In 1972, I graduated from college and joined my father’s mortgage banking firm. He started in the mortgage business in 1948, and formed his own company in 1950. My dad enjoyed the fatherly trait of passing pearls of wisdom to his sons. This is one of my favorites. “Treat your warehouse lender with the same respect that you treat your wife.” I’ve carried that all these years. I still have the same wife I had 37 years ago. But our warehouse lenders seem to have run off with the tennis pro. Is it something I said, or should I work on my backhand?
The availability of warehouse financing is critical to the survival of independent mortgage bankers. Because banks can fund their own mortgage banking operations with deposits, it is not necessarily critical to the viability of bank-owned mortgage companies. Independent mortgage bankers created this industry and provide a valuable source of mortgage loans for the communities they serve. Their presence greatly contributes to the free market dynamics of competition. Their preservation is important to the availability of affordable mortgage loans.
The solution to this challenge will require creative compromise and thought. Banks and lenders, the federal regulators and the mortgage banks themselves must work for the solution. Each has its own set of issues and agendas. Let's take a high level and simplistic look at how we got in this position, and the most significant issues that each party faces. By doing so, we can then look for solutions.
The capital challenge
For warehouse lenders—usually banks or Wall Street firms—the fundamental issue is CAPITAL. I often hear that lack of liquidity is the source of the problem. Banks with adequate levels of capital do not have liquidity problems. They simply raise liquidity by accepting more insured deposits, or by borrowing money from the Federal Reserve or one of the federal home loan banks. The banks can then loan that money at a rate higher than the rate they pay for it. But if the bank does not have adequate capital, it cannot raise more deposits, or borrow money, to invest in new loans. That activity grows the assets of the bank. Capital adequacy is measured as a percentage of the assets that the bank holds. If the bank has inadequate capital, it cannot grow its assets.
A couple of years ago, many banks started losing money due to losses on bad loans and exotic derivatives. The capital markets lost confidence in the traditional banking business model. Investors do not want to put money into a losing business that had an uncertain future. The availability of new capital dried up.
Federal regulations require that banks hold minimum levels of capital as a percentage of their assets. Many banks have been losing money, and they are not growing capital through earnings. In some banks, the losses have actually caused their capital to fall dramatically. Banks cannot easily raise capital through new stock offerings. They really have only two choices—sell the bank or stop growing the bank.
Healthier or larger banks have bought banks that had to sell, or that were closed by the government. Some of the acquiring banks did not have enough excess capital to absorb the banks (and all of their loan losses) they bought, so they made deals with the government to protect them from asset losses. Then things grew worse. The loan and asset losses got even bigger. Private capital wanted no part of it. Banks needed more capital. The government had to start investing capital in these banks.
The capital effect
The lack of new capital—through earnings or new stock offerings—makes it very difficult for a bank to embrace a lending strategy that offers significant growth potential. The mantra of most banks is presently capital preservation and not balance sheet growth. Banks are just trying to survive this period. If a bank enters a lending program that grows its balance sheet size, it will need capital to support that growth. Capital is scarce.
Many of the banks in the warehouse business have been bought, closed or merged (IndyMac, Countrywide, Wachovia, Washington Mutual, PNC, Guaranty Bank, Chase etc.). In most cases, the acquiring entity has not preserved the business line in its present form. They closed or significantly shrunk the warehousing unit of the bank they acquired. The loss of these banks has negatively impacted the availability of warehouse financing. On a positive note, Wells Fargo has recently pledged their support to warehouse financing.
Bank capital is scarce. In order to safely maintain adequate regulatory capital levels, banks must slow down the growth of their balance sheet, or shrink it. The only way to do that is sell or liquidate assets. During this period, it is incredibly difficult, and costly, to sell assets. Although warehouse lending is profitable, “mortgage” is presently a dirty word and an easy target for discontinued operations. Most importantly, warehouse assets provide an easy way to shrink a bank’s balance sheet—without having to sell anything. The warehouse loans run off quickly—as the mortgages sell—the bank’s assets decrease and capital ratios increase. Some warehouse banks have either exited or shrunk their warehouse lending business. This has decreased the availability of warehouse financing.
The nature of mortgage warehousing is best suited to large banks. Mortgage warehousing requires sophisticated systems and personnel. Small banks usually do not have that. Banks also have regulatory limits that they can loan to any one borrower, called “LTOB” or “loans to one borrower” limits. For national banks, it’s 15 percent of capital. For some state banks, it’s 25 percent of capital. For example, a national bank with $50 million in capital would have an LTOB limit of only $7.5 million. Most banks set an even more conservative internal limit that is below the regulatory maximum. Warehouse lines of credit can often exceed $50 million. This makes it very difficult for a small community bank to be a warehouse lender.
Through the financial crisis, our small community banks remain healthy. Larger banks, for the most part, were involved in the riskier endeavors and have taken the largest hits. Ironically, they had the expertise and capital to take more risk. If there is excess capital in the banking system, it is primarily found at community banks. But most small community banks do not have, or do not want to concentrate their risk at the maximum LTOB limits that are necessary to support large warehouse lines of credit. Many of them do not have the resources or inclination to create or buy the requisite systems, and hire the expensive personnel, necessary to safely run a warehouse division. Community banks can help with warehouse lending capacity. But they are not the total solution.
Collateral management is one of the most important aspects of safe warehouse lending. As banks exit or shrink the warehouse lending business, the prevalence of qualified mortgage warehouse operations platforms is scarce. It takes time and money to recreate these platforms. In these days of profitability and capital concerns, the incentive to embrace overhead and operations risk is less. Those who have these platforms have similar concerns and are not necessarily anxious to “rent them” to other banks by expanding their business and selling participations to other banks. This too has restricted the availability of credit.
Bank capital: The math
Bank regulatory capital standards are a very complicated subject. I will try to highlight the basics in very broad and simple terms. If you are a regulator or accountant, please excuse my brevity. Banks should maintain capital of at least six percent of total assets to be classified as well capitalized. There is also a capital standard called risk-based assets. Banks should hold capital of at least eight percent of their risk based assets, and 10 percent to be classified as well-capitalized.
Banking regulations have established risk-based asset percentages for the various types of assets/loans in which banks can invest. The riskier assets/loans have a higher percentage, and the less risky a lower percentage. Traditional warehouse lines of credit have a 100 percent risk-based asset allocation. In contrast, Federal Housing Administration (FHA)- and Veterans Affairs (VA)-insured loans have a 20 percent risk-based asset allocation. Conventional loans with a loan-to-value (LTV) exposure at or below 90 percent have a 50 percent risk-based asset allocation and conventional mortgages above 90 percent LTV exposure have a 100 percent allocation.
The underlying loans that secure traditional warehouse lines of credit mostly fall into lower risk-based asset allocations—if held directly by the bank. However, a traditional warehouse line of credit is treated like most commercial loans, and treated as a 100 percent risk-based asset. Therefore, banks with limited capital are less inclined to invest in traditional warehouse lines of credit. Banks with scarce capital may reallocate, or target, their assets to more favorably treated risk-based assets. For the last two years, I believe this has been happening and it has impacted the availability of warehouse lines of credit.
Let’s take a look at a hypothetical example. A community bank has $500 million in total assets and generally accepted accounting principles (GAAP) capital of $35 million. They have invested their assets as follows:
◄ Cash deposits at the Federal Reserve..............................$20 million
◄ Traditional warehouse lines of credit................................$300 million
◄ FHA and VA loans..............................................................$100 million
◄ Conventional loans with an LTV less than 90 percent......$30 million
◄ Conventional loans with LTV greater than 90 percent......$50 million
This bank has an LTOB limit of $5.25 million (15 percent of $35 million). This means that the maximum loan commitment to each of its warehouse customers cannot exceed that amount. Their total capital is seven percent of assets ($35 million divided by $500 million), which is safely above the six percent requirement. Their risk-based capital is calculated as follows:
Risk-based % Amount Risk based $
Cash deposits at the Fed............................0%............................$20 million.............$0
Warehouse lines.......................................100%..........................$300 million..........$300 million
FHA and VA loans.......................................20%...........................$100 million..........$20 million
Conventional loan less than 90%..............50%...........................$30 million............$15 million
Conventional loans greater than 90%......100%..........................$50 million............$50 million
Total risk-based assets.............................................................................................$385 million
This bank has risk based capital of 9.09 percent ($35 million divided by $385 million). That is above the minimum, but below the required regulatory minimum for a well-capitalized bank, and exposes the bank to increased regulatory scrutiny or criticism. This is a simplistic and extreme example. There are many variables and factors that go into these calculations, and other capital measures that banks must meet. But this example exhibits the importance for banks to manage the risk-based allocations for the loans in which they invest. They can use much less capital, and enjoy greater leverage, by investing in loans that have lower risk-based asset allocation percentages. This example also exhibits that a bank has more incentive to invest in individual mortgage loans, rather than traditional warehouse lines that are secured by individual mortgage loans. When capital is scarce, one cannot blame the bank for maximizing its capital utilization. A bank that owns a mortgage company and funds its mortgage production with deposits can usually count those loans at the lower, loan level risk-based asset percentages. But if they are also a traditional warehouse lender, they have to count those lines of credit, secured by similar mortgage loans, at 100 percent. If they have limited capital, you can guess what they will likely do. They will support their internal mortgage banking operations. That’s just smart business.
Warehouse lending: Evolution
Use of purchase/repurchase agreements (repos) has been with us since the creation of Ginnie Mae mortgage-backed securities in the late 1960s. Mortgage companies were empowered to issue Ginnie Mae securities backed by the FHA and VA loans that we originate. Mortgage bankers gather bundles of mortgage loans, prepare a schedule of the loans, send it to Ginnie Mae, send the mortgage collateral to an approved custodian/trustee and Ginnie Mae sends back a security guaranteed by them and backed by the loans. The mortgage banker enters into a trade to sell that security to a Wall Street firm on a specific settlement date.
The agency security often arrives a week or two before the settlement date. Most warehouse banks allow those securities as eligible collateral under the warehouse line of credit—until the trade settles. Because these securities are backed by the full faith and credit of the United States government, Wall Street developed a process by which mortgage bankers can sell these securities to them before the actual security settlement date (the loan sale date). The mortgage banker has the obligation to repurchase the securities simultaneous with the settlement of the security. The difference between the price at which the Wall Street firm initially buys the security and the price at which the mortgage banker buys back the security is the effective cost of the repo and similar in nature to the interest rate charged on a warehouse line of credit. The repo agreement is almost always with the Wall Street firm to which the security is sold. This process allows the mortgage banker to pay off its warehouse lines of credit with the proceeds of the repo transaction. The effective interest rate on the repo transaction is usually much lower than the rate on a traditional warehouse line. More importantly, the mortgage banker does not have to wait for the securities settlement date to move the loan off its balance sheet and pay down the warehouse line of credit. Most banks do not treat the repos as other debt in the debt to equity calculation. This improves the mortgage banker’s debt-to-equity ratio. Repos still exist and are widely used.
As the market matured, Wall Street and the banks expanded the repo mechanism to Fannie Mae and Freddie Mac mortgage-backed securities. They also introduced a snazzy hybrid called the “Gestation Repo.” The Gestation Repo allows mortgage bankers to repo the individual whole loans that have been designated to go into the Ginnie, Fannie or Freddie security before getting the security back from the agency. The loans that are going into the security are specifically identified, and sold into the repo agreement. This lowers the mortgage banker’s cost of credit, gets the loans off the balance sheet sooner and allows them to do even more business.
In the early 1990s, some banks began to use this same Whole Loan Repo process in their warehouse lending programs. Several banks still use this today. Rather than establishing a traditional, secured warehouse line of credit to the mortgage banker, the bank actually purchases the individual mortgages, or a 100 percent participation in the mortgages, with an agreement to sell the loan back to the mortgage banker simultaneous with the purchase of the loan by the takeout investor. This allows the warehouse bank to:
◄ Enjoy the lower risk-based asset allocations for the individual mortgages, rather than the 100 percent risk-based asset allocation for a traditional warehouse line of credit.
◄ Avoid the LTOB limitations. Because the bank is not extending credit to the mortgage banker and is relying solely on the individual loans and the loan sale takeout proceeds for retirement of the loans, the LTOB limits apply to the individual mortgage borrowers and not the mortgage banker. This allows the bank to fund a large mortgage banker that they might not otherwise be able to fund under their LTOB limits.
In the last 10 years, Fannie, Freddie and several conduits have developed early purchase programs. These programs look very much like the Whole Loan Repo process. The takeout investor (Fannie, Freddie or the conduit) funds the purchase of the loan, or part of the purchase price, within two or three days of the funding by the mortgage banker. The mortgage banker then has a defined deadline by which it must deliver all of the required documentation, and receive the balance of the money due to them. If they fail to do so, they have to buy the loan back. This allows the mortgage banker to quickly get the loan off the balance sheet, reduce its warehouse line of credit and improve its debt-to-equity ratio.
Warehouse lending: Profitable and safe
Without question, the risks of warehouse lending have increased. Nonetheless, for those who run it well, warehouse lending is a safe and profitable business. The lender’s yield on the warehouse line of credit, and the rapid repayment of amounts advanced, makes this lending a very attractive asset for a commercial bank. Those lenders who profit from this lending watch the things that always mattered:
◄ The character and track record of their customer and its management
◄ The debt-to-equity and profitability of their customer
◄ The liquidity of their customer
◄ The speed at which their customer turns their loans, including aggressive pay-down requirements for aged loans
◄ The timeliness, substance and quality of the takeout and the takeout investor to which their customer is selling their loans
◄ The advance rate under the line, versus the takeout price
◄ Careful oversight and control of the mortgage collateral, including use of the Mortgage Electronic Registration Systems (MERS)
◄ Careful control over the funding of the loan and the proceeds of the loan sale
Mortgage bankers: Challenge and adaptation
Mortgage bankers also have challenges. When I started in this business, the prevailing debt-to-equity requirement for warehouse lines of credit was 10 to one. In other words, the mortgage banker needed GAAP capital of $1 million for every $10 million of warehouse line outstanding and, in most cases, for the amount of line committed. Additionally, warehouse lenders looked at working capital (GAAP current assets minus GAAP current liabilities) as an important ratio. We tried to maintain positive working capital equal to at least 75 percent of GAAP capital. We did not capitalize, nor did we often sell, servicing. Most warehouse lines of credit advanced the lesser of 98 percent of par or the loan sale takeout price. In summary, the industry operated with much less leverage than today. As we began to capitalize and sell servicing, things got more complicated. A more competitive and permissive credit environment led to higher advance rates and debt-to-equity ratios. In the last 10 years, I have seen warehouse deals with debt-to-equity ratios as high as 25 to one and advance rates as high as 102 percent of par. As to working capital, “What’s that?” has often graced the tongues of lenders and borrowers.
Mortgage bankers are also at the mercy of the institutions to which they sell their loans. For many mortgage bankers, that is a conduit, and the conduits have their own funding challenges—whether it is the funding capacity of the bank that owns them or the capacity of their own warehouse lines. The mortgage business is very volatile. When business volume spikes, the speed at which institutional investors buy loans slows dramatically. This slows down the turnover of the mortgage banker's warehouse inventory and increases the size requirements of their warehouse credit needs.
Warehouse lending: Solutions
Now let's look at some possible solutions. Some are more dramatic than others. I believe that they can all have a positive impact on the challenge.
If you are a mortgage banker:
◄ If you have a warehouse lender, treat them with the same respect you treat your wife (or spouse).
◄ Manage your aged inventory. If you have a problem, call it to the attention of your warehouse lender before they call it to your attention. When you call them, offer a reasonable and achievable plan for resolution of the specific problem.
◄ Prepare and model your business for higher capital requirements—a lower debt –to-equity ratio.
◄ Carefully monitor the liquidity (working capital) of your business, and maintain adequate levels to safely run your business.
◄ Don't defer problems. Hoping is not a plan.
◄ Visit your community bank(s) and explain the business to them. Ask them if they will consider providing warehouse financing to you and/or other mortgage bankers. If they will, contact your current warehouse lender and see if they will sell them a participation in your line of credit.
If you are a successful warehouse lender:
◄ Thank you for supporting our industry!
◄ Please consider using your operations platform and expertise to expand your lending program by selling participations to other banks that need loans and are willing to consider warehouse financing. Charge a fee for this extra service.
If you are a bank that is willing to consider warehouse financing:
◄ Please consider the purchase of warehouse line participations from experienced banks
◄ If you have the resources, consider forming a unit to provide warehouse financing. It can be a very lucrative and safe business channel.
If you are a Wall Street firm:
◄ Do you or can you still offer repos?
◄ Do you or can you still offer Gestation Repos?
If you are a federal home loan bank or “banker's bank:”
◄ Please consider creating an operational platform to serve your member banks that would like to invest in mortgage warehousing. This can increase your fee income, and help your member banks invest in a profitable asset.
◄ Consider using your resources to be a clearing house for sale of warehouse line of credit participations to your member banks.
◄ To the extent your charter permits, consider investing in warehouse lines of credit that are secured by loans eligible for sale to Ginnie Mae, Fannie Mae or Freddie Mac.
If you are a federal regulator:
◄ Please consider allowing risk-based capital treatment, for qualifying warehouse lines of credit, to be based on the risk-based allocations for the underlying mortgages that secure the line of credit. That will eliminate the disparity between bank-owned and independent mortgage companies. The Mortgage Bankers Association has recently made a similar request.
◄ Bank-owned mortgage companies that are funding their loans “on balance sheet” can already use this capital treatment.
◄ Banks using a Whole Loan Repo process are also already using this capital treatment. By definition, Whole Loan Repo agreements are not supposed to have specific recourse to the mortgage banker. Traditional warehouse lines of credit, backed by agency loans, afford the same collateral protection to the bank, and have the added credit enhancement of specific recourse to the mortgage banker.
If you are Fannie Mae, Freddie Mac or Ginnie Mae:
◄ Please consider the purchase of warehouse line participations from experienced banks. As this article goes to press, Ginnie Mae has announced that they are considering some type of warehouse support for Ginnie Mae issuers.
◄ Thank you for your years of support of and collaboration with our industry!
Mortgage banking was created to transport mortgage lending capital from capital surplus areas of the country to growing, capital starved regions of the country. Independent mortgage bankers are vital to the sustenance of our country's mortgage financing. Without adequate and affordable warehouse inventory financing, independent mortgage banks will become scarce. For many years, banks and independent mortgage bankers have enjoyed a symbiotic relationship. We are all aware of the challenges that banks face. The provisions of warehouse financing are good for the banks, mortgage bankers, the availability of mortgage loans and the cost of mortgage loans to the consumer.
For many years, this industry has contributed to the American dream of homeownership. Our industry needs some help and some compromise. The cost of that compromise is affordable and, when properly managed, safe. We must all work together for prompt resolution. The tools are available, and the requisite compromises are tolerable. It’s time for a solution!
James Hinton is chairman of Hinton Mortgage & Investment Company in Dallas, and is a 37-year veteran of the mortgage and banking industries. His company provides consulting and advisory services to the financial services industry.