With interest rates at rock-bottom lows courtesy of the Federal Reserve, the mortgage banking sector is having one of those once-in-a-decade years. One of the beneficiaries, Rocket Companies (NYSE:RKT), the parent company of Quicken Loans, Rocket Mortgage, and Amrock, went public in early August at $18 per share and its stock price is already up 47% since being put on the market.

Rocket has been dominating the mortgage space, with higher growth and profits per loan than its competitors. Technology and the Rocket Application certainly play a part, but Rocket's business is fundamentally different than the typical publicly traded mortgage aggregator. Let's find out a bit more about this IPO darling.

Photo of a mortgage document, a calculator, and a set of keys

Image source: Getty Images.

Huge uptick in volume and profitability

Rocket originated $72.3 billion in mortgages in the second quarter (ending June 30), which was up 40% from the first quarter and 126% from the prior-year quarter. The most striking number, however, was Rocket's margin: a whopping 5.19% gain on sale margin. That is gargantuan. To put that number into perspective, the Mortgage Bankers Association reported that the industry average was 4.29% for the second quarter. That said, Quicken is guiding for third-quarter margins to fall to 4.05% to 4.3%, although origination volume is expected to rise to $82 billion to $85 billion. Quicken's capacity goal is to get to $40 billion per month.

The company's bottom line was even more impressive. Quicken earned $3.4 billion in net income on $72.3 billion in origination, which works out to be a 4.84% net profit margin. The Mortgage Bankers Association reported that the typical independent mortgage bank made 1.67% in pre-tax income on its production. Note that Quicken is not a mortgage aggregator like its competitors PennyMac Financial Services or Mr. Cooper. Those companies buy production from smaller clients. Quicken originates most of its production in-house. 

Rocket views servicing differently than its competitors

Rocket takes a different view of mortgage servicing than most of its competitors. A mortgage servicer performs much of the administrative tasks of handling the mortgage. The servicer will collect the monthly payments from the borrower, ensure that property taxes and insurance are paid, forward the payment to the ultimate holder of the mortgage, and handle delinquencies and foreclosures. The servicer will receive 0.25% of the loan balance as a fee for performing this service. Since it generally doesn't cost 0.25% to perform these duties, mortgage servicing rights generate cash flow and are booked as an asset. 

Most mortgage originators retain servicing for two main reasons: first, it is a source of cash flow, and second, it will go up in value if interest rates rise. When rates rise, refinancing volume will dry up, but the value of the servicing asset will rise. It acts as a natural hedge. Rocket doesn't really hold servicing for that reason, however -- it actively tries to refinance the loans in the servicing portfolio.

On the one hand, it is losing the value of the servicing asset, but on the other, it is making a profit on the loan. Since the typical mortgage servicing asset is worth, say 1% of the loan amount, and the company is making anywhere from 4% to 5% on the refinancing, it would seem to be a smart decision. That said, most mortgage banks prefer to hold the servicing asset in hopes of earning profits when rates rise. This will leave the company somewhat more exposed than its competitors when rates eventually rise. 

Technology versus loan officers

Quicken's view on rising rates is that it will take share at that point. The company has a goal of achieving 25% market share by 2030. As a technology-driven company, about 25% of its origination costs are variable; the rest is fixed. Quicken is adamant about protecting its margins, and technology gives it an advantage. Most originators employ loan officers who will always advocate for lower margins. Why? Because under current regulations, they are paid the same, whether the company makes a lot on a loan or a little.

So at most banks, you will see a tension between loan officers, who want the lowest rates possible, and the secondary desk, which wants to maximize profits on a loan. Since the loan officers are generally in control of the business, banks tend to cut margins to keep them from leaving for another bank. With Rocket, the technology controls the business, which allows the company to keep margins high. So when rates begin to rise, growth will come from taking market share. 

Rocket is trading at 8.5 times expected 2020 earnings per share of $3.14. This is more expensive than PennyMac Financial (which trades at 3.3 times expected 2020 earnings). But Rocket's ability to take share may be a good reason for a premium multiple. The stock has certainly performed well. However, these are the best of times for originators, and the business is cyclical. That said, the Rocket probably deserves a premium multiple given its hard-to-replicate technology advantage and its competitive cost structure. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.