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Right now, the mortgage banking sector is red hot. It’s experiencing its best year since the salad days of the real estate bubble about 15 years ago, with the Mortgage Bankers Association predicting $3 trillion in mortgage origination volume in 2020.
At the same time, we are seeing mortgage companies go public, with Rocket Companies (NYSE: RKT), the parent of Quicken Loans, doing so recently, and now crosstown rival United Wholesale Mortgage going public via a potential merger with a special purpose acquisition company (SPAC) called Gores Holdings IV (NASDAQ: GHIV).
Are you an investor interested in getting in on the mortgage banking sector’s current popularity? Here are two mortgage originators that are indeed the real deal and worth further investigation.
1. Rocket Companies: The market leader has a different business model
Rocket went public in August, and although the IPO was downsized, the stock is up about 11% since the offering. Rocket, through its main business operation Quicken Loans, is best known for its “Push button, get mortgage” app, which allows the borrower to handle almost all of the mortgage application process via technology. This service to users includes uploading documents, interacting with the loan processing team, signing documents, and making payments all via an app.
The app helps Quicken reduce costs, and this translates into much higher profit margins than just about every other loan originator operating. Last quarter, Quicken earned $3.5 billion on $72.3 billion in origination volume, which works out to a net income margin of 4.8%. To put that number into perspective, the Mortgage Bankers Association reported that the typical originator earned 1.7% in net income during the same quarter.
Why is Rocket so profitable? Technology allows it to originate its own mortgages without having to use an army of loan officers, who generally handle the customer acquisition and shepherd the loan through the origination process. In return for this, the loan officer earns a commission, usually anywhere from 0.5% to 2%. Rocket gets its customers via the application, and all of the loan management is done electronically, which is a huge time and cost savings.
Volumes increased 126% on a year-over-year basis, and the stock is trading at a 2020 P/E ratio of 6. While the mortgage banking business is highly cyclical, an investor can pick up one of the top mortgage lenders in the U.S. for a mid-single-digit P/E.
2. PennyMac: One of the biggest non-bank originators
PennyMac Financial Services (NYSE: PFSI) is another mortgage originator that is experiencing record-setting performance. PennyMac Financial has a different business model than Rocket. It’s an aggregator, which means it mainly buys completed mortgage loans from smaller originators, then resells those loans into the market as a bundled product as securities or it sells them to its sister real estate investment trust PennyMac Mortgage Trust (NYSE: PMT). PennyMac Financial retains the mortgage servicing asset, which generates cash flows for the company and will increase in value as interest rates rise.
PennyMac Financial reported $37.6 billion in origination volume in the second quarter, which was up 56%. The company earned $353 million in net income, for a profit margin of 0.94%, which is more in line with the typical mortgage originator. PennyMac increased its quarterly dividend from $0.12 to $0.15 per share and bought back 7 million shares (or about 9% of shares outstanding). Lastly, PennyMac Financial Services is trading at 3.5 times expected 2020 EPS.
Is the market underestimating the opportunity?
PennyMac Financial and Rocket Companies are currently trading at rock-bottom multiples due to the natural cyclicality of the mortgage banking business right now. When times are good, mortgage bankers feast. But when rates rise, mortgage refinancings (which are driving volume) dry up. So during good times, P/E ratios fall, and during bad times they increase.
The big question for the industry is: How long will the good times last? According to Black Knight Financial Services, a mortgage data provider, 19.3 million mortgages are “high quality refinances,” which means the borrower has strong credit, at least 20% equity, and can get a rate at least 0.75% lower. Removing the credit and equity constraints, the number increases to 32.4 million borrowers who can save at least 0.75% on their mortgage interest rate by doing a refinance.
Last year, the average mortgage size was $354,000, which means there is a potential $11.5 trillion in refinancing transactions out there. The Mortgage Bankers Association just upped its estimate for 2020 volume to $3 trillion, which leaves another $8.5 trillion in potential business for 2021 and beyond.
The Fed is forecasting that interest rates will remain at their current low levels through 2023, so there is a huge amount of potential business for these companies to go after. The mortgage-origination party has the legs to last a few more years. You can buy two real-deal market leaders in the space at mid-single-digit P/E ratios.
Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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