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PennyMac Looks Iffy Despite Upgrades

NEW YORK (TheStreet) -- PennyMac Financial Services (PFSI - Get Report) has received a pair of analyst upgrades lately following a recent sell-off, but an investment in the non-bank mortgage lender and servicer still looks risky.

PennyMac shares hit a multi-week high of $18.69 on March 24 but fell sharply in subsequent days after the company announced that Fidelity Investments Charitable Gift Fund would sell 6.1 million shares, equal to 8% of the total outstanding. Fidelity acquired the shares at the time of PennyMac's initial public offering, according to a report from Jefferies analyst Daniel Furtado Tuesday.

Furtado upgraded PennyMac to "buy" from "hold" in his write-up, arguing the company will be a "long-term beneficiary [from] US residential mortgage reform." His upgrade follows one from Wells Fargo analyst Joel Houck Friday.

PennyMac shares, which hit a recent low of $15.80 March 27 were up 3.45% to $17.21 Tuesday morning.

But the potential for further dilution is still very real. Even after the sale by Fidelity, Furtado's report notes that "only about 25% of authorized shares currently float with three large investors holding concentrated positions."

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On the other hand, Furtado's argument for recommending PennyMac seems a bit thin. His report states that PennyMac will be a beneficiary as "the mortgage market evolves away from heavy government intervention."

But that transition will inevitably take longer than everyone thinks. Government moves at a snail's pace even when the appetite for reform is great. But when it comes to mortgage reform, no politician is eager to risk stalling or potentially crashing the fragile recovery by removing government support.

Furtado further argues PennyMac has an advantage over other non-bank servicers such as Ocwen Financial Corp. (OCN - Get Report) and Nationstar Mortgage Holdings (NSM). The latter two have run into regulatory trouble of late because they are acquiring servicing rights very quickly and allegedly doing a sloppy job. PennyMac, on the other hand, services mortgages it originates itself, which is less likely to be of concern to regulators, Furtado contends.

While this may be true to an extent, it isn't a compelling reason to dive into PennyMac shares. Ocwen is adept at enlisting support from consumer advocates, which will likely help soften the ire of regulators, and Nationstar has undoubtedly studied Ocwen's moves pretty closely. At the same time, PennyMac Chairman and CEO Stanford Kurland always has the potential to become a lightning rod for industry critics since the former Countrywide Financial President is now profiting handsomely from a mess he in some respects helped create. Further, PennyMac is a shadow bank, and while shadow banks benefit from lighter regulation as a result of not being banks, it seems hardly a month goes by without some regulator warning about the risks from shadow banks. Also, Ocwen and Nationstar originate their own mortgages too, and plans by those companies to do more of their own mortgage origination will create competition for PennyMac.

PennyMac may still find a way to thrive, and at less than seven times projected 2015 earnings it doesn't appear pricey. But that assumes no further dilution, which is something one can't really count on. And if mortgage reform or a belief PennyMac will get a free pass from regulators are your main reasons for buying this stock, you probably ought to reconsider.

Follow @dan_freed

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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