The last two years have been the best for the mortgage industry since the early 2000s. The COVID-19 pandemic pushed the Federal Reserve to lower interest rates, which kicked off a refinance boom and unprecedented profitability for the industry.
Today, however, the lay of the land looks different in that the Federal Reserve is beginning to reverse the actions it took early on in the pandemic. These actions will negatively affect the entire mortgage industry.
Let's look at how Rocket Companies (RKT 2.07%) plans to navigate these potentially stormy seas.
The Fed is about to become a headwind for the industry
At the November Federal Open Market Committee meeting, the Fed announced that it would begin reducing its purchases of Treasuries and mortgage-backed securities. This move had been telegraphed by the central bank for months, so it was expected.
The Fed's purchases of mortgage-backed securities had the effect of artificially lowering mortgage interest rates. Mortgage rates have been gradually rising for months as the market adjusts to the new policy.
Rocket's technology gives it a leg up over its competitors
Rocket Mortgage is the biggest mortgage originator in the United States, and its technology gives it a huge competitive advantage over other lenders. Rocket's technology allows the company to reach the consumer directly, which means it doesn't need to rely as heavily on loan officers to drum up business. Loan Officers generally get anywhere from 0.50% to 2% of the mortgage amount as a commission, so the savings (which amount to thousands of dollars in fees) allow Rocket to either cut fees or earn more on the loan.
Rocket is best known for its "push button, get mortgage" app. However, the company has been diversifying its revenue stream by creating partnerships with other lenders and branching out into realty, title, and auto lending. The company recently announced a deal with Salesforce (CRM -0.34%) which will help it partner with banks and credit unions to offer Rocket products. Rocket has developed a system that adds value during the entire home buying process. On the earnings conference call, Rocket CEO Jay Farner explained the concept:
Through our integrated platform, clients can find their next house on Rocket Homes' 50 state home listing search platform, secure an agent from the company's agent network, get financing through Rocket Mortgage, have Amrock conduct the title work and appraisal for them and then after closing, have their mortgage serviced by Rocket Mortgage, all from one centralized platform.
Rocket is preparing for higher rates
The focus on realty and title will help Rocket absorb the effects of higher interest rates. Once the Fed starts hiking rates, the number of homes that can be profitably refinanced should drop sharply. Rocket has been focusing on reaching homebuyers in order to capture home purchase loans. These will be less sensitive to interest rates than refinances.
That said, there will always be debt consolidation refinances, and these are much less rate-sensitive. In this instance, a borrower might take advantage of home price appreciation to extract cash and use it to repay high-interest rate credit card debt. This should be a fertile area for the company going forward, even if rates rise.
Despite the increase in rates, Rocket reported an increase in profitability per loan, which has been depressed for the entire industry. Rocket and crosstown rival UWM Corp. (UWMC 1.79%) have been battling for share and cutting prices. During the third quarter, revenue per loan (also known as gain on sale) increased from 2.78% to 3.05%.
This is a far cry from the 4.52% the company earned during the third quarter of 2020; however, 2020 was one of those years that comes around rarely. Rocket is guiding for margins to fall slightly in the fourth quarter to a range of 2.65% to 2.95%.
Rocket is trading at 7.2 times expected 2021 earnings per share, which is on the high side for a mortgage originator. Since the mortgage business is incredibly cyclical, these companies often trade at mid-single-digit price-to-earnings ratios. The low multiple reflects the feast-or-famine nature of mortgage banking.
Rocket is betting that its investment in ancillary businesses will help it reduce earnings volatility and increase the multiple people are willing to pay for the company. Rocket has taken steps to ensure this happens; however, Wall Street will probably treat it like a plain old mortgage originator instead of a fintech until the company shows a decline in earnings volatility.