It’s not just a strategy, it’s a slogan: “Push the button, get a mortgage”.
For Rocket companies (NYSE: RKT), the application developed by the company is the key that distinguishes it from its competitors. The Rocket app provides the business with a cost advantage as well as a marketing advantage. While most financial companies have some kind of technological interaction with their customers, Rocket takes it to a new level.
Retail: the classic mortgage banking model
First, it helps to understand the different business models of mortgage banks.
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Most mortgage bankers follow the retail model. This is also the model Rocket is pursuing. With the retail model, the originator obtains its own loans, does the underwriting and processing, and then finances the production. Most of these mortgage bankers then resell the output on the secondary market, usually via Fannie Mae Where Freddie Mac securitizations.
The retail production model tends to have the highest profit margins per loan of all the different business models.
Aggregators: The most common model for listed mortgage bankers
The second type of model is the aggregator model. This would be the type of model that PennyMac Financial (NYSE: PFSI) uses. In the aggregation model, the banker purchases funded mortgages from retail originators and then securitizes them. These bankers are bidding on thousands of loans a day from small originators. The advantage of this model is that it is extremely easy to scale up or down production. Want to speed up production? Be aggressive on the bidding side. Want to step back? Do the opposite.
The disadvantage of this model is that the margins on production are really low. That said, companies that sell loans to customers have already done the underwriting, processing, and funding work. So even though the margins are smaller, so are the costs.
Wholesaler: A model who returns
The third type of model is the wholesale model, i.e. united wholesale (NASDAQ:GHIV) uses. He works with mortgage brokers, not retail lenders. Mortgage brokers are different from personal loan officers, who can only make loans to the company that hires them. Mortgage brokers are free to use the wholesale lender that offers the best deal to the borrower. It is much more of a relationship business since the brokers will bring in dozens of loans per month. Ensuring brokers get the best service is one of the keys to the business.
Prior to 2008, the brokerage business accounted for about half of the mortgage market. In the aftermath of the 2008 crisis, it fell to around 20% as many brokers left the business, but United Wholesale is betting that brokers will take more shares in the future.
The app is a huge plus
Rocket’s app is the secret sauce. First, young borrowers prefer to interact with an app rather than a human. There is a clear generational difference between older borrowers, who prefer face-to-face interaction, and younger borrowers, who prefer using technology.
Once the app is on the borrower’s phone, Rocket can send push notifications indicating when it might be a good idea to refinance. The other benefit is that Rocket doesn’t have to pay an army of loan officers (who can earn well over a 1.5% commission per loan). This is a huge cost advantage for the business. When refinancing activity dries up and the business becomes more competitive, Rocket will be able to outperform many smaller lenders.
That day may not come for another year or two, but it will come eventually. Rocket is much more profitable than the average mortgage bank; in the third quarter of 2020, it made a profit of 3.4% on its origination, more than twice the average profit of an independent retail mortgage originator.
Rocket’s app is sure to be emulated, and at some point most lenders will have an entirely online offering. But Rocket has the first-mover advantage here, and it’s focused on the lowest fruit in the mortgage market: salaried borrowers buying or refinancing a primary residence. This reduces the cost of making a loan.
Takeaway for investors
Rocket is trading at 5.6 times expected 2020 earnings per share and 12 times expected 2021 EPS. Wall Street clearly expects rates to rise in the second half of 2021 as the economy recovers. The Fed has indicated that it intends to maintain low interest rates and mortgage purchases for the foreseeable future. If the market is wrong and rates don’t rise in 2021, earnings estimates for the entire mortgage banking industry are likely to rise. Rocket is one of my CAPS picks.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging 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 wealthier.
