Last year ended up being a great time for the mortgage originators. The economic fallout from the COVID-19 pandemic pushed the Federal Reserve to cut interest rates to the floor in order to support the economy. This kicked off a refinancing boom that was the best environment for mortgage originators since the early 2000s. Some originators, like Rocket Companies (RKT +0.14%), took advantage of the environment to go public.
But the salad days of 2020 have turned into a much more competitive environment in 2021, and originators are making much less on a loan than they did a year ago in an effort to milk every last bit of potential profit from the home-buying trend. That has led to a pricing war and a drop in margins. Some have wondered how long competitors in the industry could keep it up.
Rocket recently reported second-quarter earnings, and its guidance gave an indication that the price war might be de-escalating.
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Profitability is a function of volume and margin
Profitability for mortgage originators is driven by two major concepts: volume and margin. Volume corresponds to the dollar value of the loans the originator funds during a particular month or quarter. Margin corresponds to the profit margin the originator earns when the loan is sold. Independent, non-bank originators like Rocket generally do not long-term manage the loans they originate. They fund their production and then package the loans into a security and sell it into the market. The difference between the amount they lend to the borrower and the amount they get in the market is called their margin.
As a general rule, volume tends to correlate with interest rate movements. When rates fall, borrowers find it advantageous to refinance their mortgages. When rates rise, that refinance activity falls away and volume is mainly determined by home purchase activity. Since purchase activity is generally interest rate insensitive (people will continue to move to new locations regardless of the 10-year bond yield), volumes tend to be more stable. Margins, on the other hand, can swing wildly, and these can really be the drivers of profitability.
Margins are down almost 50% compared to a year ago
Last year, when the Fed cut interest rates, the mortgage origination industry had more volume than it could handle. Origination takes specialized personnel, and it takes time to get underwriters up to speed. Since originators had more loan demand than they could possibly satisfy, they did what every business does -- they raised prices. Eventually, the industry increased capacity and was able to satisfy demand, and margins began to fall as companies competed more.
Rocket has been in a price war with crosstown rival UWM Holdings (aka United Wholesale) (UWMC +3.39%), and this has pushed down margins for the entire sector. The two companies (both have corporate headquarters in suburban Detroit) do not like each other, and United Wholesale has told its clients (loan brokers) that they can do business with Rocket or United Wholesale, but not both. Both companies have different business models, although they have both invested heavily in technology as a way to compete.
In 2020, Rocket's gain on sale margin was 4.46%, compared to 3.19% in 2019. In the first quarter of 2021, that margin fell to 3.74% and then fell further to 2.78% in the second quarter. This was a drop of almost 50% compared to the second quarter of 2020. On the earnings conference call, company management guided for third-quarter margins to come in between 2.7% and 3%, so it indicates that we could be seeing some margin stabilization. For what it's worth, United Wholesale also saw margins stabilizing in their guidance.
Investor takeaway
Rocket has been working to diversify its business, getting into auto loans and real estate brokerages. This will help make the company less dependent on mortgage banking, which is so volatile that these companies tend to trade on low multiples. Rocket is expected to earn $2.11 per share this year, which gives the company a price-to-earnings ratio of about 8. Rocket has a key cost advantage over other originators in its direct-to-consumer app, which means the company doesn't have the high commission costs that other originators have. This gives the company an advantage over other originators, which means it can win a price war. For the moment, however, it looks like there is a détente in the Greater Detroit Mortgage war between Rocket and United Wholesale.
Where does this leave Rocket shareholders? The mortgage business is going into a more difficult environment. However, Rocket is one of the best companies in the business and should be a survivor. As Rocket diversifies its exposure to different real estate-related businesses, the multiple should increase. In the near term, rising rates and competition will do some damage to investor sentiment. Rocket is probably a hold here, and investors who like Rocket's story should refrain from chasing it for now.
