The current low interest rates have created the perfect environment for mortgage originators. Refinancing volumes are pushing estimates for 2020 originations to $3.2 trillion, which would be the highest rate in almost 20 years. The housing sales environment has been so strong, a number of mortgage companies -- including Rocket Companies (RKT 1.93%), Guild Holdings (GHLD +0.00%), and United Wholesale -- have chosen to go public (United Wholesale's SPAC IPO through Gores Holdings IV (GHIV +0.00%) is still being finalized).
While the origination market is good, is it too good? Are we at risk of another meltdown? How risky is an investment in Rocket Companies stock at the moment?
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Housing prices are not in a bubble
First of all, the 2008-09 mortgage meltdown was driven by a burst residential real estate bubble, a rare event that only comes around every century or so. Prior to the 2008 bubble, the last one occurred during the 1920s.
Bubbles occur when borrowers, lenders, and regulators all believe an asset is special and cannot fall in price. The institutional memory of the financial system, the addition of post-crisis regulations, and the prevalence of government-guaranteed mortgages make it almost impossible for another one to occur anytime in near future. So fears of a repeat are probably overblown.
Rocket doesn't hold its loans, so its credit risk is low
Given that another bubble is not in the cards, what else can go wrong with Rocket's business model?
The biggest risk for mortgage originators is credit risk. That isn't really applicable here, since Rocket is a nonbank mortgage originator that generally sells the loans it makes in the secondary market. This means that if the loans don't perform, the buyer bears that risk, not Rocket.
Note too that Rocket's production involves government-guaranteed loans, so credit risk is already limited to begin with.
Mortgage servicing can be volatile, but Rocket's performance is better than average
Rocket does have mortgage servicing rights on its book as an asset, and mortgage servicing can be a volatile and difficult-to-value asset. A mortgage servicing right is the compensation the servicer receives for handling the administrative duties of a loan. These include processing payments, ensuring property taxes are paid and that insurance is valid, and loss mitigation when the borrower goes delinquent. For compensation, the servicer gets paid 0.25% of the loan balance. Since it generally doesn't cost 0.25% to service a loan, that asset is worth money.
Servicing assets can fall in value if delinquencies shoot up. Rocket's delinquency rate was only 4% as of Sept. 30, compared to an overall U.S. delinquency rate of 6.3%. This means Rocket's mortgage servicing rights are high quality, and so the risk of a major write-down is unlikely.
The Street is probably underestimating earnings for next year
Probably the biggest risk for Rocket is an abrupt increase in interest rates, which would choke off the current refinancing wave. This would mean that earnings could decrease. Mortgage originators are in a highly cyclical business, which explains why earnings multiples are so low right now.
For example, Rocket trades at under six times estimated 2020 earnings per share, and PennyMac Financial (PFSI 1.12%) trades at three times estimated EPS. While earnings are expected to fall next year (here's why I think Wall Street is getting earnings estimates for mortgage originators wrong), the super-low existing multiples give the investor quite the margin of safety. For what it's worth, the Street expects EPS to fall by over 50% next year, so an increase in rates is baked into the estimates already. If rates don't increase, those estimates are probably low.
Rocket's business model gives the company an advantage over most mortgage originators in that it doesn't require an army of loan officers to generate sales volume, as the Rocket app takes care of much of that. Loan-officer commissions are far and away the biggest expense for originators, and that gives Rocket the ability to outperform almost every other retail originator. Rocket is one of my CAPS picks.
