This year has been one for the ages for the mortgage origination sector. The Fed's aggressive actions in response to the coronavirus crisis lowered mortgage rates and triggered one of the best refinancing waves in the past 20 years.
Mortgage originators such as Rocket Companies (RKT +1.37%), Guild Holdings IV, and United Wholesale Mortgage found the market to be receptive to mortgage banking initial public offerings (IPOs). Rocket has been public for a few months now and continues to report strong earnings.
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Rocket Companies is highly profitable
During the third quarter, Rocket originated $89 billion in mortgage volume, which was an increase of 122% on a year-over-year basis. Earnings per share came in at $0.54, and net income was $3 billion. This means that Rocket's net income margin as a percentage of origination volume was 3.4%, which is head and shoulders above the rest of the industry. In the second quarter of 2020, the Mortgage Bankers Association (MBA) reported that the average profit margin for independent mortgage originators was 1.7%.
It is important to remember that the different publicly traded originators have different business models. Rocket is mainly a direct-to-consumer model, which is made possible by the Rocket App. While it does purchase completed loans from smaller originators, that isn't its main business.
PennyMac Financial (PFSI +1.25%) is the most common model, which is an aggregator. PennyMac buys completed loans from smaller originators and sells them. And Guild Holdings is a retail originator, which consists of loan officers sourcing and funding new production. Most originators out there follow Guild's model.
Rocket's advantage is its app. The biggest expense for originators is generally loan officer compensation, which can run anywhere from 0.5% of the loan amount to 2%. Rocket doesn't need an army of loan officers since its consumers interact directly with the automated app. While aggregators can throttle production up and down quickly, their net income margins are much smaller. In many ways, Rocket has the best of both worlds in that it has the higher margins of a retail originator without the cost structure.
When will the good times end?
The big question for the originators concerns how long the party will last. The MBA predicts that mortgage originations will hit $3.2 trillion in 2020, which will be the best year since 2003. That said, it also expects originations to fall to $2.5 trillion in 2021 as potential interest rate increases choke off refinancing. Of that $2.5 trillion, $1.5 trillion would be purchase activity and $1 trillion refinance activity.
This estimate is probably conservative. Black Knight Financial recently estimated that over 32 million borrowers could save at least 0.75% on their mortgage rate by refinancing, which the company estimates is about 75% of the mortgage market. The Fed estimates that $10 trillion of mortgage debt is outstanding, which means that there is potentially $7.5 trillion in refinanceable mortgages out there.
The demand for refinancing should remain robust as long as the Fed cooperates. Fed leaders anticipate no rate hikes through 2023, and San Francisco Fed President Mary Daly said the Fed is having "robust" talks about increasing mortgage-backed securities purchases.
Wall Street analysts estimate that Rocket will earn about $3.78 per share this year and then earnings will fall by 53% next year. If the MBA forecast of refinance activity falling to $1 trillion next year is accurate, that sort of a drop is possible, but the Fed is pulling out all the stops to try to prevent that from happening.
The takeaway
Rocket is trading at six times 2020 earnings per share, and 13 times 2021's earnings per share. I suspect the Street is taking the MBA forecast at face value, and it will be increased. Finally, Rocket's cost structure enables it to out-compete all of the other originators out there. Rocket probably has upside to its 2021 numbers, and the party will last a while longer. Rocket is one of my CAPS picks.
