Be careful with Rocket and other mortgage companies right now

Actions of Rocket companies (NYSE: RKT), the nation’s largest mortgage originator, jumped 70% on Tuesday, to close just under $ 42 a share. This was probably fueled by the WallStreetBets (WSB) traders behind the meteoric rise in GameStop and AMC. Members of the WSB Reddit group have spoken of buying Rocket, and nearly 40% of the company’s stock has been sold short, making it a prime target for a short squeeze.

Rocket shares fell more than 30% on Wednesday, but may remain volatile for the next several weeks. While no one knows how long the potential short squeeze will last, investors should be careful about investing in Rocket and other mortgage companies as they could soon find themselves in a difficult environment in which to operate.

How Mortgage Companies Work

Mortgage companies specialize in providing home loans to people looking to buy a home or refinance an existing home loan. However, mortgage companies like Rocket, loan deposit, and UWM Holdings, which have also seen pops recently, are not licensed banks, so they don’t have a lot of mortgages on their balance sheets.

Instead, companies like Rocket take most of the loans they take and sell them on the secondary market to government-sponsored entities like Fannie Mae, Freddie mac, and Ginnie Mae. In return, they are paid a fee. It’s not Rocket’s only form of income, but it’s the main one, so the more loans the business takes, the more money they’ll make.

Image source: Getty Images.

For example, the income from the gain on the sale of these loans represented approximately 61% and 76% of Rocket’s total income in 2019 and 2020, respectively.

Mortgage companies like Rocket also charge a fee for servicing the mortgages they sell in the secondary market, but selling the loans in the secondary market is the heart of the business.

Why should you be careful

The mortgage industry is very sensitive to interest rates, which, on second thought, makes sense. When mortgage rates go down, more and more people want to buy a home because they can get a loan at a lower interest rate. Existing homeowners also want to refinance their loans, as they can swap their current higher mortgage rate for a lower rate, resulting in lower monthly mortgage payments. As a result, lower mortgage rates benefit mortgage companies.

This scenario fully manifested itself in 2020. Due to the coronavirus pandemic, the Federal Reserve lowered its benchmark federal funds rate from 2% to virtually zero. This, in turn, pushed the yield on the 10-year US Treasury bill, a direct benchmark for mortgage rates, to record highs. The sudden drop sparked a wave of refinancing activity, which mortgage companies like Rocket surfed to record loan origination and record profits in 2020.

But investors are looking to the future. While 2020 has been a great year, many investors now believe the mortgage market has peaked, which is probably the reason for the low interest in Rocket. In addition, the powered WSB trades in Rocket literally occur as the yield on the 10-year note has soared.

Keep in mind that mortgage rates are directly tied to this benchmark, so as the yield on the 10-year note rises, mortgages become less attractive to new and existing homeowners, which is bad for Rocket activities. Additionally, the Fed could decide to raise its fed funds rate in 2022 or 2023, which could then push up the yield on the 10-year note, pushing mortgage rates further up. As a result, people are investing money in the business as its prospects deteriorate.

Final thoughts

Just a few days ago, Rocket wasn’t trading too much above its IPO price from August of last year. I don’t think the company deserves so much interest at this level. It is the biggest initiator in the country and it has good technology, which puts it in the best position to grab a dominant market share in a fragmented mortgage market. A more dominant market share will allow Rocket to increase its purchase mortgage origination when rates rise.

Rocket also has other lines of business, such as auto loans, which can help ease the heavy reliance on mortgages. But the sudden jump in Rocket’s share price this week created too rich a valuation. While Wednesday’s $ 28.01 closing price doesn’t look unrealistic in the long term, it leaves little real benefit at the moment other than a potential WSB-fueled jump.

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.

About Arla Lacy

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