect of the COVID-19 pandemic on certain industry participations’ ability to maintain their loan production levels.
Our net gains on loans held for sale are summarized below:
Year ended December 31,
(in thousands)
From non-affiliates:
Cash gain (loss):
Non-cash gain:
Reduction in liability due to change in estimate 8,667 7,877 4,672
During the year:
Interest rate lock commitments issued:
Home equity lines of credit 1,676 9,186 —
At end of year:
(1) Gain on sale of loans to PMT are primarily cash gains.
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Our gain on sale of loans held for sale includes both cash and non-cash elements. We recognize a significant portion of our gain on sale of loans when we make a commitment to purchase, fund or modify a mortgage loan. We recognize this gain in the form of an interest rate lock commitment. We adjust our initial gain amount as the loan purchase, origination or modification process progresses until the loan is either funded or cancelled. We also receive non-cash proceeds on sale that include the fair value of MSRs and we incur liabilities for mortgage servicing liabilities (which represent the fair value of the costs we expect to incur in excess of the fees we receive for early buyout of delinquent loans (“EBO loans”) we have resold) and for the fair value of our estimate of the losses we expect to incur relating to the representation and warranties we provide in our loan sale transactions.
Non-cash elements of gain on sale of loans
The MSRs, mortgage servicing liabilities (“MSLs”), and liability for representations and warranties we recognize represent our estimate of the fair value of future benefits and costs we will realize for years in the future. These estimates represented approximately 40% of our gain on sale of loans at fair value for the year ended December 31, 2020, as compared to 117% and 234% for the years ended December 31, 2019 and 2018, respectively. These estimates change as circumstances change and changes in these estimates are recognized in income in subsequent periods. How we measure and update our measurements of MSRs and MSLs is detailed in Note 6 – Fair value – Valuation Techniques and Inputs to the consolidated financial statements included in this Annual Report.
Our agreements with the purchasers and insurers include representations and warranties related to the loans we sell. The representations and warranties require adherence to purchaser and insurer origination and underwriting guidelines, including but not limited to the validity of the lien securing the loan, property eligibility, borrower credit, income and asset requirements, and compliance with applicable federal, state and local law.
In the event of a breach of our representations and warranties, we may be required to either repurchase the loans with the identified defects or indemnify the purchaser or insurer. In such cases, we bear any subsequent credit loss on the loans. Our credit loss may be reduced by any recourse we have to correspondent originators that sold such loans to us and breached similar or other representations and warranties. In such event, we have the right to seek a recovery of related repurchase losses from that correspondent seller.
Our representations and warranties are generally not subject to stated limits of exposure. However, we believe that the current UPB of loans sold by us and subject to representation and warranty liability to date represents the maximum exposure to repurchases related to representations and warranties.
The level of the liability for losses under representations and warranties is difficult to estimate and requires considerable judgment. The level of loan repurchase losses is dependent on economic factors, purchaser or insurer loss mitigation strategies, and other external conditions that may change over the lives of the underlying loans. Our estimate of the liability for representations and warranties is developed by our credit administration staff and approved by our senior management credit committee which includes our senior executives and senior management in our loan production, loan servicing and credit risk management areas.
The method used to estimate our losses on representations and warranties is a function of our estimate of future defaults, loan repurchase rates, the severity of loss in the event of default, if applicable, and the probability of reimbursement by the correspondent loan seller. We establish a liability at the time loans are sold and review our liability estimate on a periodic basis.
During the years ended December 31, 2020, 2019, and 2018 we recorded provisions for losses under representations and warranties relating to current loan sales as a component of Net gains on loans held for sale at fair value totaling $21.0 million, $8.4 million, and $5.8 million, respectively. We also recorded reductions in the liability relating to previously sold loans of $8.7 million, $7.9 million, and $4.7 million, for the years ended December 31, 2020, 2019 and 2018, respectively. The reductions in the liability relating to previously sold loans resulted from those loans meeting performance criteria established by the Agencies which significantly limits the likelihood of certain repurchase or indemnification claims.
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Following is a summary of mortgage loan repurchase activity and the unpaid balance of mortgage loans subject to representations and warranties:
Year ended December 31,
(in thousands)
During the year:
Indemnification activity:
Loans indemnified by PFSI at beginning of year $ 15,366 $ 8,899 $ 7,579
Less indemnified loans sold, repaid or refinanced 6,122 5,162 3,191
Loans indemnified by PFSI at end of year $ 13,788 $ 15,366 $ 8,899
Repurchase activity:
Less:
At end of year:
Liability for representations and warranties $ 32,688 $ 21,446
During the year ended December 31, 2020, we repurchased loans with unpaid principal balances totaling $58.4 million and charged $1.1 million in net incurred losses relating to repurchases against our liability for representations and warranties. If the outstanding balance of loans we purchase and sell subject to representations and warranties increases, the loans sold continue to season, economic conditions change, correspondent lenders become unwilling or unable to repurchase defective loans, or investor and insurer loss mitigation strategies are adjusted, the level of repurchase and loss activity may increase significantly.
Loan origination fees
Following is a summary of our loan origination fees:
Year ended December 31,
(in thousands)
Loan origination fees increased $111.4 million and $72.5 million during the year ended December 31, 2020 and 2019, compared to the years ended December 31, 2019, and 2018, respectively, and the increases were primarily due to an increase in the volume of loans we produced.
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Fulfillment fees fron PennyMac Mortgage Investment Trust
Following is a summary of our fulfillment fees:
Year ended December 31,
(in thousands)
Fulfillment fees from PMT represent fees we collect for services we perform on behalf of PMT in connection with the acquisition, packaging and sale of loans. The fulfillment fees were calculated as a percentage of the UPB of the loans we fulfilled for PMT through June 30, 2020. Effective July 1, 2020, fulfillment fees are calculated based on the number of loans we lock and fulfill for PMT.
Fulfillment fees increased $61.6 million and $79.3 million during the years ended December 31, 2020 and 2019, compared to the years ended December 31, 2019 and 2018, respectively. The increases were primarily due to increased volume of loans we fulfilled for PMT, partially offset by a decrease in the fulfillment fee collected per loan during the year ended December 31, 2020 compared to the years ended December 31, 2019 and 2018, respectively.
Net loan servicing fees
Following is a summary of our net loan servicing fees:
Year ended December 31,
(in thousands)
Net loan servicing fees:
Loan servicing fees:
From Investment Funds — — 3
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Change in fair value of mortgage servicing rights and excess servicing spread financing net of hedging results are summarized below:
Year ended December 31,
(in thousands)
Change in fair value of excess servicing spread 24,970 9,256 (8,500)
Average balances:
At year end:
Following is a summary of our loan servicing portfolio:
December 31, December 31,
(in thousands)
Loans serviced
Prime servicing:
Owned:
Mortgage servicing rights
Special servicing subserviced for PMT 58,274 125,724
Net loan servicing fees increased $145.8 million, during the year ended December 31, 2020 compared to the year ended December 31, 2019. The increase was primarily due to an increase of $120.8 million in loan servicing fees resulting from an increase of 18% in our average servicing portfolio during 2020 compared to 2019.
Net loan servicing fees decreased $151.7 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was primarily due to an increase of $338.0 million in losses in fair value of MSR, MSLs and excess servicing spread financing, net of hedging results, compared to the year ended December 31, 2018, resulting from the effect of decreasing interest rates on the fair value of our mortgage servicing assets and liabilities. The increased losses were partially offset by an increase of $186.2 million in loan servicing fees, resulting from an increase of 24% in our average servicing portfolio for the year ended December 31, 2019 compared to the year ended December 31, 2018.
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During the year ended December 31, 2020, the prepayment expectations resulting from the decreasing interest rate environment, along with expectations of higher costs to service loans in the coming months and increased returns demanded by market participants in response to the uncertainties created by the COVID-19 pandemic, resulted in a 37% reduction in fair value (as measured by the December 31, 2019 fair value) of our investment in MSRs. This reduction in fair value was partially offset by our hedging results and change in fair value of ESS.
Many of the risks of owning MSRs, such as changing costs to service loans and changing returns demanded by MSR market participants are difficult to hedge. There can be no assurance that future hedging results will effectively offset changes in fair value of MSRs. As discussed above, we expect the ongoing effects of the COVID-19 pandemic and the requirements of the CARES Act to reduce our servicing income and to increase our servicing expenses due to the increased number of delinquent loans, and significant number of forbearances that we have granted and continue to grant, as well as the resolution of loans that we expect to ultimately default as the result of the COVID-19 pandemic.
Net Interest (Expense) Income
Net interest income decreased $101.2 million during the year ended December 31, 2020 compared to the year ended December 31, 2020. The decrease was primarily due to:
Net interest income increased $4.9 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase was primarily due to:
●a $22.7 million increase in interest shortfall on repayment of loans serviced for Agency securitizations.
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Management fees and Carried Interest
Management fees and Carried Interest are summarized below:
Year ended December 31,
(in thousands)
Management fees:
PennyMac Mortgage Investment Trust:
Performance incentive — 7,189 1,432
Management fees decreased $2.0 million during the year ended December 31, 2020, compared to the year ended December 31, 2019. The decrease was due to a decrease of $7.2 million in incentive fees due to losses PMT incurred during the quarter ended March 31, 2020, partially offset by an increase of $5.2 million in base management fees reflecting the increase in PMT’s average shareholders’ equity upon which our base management fees are based, during the year ended December 31, 2020 compared to the year ended December 31, 2019.
Management fees from PMT increased by $12.0 million during the year ended December 31, 2019, compared to the year ended December 31, 2018, reflecting the combined effect of the performance incentive fees arising from PMT’s increased profitability and the increase in PMT’s average shareholders’ equity upon which its management fees are based. The increase in average shareholders’ equity was primarily due to the issuance of new common shares by PMT during the year ended December 31, 2019.
Change in Fair Value of Investment in and Dividends Received from PMT
The results of our holdings of common shares of PMT, which is included in Changes in fair value of investment in, and dividends received from PMT are summarized below:
Year ended December 31,
(in thousands)
Dividends from PennyMac Mortgage Investment Trust $ 114 $ 141 $ 140
Dividends received and change in fair value $ (453) $ 416 $ 332
Change in fair value of investment in and dividends received from PMT decreased $869,000 during the year ended December 31, 2020, compared to the year ended December 31, 2019, and increased $84,000 during the year ended December 31, 2019, compared to the year ended December 31, 2018, due to changes in the fair value of our investment in PMT. We held 75,000 common shares of PMT during each of the three years ended December 31, 2020.
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Expenses
Compensation
Our compensation expense is summarized below:
Year ended December 31,
(dollars in thousands)
Head count:
Compensation expense increased $235.1 million during the year ended December 31, 2020, compared to the year ended December 31, 2019. The increase was primarily due to growth in head count made to accommodate the growth in our loan production and servicing activities as well as to increases in incentive compensation resulting from performance-based incentives and higher than expected attainment of profitability targets.
Compensation expense increased $100.2 million during the year ended December 31, 2019, compared to the year ended December 31, 2018. The increase in compensation was primarily due to increases in incentive compensation resulting from performance-based incentives in our mortgage banking business and higher than expected attainment of profitability targets along with increases in base salaries, taxes and benefits due to increased average head count resulting from the growth in our mortgage banking activities during 2019.
Servicing
Servicing expense increased $92.2 million and $27.6 million in the years ended December 31, 2020 and 2019 compared to the years ended December 31, 2019 and 2018, respectively. The increase in 2020 compared to 2019 was primarily the result of the increase in delinquencies we experienced due to the effects of the COVID-19 pandemic on borrower delinquencies. The increase in 2019 compared to 2018, was due to growth in our government-insured or guaranteed mortgage servicing portfolio, which includes loans that are subject to nonreimbursable servicing advance losses, and to our EBO program to purchase defaulted loans from Ginnie Mae pools. During the years ended December 31, 2020, 2019, and 2018, we purchased $9.6 billion, $4.4 billion and $3.0 billion in UPB of EBO loans, respectively.
The EBO program reduces the ongoing cost of servicing defaulted mortgage loans subject to Ginnie Mae MBS when we purchase and either sell the defaulted loans or finance them with debt at interest rates below the Ginnie Mae MBS pass-through rates. While the EBO program reduces the ultimate cost of servicing such mortgage loan pools, it accelerates loss recognition when the mortgage loans are purchased. We recognize expense because purchasing the mortgage loans from their Ginnie Mae pools causes us to write off accumulated non-reimbursable interest advances, net of interest receivable from the mortgage loans’ insurer or guarantor at the debenture rate of interest applicable to the respective mortgage loans to the extent the loan is immediately modified. The losses we recognize when we purchase EBO loans are anticipated and included in our valuation of the MSRs related to such loans before we repurchase the respective loans.
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Technology
Technology expense increased $44.6 million and $7.8 million in the years ended December 31, 2020 and 2019 compared to the years ended December 31, 2019 and 2018, respectively. The increases were primarily due to growth in our loan servicing operations and continued investment in our loan production and servicing infrastructure and $13.1 million of impairment of capitalized software recorded during the year ended December 31, 2020.
Occupancy and equipment
Occupancy and equipment expenses increased $4.4 million and $1.8 million during the years ended December 31, 2020 and 2019, compared to the years ended December 31, 2019 and 2018, respectively. The increases are primarily attributable to expansion of our facilities to accommodate our growth.
Provision for Income Taxes
For the years ended December 31, 2020, 2019 and 2018, our effective tax rates were 26.5%, 25.8%, and 8.7%, respectively. The difference in the effective income tax rate between the year ended December 31, 2020 and the year ended December 31, 2019 results from the lesser impact of favorable tax adjustments for total permanent differences in the year ended December 31, 2020. When compared to the same period in 2019, the tax adjustment for permanent differences was reduced by $3.7 million while pretax income increased by $1.7 billion, thereby diluting the impact of the tax adjustment on the effective income tax rate.
The large difference between our effective tax rate and the statutory rate for the year ended December 31, 2018 was primarily due to the allocation of earnings to the noncontrolling interest unitholders who were partners in PennyMac and therefore responsible for the income taxes relating the income attributable to them. Pursuant to the Reorganization, the noncontrolling interest unitholders converted their ownership units into our shares and as a result, we were allocated starting on that date and will in the future be allocated 100% of PNMAC earnings that will be subject to corporate federal and state statutory tax rates, which has in turn increased our effective income tax rate.
The CARES Act, passed in March 2020, introduced a number of tax law changes which are generally taxpayer favorable. In December 2020 the Taxpayer Certainty and Disaster Tax Relief Act was signed into law. No material changes in our effective income tax rates resulted from the either Act.
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Balance Sheet Analysis
Following is a summary of key balance sheet items as of the dates presented:
December 31, December 31,
(in thousands)
ASSETS
Investments in and advances to affiliates 168,972 157,343
LIABILITIES AND STOCKHOLDERS' EQUITY
Total assets increased $21.4 billion from $10.2 billion at December 31, 2019 to $31.6 billion at December 31, 2020. The increase was primarily due to an increase of $13.6 billion in loans eligible for repurchase, $6.7 billion in loans held for sale at fair value, $551.6 million in derivative assets, $285.0 million in cash and short-term investments, $360.5 million in other assets and $248.4 million in servicing advances, partially offset by a decrease of $345.6 million in MSRs. The increases in loans eligible for repurchase and servicing advances reflect an increase in delinquent loans as a result of the COVID-19 pandemic and the CARES Act forbearance requirements. The decrease in MSRs reflects the $1.1 billion in fair value losses discussed above, partially offset by additions resulting from our loan production activities. The increase in derivative assets primarily reflects growth in the fair value of our IRLCs as the result of the growth in our commitments to fund and purchase loans as well as the increased margins inherent in such commitments at December 31, 2020 as compared to December 31, 2019. We increased our holding of cash and short-term investments during the year ended December 31, 2020 as a means of enhancing our liquidity during the COVID-19 pandemic.
Total liabilities increased by $20.1 billion from $8.1 billion as of December 31, 2019 to $28.2 billion as of December 31, 2020. The increase was primarily attributable to an increase of $13.6 billion in liability for loans eligible for repurchase and $6.1 billion in borrowings required to finance a larger inventory of loans held for sale.
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Cash Flows
Our cash flows for the three years ended December 31, 2020 are summarized below:
Year ended December 31,
(in thousands)
Operating activities
Net cash (used in) provided by operating activities totaled $(6.2) billion, $(2.2) billion, and $572.4 million during the years ended December 31, 2020, 2019, and 2018 respectively. Our cash flows from operating activities are primarily influenced by changes in the levels of our inventory of loans held for sale as shown below:
Year ended December 31,
(in thousands)
Cash flows from:
The decrease in cash flows from other operating activities during the year ended December 31, 2020 compared to the years ended December 31, 2019 and 2018 was primarily due to an increase in deposits securing certain of our borrowings and an increase in servicing advances caused by pandemic-induced borrower delinquencies.
Investing activities
Net cash provided by investing activities was $783.0 million during the year ended December 2020, primarily comprised of $913.1 million in net settlement of derivative financial instruments used to hedge our investment in MSRs, partially offset by $131.8 million increase in margin deposits.
Net cash provided by investing activities was $148.8 million during the year ended December 2019, primarily comprised of $366.1 million in net settlement of derivative financial instruments used to hedge our investment in MSRs, partially offset by $227.4 million used in purchase of MSRs.
Net cash used in investing activities was $322.6 million during the year ended December 31, 2018 primarily comprised of cash used in purchase of MSRs and net settlements of derivative financial instruments used to hedge our investment in MSRs.
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Financing activities
Net cash provided by financing activities totaled $5.8 billion during the year ended December 31, 2020, primarily due to an increase of $6.1 billion in borrowings to finance the growth in our inventory of loans held for sale, partially offset by a $337.5 million of repurchase of common stock and $30.9 million of dividends paid to our common stock holders.
Net cash provided by financing activities totaled $2.1 billion during the year ended December 31, 2019 which was primarily to finance the growth in our inventory of loans held for sale and our investments in MSRs.
Net cash used in financing activities totaled $132.0 million during the year ended December 31, 2018 which was primarily due to net repurchases of assets sold under agreements to repurchase and mortgage loan participation purchase and sale agreements of $440.9 million, reflecting a reduction in our financing of loans held for sale, and repayments of excess servicing spread financing of $46.8 million, partially offset by net proceeds from issuance of notes payable secured by of $400 million.
Liquidity and Capital Resources
Our liquidity reflects our ability to meet our current obligations (including our operating expenses and, when applicable, the retirement of, and margin calls relating to, our debt, and margin calls relating to hedges on our commitments to purchase or originate mortgage loans and on our MSR investments), fund new originations and purchases, and make investments as we identify them. We expect our primary sources of liquidity to be through cash flows from business activities, proceeds from bank borrowings, proceeds from and issuance of ESS and/or equity or debt offerings. We believe that our liquidity is sufficient to meet our current cash requirements.
The effect of the COVID-19 pandemic on our operations, liquidity and capital resources remains uncertain and difficult to predict. For further discussion of the potential impacts of the COVID-19 pandemic ic please also see “Risk Factors” in Part I, Item 1A.
The CARES Act allows borrowers with federally-backed loans to request temporary payment forbearance in response to the increased borrower hardships resulting from the COVID-19 pandemic and may require us as the servicer to advance principal and interest, property taxes, insurance premiums and other expenses to the investors for up to four months on Fannie Mae and Freddie Mac loans and longer on Ginnie Mae and other government agency backed loans. In April 2020, the Company entered into a new Ginnie Mae servicing advance financing transaction allowing the Company to borrow $600 million against Ginnie Mae MSRs and servicing advances. The Ginnie Mae servicing advances eligible for financing include advances made to support regularly scheduled monthly principal and interest to mortgage-backed securities holders, taxes, homeowners insurance and escrowed items and other costs related to servicing delinquent loans. We are also in ongoing discussions with our lending partners to align our servicing advance assets and financing capacity, and to further diversify our financing alternatives.
The COVID-19 pandemic has significantly increased the number of loans that are delinquent in our Ginnie Mae MSR portfolio. The Ginnie Mae guidelines provides us with the option to purchase loans that are at least three months delinquent out of the underlying Ginnie Mae securities as an alternative to continuing to advance principal and interest payments to the holders of the Ginnie Mae securities. We refer to such loans as “early buyout” or EBO loans.
During the year ended December 31, 2020, we repurchased $9.6 billion in UPB of EBO loans from our Ginnie Mae MSR portfolio. Our objective is to work with the borrowers to cure the loan delinquency through either borrower reperformance or modification of the loans’ terms. When curing the delinquency is not feasible, we work to settle the loan and collect our claims from the applicable insurer or guarantor. When we are able to cure the delinquency, we are able to re-deliver the cured loan into another Ginnie Mae guaranteed security. Depending on the method used to cure a borrower delinquency, the Ginnie Mae program may require at least a six month period of timely borrower payments before we are able to re-deliver the loan into another Ginnie Mae guaranteed security. Therefore, regardless of whether we cure or settle the repurchased loan, our investment in the EBO loans may require a substantial holding period.
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Our current borrowing strategy is to finance our assets where we believe such borrowing is prudent, appropriate and available. Our borrowing activities are in the form of sales of assets under agreements to repurchase, sales of mortgage loan participation purchase and sale certificates, ESS financing, notes payable, a capital lease and unsecured senior notes. A significant amount of our borrowings have short-term maturities and provide for terms of approximately one year. Because a significant portion of our current debt facilities consists of short-term borrowings, we expect to renew these facilities in advance of maturity in order to ensure our ongoing liquidity and access to capital or otherwise allow ourselves sufficient time to replace any necessary financing. During September and October 2020, we issued a total of $650 million long term unsecured senior notes that mature on October 15, 2025. We used the proceeds from the unsecured senior notes to repay some of our existing short-term borrowings.
Our repurchase agreements represent the sales of assets together with agreements for us to buy back the assets at a later date. The table below presents the average outstanding, maximum and ending balances for each of the three years ended December 31, 2020, 2019 and 2018:
Year ended December 31,
(in thousands)
The differences between the average and maximum daily balances on our repurchase agreements reflect the fluctuations throughout the month of our inventory as we fund and pool mortgage loans for sale in guaranteed mortgage securitizations and the growth in our EBO inventory through the year.
Our secured financing agreements at PLS require us to comply with various financial covenants. The most significant financial covenants currently include the following:
● positive net income during one of the two most recent calendar quarters;
● a minimum in unrestricted cash and cash equivalents of $40 million;
● a minimum tangible net worth of $1.25 billion;
● a maximum ratio of total liabilities to tangible net worth of 10:1; and
With respect to servicing performed for PMT, PLS is also subject to certain covenants under PMT’s debt agreements. Covenants in PMT’s debt agreements are equally, or sometimes less, restrictive than the covenants described above.
In addition to the covenants noted above, the indenture governing our unsecured senior notes contains covenants that limit our and our restricted subsidiaries’ ability to engage in specified types of transactions. These covenants limit our and our restricted subsidiaries’ ability to, among other things:
● incur, assume or guarantee additional debt or issue preferred stock;
● incur liens on assets;
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● enter into transactions with affiliates; and
Although these financial covenants limit the amount of indebtedness that we may incur and affect our liquidity through minimum cash reserve requirements, we believe that these covenants currently provide us with sufficient flexibility to successfully operate our business and obtain the financing necessary to achieve that purpose.
Our debt financing agreements also contain margin call provisions that, upon notice from the applicable lender at its option, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. A margin deficit will generally result from any decline in the market value (as determined by the applicable lender) of the assets subject to the related financing agreement. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice.
We are also subject to liquidity and net worth requirements established by FHFA for Agency seller/servicers and Ginnie Mae for single-family issuers. FHFA and Ginnie Mae have established minimum liquidity requirements and revised their net worth requirements for their approved non-depository single-family sellers/servicers or issuers as summarized below:
On January 31, 2020, FHFA proposed changes to the eligibility requirements, which would increase the tangible net worth requirement to $2.5 million plus 35 basis points of the UPB of loans serviced for Ginnie Mae and 25 basis points of the UPB of all other 1-4 unit loans serviced, and increase the liquidity requirement to 4 basis points of the aggregate UPB serviced for Fannie Mae and Freddie Mac and 10 basis points of the UPB serviced for Ginnie Mae plus 300 basis points of total nonperforming Agency servicing UPB (including nonperforming Agency loans that are in payment forbearance) in excess of 4% of total Agency servicing UPB. On June 15, 2020, FHFA announced that it will be re-proposing changes to these requirements.
We believe that we are currently in compliance with the applicable Agency requirements.
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We have purchased portfolios of MSRs and have financed them in part through the sale to PMT of the right to receive ESS. The recorded amount of the ESS is its current fair value.
On February 4, 2021, our Board of Directors increased our common stock repurchase program from $500 million to $1 billion. Share repurchases may be effected through open market purchases or privately negotiated transactions in accordance with applicable rules and regulations. The stock repurchase program does not have an expiration date and the authorization does not obligate us to acquire any particular amount of common stock. From inception through December 31, 2020, we have repurchased $352.4 million of shares under our stock repurchase program.
We continue to explore a variety of means of financing our continued growth, including debt financing through bank warehouse lines of credit, bank loans, repurchase agreements, securitization transactions and corporate debt. However, there can be no assurance as to how much additional financing capacity such efforts will produce, what form the financing will take or whether such efforts will be successful.
Off-Balance Sheet Arrangements
As of December 31, 2020, we have not entered into any off-balance sheet arrangements or guarantees.
Debt Obligations
As described further above in “Liquidity and Capital Resources,” we currently finance certain of our assets through borrowings with major financial institution counterparties in the form of sales of assets under agreements to repurchase, mortgage loan participation purchase and sale agreements, notes payable, ESS and a capital lease. The borrower under each of these facilities is PLS or its subsidiary Issuer Trust with the exception of the unsecured senior notes and the capital lease, where the borrower is PFSI and PennyMac, respectively. All PLS obligations as previously noted are guaranteed by PennyMac.
Under the terms of these agreements, PLS is required to comply with certain financial covenants, as described further above in “Liquidity and Capital Resources,” and various non-financial covenants customary for transactions of this nature. As of December 31, 2020, we believe we were in compliance in all material respects with these covenants.
The agreements also contain margin call provisions that, upon notice from the applicable lender, require us to transfer cash or, in some instances, additional assets in an amount sufficient to eliminate any margin deficit. Upon notice from the applicable lender, we will generally be required to satisfy the margin call on the day of such notice or within one business day thereafter, depending on the timing of the notice.
In addition, the agreements contain events of default (subject to certain materiality thresholds and grace periods), including payment defaults, breaches of covenants and/or certain representations and warranties, cross-defaults, guarantor defaults, servicer termination events and defaults, material adverse changes, bankruptcy or insolvency proceedings and other events of default customary for these types of transactions. The remedies for such events of default are also customary for these types of transactions and include the acceleration of the principal amount outstanding under the agreements and the liquidation by our lenders of the mortgage loans or other collateral then subject to the agreements.
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The borrowings have maturities as follows:
Outstanding Total Committed
Lender indebtedness (1) facility size (2) facility (2) Maturity date (2)
(dollar amounts in thousands)
Assets sold under agreements to repurchase
Mortgage loan participation purchase and sale agreements
Notes payable
Credit Suisse AG (3) $ — $ — $ — April 23, 2021
Obligations under capital lease
(1) Outstanding indebtedness as of December 31, 2020.
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The amount at risk (the fair value of the assets pledged plus the related margin deposit, less the amount advanced by the counterparty and accrued interest) relating to our assets sold under agreements to repurchase is summarized by counterparty below as of December 31, 2020:
Weighted average
maturity of
advances under
Counterparty Amount at risk repurchase agreement Facility maturity
(in thousands)
All debt financing arrangements that matured between December 31, 2020 and the date of this Report have been renewed or extended and are described in Note 13—Borrowings to the accompanying consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices, real estate values and other market-based risks. The primary market risks that we are exposed to are fair value risk, interest rate and prepayment risk.
Fair Value Risk
Our IRLCs, mortgage loans held for sale, MSRs, MSLs and ESS financing are reported at their fair values. The fair value of these assets fluctuates primarily due to changes in interest rates. The fair value risk we face is primarily attributable to interest rate risk and prepayment risk.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. Changes in interest rates affect both the fair value of, and interest income we earn from, our mortgage-related investments and our derivative financial instruments. This effect is most pronounced with fixed-rate mortgage assets.
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In general, rising interest rates negatively affect the fair value of our IRLCs, inventory of mortgage loans held for sale and ESS financing and positively affect the fair value of our MSRs. Changes in interest rates significantly influence the prepayment speeds of the loans underlying our investments in MSRs and ESS, which can have a significant effect on their fair values. Changes in interest rate are most prominently reflected in the prepayment speeds of the loans underlying our investments in MSRs and ESS and the discount rate used in their valuation.
Our operating results will depend, in part, on differences between the income from our investments and our financing costs. Presently our debt financing is based on a floating rate of interest calculated on a fixed spread over the relevant index, as determined by the particular financing arrangement.
Prepayment Risk
To the extent that the actual prepayment rate on the mortgage loans underlying our MSRs differs from what we projected when we initially recognized these assets and liabilities when we measure fair value as of the end of each reporting period, the carrying value of these assets and liabilities will be affected. In general, a decrease in the principal balances of the mortgage loans underlying our MSRs or an increase in prepayment expectations will decrease our estimates of the fair value of the MSRs, thereby reducing net servicing income, partially offset by the beneficial effect on net servicing income of a corresponding reduction in the fair value of our MSLs and ESS.
Risk Management Activities
We engage in risk management activities primarily in an effort to mitigate the effect of changes in interest rates on the fair value of our assets. To manage this price risk, we use derivative financial instruments acquired with the intention of moderating the risk that changes in market interest rates will result in unfavorable changes in the fair value of our assets, primarily on our MSR investments as well as IRLCs and our inventory of loans held for sale. Our objective is to minimize our hedging expense and maximize our loss coverage based on a given hedge expense target. We do not use derivative financial instruments other than IRLCs and repurchase agreement derivatives (both of which arise from our operations) for purposes other than in support of our risk management activities.
Our strategies are reviewed daily within a disciplined risk management framework. We use a variety of interest rate and spread shifts and scenarios while defining target limits for market value and liquidity loss in those scenarios. With respect to our IRLCs and inventory of loans held for sale, we use MBS forward sale contracts to lock in the price at which we will sell the mortgage loans or resulting MBS, and further use MBS put options to mitigate the risk of our IRLCs not closing at the rate we expect. With respect to our MSRs, we seek to mitigate mortgage-based loss exposure utilizing MBS forward purchase and sale contracts, address exposures to smaller interest rate shifts with Treasury and interest rate swap futures, and use options and swaptions to achieve target coverage levels for larger interest rate shocks.
Fair Value Sensitivities
The following sensitivity analyses are limited in that they were performed at a particular point in time; only contemplate the movements in the indicated variables; do not incorporate changes to other variables; are subject to the accuracy of various models and inputs used; and do not incorporate other factors that would affect our overall financial performance in such scenarios, including operational adjustments made by management to account for changing circumstances. For these reasons, the following estimates should not be viewed as earnings forecasts.
Mortgage Servicing Rights
The following tables summarize the estimated change in fair value of MSRs as of December 31, 2020, given
several shifts in pricing spreads, prepayment speed and annual per loan cost of servicing:
Change in fair value attributable to shift in: -20% -10% -5% +5% +10% +20%
(in thousands)
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Excess Servicing Spread Financing
The following tables summarize the estimated change in fair value of our ESS accounted for using the fair value
method as of December 31, 2020, given several shifts in pricing spreads and prepayment speed (decrease in the liabilities’ fair values increases net income):
Change in fair value attributable to shift in: -20% -10% -5% +5% +10% +20%
(dollar amounts in thousands)
Item 8. Financial Statements and Supplementary Data
The information called for by this Item 8 is hereby incorporated by reference from our Financial Statements and Auditors’ Report in Part IV of this Report.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. However, no matter how well a control system is designed and operated, it can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in our periodic reports.
Our management has conducted an evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report as required by paragraph (b) of Rule 13a-15 under the Exchange Act. Based on our evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective, as of the end of the period covered by this Report, to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting