It isn’t only a strategy, it’s a slogan: “Push button, get mortgage.”
For Rocket Companies (NYSE:RKT), the app the company has developed is the key that sets it apart from its competition. The Rocket App gives the company a cost advantage as well as a marketing advantage. While most financial companies have some sort 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 mortgage-banking business models out there.
Most mortgage bankers follow the retail model. This is the model Rocket pursues as well. With the retail model, the originator sources its own loans, does the underwriting and processing, and then funds the production. Most of these mortgage bankers then sell the production into the secondary market, usually via Fannie Mae or 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 publicly traded mortgage bankers
The second type of model is the aggregator model. This would be the model type that PennyMac Financial (NYSE:PFSI) uses. In the aggregator model, the banker buys funded mortgages from retail originators and then securitizes them. These bankers bid on thousands of loans a day from smaller originators. The advantage of this model is that it is extremely easy to throttle production up or down. Want to ramp up production? Get aggressive on the bid side. Want to back off? Do the opposite.
The disadvantage of this model is that margins on the production are really small. That said, the firms that sell loans to the customers have already done the work of underwriting, processing, and funding. So while margins are smaller, so are the costs.
Wholesale: A model making a comeback
The third type of model is the wholesale model, which is what United Wholesale (NASDAQ:GHIV) uses. It works with mortgage brokers, not retail lenders. Mortgage brokers are different than retail loan officers, who can only originate loans for the firm that hired them. Mortgage brokers are free to use whichever wholesale lender gives the borrower the best deal. This is much more of a relationship business since brokers will bring dozens of loans a month. Ensuring that the brokers get the best service is one of the keys to the business.
Prior to 2008, the brokerage business was roughly half the mortgage market. In the aftermath of the 2008 crisis, it shrunk to about 20% as many brokers exited the business, but United Wholesale is betting that brokers will take more share in the future.
The app is a huge advantage
Rocket’s app is the secret sauce. First, younger borrowers prefer interacting with an app as opposed to a human. There is a definite generational difference between older borrowers, who prefer a face-to-face interaction, and younger borrowers, who would rather use technology.
Once the app is on the borrower’s phone, Rocket can send push notifications about 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 a 1.5% commission per loan). This is a huge cost advantage for the company. When refinance activity dries up and the business gets more competitive, Rocket will be able to outcompete 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 earned 3.4% profit on its origination, which was over two times the average independent retail mortgage originator’s profit.
Rocket’s app will certainly be imitated, and at some point, most lenders will have a fully online offering. But Rocket does have the first-mover advantage here, and it concentrates on the lowest-hanging fruit of the mortgage market: salaried borrowers purchasing or refinancing a primary residence. This lowers the cost to do a loan.
Rocket is trading at 5.6 times expected 2020 earnings per share and 12 times expected 2021 EPS. Wall Street clearly anticipates that rates will rise in the second half of 2021 as the economy recovers. The Fed has indicated it intends to maintain low interest rates and mortgage purchases for the foreseeable future. If the market is getting it wrong, and rates don’t rise in 2021, there is probably upside to the entire mortgage banking sector’s earnings estimates. Rocket is one of my CAPS picks.
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