I just had a conversation with the chairman and CEO of a bank about warehouse lending. Like some other bankers I've talked to in the last few months, he looks at warehousing as nothing more than mortgage financing.
"Warehouse lending is mortgage lending and too much risk in taking mortgages as collateral without an exit strategy to sell the mortgage," he told me. "Look what happened in the meltdown. … I would rather be in asset based lending."
Actually, warehouse lending is asset-based lending. In fact, I'd argue it's the most risk-mitigated sector of asset based lending.
Warehouse loans are bankruptcy-remote. They can be used as collateral at the Federal Home Loan Banks for leveraged financing. Having a warehouse business guarantees you’ll have more non-interest bearing demand deposit accounts. You can get Community Reinvestment Act credit in this business. The return on equity can be 20% or more and the return on assets 1.5%.
This type of lending actually adds to both the asset side of the balance sheet by increasing the short-term loan portfolio (warehouse loans liquidate within 30 days) and the deposit side.
Let's look at the client risk. All mortgage bankers must be approved by the Department of Housing and Urban Development these days, as FHA loans are one of the few viable products. That means most customers need a minimum tangible net worth of $1 million. At least 1% of the warehouse line will be held in a non-interest bearing demand deposit account as collateral for which only the warehousing bank has signing authority. No mortgage is funded without a firm takeout commitment, indicating the home loan is "clear to close," from a major investor such as Wells Fargo. A warehousing client must have at least two approved take out investors with similar underwriting guidelines. Due diligence is performed on site for every prospective warehouse client.
Since each mortgage banker must put up at least 1% in the pledged collateral account as well as an operating account to fund the "haircut," deposits are generated. That's new money that the bank can lend out ten times over, assuming a 10% reserve ratio. The bank can also borrow 90% on warehouse loans from the FHLB prior to take out from the investor. The maximum time on the books is 30 days, and the usual time is 15 days.
Technology is outsourced so the cost per month is minimal and the operation needs only two new hires to operate until volume requires additional personnel. The ramp-up period to fund the first warehouse loan is about 90 days.
Let's analyze further the misconception regarding risk.
The probability that an approved investor will default on its commitment to buy a loan is nil. But let's suppose it happens and the mortgage banker is not able to substitute another loan acceptable to the bank, and even further files for bankruptcy protection. Now what?
Let’s use $200,000 as the mortgage amount and subtract $4,000, as the "haircut" on the loan that the mortgage banker supplied is 2%. So your warehouse loan is for $196,000. Assume the mortgage banker pledged 1% of its $10 million line, or $100,000, in the pledged account that only the bank has signing authority on. Now the amount outstanding is reduced to $96,000.
As the mortgage was originally okayed for sale by an approved investor, you as the warehouse bank have all the required documents to sell this collateral to another investor on the approved list, sell it into the market or put it in your bank's own portfolio. Remember the bank is exposed for only $96,000 on a loan originally at $200,000.
Where is the risk? This is asset based financing at its best.
Barry Epstein is a mortgage industry consultant in Los Angeles.