Origination Views

Why Warehouse Lending Should Not Be Shunned

By Barry P. Epstein

Mr. Epstein, a Los Angeles-based consultant and a former senior vice president and correspondent lending department manager at Ocwen Financial Services, has written an opinion piece on why he believes warehouse lending can be a key business strategy for banks.

I have read many articles concerning the lack of liquidity in the warehouse-banking sector, but they only served to underline that liquidity is a serious issue for the resurgence of homebuying and refinancing. The current state of warehouse lending is best described as non-existent. To date, no one has spelled out the financial benefits for a bank to enter this lucrative lending space. Bankers in this country need to know that this type of lending is very profitable, risk-mitigated and increases DDA and CRA credits, especially compared to any other type of commercial lending. Without warehouse banking for the small to midsize mortgage banker, the megabanks such as Well Fargo, Chase and Bank of America will control the marketplace. Participation in this sector will assist the economy in rebounding.

Many articles have been written highlighting the almost demise of the warehouse banking sector for the small to medium size banker (net worth of $500,000-$20 million) as the remaining warehouse lenders such as Bank of America (Countrywide), Wells Fargo, Comerica etc., have little appetite to expand for these type of mortgage bankers and the Wall Street firms still in the business, such as RBS Greenwich Capital and Deutsche Bank, would only entertain warehouse lines for the much larger mortgage bank originator with a net worth of more than $50 million and a bit less on an exception basis. This leaves the backbone of the mortgage bank originator with limited choices as the liquidity crisis for this sector is evident. Only about 10 warehouse lenders of any size remain down from over 100 a few years ago, and less then $20 billion is available down from over $200 billion! Some of the smaller warehouse lenders such as Texas Capital and Southwest Securities are pretty well "loaned up" and have little room to expand due to their asset and capital size.

The truth is there are many compelling reasons for banks to enter the warehouse banking space. Warehouse lending to FHA Full Eagle mortgage bankers is risk-mitigated. Mortgage bankers must have two years of certified financial statements and go through a rigorous approval process by HUD. Banks should not fund a loan for a mortgage banker unless they have the insurance certification, have an approved megabank takeout and also pre-funding due diligence.

If structured as repurchase agreements they are "off balance sheet" and do not affect capital ratios, as they are only on the books for two to 15 days. Structured as a true sale of underlying loans, they create a bankruptcy remote asset that can be hypothecated and resold, providing leverage opportunities. Commercial loans require 100% reserve, whereas if structured as repurchase agreements they would require only a 50% reserve, since these loans will be boarded as individual single-family loans, because the bank owns the asset that is in compliance with regulations regarding loans to one borrower. ROE just for warehouse lending is above 30% within 12 months, as the net spread is at least 3.25% (note rate minus cost of funds) and turns twice per month.

Warehouse banking promotes building non-interest demand deposits. Each mortgage banking client must deposit up to 5% of line as compensating balances and as a reserve against any losses and, warehouse bankers earn CRA credits as well as build positive economic activity in areas the bank lends through residential financing. This defeats some of the reasons I hear that warehouse banking doesn't contribute to relationship banking. Certainly a fallacy as just the opposite occurs in warehouse banking.

Commercial and consumer-type loans earn a much lower ROE for the bank than warehouse lending. Also, if a bank chooses to enter the GNMA market and become an issuer, it realizes an ROE of 100% within 12 months, assuming it purchases 50% of the loans off the warehouse line and sells them as GNMA securities, service retained and/or service released. Most warehouse lenders in today's market have "captive" lines which states the mortgage banker must sell to the warehouse bank a stipulated percentage of the warehouse loans or else be penalized with a pare-off fee. This promotes correspondent purchasing so warehouse banking promotes profits in three separate segments of the bank lending sector; warehouse lending to the mortgage banker, purchases off the warehouse line to portfolio and then GNMA securitization.

Warehouse banking is not capital-intensive. With initial capital of $2,350,000 and total capital for 10 months of $18,550,000 the returns would be 32% for warehouse lending only, and over 100% including correspondent purchasing and GNMA securitization. Pretax profits by the end of year two will be over $100,000,000 with no further capital investment. The returns are based on leverage that the bank can utilize.

Warehouse banking is very transparent. All originations submitted by client mortgage bankers must be underwritten to very specific credit guidelines and must be done via desktop software. All mortgage bankers must have E&O and fidelity coverage of $1 million minimum, a quality-control plan, compliance audit guidelines and use risk-mitigation engines and processing systems such as MARI, Lexis Nexis, CoreLogic, MERS registration and the software system such as SRG so that the process is seamless and almost paperless. These practices are crucial in mitigating fraud.

If the word spreads about the compelling and unique opportunity to earn substantial ROE of over 70%+ and create CRA credits, expand non-interest demand deposits and build long term banking relationships, I believe once one major regional or a few mid-size community banks enter the space, word will spread very quickly and more will jump on the bandwagon.

Hopefully articles like this will be read by top executives at liquid and well-capitalized banks and they should have a better understanding of the compelling opportunity in warehouse banking and understand that this process can be risk mitigated and very profitable to the banks and they should not shun the opportunities in today's warehouse lending sector.