With most investors focusing on tech stocks, it's easy to overlook other parts of the financial markets. But in some ways, this year has been an extraordinary one for the mortgage sector, arguably the best since the real estate bubble in the early and mid-2000s. early 00s, when the real estate bubble was really taking off.
After very little activity in the financial markets, a slew of mortgage originators have gone public. The impetus is what could be a once-in-a-generation refinancing wave. The Fed has taken extraordinary steps to support the economy, and the lenders have all enjoyed record origination numbers and profits.
The refinancing wave probably has longer legs than the markets are thinking, at least given the price-to-earnings multiples being paid for these stocks. The most recognizable name in the sector has been Rocket ( RKT -0.12% ), which went public last summer. While the near-term opportunity is compelling, what happens after the refi wave is finished? Where will Rocket be then?
Bond market and stock market cycles are vastly different
While most investors don't give bond markets much thought, bond bull markets and stock bull markets are completely different animals. While the stock market doesn't have any sort of ceiling on valuations or multiples, the bond market has real constraints on future growth, which is the zero bound. Rates are close to zero. The stock market can double from here, but the bond market cannot.
The other important thing to keep in mind is that interest rate cycles are long. Stock bull markets generally last around four years. Bond bull markets last decades. In fact, the beginning of the current bond bull market dates back to early in the Reagan administration, when Fed Chairman Paul Volcker raised rates to break the back of 1970s inflation, almost 40 years ago. Take a look at the chart below, which shows the mortgage rate in the 1970s. Interest rate cycles are long. Remember, bond prices go up when interest rates fall. Bond prices fall when rates rise.
There are very few investors left who have a memory of what it was like to trade financials during a rising interest rate environment. This will be a new phenomenon for most.
For Rocket, a bond bear market will depress refinancing activity as rates rise and borrowers hang on to their low rates until they move or pay off the mortgage. Old-timers may have remembered their parents financing their home at double-digit rates, while their grandparents had 3% loans made in the 1960s. When rates go up, the refinancing activity that has driven the industry for 40 years will dramatically shrink as nobody will refinance a 3% mortgage at 5% or higher.
One of the only assets that goes up when interest rates rise
Luckily for Rocket, it does have an asset that performs well during a rising interest rate environment: servicing. Servicing is the right to perform duties on behalf of the lender. Servicers collect the monthly payments, send out the bills, ensure taxes and insurance are paid, and handle delinquencies. As compensation, the servicer earns an annual fee of 0.25%. The right to perform that service is worth something, and its value is a function of interest rates.
When rates rise, people hang on to their great rates, and the servicer will get that cash flow for a lot longer. Conversely, when rates are falling, the borrower might refinance every other year, which means the servicer only gets that 0.25% fee for a couple years. Servicing valuations are pretty much rock bottom at the moment, and between falling rates and the CARES Act, have almost nowhere to go but up. Rocket will gain from the servicing income received, and probably some sort of mark-to-market gain as the portfolio increases in value. Almost no asset correlates positively with interest rates. Servicing is one of them.
The 800-pound gorilla in the mortgage market
For Rocket's lending arm, the name of the game will be to maximize its share of purchase mortgages, since that will be what drives the business going forward. Rocket's app certainly gives it a first-mover advantage, and it has a business model that combines stickiness and low cost. While no one knows how long this refinancing wave will last, it will almost certainly be played out in five years. The multiples given to the mortgage originators in the market indicate the investment community sees it ending sooner rather than later.
Rocket trades at just over five times where it expects its adjusted earnings for 2020 to end up. But most of those watching the stock expect earnings to get cut in half in 2021.
As I see it, that expectation assumes that rates will have to rise next year. Yet at the September Federal Open Market Committee meeting, the Fed projected that the Fed Funds rate would stay at current levels for the next three years. The Fed is also buying mortgage backed securities to support the economy. These purchases push mortgage rates down. As more borrowers refinance, their monthly payments fall, and those savings will get recycled into the economy, which is the rationale for the Fed's policy. Don't think of the bond market (or mortgage market) as a "market" in the normal sense of the word. It isn't. Rates will stay here as long as the Fed wants them here.
While what happens to short-term rates over the next five years is anyone's guess; in five years, the refi boom will probably be over. This means that Rocket's business model will rely more heavily on servicing and building the purchase business. The mortgage market will certainly be more competitive, and almost surely smaller.
Many smaller originators will probably struggle to compete, which means that we will probably see a wave of mergers and acquisitions activity. Rocket will almost certainly be an acquirer. In the meantime, by some estimates, 75% of the U.S. mortgage market can cut its rate by at least three-quarters of a percentage point, which means that the near-term opportunity is one for the ages. While the party will eventually have to end, it may last longer than the investment community thinks. This is why Rocket is one of my CAPS picks.