1 financial action that has a decisive advantage
It’s not just a strategy, it’s a slogan: “Push the button, get a mortgage”.
For Rocket companies (NYSE: RKT), the application that the company has developed is the key that sets it apart from its competitors. The Rocket app gives the business 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 banking.
Most mortgage bankers follow the retail model. This is the model that Rocket is also pursuing. With the retail model, the originator gets their own loans, does the underwriting and processing, and then finances the production. Most of these mortgage bankers then sell the output on the secondary market, usually through 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 aggregator model, the banker purchases funded mortgages from retail originators and then securitizes them. These bankers bid on thousands of loans a day from small principals. The advantage of this model is that it is extremely easy to increase or decrease production. Do you want to speed up production? Be aggressive on the bid side. Want to go back? Do the opposite.
The downside of this model is that the production margins are really low. That said, companies that sell loans to clients have already done the underwriting, processing, and financing work. So while the margins are smaller, so are the costs.
Wholesaler: a model that is making a comeback
The third type of model is the wholesale model, this is what Wholesale plain (NASDAQ: GHIV) uses. He works with mortgage brokers, not retail lenders. Mortgage brokers are different from retail loan officers, who can only issue loans for the company that hired them. Mortgage brokers are free to use the wholesale lender who offers the borrower the best deal. It is much more a matter of relationships since brokers will bring in dozens of loans per month. Making sure brokers get the best service is one of the keys to the business.
Prior to 2008, brokerage activities represented 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 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 to use technology.
Once the app is on the borrower’s phone, Rocket can send push notifications indicating when it might make sense to refinance. The other advantage is that Rocket doesn’t have to pay an army of loan officers (who can earn well over 1.5% commission per loan). This is a huge cost benefit for the business. As the refinancing business dries up and the business becomes more competitive, Rocket will be able to compete with many smaller lenders.
That day may not come for a 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 maker.
Rocket’s app will certainly be emulated, and at some point most lenders will have an offer entirely online. But Rocket has the first-mover advantage here, and he focuses on the lowest fruit of the mortgage market: salaried borrowers who buy or refinance a primary residence. This reduces the cost of a loan.
Takeaway for investors
Rocket is trading at 5.6 times expected earnings per share in 2020 and 12 times expected EPS in 2021. Wall Street clearly anticipates rates will rise in the second half of 2021 as the economy recovers. The Fed has indicated its intention to keep interest rates and mortgage purchases low for the foreseeable future. If the market is wrong and rates don’t increase in 2021, there is likely a benefit to the whole mortgage bank sector profit estimates. Rocket is one of my CAPS selections.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.