Last August 6, leading mortgage banker Rocket Companies (NYSE:RKT) went public. On October 21, Guild Holdings (GHLD) went public. Other privately held mortgage bankers that have announced their interest in joining them as public companies are:
Why this sudden burst of enthusiasm for public ownership? For two obvious reasons. First, mortgage lending is currently red hot because of suddenly booming home sales and a refi wave. Second, the stock market is red hot.
Why my lack of enthusiasm for the mortgage banking IPOs? Because:
So, even though that I greatly admire Rocket Companies as an operating entity, I suggest you avoid the stock and steer clear of the coming IPOs.
Before I address my three negatives, a quick review of the mortgage banking business and its quirky accounting.
Mortgage bankers originate, sell and service home mortgage loans.
Loan origination means dealing with the borrower, which includes marketing to acquire them as customers, collecting the data to underwrite them and getting the forms completed. Mortgage bankers who perform this function are “retail”. Some mortgage bankers acquire loans from mortgage brokers, who perform the customer functions. This model is called “wholesale”. Most large mortgage bankers are have both retail and wholesale businesses.
Loan selling means transferring ownership of the mortgage loan to an investor. The “ownership” of the economics of the loan is generally split between two types of investors. The credit risk of a mortgage (a default) is usually transferred to “GSEs” Fannie Mae and Freddie Mac, and if the loan has a low downpayment, also to a private mortgage insurer, or PMI. Once the GSEs and PMIs insure the loan, it is usually placed into a mortgage-backed security or MBS. The interest rate risk of owning a mortgage is then borne by the buyer of the MBS.
Loan servicing is collecting the monthly payments from the borrower and chasing down delinquent borrowers.
Rocket had blow-out $3.0 billion of earnings this past Q3, and $6.6 billion year-to-date (YTD) for 2020. But it lost $2.4 billion of operating cash flow during 2020 YTD. Similarly, Guild Holdings earned $293 million for 2020 YTD, but lost $633 million in operating cash flow. What gives?
Mortgage banking has “investment and return” economics. Originating and selling a mortgage loan actually costs a mortgage banker cash money. For example, Rocket’s $210 billion of loan originations YTD 2020 cost it roughly $3.1 billion, or 140 basis points of loan volume. The return is the fees earned from servicing the loans. For example, Rocket earned $272 million during Q3 from collecting payments on about $400 billion of home mortgage loans, or about 28 bp annualized.
So 2020 YTD Rocket spent 140 bp in cash to earn 28 bp a year for the life of the loan. The loans serviced must therefore stay on Rocket’s books for at least five years to cover the upfront investment. To generate at least a 10% return, the loans serviced must on average stay on the books for seven years. That describes a good but not great business.
That “spend 140 bp to earn 28 bp” I described is a good outcome. But things often go wrong in mortgage banking. Wrong enough that nearly every mortgage banker I covered as a professional stock analyst over 25 years went bankrupt. From industry leader Lomas & Nettleton in the1980s to industry leader Countrywide Credit in 2008, with many smaller players in between.
This is obvious. We take out new mortgages for one of two reasons – buying a home or refinancing an existing mortgage. This chart shows a history of the two activities, plus Fannie Mae’s forecast for the next two years:
Source: Fannie Mae
Home sales are in a cyclical upswing, which is good. But mortgage refinancing activity is the big swing item for mortgage origination demand. We are currently in a refinancing boom because the Fed engineered a sharp drop in mortgage rates last year. But mortgage rates stabilized over the past few months, so Fannie Mae expects refi activity to drop by 50% from a Q3 ’20 peak over the course of the next year. In total, Fannie Mae expects 20% declines in mortgage originations this year and next year. How many industries have to manage through 40-50% declines in demand for their products?
Those demand swings create major swings in profit margins, as the following chart illustrates. It compares two data series. The first is “mortgage turnover”, which is mortgage originations divided by mortgage debt outstanding, to account for natural growth in mortgage demand over time. The second is the “mortgage spread” which compares the 30-year mortgage yield to the 10-year Treasury yield. The spread is a rough estimate of mortgage origination profitability; the wider the better.
Note the good correlation between the two, except during the Great Recession, when investors didn’t want to touch mortgage investments. Mortgage origination profitability has already fallen back from its Q1 ’20 peak, and Fannie Mae expects demand to fall for another year!
The economic law of supply and demand says that pricing equilibrium can be maintained during a demand decline if supply declines by the same amount. So is the industry pulling back enough capacity to manage falling demand?
That is not an easy question to answer because the mortgage banking business is highly fragmented; industry leader Rocket Mortgage had only a 9% market share last year. We therefore need to work with anecdotes. And those anecdotes suggest that if anything, industry supply is growing, not shrinking. Here’s a sample of the IPO group:
Rocket: “We will continue to invest significantly in our brand, technical capabilities and our award-winning client experience, which we expect will support a considerable increase in our market share…” (Rocket Companies S-1)
“At about 8% to 9%, Rocket still has a way to go to meet its goal of controlling a quarter of the mortgage market by 2030.” (CNN Business, November 12, 2020)
loanDepot CEO Hsieh: “We now possess roughly 3% market share of annual mortgage origination volumes, which makes up part of the $11T total addressable market. Thanks to our brand investment over time, we are also one of the most recognized brands in the industry today. All of this gives us enormous runway.” (Housing Wire, January 11, 2021))
Better Mortgage: “[The company] is looking to gobble up market share through its tech platform and the convenience it provides prospective borrowers.” (Housing Wire, November 12, 2020)
And of course a lot of fintech players see mortgage lending as a natural extension of their core businesses:
Finally, banks and savings and loans are the traditional home mortgage lenders. Are they going to walk away from this business? Probably a few, but they won’t cede nearly enough market share to satisfy the expectations of the stand-alone mortgage bankers and fintechs.
Where are the IPO proceeds going to? So far, all to the owners:
Guild Holdings: “The selling stockholders will receive all of the proceeds from the sale of shares of our Class A common stock in this offering.” (Guild Mortgage S-1 filing, page 58)
Rocket Companies: “Prior to the completion of the reorganization transactions, the Combined Businesses will have made cash distributions to RHI [existing shareholders)…of $3,878 million.” (Rocket Companies S-1 filing, page 92). Note that Rocket raised about $1.8 billion in the IPO.
I have nothing against business owners pulling cash out of their enterprises. They built the businesses; they have every right to benefit from their successes. But as an investor, I get nervous when founders and private equity investors are selling. They are smart people. I want to do what the smart people are doing. So why are they are selling now? And because they are selling, why should I be buying? For example, those of you with longer memories may recall this story about Angelo Mozilo, the CEO of then-leading mortgage banker Countrywide Credit:
“After starting a [stock selling] plan in October 2006, Mr. Mozilo twice raised the number of shares that could be sold: once in December 2006, when Countrywide stock was $40.50, and again in February, when it hit a high of $45.03…He expects to sell his remaining shares by the end of the week, a move that will generate millions more.” (The New York Times, October 11, 2007)
Countrywide sold to Bank of America in early 2008 for $7 a share and subsequently went seriously bankrupt within BofA.
In the best of times mortgage banking is not a great business. But the industry is now facing a year or two or declining demand and rising supply, which is a dangerous mix, when historically many players go bust. And the insiders are selling, not buying.
Rocket Companies in my view doesn’t fully reflect this bad news. Yahoo Finance says that Wall Street analysts see Rocket’s EPS declining from $3.85 in 2020 to $1.88 in 2021. And 2022 is very likely to be notably worse. With the stock at $19.60, it has a 10 P/E. Not crazy (check out Zillow!). But not yet cheap enough to reflect the coming storm.
I hope to be a Rocket owner one day. As I said above, it’s a great company. But just not yet.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.