Landing softly on the far side of chaos: how originators and warehouse lenders are meeting the challenges of a drastically reconfigured marketplace.
A year of turmoil
This past year saw continued shrinkage of the warehouse lending marketplace. There are approximately 25 percent fewer warehouse suppliers in operation today than there were a year ago, with the overall industry seeing a roughly 40 percent decline in commitments and a 44 percent decline in actual balances outstanding. As would be expected, these numbers are in line with similar contractions in both secondary marketing and the overall mortgage marketplace.
What was surprising was the tremendous redistribution of warehouse customers triggered by the exits of many longstanding and institutional warehousing providers. Wall Street has a history of being fickle in the business of providing warehouse funds. Nevertheless, the abrupt withdrawal by some investment firms contributed directly to the demise of several investors, aggregators and conduits to which they provided treasury finance.
Under any market conditions, reliable and available gap financing is one of the most critical components of the viability of mortgage banking. Warehouse funds, in one form or another, supply much of the oil that lubricates the engine of mortgage origination, secondary market trading and securitization.
That dependency did not change for the mortgage bankers that survived the initial market shakeout. After losing access to large credit lines from top-tier providers that exited the market, originators looked instead to middle-tier warehouse lenders to make up the loss in supply. Rather than being wholly dependent on a single line from a major warehouse, originators were being prudent--if not forced by circumstance--in seeking multiple smaller lines with different warehouses to meet their funding needs. With mortgage bankers having already been bruised in the fall, it is now more important than ever that they diversify their supplier-dependency risk.
Middle-tier warehouses generally suffered much less impact from the market fallout, given the distribution of customer size and restrictions on portfolio product risk. It is my observation that warehouses in the middle tier are actually seeing increases in volume, numbers of customers and commitments.
Every warehouse lender suffered from the demise of institutional mortgage investors, with many left holding loans that could not be sold other than at a significant loss. Once collateral valuations came into question, mark-to-markets triggered massive margin calls. And when the confidence dominos began to fall, the subsequent turmoil directly affected warehouse lenders.
At the same time, investors increased repurchase requests and changed product guidelines--even mid-delivery--which further compromised the payoff of warehouse-financed obligations. Originator buybacks forced by investor repurchase demands propelled many otherwise solid companies into failure. Warehouse lenders were now faced with a whole new level of business risk.
The investor market, for its part, has contracted dramatically during the last two years. In 2005, there was a base of more than 600 institutional investors purchasing warehouse-financed loans. By the next year, that number had dropped to about 200. By September 2007, according to Street Resource Group's research, some 40 percent of all production volume was flowing through 10 investors, with 60 percent through just six of the largest investors.
Has this contraction run its course?
The remaining investors appear to be stable, solid and willing to continue buying loans. Still in question, however, is whether secondary market pricing will be enough to sustain originator profitability when offset by increased warehousing costs.
The dynamics of the mortgage secondary market process, as the industry has come to know it, have been in total chaos for the past year.
Reconfigured business model
As a result, warehouse lenders have been making pronounced adjustments to the overall business process in terms of loan funding requirements, guidelines and conditions. Pricing has changed, in that the decrease in suppliers has increased the cost of warehousing in some circles. Based upon recent pricing inquiries, some warehouse lenders are actually charging originators premium pricing right now. In my view, this is fair, considering the declining market and increased risk, but it definitely cuts into originators' already-thin profit margins.
It is, however, a fact of the current market that warehouses have taken on an inordinate and non-traditional level of risk. Consider the rise in the number of so-called hospital facilities in operation today. Hospital facilities allow loans currently unfit for market to convalesce. Because these are generally performing loans, there then comes the need for servicing.
Obviously, neither the warehouse lender nor many originators have the capacity or infrastructure to service loans. For loans that are not sold at market, both originators and warehouse lenders are finding it necessary to either service loans in-house or secure external servicing capacity.
Warehouse lenders are bringing increased scrutiny to the process of renewing existing lines and evaluating new line requests. As mentioned, many originators are seeking multiple smaller lines to make up for the loss of singular larger lines from top-tier funds providers. This unavoidable shift in finance strategy brings with it increased demands on management time, which further detract from keeping the focus on staying viable and profitable.
Warehouse lenders, wary of further losses, are placing much closer scrutiny on applications, becoming stricter in terms of information requirements and less lenient on covenant violations. This is a simple function of risk management, given recent history and some of the challenges already mentioned. The surviving warehouse lenders want the business, but only so far as the risk exposure is manageable and tolerable.
The originator's ability to maintain sufficient equity, tangible capital and sustained profitability to satisfy the contractual covenants of the warehouse agreements remains paramount. The failure to do so and the possibility of losing the line completely could be fatal, given the diminished supply and increased competition for available warehouse funds.
The success of warehouse lenders is wholly dependent upon profitable originator shops with continued viability--just as dependent as the originators are on the warehouse lines, in fact. It's a symbiotic relationship.
As the mortgage market continues to adjust to totally new market dynamics, the warehouse lender's best hope for success is based on bolstering successful originators and avoiding costly problems.
Warehouse lending technology
Recent feedback also underscored the importance of warehouse lending technology--to both the warehouse and its originator clients--as a means of surviving the current turmoil. With pricing from warehouse to warehouse being somewhat similar, advanced technology and the serviceability it facilitates differentiates the competition when originators shop for new funding sources.
Mortgage bankers will be looking to lessen the operational complexity of having multiple warehouse lines, and are more likely to choose among different warehouse lenders that provide the same software application. In addition to the benefits of more standardized business processes, mortgage bankers gain the advantages of automated, real-time technology--operating at a lower cost, having greater efficiency and accessing more useful information with which to make better decisions.
Traditionally, warehouse lenders were more restrictive with mortgage originators having multiple lines because of the risk of having the same loan on two different lines, whether with intent to defraud or by accident. Today, shared database services available through the Warehouse Information Network[sm] (WIN) industry consortium allow warehouses to detect simultaneous funding requests on individual properties and borrowers. Warehouse lenders now have access to risk-management tools to monitor multiple lines for signs of fraud, further decreasing the risks brought on by the changing business model.
From the warehouse lenders' perspective, technology helps them to maintain their efficiency, protect their market position and--most important--improve profits. It allows them to integrate risk-management tools that are appropriate for such a rapidly changing marketplace.
As the business model continues to shift, so do the points of risk. Business process re-engineering, supported by responsive and capable technology, is key to adapting quickly to the changing marketplace. By leveraging lending efficiencies and the flexibility of the best technology, a warehouse can accommodate fundamental changes in the business process and adapt to different pricing models as the industry requires.
I have confidence in the long-term success of prudent warehouse lenders capitalizing on the redistribution in the marketplace. Experienced management teams from now-defunct warehouses are eager to launch new enterprises, recognizing the tremendous opportunities. The future looks bright for these new players, unburdened by the problems of legacy portfolios and able to structure operations and controls based on new models and supporting technology. These new warehouse-lending suppliers will be predominantly financial-institution-based and confident in their ability to control risk.
The good news for mortgage bankers is that more financial institutions have a renewed interest in operating in this segment. The better news is that Wall Street firms, burned so badly this time, are likely to stay out of the marketplace for a while--that is, until memory fades.
Ultimately, this will mean more rational and experienced suppliers, combined with more effective use of technology, with intelligently re-engineered business processes, bringing greater stability and profitability to both mortgage banking and warehouse lending operations.
How can a warehouse lender weather any further deterioration, take advantage of new business opportunities and increase its attractiveness to originators actively seeking new funding? The following four strategies will be key to success.
* Adopt new technology: Warehouse lending technology will allow the lender to access new automated risk-mitigation services, adopt innovative risk-management technologies and position for the incorporation of eMortgages as that segment gains momentum.
* Re-engineer business processes: Taking advantage of the market slowdown to examine their processes, lenders will find ways to increase efficiencies, integrate business intelligence, automate verification and validation services, and re-engineer business processes to maximize their market attractiveness. Originators will gravitate to these warehouses--as opposed to traditional legacy lenders using antiquated technology and outdated operational and workflow processes.
* Emphasize mentoring resources: Adopting technology and re-engineering processes might provide the opportunity for warehouses, if they choose, to place more emphasis on their role as a mentor and consultant. Originators in need of assistance with problem loans or access to expertise when creating survival plans may rely more on their warehouse lender--a resource already familiar with the originator's operation.
* Restructure archaic revenue models: Warehouse lenders should transition from broad portfolio pricing to more granular transaction pricing, to maximize revenue relative to collateral and operational risk. With an expanding supply of property, borrower and market information databases, warehouse lenders can incorporate more technology-based, analytical processes to evaluate collateral, counterparty, third-party supplier and investor delivery risk. Originators might finally see warehouse costs that are truly reflective of quality mortgage product and delivery.
As we continue to see new changes, one thing remains certain: The mortgage industry will ultimately rebound.
The nature of this business is cyclical, which is why it's so important to have the adaptability required for survival in down times. It may take some time, but the mortgage market will return, with new and more rational products.
Those originators and warehouse lenders that have survived the chaos of 2007 and position themselves to survive 2008--because this shakeout is not yet complete--will find themselves both technologically and operationally prepared to take advantage of emerging opportunities as business returns.
Stanley M. Street is president of Street Resource Group Inc., Atlanta. He can be reached at email@example.com.
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|Title Annotation:||Cover Report: Secondary Market|
|Comment:||Landing softly on the far side of chaos: how originators and warehouse lenders are meeting the challenges of a drastically reconfigured marketplace.(Cover Report: Secondary Market)|
|Author:||Street, Stanley M.|
|Date:||Apr 1, 2008|
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