Last year has been a great time for mortgage makers. The economic fallout from the COVID-19 pandemic has forced the Federal Reserve to cut interest rates to a minimum to bolster the economy. This sparked a refinancing boom, which has been the best medium for mortgage lenders since the early 2000s. Some creators, for example Rocket companies (NYSE: RKT)took advantage of the environment to become public.
But the salad days of 2020 have turned into a much more competitive environment in 2021, and originators are earning far less on loans than they did a year ago to squeeze every last drop of potential profit from the home buying trend. This led to a price war and a drop in profitability. Some wonder how long competitors in the industry will be able to sustain it.
Rocket recently posted a profit and loss statement for the second quarter and its forecast indicated that the price war could be lower.
Profitability is a function of volume and margin.
The profitability of mortgage makers is driven by two main concepts: volume and margin. The volume corresponds to the dollar value of the loans provided by the sender during a specific month or quarter. The margin corresponds to the amount of profit that the recipient receives from the sale of the loan. Independent non-bank lenders like Rocket do not usually manage the long-term loans they provide. They finance their production and then pack the loans into securities and sell them on the market. The difference between the amount they lend to the borrower and the amount they receive in the market is called their margin.
Typically, volume tends to correlate with movement in interest rates. When rates fall, it is beneficial for borrowers to refinance their mortgages. When rates rise, refinancing activities cease and volume is largely driven by home purchases. Since buying activity is usually insensitive to interest rates (people will continue to move to new locations regardless of 10-year bond yields), volumes tend to be more stable. On the other hand, margins can fluctuate a lot and this can indeed be the driving force behind profitability.
The margin has dropped by almost 50% compared to last year.
Last year, when the Fed cut interest rates, there was more volume in the mortgage lending industry than it could handle. Creation requires specialized staff and it takes time for the underwriters to get up to speed quickly. Because the originators had more demand for loans than they could satisfy, they did what every business does — they raised prices. Eventually, the industry increased production capacity and was able to meet demand, and margins began to fall as companies began to compete more.
The rocket was in price war with an opponent at the crossroads UWM Holdings (aka United Wholesale) (NYSE: UWMC)and this has led to a decline in profitability for the entire sector. The two companies (both headquartered in suburban Detroit) don’t like each other, and United Wholesale told its clients (loan brokers) that they could do business with Rocket or United Wholesale, but not both. Both companies have different business models, although both have invested heavily in technology to compete.
In 2020, Rocket’s sales revenue was 4.46%, up from 3.19% in 2019. In the first quarter of 2021, this margin fell to 3.74% and then declined to 2.78% in the second quarter. This is 50% less than in the second quarter of 2020. conference call with incomeAccording to the company’s management, the company’s third-quarter profitability was forecast to be between 2.7% and 3%, so this indicates that we may see some stabilization in profitability. Be that as it may, the forecasted profitability of United Wholesale has also stabilized.
Conclusion for the investor
Rocket is working to diversify its business with car loans and real estate brokerage. This will help reduce the company’s dependence on mortgage banking, which is so volatile that these companies tend to trade at low multiples. Rocket is expected to earn $ 2.11 per share this year, giving the company price-benefit ratio out of roughly 8. Rocket has a key cost advantage over other developers in its direct-to-consumer app, which means the company doesn’t have the high commission costs that other developers have. This gives the company an edge over other originators, which means it can win the price war. For now, however, there seems to be a detente in the Greater Detroit mortgage war between Rocket and United Wholesale.
What does this mean for Rocket shareholders? The mortgage business finds itself in more difficult conditions. However, Rocket is one of the best companies in the business and must survive. As Rocket diversifies into various real estate businesses, the multiplier should increase. In the short term, the rise in rates and competition will do some damage to investor sentiment. Rocket is probably here, and investors who like Rocket’s history should refrain from chasing it for now.
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