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Thinking for a change

Sep 06, 2005

Risk Vs. ReturnsKelly A. GrangerWarehouse lines, broker or banker, risk, returns, secondary marketing How Should I Fund My Loans in Today's Marketplace? Someone asks me that question everyday. Many successful mortgage originators have recently taken a step back from funding their loan volume as direct lenders and are once again delivering their production as brokers. Is this a prudent response to what seems to be the never-ending turmoil in the mortgage industry? Or, is it an overreaction to risk that misses unique opportunities for growth in volume, revenue and market position? Certainly, the "return for risk" trade-off of operating as a direct lender--by funding your loans through the use of a warehouse or other means--has tightened somewhat. In many cases, there has been an increase in the risk associated with the secondary marketing of closed loans while there has been a decrease in the additional margin or return from the funding and sale of closed loan products. Since this varies by product types and markets, does this mean that it is automatically a losing proposition? Or, does it simply require better execution designed to meet the challenges of the different loan products? If the answer to the latter question is "yes," then originators who have developed strong organizations have an opportunity to leverage off of their expertise to fill a void. So, Should I Be a Banker or Broker? As is often the case with these types of questions, there is more than one correct answer. The correct answer for particular originators depend on several key factors specific to them, their operation and their market position. The questions that originators must answer for themselves in order to make the right decision for their companies are: ++With full control over my lending process, can I become more competitive in my market? ++Will expanded pricing flexibility and control give me more market opportunities? ++Have I done the in-depth research and gathered the information needed to fully analyze the incremental revenues and costs associated with direct lending? ++Can I qualify for the correspondent programs and warehouse facilities needed to implement my plan? ++Are premium disclosure issues important to me? ++Can I develop the infrastructure to support an efficient direct lending operation? As a non-traditional warehouse provider, I have the unique opportunity to interact with lenders in almost all segments of the mortgage industry--originators and end-investors, brokers and bankers, retail and wholesale, conventional, government and sub-prime, big and small, new and mature companies. Feedback from these sources leads me to conclude that, contrary to popular belief, the benefits of delivering funded loans versus brokered loans are as viable as ever for lenders who identify a need for the advantages listed above. Making the "return for risk" trade-off work for you just requires digging a little deeper to find the gold. How Do You Make It Work for You? ++Do Your Homework Many brokers considering the transition don't fully examine all of the changes involved. I don't know how many individuals have said that they don't think banking is right for them because they don't want to assume all that work and risk just to obtain a modest increase in yield spread premiums. This perception may be fueled by their investor sales representatives, some of whom strongly discourage the move because they will lose the relationship and their commission. Some of the other direct enhancements of correspondent lending should be investigated and taken into account. These include: ++a lower par rate sheet allowing for more pricing flexibility and a more competitive position in the market; ++a smaller incremental rate margin required to increase yield spread premium; ++the ability to structure and collect virtually all lender loan fees; and ++much lower lender fees charged by your end investor. Remember that strong existing relationships with investors may be taken into account when meeting their higher qualifications for approval as a correspondent. Besides the end investor loan programs, many perspective bankers overlook the important differences in service levels provided by available warehouse lenders. While there has been a reduction in the number of warehouse lenders in the market, there are still plenty of funding facilities available. The important consideration is that there are significant differences that must be analyzed in order to pick the facility right for you. While price is always a consideration, it is only one of many. Funding turnaround time will determine how much your facility contributes to your improved service. The tolerance for different loan product types should fit your lending plans for not only the present, but also the future. Haircuts--the reduction in the funding amount sent to the table--may be required by some providers or for certain loan product types. Easy access to detailed information on your funding activities should be made available by your provider so you can efficiently manage your process to the lower cost. Some warehouse programs actually help you manage your risk by providing additional services in conjunction with the line. These can include assistance in developing your quality control and fraud avoidance programs, performing limited cross-checks on funding requests, contract quality control programs, and interim servicing of loans while they are on the line to protect their value. Qualification to obtain the funding facilities varies widely from traditional lines that are primarily net worth-based to small-cap lines that are more flexible. Small-cap lines can offer this flexibility by looking at a variety of other factors, including operational experience. ++Consider Indirect or "Hidden" Benefits Closely Believe it or not, most of my warehouse clients tell me that the biggest advantages they receive from being a direct lender are not the obvious revenue enhancements. Rather, control of their lending process is normally cited as the number one benefit. However, this enhanced control can create greater revenues through more competitive service and increased unit production. Another indirect advantage they commonly mention is the ability to attract and, more importantly, retain the best possible loan officers. Many clients tell of investing significant time, money, and effort to hire and train loan officers, only to have them migrate to a lender who provides more opportunities for lending success and fee income once they become productive. The status and flexibility of operating as a banker presents a stronger profile to both the market and the industry itself. ++Leverage Off of Your Strengths By focusing on your area of expertise, whether that be sub-prime or conforming loans, you greatly reduce your risk. For every conventional lending expert who tells me that sub-prime is too risky in relation to the return to fund it on the warehouse line, there is a sub-prime lender who tells me that conventional loans have margins that are too tight to justify funding them. Who is right? Well, since both are profitably funding and selling what the other considers inappropriate, neither can be considered correct in all cases. Once again, it depends on your individual situation. While you may want to initially fund only the products with which you are most comfortable, you can explore new areas and deliver these products as a broker. Then, once a comfort level is reached, they can be moved to funded loan production to gain the advantages outlined above. In this progressive approach, risk is limited. This approach works not only as it pertains to product types, but also as sources of origination, such as refinance or purchase and retail or third-party origination. I know several lenders who have leveraged off of strong investor relationships and an expertise in certain loan products by expanding their origination in these specific product lines to third party origination. They have a competitive advantage in this area that is valuable to other brokers in their market. ++Internal Controls and External Relationships By operating as a banker, you are accepting many of the risks of your lending transactions in order to gain the many benefits outlined. An overriding focus on dedicated internal controls and the development of strong external relationships is imperative to making this trade-off work for you. Guidelines for origination, processing, funding and quality control must be well thought out, comprehensive and implemented religiously. The risks that generate so much fear are all essentially within your control. Attention to detail, re-verifications, separation of duties and document reviews are only a few of the features that must be present throughout the loan process. While space does not allow for a comprehensive discussion of this area, there are many resources available to help you ensure that you have a plan in place that covers all of the pertinent issues. Strong accounting and reporting processes will identify and document areas for improvement and keep the operation strong and healthy. The commitment to the development of strong external relationships must be taken to a much higher level than broker origination requires. The payoff in correspondent lending isn't realized until the last step in the process--the purchase of the loan by the end investor. Up to this point, the originators base their entire lending process on the expectation of purchase based on a commitment from the investor. To make the transaction, the expectations must be clearly understood by both parties. Commitments to specific levels of service and detail must be met by both sides. This requires that the relationships be nurtured and developed to the point that they can withstand the strain of the inevitable problem file. Too often, a short-term broker mentality does not recognize the importance of win-win investor relationships as an absolute requirement of prosperity and survival. Multiple outlets for each loan type must also be made available so that these problem loans can be marketed quickly with a minimum reduction in sale price. The relationship with your warehouse lender is just as crucial. A mutual understanding of the commitment and expectations is necessary to move your lending process forward with confidence. There must be a clear understanding of the tolerances for certain products, the service level to be expected, the availability of increases to the line limit and the game plan for any aged loans on the line. Aged problem files must be attacked and quickly removed from the line to protect this important relationship. Be aware of the increased risk that your warehouse providers are now subject to, and be prepared to work within a more structured program. This will ensure that you will both be around for the long haul. At the same time, there must be an understanding of how the warehouse provider will assist you by offering help with secondary marketing or making work-out arrangements. Some warehouse providers will even offer to bid on aged loans as an additional option. I believe that where others see danger, the confident see opportunities, just as the best returns in the stock market are not realized by waiting until everyone is on the bandwagon and then buying when the price is up. The successful investor does research, leverages off of knowledge and gains a competitive advantage. With preparation and confidence, you can have an edge over your competition. Kelly A. Granger is the regional warehouse business director of PCFS Financial Services. He may be reached at (800) 838-9727, ext. 15116, or e-mail [email protected].
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