I just had a conversation with the chairman and CEO of a bank about warehouse lending. Like some other bankers I’ve talked to in the last few months, he looks at warehousing as nothing more than mortgage financing. “Warehouse lending is mortgage lending and [involves] too much risk in taking mortgages as collateral without an exit strategy to sell the mortgage,” he told me. “Look what happened in the meltdown… I would rather be in asset-based lending.”
It is not uncommon for conversations with the uninitiated to sound this way. Those familiar with the Abbott and Costello comedy routine “Who’s on First” understand that Costello is hearing the conversation but not listening to what Abbott is saying. So it goes many times with warehouse lending.
Warehouse Lending Is Asset-Based Lending
It is easy to understand the confusion when the terms “residential mortgage” and “commercial line of credit” are used in the same discussion. Warehouse lending is asset-based lending of the commercial variety. And just like other types of commercial asset-based lending, the underlying driver of deal flow is mostly the consumer (home purchaser), but it is not mortgage lending.
To add to the confusion, bank regulators often treat warehouse loans as commercial lines of credit and give them a 100% risk-weighted classification even though the collateral, if held as a mortgage note, is considered less risky by the same regulators and is classified differently. Yet the time / risk exposure for a warehouse line is days versus years for a mortgage note.
In many ways, warehouse lending can be closely compared to accounts receivable financing for industry sectors such as distributors or manufacturers, with the exception of the collateral, which is generally much stronger. A mortgage banker (an entity or person originating mortgages and selling the note to a mortgage investor; not to be confused with mortgage broker) is granted a short-term revolving line of credit from a warehouse lender to fund the closings of mortgages, which are to be sold to the secondary mortgage market. Funds and collateral (i.e., the note and UCC document) simultaneously cross through the use of a closing agent that oversees the transaction, assuring that all documentation that includes a perfected interest in the note along with funds is in good order. The notes are then sold primarily to major investors such as Wells Fargo or directly to the GSEs or FHA with a prior firm commitment to purchase the mortgage note. Mortgage bankers draw upon this line as interim funds until the purchaser (i.e., investor) completes the transaction, at which time the line is paid off.
Banks — particularly community banks — made up a large part of the lending in this industry, and during the Great Recession, many sources of warehouse lines disappeared for reasons that we are all too aware of. Needless to say, the playing field has now changed, lessons have been learned and more asset-based lenders are recognizing the opportunity in this area with a minimum of competition. In California alone, there are only about six community-based banks that have recognized this market and now have warehouse lending operations in place.
For banks, warehouse lending adds to both the asset side of the balance sheet by increasing the short-term loan portfolio (warehouse loans liquidate within 30 days) and the deposit side through creation of new DDA, which can amount to 10%-15% of the line amount, thereby self-financing the lending platform.
In addition, community banks offering warehouse lending can use the lines as collateral at the Federal Home Loan Bank for leveraged financing. Having a warehouse business guarantees you’ll have more non-interest-bearing demand deposit accounts. Community banks can also get Community Reinvestment Act credit in this business. The return on equity can be 20% or more, and the return on assets is more than 2%.
A few types of lending are generically called “warehouse lending,” but we are only talking about loans sold to the secondary market and government agencies. As mentioned before, and an important part of the transaction, the closing agent is an escrow or title company (depending on the state) to certify documents bonded and regulated, usually under state authority. Mortgage bankers are licensed and must comply with state regulatory departments that require bankers to carry E&O insurance, fidelity bonds and have a minimum net worth to conduct business. Many are approved by the Department of Housing and Urban Development these days, as FHA and GSE loans are the primary conventional mortgage products other than jumbo products. That means most mortgage bankers need a minimum tangible net worth of $1 million. If a mortgage banker has less than $1 million in net worth, the banker is ineligible to underwrite the loans, and the investor will underwrite the loans.
All jumbo loans are non-delegated and underwritten by the investor. To further mitigate risk, some bankers require at least 1% of the warehouse line be held in a non-interest-bearing demand deposit account as collateral for which only the warehousing bank has signing authority. It is not unusual for banks to apply a “haircut” to the line lending 97%-98% of funds requested.
No loan is funded without a firm take-out commitment, indicating the loan is “clear to close” from a major investor such as Wells Fargo. A warehousing client must have at least two approved take-out investors with similar underwriting guidelines, and due diligence is performed on site for every prospective warehouse client. Just as in accounts receivable financing, the credit worthiness of the mortgage banker is also reviewed and a determination is made as to whether the entity is creditworthy and how much credit will be extended. Just like other types of businesses that have survived the economic downturn, mortgage bankers that are still in business have passed the acid test, and usually have strong business fundamentals and understand the business they are in and its cycles.
As with other forms of ABL, warehouse lending is not risk-free, and perhaps most of the forms of risk that the reader is familiar with are present to some degree in warehouse lending. As in other forms of lending, the customer’s character is usually the most difficult to determine and possibly represents the biggest risk for the lender. In comparing the risk of warehouse lending to other forms of ABL, it would be the degree of risk that distinguishes the two. A lending platform properly designed and staffed with experienced people mitigates such risk. All said, warehouse loans are bankruptcy–remote and probably the most risk-mitigated sector of asset-based lending.
Truly, warehouse lending is underserved when one considers the size of the mortgage industry by way of the dollar value (about $1.2 trillion) GSE representing 65%, FHA 20% and jumbo loans at 15% and growing and the number of warehouse lenders participating. Reviewing these industry numbers by themselves speaks volumes as to the opportunity that exists for warehouse lending activity, but when they are viewed in comparison to domestic accounts receivable factoring by deal size, volume and the number of companies that compete for factoring deals, one gets a better understanding of this opportunity. An estimate of outstanding warehouse lines is about $150 billion. In 2008 this number was around $200 billion and declined to less than $100 billion. An average size loan in California is around $350,000, so it’s not difficult to understand that a warehouse lender who marketed in this state would not need many mortgage bankers as customers to be active in this industry. The exact number of warehouse lenders actively pursuing deals nationally is difficult to determine, but a safe bet would be fewer than 100, and would not include small community banks that offer a line of credit to their mortgage banking customer based on business cash-flow.
With broad and sweeping regulator changes that have affected financial markets and commercial asset-based lending, new CFPB regulations have caused many experienced mortgage brokers to transition and become “emerging bankers” in the mortgage industry. This transformation brings an exceptional opportunity for the “emerging” warehouse lender to capture new broker business and become a frontrunner in an industry that will continue to grow and reshape itself.
Barry Epstein is a mortgage warehouse lending consultant in Los Angles and principal of Mortgage Warehouse Network. Rick Zitelli, an asset-based lending consultant to community banks and small business in California, contributed to this article.