Shares of Rocket Companies (NYSE:RKT), the largest mortgage originator in the country, surged by 70% on Tuesday, to close just under $42 per share. This was likely fueled by the WallStreetBets (WSB) traders behind the meteoric rise of GameStop and AMC. Members of the WSB Reddit group spoke of buying Rocket, and nearly 40% of the company's shares were sold short, making it a prime target for a short squeeze.

Shares of Rocket dropped more than 30% on Wednesday but may remain volatile for the next few weeks. While no one knows how long the potential short squeeze will last, investors should be careful about investing in Rocket and other mortgage companies, as they could soon find themselves in a difficult environment in which to operate.

How mortgage companies work

Mortgage companies are in the business of originating home loans for people looking to buy a house or refinance an existing home loan. However, mortgage companies like Rocket, loanDepot, and UWM Holdings, which have also experienced pops recently, are not licensed banks, so they don't hold a lot of mortgages on their balance sheets.

Instead, companies like Rocket take most of the loans they originate and sell them into the secondary market to government-sponsored entities like Fannie MaeFreddie Mac, and Ginnie Mae. In return, they're paid fees. This isn't Rocket's only form of revenue, but it's the main one, so the more loans the company originates, the more money it will make.

Picture of toy rocket taking off.

Image source: Getty Images.

For instance, revenue from the gain on the sale of these loans accounted for roughly 61% and 76% of Rocket's total revenue in 2019 and 2020, respectively.

Mortgage companies like Rocket also earn fees for servicing the mortgages they sell into the secondary market, but selling the loans into the secondary market is the meat of the business.

Why you should be careful

The mortgage business is very sensitive to interest rates, which, if you think about it, makes sense. When mortgage rates come down, more people want to buy a house because they can lock in a loan with a lower interest rate. Existing homeowners also want to refinance their loans because they can swap their higher existing mortgage rate for a lower one, resulting in smaller monthly mortgage payments. Therefore, falling mortgage rates benefit mortgage companies.

That scenario came on full display in 2020. Due to the coronavirus pandemic, the Federal Reserve dropped its benchmark federal funds rate from 2% to practically zero. That, in turn, sent the yield on the U.S. 10-year Treasury note, a direct benchmark for mortgage rates, plunging to record low levels. The sudden decline triggered a wave of refinancing activity, which mortgage companies like Rocket rode to record loan originations and record profits in 2020.

But investors are focused on the future. While 2020 was a tremendous year, many investors now believe the mortgage market has peaked, which likely explains the short interest in Rocket. Additionally, the WSB-fueled trades in Rocket are literally happening as the yield on the 10-year note has been climbing.

Remember, mortgage rates are directly linked to that benchmark, so as the yield on the 10-year note rises, mortgages become less and less appealing for new and existing homeowners, which is bad for Rocket's business. Additionally, the Fed could decide to raise its federal funds rate in 2022 or 2023, which could then push up the yield on the 10-year note, which would further push up mortgage rates. Therefore, people are pouring money into the company as its outlook worsens.

Final thoughts

Just a few days ago, Rocket traded not too much higher than its IPO price from August of last year. I don't think the company deserves so much short interest at this level. It's the largest originator in the country and has good technology, putting it in the best position to grab a dominant amount of market share in a fragmented mortgage market. A more dominant market share will enable Rocket to increase its purchase mortgage originations when rates rise.

Rocket also has other business lines, such as auto lending, which can help ease the heavy reliance on mortgages. But the sudden jump in Rocket's share price this week has created too rich a valuation. While Wednesday's closing price of $28.01 doesn't look unrealistic long-term, it leaves little real upside for now other than a potential jump fueled by WSB.

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.