Update: Rocket Companies & United Wholesale Mortgage

May 14, 2021 | In this issue of The Institutional Risk Analyst Premium Service, we take a look at the Q1 2021 results for United Wholesale Mortgage (NYSE:UWMC) and Rocket Companies (NYSE:RKT). Market valuations for both firms have suffered in recent days due to the selloff related to heightened inflation fears, but in truth the declining volumes and profit levels in the mortgage sector justified an adjustment.

Source: Google Finance

Notice the huge surge in RKT in March, a phenomenon likely facilitated by the following that RKT has gained among day-traders on social media such as Reddit. Since March, however, both stocks have given ground as earnings reports confirm the cooling of demand in the mortgage sector. Both stocks are off roughly 25% in the past six months.

The results from UWMC confirm the trend in terms of both mortgage origination volumes and gain-on-sale (GOS) margins. The “total gain margin” reported by UWMC is an ersatz measure that is not directly comparable to either the metrics published by other issuers or the average GOS margins published by the MBA and other sources. The table below shows the financial results from the latest UWMC earnings report.

UNITED WHOLESALE MORTGAGE CORP

Q1 2021

UWMC defines “total gain margin” as total loan production income divided by total production. But what income? UWMC does not say. Our definition of GOS comes from Appendix C of the OCC’s handbook on mortgage banking, as shown below.

When you look at the fact that total gain margin for UWMC was just 95bp in Q1 2020, and you factor in QE by the Fed and the huge amount of capacity the industry has thrown at the mortgage opportunity since March of last year, the idea that sale margins could be lower -- a lot lower -- in Q2 2021 is not so outlandish. That, indeed, is our view.

The MBS survey shows that profit margins (excluding MSR adjustments and servicing income) averaged just 47bp since 2016. As our friend Joe Garrett notes, some mortgage lenders lost money in Q1 as the industry seemingly reverts to the mean, but making 47bp on a loan is not the worst thing in the world. The table below shows average loan profits from the MBA.

Looking at the table above, 2020 was obviously an extraordinary year. Such cheery views aside, many independent mortgage banks (IMBs) slipped into loss in Q1 2021 and more will follow this quarter as falling revenues and profits, and inflated operating expenses, come into conflict. The table below shows the loan production results for UWMC as of Q1 2021.

UNITED WHOLESALE MORTGAGE CORP

Q1 2021

Notice that two thirds of UWMC’s production comes from refinance volumes, a sector of the market that is likely to contract rather significantly in the next several quarters, looking at the projections from the MBA. UWMC is predominantly a wholesale buyer of loans from brokers and has little retail or correspondent business. Thus the wild statements from UWMC CEO Mat Ishbia regarding catching up with market leader RKT in terms of lending volumes must be viewed as hyperbole at best and misleading to investors at worst.

Since the UWMC earnings release is merely seven pages long and carries little in the way of detail or explanation, it is hard to know how to assess the information presented. What we can say, however, is that the gain figures show a 30% sequential decline in profit margins. Note in the table above that most of UWMC’s volumes are in conventional loans sold to Fannie Mae and Freddie Mac. Conventional loans have far lower profit margins than do government loans in the FHA and VA markets.

The results for RKT are even more austere in terms of the amount of information provided to investors, with only year-over-year data provided in the table below from the RKT Q1 2021 earnings release.

ROCKET COMPANIES

Q1 2021

Looking back at the Q4 2020 earnings release for RKT, we see that the GOS margin at year-end 2020 was 4.41% and the average for the year was 4.46%. Based upon what we see in the secondary market today, we estimate that the GOS margin reported by RKT in Q2 2021 will be lower than Q1 of 2020. Ever optimistic, RKT states in its earnings release that: “Our flywheel only continues to accelerate as we look forward to the second quarter and the rest of 2021.”

Of course, “flywheel” is not a GAAP term, but obviously RKT is trying to put its best foot forward in a declining market, both in terms of volumes and profitability. Both UWMC and RKT are dependent upon refinance business for the vast majority of their volumes, although RKT does at least have a modest retail channel.

RKT states: “Q1 '21 represented our strongest first quarter purchase closed loan volume in company history. In addition, we achieved our highest monthly purchase application volume ever in March 2021.”

Unfortunately, RKT does not break down the components of loan volume in terms of refinance and purchase mortgage loans. Refinance loans are more profitable than purchase loans due to lower cost of lead acquisition and underwriting, but refinance volumes tend to disappear in a rising rate environment. We view RKT's refusal to provide this material information to investors as a significant omission in its public disclosure.

Also, RKT's presentation regarding recapture rates is also misleading in our view. The conventional industry convention for presenting recapture is to divide the loans retained by the total unpaid principal balance (UPB) of the servicing book, which usually results in a recapture rate in the 20-30% range for industry leaders. But RKT states in its 2020 10-K:

RKT states: "We define mortgage recapture rate as the total UPB of our clients that originate a new mortgage with us in a given period divided by total UPB of the clients that paid off their existing mortgage and originated a new mortgage in the same period. This calculation excludes clients to whom we did not actively market due to contractual prohibitions or other business reasons."

We think that RKT's presentation of recapture of refinance loans is misleading to investors. As one senior industry executive told The IRA: "The cleanest and absolute way to calculate recapture is: recapture fundings over all payoffs. Nothing is excluded." That is:

Recapture Rate = Recapture Fundings / All Payoffs

The Bottom Line

RKT is the market leader in 1-4 family mortgages in terms of both volumes and operating efficiency, one reason that its GOS margins are significantly higher than the industry average. Also, RKT has a substantial portfolio of mortgage servicing rights (MSRs) that should contribute positively to earnings as 2021 progresses.

That said, we expect both lending volumes and GOS to be lower than expected in Q2 2021 and for the remainder of the year due to the large refinance component in RKT's volumes. The fact that RKT will not break out its refinance volumes as a percentage of total lending volumes does not make us have great confidence in the company's public disclosure.

UWMC, on the other hand, is a one-armed bandit that operates predominantly in the wholesale channel, but is trying to mutate into a full-service IMB with correspondent and retail channels. As in the case of historical antecedents such as Countrywide, we do not expect this story to end well.

A little more than a year ago, UWMC was on the brink of collapse when the FOMC "went big" in terms of adding liquidity to the markets. Today, the company is trying to defend its stock price by making a lot of inflated statements about future financial performance.

CEO Mat Ishiba has a well-earned reputation for making wild and often times false statements about his firm's operations. So far the result is a stock price at all-time lows and a class action lawsuit against UWMC from a growing list of mortgage brokers.

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