By now, hapless mortgage bankers are probably asking themselves what other shoes can drop and from where. They have already been hit by rising rates, declining originations, and fierce competition from thrifts.

Unfortunately, the next thud they hear may be the sound of defective loans hitting their balance sheets.

Welcome to the perils of rampant diversification. In hindsight, mortgage bankers had it easy during the good old days of the refinancing boom. Not only was volume plentiful, and margins fatter, but the product mix was rich in simple fixed-rate products.

Moreover, sellers were able to limit their number of investors to one or two conduits, such as Prudential Home Mortgage and the agencies, Fannie Mae and Freddie Mac. This made life simple for their underwriting departments, as well as their packaging and shipping areas.

With these longstanding relationships came understanding and trust. This resulted in relatively few errors, and very few loans ended up in the trash pile, or what we in the industry call the extended warehouse.

Extended warehouse loans can become an expensive proposition, particularly when mistakes produce unhedged loans in a rising rate environment. Flawed loans often can only be sold at distressed prices. The worst-case scenario, of course, involves unsalable loans that tie up precious capital and act as a drag on earnings.

In today's environment of dramatically reduced volumes and competition from financial institutions' below-market adjustable-rate mortgage pricing, secondary marketing units are being pressed by the origination side to find investors for any niche product that will bring in some business. The perfectly logical argument is that "we have these fixed costs to cover anyway and we must protect our strategic relationships with brokers, builders, affinity groups, etc."

In response to these demands, the secondary marketing group negotiates commitments for a no-documentation program, B, C, and D programs, a construction-perm program, and a COFI, a Treasury, and a Libor program. Frequently, these commitments are with new and unseasoned investors.

Now the rate sheet is no longer one page but 10, and it has more footnotes than rates. Every investor has slightly different rate lock parameters, underwriting guidelines, documentation requirements, etc. This means that, even under the best of circumstances, production costs will rise.

Unfortunately, Swedroe's principle of mortgage banking states that production mistakes rise in geometric proportion to the number of programs and parameters involved. A small error - particularly in a rising rate environment when many unscrupulous investors look for excuses to reject loans - can leave the originator with a major loss and restricted capital.

These problems are compounded by the substantial negative-carry situation that exists today with warehouse ARMs, where such loans are a cost to the lender rather than a source of interest income.

Given the dangers inherent in an ever-expanding product menu, secondary- marketing executives must seriously question the clarion call from the origination side for more product. The secondary marketing unit's role must be to make sure that all of the known risks and increased costs can be justified by the uncertain rewards.

Warehouse lenders need to have their antennae up when they get requests from their mortgage banking customers to waive covenants on amounts of loans, or number of days allowed, in extended warehouse.

These are the kinds of sounds that usually precede the aforementioned thud.

With the sound of all these shoes dropping, mortgage bankers and their warehouse lenders must be wondering whether whoever is up there is a centipede.

Mr. Swedroe is vice chairman of Residential Services Corporation of America, Clayton, Mo., the parent company of Prudential Home Mortgage Corp.

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