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The inside line on warehouse lending.

THE INSIDE LINE ON Warehouse Lending

With more and more new companies being added to the roster of mortgage lenders, and with demand for warehouse credit lines growing, we decided an assessment of warehouse lending was in order. We initially set out to determine why so many small, new mortgage companies were having difficulty establishing credit lines. The investigation took us through a maze of procedures and regulations.

The inquiry involved contacting 14 warehouse lenders from various parts of the country. Unfortunately, most of them requested that the discussions be kept confidential because they did not want to reveal their specific requirements. This article is a compilation of those discussions and what was gleaned from them.

Representatives of the following warehouse banks were interviewed: First Bank National Association, Minneapolis; First Collateral Services, Walnut Creek, California; First Fidelity Bank N.A., Newark, New Jersey; First Interstate Bank of Denver; First National Bank of Chicago; First National Bank of Louisville; First Pennsylvania Bank N.A., Philadelphia; Greenwich Capital Financial, Inc., Irving, Texas; Marine Midland Bank N.A., Buffalo; MidAtlantic National Bank, Edison, New Jersey and Peoples Westchester Savings Bank, Hawthorne, New York.

The experience of these companies as warehouse lenders is categorized as follows: five had under five years, five had ten to twenty-five years and one had more than twenty-five years. The total number of warehouse customers they serve ranges widely: one has less than fifteen customers, three have fifteen to twenty-five customers, four have twenty-six to forty, two have more than forty and the remaining lender declined to identify its customer count. In one warehouse lender's attempt to locate banks with which to participate, the lender was able to identify only fifty other lenders in this field. Other interview participants confirmed that warehouse lending is done on a limited scale.

Warehousing is defined as the extension of a short-term, secured line of revolving credit from a financial institution to a mortgage banker that enables a mortgage banker to fund and inventory loans until they are delivered to a permanent investor. Other terms that substitute for warehouse lending include asset-backed lending, inventory financing and revolving credit. An expanded definition includes other types of short-term arrangements. Some warehouse lenders provide "within line allocations" that allow a portion of the credit line to be used for servicing acquisition loans, repurchasing facilities, foreclosure processing, principal and interest advances on modified pass-through securities, construction financing, commercial paper back-ups or general working capital needs. In addition, there are some warehouse lenders who offer custodial and deposit/cash management services.

Background

Following World War II, the housing industry entered a boom period that brought mortgage bankers into the limelight as a major force in mortgage finance. However, because of the industry's limited capital positions, warehousing was developed as an alternative means to support the consumer's need for financing. Initially, warehousing was done with FHA and VA loans and lenders required fully documented loan packages prior to funding.

Historically, warehouse lenders followed the negotiable instruments body of law. Subsequently, the Uniform Commerical Code (UCC) was utilized to govern warehousing practices and procedures. During the transition, the lack of continuity between the two sets of legal requirements left some lenders in unsecured positions, because they did not control the collateral or have the proper documentation. In addition, the secondary market became a more significant factor; its volatility in the 1970s and early 1980s increased warehouse lenders' risks.

These events caused a re-evaluation of the industry's warehouse lending structure as lenders implemented procedures to comply with the UCC. As a result, methods were developed for stricter control of the collateral and the funds advanced. Before these changes, a mortgage banker could deliver the collateral to a take-out investor and then send the funds to the warehouse bank. The new UCC procedures eliminated the mortgage banker's control over these items. No longer would the mortgage banker be the middle man; instead, the warehouse bank and the take-out investor would deal directly with each other. The lender's control over these functions remains a vital concern today, because some warehouse banks view the return of the collateral documents to the mortgage banker as moving them from a secured to an unsecured lending position.

Types of arrangements

There are three types of short-term, secured lending. Direct warehousing is the extension of credit on a loan-by-loan basis from a lender to a mortgage banker. Participations involve a direct (or lead) warehouse bank soliciting other lenders to participate in the credit arrangement once the direct bank has reached its legal or policy lending limit. Each participating bank investigates the mortgage banker (as well as the lead bank's operational capacity to handle the collateral and quality control procedures). If the review is satisfactory, a participation agreement is entered into with the lead bank. Participants deal directly with the lead bank, not the mortgage banker. A third type of lending is warehouse pooling or syndication. Under this arrangement, several warehouse lenders provide credit to the mortgage banker who individually negotiates a price with each bank. One bank is appointed the agent (or lead) bank for the collateral, and each bank receives a pro rata interest in the entire collateral pool. Almost all the lenders we interviewed engaged in participations and pooling.

Interest rate risk is the warehouse lender's primary risk, but inadequate loan documentation, delinquencies, foreclosures and the mortgage banker's potential for cash flow problems pose additional risks. The cushion between the mortgage banker and the warehouse lender is the mortgage banker's net worth; most lenders use it to determine leverage ratios.

Management of the credit line is important because the mortgage banker's capital position is usually small compared to his credit needs. The early 1980s provided many examples of poorly managed mortgage banking operations that became fatalities, as capital dissipated during periods of rapid and severe interest rate fluctuations. To protect themselves, most warehouse lenders require evidence of a take-out commitment prior to funding, thus ensuring that a line advance will be paid down without relying on the mortgage banker's capital.

To minimize risks, a warehouse lender looks at delinquency and foreclosure statistics, the mortgage banker's market positions and operating results (over several quarters), changes in senior management, the company's growth, changes in marketable loans and compliance with the warehouse agreement. Excessive delinquencies are among the indicators that the warehouse lender uses to identify potential problems.

The customer

Not surprisingly, warehouse lenders want to deal with financially sound, profitable companies with competent, experienced management that originate quality loans and prudently market them. Many require mortgage bankers to service as well as originate loans.

The focus for the initial review of the mortgage banker's operation is its management. This is done through an examination of the principals' resumes, and the company's history and financial information to identify its capital base and financial performance. Usually, three years of audited financial statements are required to determine if consistent, increasing profitability exists.

Seventy-three percent of the warehouse lenders we polled require three years of audited financials; yet one required none. Minimum net worth requirements ranged from $250,000 to $2.5 million; again, one had no minimum requirements.

If this phase of the review is satisfactory, the mortgage banker's list of references is checked to assess the firm's reputation and determine whether or not the referenced relationships have been satisfactorily maintained. Evidence of applicable operating licenses, insurance coverages and agency approvals also are obtained, and a UCC search may be conducted to identify any existing encumbrances. Upon completion of this step in the customer assessment, most warehouse lenders perform an on-site interview with management to review the mortgage banker's operation. Such visits and discussions help develop a feel for quality and build trust. Several of the lenders we talked with indicated they conduct quarterly or even monthly on-site visits to examine such things as: earning trends, balance sheet ratios, servicing portfolio growth, delinquency ratios, other credit lines, position reports and the age and liquidity of the warehouse inventory. This analysis is deemed important to help the lender gain an understanding of the mortgage banker's approach to risk management and secondary marketing. The absence of real estate owned and unsalable mortgage products serve as indications that the mortgage banker is generating quality loans. Another quality control measure is a review of the mortgage banker's take-out investors. All lenders we polled reserve the right to approve these investors.

One of the final functions is the leverage calculation. It is done to separate hard assets from intangible assets, while simultaneously giving the mortgage banker credit for his servicing portfolio. The primary leverage ratios are: total available lines plus liabilities, divided by tangible net worth, and total available lines plus liabilities, divided by tangible net worth plus the net present value of the servicing portfolio. Standard ratios range from 10:1 to 25:1 for the first calculation and from 10:1 to 15:1 for the latter. Variations are allowed depending on the mortgage banker's product line and approach to secondary market risk.

The mortgage banker's capital base helps determine the size and cost of the warehouse line. Cash flow projections help identify peaks in the mortgage banker's lending cycle. This is important because the warehouse line must accommodate the mortgage banker's highest production levels. The mimimum lines of the majority of the lender group we polled ranged from $1 to $3 million; one had a $20 million minimum and two others had no specific minimums. Maximum line extensions usually ranged from $13 million to $75 million, with one lender at $200 million and another having no maximum.

Overall, trust and knowledge of the mortgage banker are the warehouse lender's primary concerns. Doing business with a mortgage banker who speculates on the market usually results in adjustments to the credit decision. In addition, such items as the mortgage banker's markets, the size of his servicing portfolio and compensating balances are factors that can influence the warehouse lender's approval process.

Most of the warehouse lenders we spoke with use the prime rate plus a margin to determine their lending rates. Others use certificates of deposits, the London Interbank Offered Rate (LIBOR) or cost-of-funds indices plus a margin. The warehouse lenders we interviewed set margins ranging from 0 to 2.5 percent. Although most of them did not charge warehouse line fees, some indicated that commitment, non-usage and custodial fees could be applicable. Occasionally, these are assessed to encourage usage and to compensate the bank for making the credit facility available. Some lenders give credit for escrow balances and allow a buydown of the rate.

Documentation

Once a mortgage banker is approved, the following documentation is needed to establish the warehouse line: a warehouse line agreement, a master note and/or security agreement, UCC-1 financing statements, corporate resolutions and personal guarantees, if possible.

The collateral securing a line of credit should have a market value in excess of the funds borrowed, so that if a default occurs, the sale of the collateral will be sufficient to satisfy the outstanding credit line.

The original loan package - credit and appraisal documentation - is the collateral. (The funding package usually consists of a note, mortgage or deed of trust, assignment, evidence of various insurance coverages and a take-out commitment letter.) Some warehouse lenders do "wet funding" advances made solely on receipt of copies of the funding package documents. The majority of the warehouse lenders we surveyed, approximately 55 percent, did "wet funding" advances: the original documents are forwarded with the completed package. Regardless of when the funding documents are received, the note must have a blank signed endorsement and a blank assignment must be filled out in recordable form. Most warehouse lenders believe it is impractical to record every mortgage assignment; as such, blank assignments are required. Recording an assignment is done only in the event of a default.

One- to four-family residential loans are normally warehoused an average of 45 to 65 days. It is an obvious benefit to the mortgage banker to move his inventory out as quickly as possible to free up his credit capacity. Furthermore, all of our lender sources have maximum periods that a loan can be warehoused. Most range from 70 to 180 days; extremes in both directions were 30 to 360 days.

Funding

All warehouse lenders require a funding package containing a minimum loan documentation prior to an advance. A list of these documents is normally specified in the warehouse agreement. In addition, some agreements stipulate that advances are approved only on loans with take-out commitments. Documentation required for an advance usually includes the mortgage note, a certified copy of the mortgage or deed of trust and an assignment. Although almost all lenders require evidence of the take-out commitment and a bailee letter, others require some or all of the following: a title policy, trust receipt, UCC filings, truth-in-lending disclosures, HUD-1, evidence of agency guarantee or insurance, hazard and flood insurance and the mortgagors's loan application. Some lenders provide advance request forms that must be submitted along with the funding package.

According to the legal interpretations of some lenders, the UCC stipulates that a bank has 21 days to take possession of a mortgage note from the day of funding. In addition, there is a second 21-day period that extends from the time the mortgage note is delivered to the take-out investor until the investor submits the purchase funds or returns the note. These lenders believe that they have a secured interest in the mortgage during both of these periods. Of course, if the note is not delivered, the advance is considered unsecured. Most of the warehouse lenders we interviewed remit advance funds to the mortgage bankers or the settlement agent.

Under the terms of one program, funding could be provided to the settlement agent at the time of loan closing or borrowings could be made based on a whole loan repurchase line of credit. A repurchase line involves the delivery of a security to a dealer with an agreement to repurchase it on a specified date. Upon receipt of the security, the deal wires the haircut proceeds to the mortgage banker who in turn pays down his line of credit. A "haircut" is the discount from 100 percent funding; it can be a percentage of the face value of the mortgage or the take-out commitment price. Most lenders advance funds using a haircut. Our warehouse lender group had haircuts between 0 and 10 percent with 2 percent being the norm. One lender requires a 25 percent haircut on foreclosures that occur.

Document custodian

Most warehouse lenders act as their own document custodians while others use a third-party bank as the custodian for their line of collateral. Automated tracking systems are utilized to monitor the status of the required legal documents including investor take-outs.

Furthermore, some warehouse agreements have specific instructions for delivery of the mortgage notes and other loan documents. They may stipulate the means of delivery and the types of institutions to which the documents can be delivered.

Various information is required by most warehouse lenders on a regular basis. Pipeline, position and aging reports can be required weekly or monthly; delinquency reports may be requested monthly or quarterly. Annual audited financial statements are typically required, although a few of the lenders we spoke with require financial information as often as monthly. Warehouse lenders require prompt notification of significant events involving changes in management ownership, legal proceedings and similar material changes.

Warehouse lenders normally produce several reports on the lines they have extended; they may focus on profitability, usage and collateral tracking reports. These reports sometimes are distributed to their line customers.

It seems relatively clear after this brief inquiry why some mortgage bankers are unable to obtain warehouse lines. A basic understanding of the risks and variables involved - those of changing interest rates, obtaining the collateral and extending credit to new or poorly capitalized firms are among those that come to mind - lead some basic conclusions about this area of the business. Knowledge, extensive experience, a solid reputation and signficant net worth are major prerequisites for securing a warehouse line of credit.

With mortgage companies continually entering and leaving the market, a lack of tight guidelines and controls could result in substantial losses to a warehouse lender if a mortgage banker were to close his doors. To understand the restrictive environment of warehouse lending - which we are told will continue - just look at the risks that lenders take in regard to wet fundings. Nowhere else is the importance of a trusting relationship with experienced management more prevalent than in this scenario. A warehouse lender is putting full faith and credit in his mortgage bankers by advancing funds on copies of mortgage documents. This is one of many instances where the warehouse lender is relying on the mortgage banker's track record and experience as critical factors in the relationship. However, these items do not carry tangible monetary value. Because most mortgage bankers have limited capital, the warehouse lender is required to assume significant risks.

So, relationships are the key to warehousing. The success of a warehouse lender's program depends not only on providing credit at a competitive price, but also on providing prompt and quality service for credit and non-credit services. A few "extras," we were told, include notifying mortgage bankers regarding fraudulent or problem take-out investors and facilitating the sale of a mortgage banker's servicing. Warehouse lending is indeed a relationship business.

The bottom line appears to be that for the small, inexperienced mortgage banker looking for a warehouse line of credit, the prospects are dim. However, two of the warehouse lenders we interviewed indicated they consider start-up shops if the principals have strong backgrounds. The lenders we polled stressed the importance of the mortgage banker's careful, dedicated involvement throughout his business dealings - a good reputation is a must. Although there are wholesalers who will table funds for these originators, the capabilities of a warehouse line would probably be welcomed by most originators. They should establish their banking relationships with this in mind and as they grow, their banker should become an even more important part of their overall operation. After an originator has repeatedly proven his "worth," it is likely that a warehouse lender ultimately will go out on the credit limb for him.

Thomas S. LaMalfa is president of Asset Backed Capital Research, Inc.., Cleveland.
COPYRIGHT 1990 Mortgage Bankers Association of America
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:survey shows why these credit lines are scarce
Author:LaMalfa, Thomas S.
Publication:Mortgage Banking
Date:Nov 1, 1990
Words:3057
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