Rocket Companies (NYSE:RKT), home of Rocket Mortgage and Quicken Loans, is a massive direct-to-consumer mortgage lender. It’s the same business model GEICO uses to sell car insurance without agents.
Rocket has become the largest mortgage lender in the U.S, according to its CEO. That’s great. However, this also means that if interest rates keep on rising, RKT stock could be hit hard.
The two most important driving factors for Rocket Companies are interest rates and market share growth in mortgage lending. But by far, the biggest influence has been the direction of interest rates.
Gain On Sale of Loans
The reason? More than 96% of Rocket’s revenues now come from a line in its income statement called, “Gain on Sale of Loans, net.” You can see this on page 54 of the company’s annual report where it lists the past 5 years’ sources of its revenue.
This page shows that of the total 2020 revenue of $15.735 billion, 95.8% of that amount or $15.07 billion came from its flipping loans that it originated. This is much higher, as you can see than five years ago. In 2016, Rocket made just 79.2% of its revenue from “Gain on Sale” revenue. It shot up 200% in 2020 from $4.91 billion.
In other words, flipping loans is now the most important source of their revenue, despite all their other businesses.
If you take out a loan with Rocket or Quicken loans, within a few days those loans are sold to someone else. Rocket keeps the right to service the loan and collect your mortgage payments, but they do not keep the loan on their books.
So they essentially make a spread or arbitrage, if you will, including fees, on the sale of that loan. That gain on loan sale (GOS) is measured as a percentage of their investment. For example, on page 61 of the annual report (actually page 88 of the actual document) you can see these margins.
On the fifth line down you can see that in 2020, Rocket made a 4.46% margin on its gain on sale revenue. This is now much over 25% higher than in 2018 when the GOS margin was 3.55%.
Effect of Rising Rates on RKT Stock
But the problem is that what drove this growth is lower interest rates, refinancing volume and people being stuck in their homes to remodel them. The opposite is starting to happen.
Rates are slowly rising, partly from pent-up inflationary demands throughout the whole economy. This could dramatically dampen the volume of mortgages that Rocket does, especially if refinancing dries up.
Moreover, this will have a double whammy effect on the Rocket’s GOS margins. A portion of the gain of sale margin includes the value of the servicing rights that come along with the sale of a loan. So as volume dries up, its servicing loan revenue will also take a hit.
Last year, servicing fee income (which you can see on page 54), the next line down, was $1.074 billion, its third-largest revenue source (6.8%). There is no reason why GOS income and loan servicing income couldn’t fall back to 2019 levels.
Market Share Growth
You can see in the line on page 61 (actual 88 of the annual report) just above the GOS margin, that Rocket has had a huge increase in market share. In 2018 they produced 5.0% market share of all U.S. mortgage loan originations. Last year, that rose by 48% to 8.4%.
This is also likely to continue as people migrate to using Rocket and Quicken’s direct-to-consumer mortgage apps, etc.
But the good news is that as Rocket continues to pick up market share this can help to ameliorate any downturn in GOS and loan servicing revenue. That implies that more and more people will move away from mortgage brokers and/or use Rocket’s partners for their loans. However, if that market share growth falters and interest rates rise, there could be a massive hit on the company’s revenue
What to Do With RKT Stock
It’s hard to forecast the earnings for this company. It all depends on your outlook for interest rates. Market share growth is important. But the bottom line is, if people don’t originate new loans with higher rates, RKT stock won’t launch off the pad.
By my calculations, give that public shareholders have just an 8% economic interest in the total earnings and equity, RKT stock trades for over 5.5 times book value. This is a very high ratio. Let buyers beware if interest rates were to rise.
On the date of publication, Mark R. Hake did not hold any long or short position in any security mentioned in the article.
Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.