Last year was a great time for the mortgage lenders. The economic fallout from the COVID-19 pandemic has led the Federal Reserve to cut interest rates to the ground to prop up the economy. This sparked a refinancing boom that has been the best environment for mortgage lenders since the early 2000s. Some creators like Missile companies (NYSE: RKT), used the environment to go public.
But the salad days of 2020 have turned into a much more competitive environment in 2021, and lenders are borrowing far less than they were a year ago to siphon off the potential gain from the home buying trend. This has led to a price war and a decline in margins. Some have wondered how long competitors in the industry could hold out.
Rocket recently released earnings for the second quarter and its forecasts indicated that the price war could be de-escalating.
Profitability is a function of volume and margin
Profitability for mortgage lenders is determined by two main concepts: volume and margin. The volume is the dollar value of the loans the originator is funding in a given month or quarter. The margin is the same as the profit margin that the originator will make on the sale of the loan. Independent, non-bank originators such as Rocket usually do not manage the loans they grant on a long-term basis. They finance their production and then wrap the loans in a security and sell it on the market. The difference between the amount they lend to the borrower and the amount they get in the market is called the margin.
In general, the volume tends to correlate with the development of interest rates. When interest rates fall, borrowers find it advantageous to refinance their mortgages. When interest rates rise, this refinancing activity ceases and the volume is mainly determined by home buying activity. Since buying activity is generally insensitive to interest rates (people will continue to move to new locations regardless of the 10 year bond yield), volumes tend to be more stable. On the other hand, margins can fluctuate a lot and these can really be the drivers of profitability.
The margins have decreased by almost 50% compared to the previous year
When the Fed cut rates last year, the mortgage industry was bigger than it could handle. Originating requires specialized staff and it takes time to bring underwriters up to date. Since lenders had more credit demand than they could possibly meet, they did what any business does – they raised prices. Eventually the industry increased its capacity and met demand, and margins began to decline as companies became more competitive.
Rocket was in one Price war with Crosstown rivals UWM holdings (also known as United Wholesale) (NYSE: UWMC)and this has depressed margins for the entire industry. The two companies (both headquartered in suburban Detroit) don’t like each other, and United Wholesale has told its customers (credit intermediaries) 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 to compete.
In 2020, Rocket’s sales margin was 4.46%, compared to 3.19% in 2019. In the first quarter of 2021, that margin decreased to 3.74% and then declined further to 2.78% in the second quarter. That was a decrease of nearly 50% from Q2 2020 Conference call on the result, management expected margins to be between 2.7% and 3% in the third quarter, suggesting that we might see some margin stabilization. United Wholesale also recorded a stabilization of margins in its forecast.
Take away investor
Rocket has worked to diversify its business and get into auto loans and real estate brokers. This will help make the company less reliant on mortgage banking, which is so volatile that these companies tend to trade on low multiples. Rocket is expected to make $ 2.11 per share this year, giving the company a Price / earnings ratio of about 8. Rocket has a significant cost advantage over other originators in its direct-to-consumer app, which means it doesn’t have the high commission costs that other originators have. This gives the company an edge over other originators, which means it can win a price war. For now, however, it looks like the Greater Detroit Mortgage War between Rocket and United Wholesale will ease off.
Where are the Rocket shareholders? The mortgage business is getting 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 various real estate-related businesses, the multiple should increase. In the short term, rising interest rates and competition will hurt investor sentiment somewhat. Rocket is likely a stop here, and investors who like Rocket’s story should refrain from chasing it for now.
This article represents the opinion of the author who may disagree with the “official” referral position of a premium advisory service from the Motley Fool. We are colorful! Questioning an investment thesis – even one of our own – helps us all think critically about investing and make decisions that will help us get smarter, happier, and richer.