The old saying that you don’t miss something until it’s gone certainly became true for the warehouse lending industry in the wake of the 2007-2008 housing crisis. In fact, it’s easy to forget that within a six-month period, the industry went from a total of 120 warehouse lenders to only 20, and that by 2009, available warehouse lines fell from around $200 billion at the peak of the market to about $20 billion. These were cataclysmic drops that effectively killed off many mortgage bankers who could not find the liquidity to survive.
Like oxygen, warehouse lending is one of the mortgage industry’s essential life-supporting elements. And fortunately, the warehouse segment is in much better health today than it was six years ago, as we are back up to around 70 warehouse lenders at my last count. But just as with the air we need to breathe, conditions can and do often change. As I see it, here are five trends currently affecting warehouse lenders that are also having an impact on the wider industry.
LOW UTILIZATION RATES
Mortgage bankers today face many restrictions, ranging from increased regulations to higher costs and lower profits. One of the pressures they can avoid is liquidity, so long as they have warehouse lines available. But right now, very little of warehouse production is actually being leveraged. Utilization rates, defined as the percentage of the warehouse line that is actually used versus what is available, are averaging only about 20% currently, which is rather low. That means that if a banker has a $10 million warehouse commitment, that banker is only using $2 million.
The result is a tremendous overcapacity in existing commitments, creating a severe competition between warehouse lenders for existing business. As a result, we have significant downward pressure on warehouse rates and fees in a business that has traditionally enjoyed very healthy margins. This competition is not such a concern for warehouse lenders, as service is more often the deciding factor when it comes to how warehouse units build business. But it is a contributing factor behind another industry challenge.
LAGGING ORIGINATION VOLUMES
According to the Mortgage Bankers Association’s latest survey, purchase applications and refinance applications are 15% and 60% lower, respectively, from this time last year. Because mortgage origination volume is inherently tied to the availability of warehouse funds, when origination volume is down, so is warehouse volume.
However, the reduction in warehouse loan commitments has not yet caught up with the decrease in production. As mortgage bankers are renewing their contracts with warehouse partners, we are starting to see a lot of warehouse line commitments being renegotiated lower. For example, a warehouse lender that provides a $10 million commitment is renegotiating that commitment to $7 million.
Even as they reduce commitments, mortgage bankers do not want to give up that liquidity because it would affect their ability to fund loans when production begins to increase. On the other hand, banks don’t want unused commitments on their books, either, because the commitment that goes unused is an earning asset that’s basically underutilized.
This presents a similar quandary for warehouse lenders. They don’t want to give up the potential yield of a highly profitable warehouse business, but they have to decide whether to redeploy their own funds into another non-mortgage related, asset-based lending product. Both essentially are on parallel tracks, with the determining factor being how each is getting the highest and best use of their money. But for warehouse lenders, there are a lot of questions to answer. How soon will volumes pick up? Should fees be lowered? How do we grow the business?
THE RISE OF ALTERNATIVE PRODUCTS
Because of the scenario I just described, we’re seeing a large uptick in warehouse providers deploying funds into non-standard products. Mortgage servicing rights, reverse mortgage tails, service released premiums and construction warehouse loans are becoming popular, for example, as they typically have very good margins. One of our clients is even doing FHA debentures, which provide bridge funding for FHA loans that go bad. With debentures, the investor puts the loan back to the originator while waiting to be paid off by the FHA, a process that can take a year or two.
All things considered, it is a very positive step that warehouse lenders are thinking outside the box while looking for other ways to serve their clients. By funding alternative products that their mortgage banker clients may already be doing, warehouse lenders can also solidify their relationships.
On the other side of the coin, I always adhere to the philosophy of doing what you do best. The further outside your comfort or experience zone that you get, the higher the risk. For warehouse lenders, the decision to get outside the box ought to be paired with having strong counsel, having the right people in place, and being educated about the products on which they are lending. As warehouse lenders move into alternative products, they also have an obligation to pay more attention to risk.
In some ways, we saw a similar trend back in 2006, when during a highly competitive environment some warehouse lenders began dipping down into lower quality products. I don’t think we are anywhere near 125% LTV loans flooding the market, which was among the products that did in a lot of warehouse lenders. But the more downward pressure there is on profitability, the more tempted some players are toward more risky behavior.
ONGOING BROKER-TO-BANKER MIGRATION
The bright spot is that there is a tremendous uptick in the broker to banker model, which is increasing the appetite for warehouse lines. While we have significant overcapacity of funds in the industry today, that overcapacity is predominately tied to existing mortgage bankers. There are still a large number of brokers trying to convert to a mortgage banker model, and this is fueling the businesses of warehouse lenders that support this market niche.
However, warehouse lenders need significant management to handle the broker-to-banker business. Many warehouse lenders serving newly converted bankers are being overwhelmed with activity — one of our clients currently has upwards of 200 banker applications. The relative inexperience of this client group is actually causing some warehouse providers to hold off altogether, because of the requirements for reporting and managing these lines can be burdensome.
THE ENTRANCE OF LARGE CORRESPONDENTS
Currently, many large commercial banks are either huge mortgage originators or have stayed away from the business altogether. There are also a number of commercial banks that have wholesale or correspondence channels that are buying and selling loans. We’re now seeing some of them explore the warehouse business after receiving calls from other banks needing funds and are choosing not to go to other warehouse lenders.
There are several reasons why large mortgage players and investors are looking at facilitating their own warehouse lines. The primary reason is that they can reap the profits of the warehouse business while solidifying their relationships in the production channel. For banks that are trying to buy loans, it’s of significant value to point out that they can also warehouse. They are interjecting themselves into the warehouse stage of funding in order to further solidify their relationships and drive more production through their doors.
The warehouse sector faces significant obstacles to growth, but has been strikingly resilient as the mortgage winds change. For example, the simple fact that small warehouse providers are considering alternative products is testament to how focused they are on maintaining profits. Warehouse lenders could also help stimulate the return of private capital by focusing on non-QM loan products, as their better yields whet the growing appetite for such loans.
Assuming lenders can find and serve borrowers whose factors place them outside the QM sphere, yet still represent safe credit risks, we may see attention from the investment community that could help the housing industry’s continued recovery.
In the days when most vehicles had carburetors, you had to watch the relationship between air and fuel in order to make the engine perform correctly. There was a knob on the dashboard called the “choke” that you pulled out to make the mixture richer in fuel when you started the motor, then you eased that back when the motor warmed up.
Chokes eventually became automatic and disappeared when fuel injection became the standard, so people don’t often think about the importance of balance between the two any longer.
It is an apt metaphor for our industry these days: in order for the entire system to work properly, we need to balance warehousing capacities with lending needs. If we don’t, the industry loses money as efficiency drops.
If warehouse lines are indeed the industry’s oxygen, I don’t anticipate we’ll experience a shortage of air supply in the near future, in spite of some of the challenges I mentioned above. But maintaining a healthy climate for liquidity depends almost entirely on the dynamic balancing act that takes place between mortgage bankers and warehouse providers. In an environment that never stays the same, the industry can’t afford to take air quality for granted.