Mortgage Lenders - Behind the Scenes

AN INSIGHT TO HOW LENDERS LEND AND THEIR RELIANCE ON OTHER LENDERS

The vast majority of mortgage brokers assume that when they are working with a mortgage bank that they have ample or unlimited funds and that all quality controls and decisions are made in-house. This article is designed to give brokers a behind the scenes look at how mortgage banks operate, why many of the mortgage banks have gone under, and the importance of portfolio capital.

The Warehouse Line- The Lender’s Lender

Just about every mortgage bank has a warehouse facility, which is their line of credit they use to make mortgage loans to the end borrowers. These warehouse lines are provided by all levels of banks and every bank borrowers from other banks (i.e. – Bear Stearns shut down two of their funds due to the termination of warehouse facilities from Merrill Lynch). The terms and requirements of these warehouse facilities vary widely depending on the loan product, borrower type, and credibility of the mortgage bank. Typically, the warehouse lender will lend the mortgage bank 98-100% of the loan amount being lent to the borrower. This means that even the very large mortgage banks are not required to have substantial capital in-house. For example, a mortgage bank that funds $1 Billion per month would in most cases not be required to have more than $20 Million of their own cash in the company. As all major mortgage banks package their loans and sell them on the secondary market through securitization, these loans are typically only held by the Company for only 30-90 days. The warehouse line allows the mortgage bank to leverage their capital many times over, allowing them to participate in advantageous market conditions. However, in poor market conditions, the caveat on the majority of warehouse lines is that they may be terminated at will by the warehouse bank at any time without notice. This has been the root cause in most of the mortgage banks having to close their doors (see: MLN, Option One, CBASS, American Home, and about 90 others). When the warehouse bank pulls the credit facility of the mortgage bank, this incapacitates the mortgage bank from closing and funding any loans, thereby making them a lame duck and forcing them to close their doors.

Per an earlier article written by Gregory Freedman in the August 2007 edition of the Scotsman Guide, I addressed the vast liquidity coming from Wall Street that was fueling most of the mortgage banks. The underlying concept is that as fast as the liquidity appeared, resulting in rampant growth and profitability of these mortgage banks, we are now learning that this liquidity can disappear even faster. This is bad news for the mortgage industry as a whole and unfortunately, this is going to continue to get worst before it gets better.

Securitzation- Wall Street's Exit Strategy

As mentioned above, all major mortgage banks aggregate their loans and sell them off in securitizations (bonds), which are sold to institutional investors throughout the world with European and Asian investors being the largest purchasers. The securitization marketplace has been booming over recent years and has been an inexpensive and profitable outlet for mortgage banks to continuously re-leverage their capital. The number of mortgage-backed securitizations has doubled since 2004, however, earlier this year the subprime securitizations that were previously sold began performing very poorly with record figures of delinquency. This, combined with real estate valuations dropping, struck an ominous chord which has reverberated throughout the markets. The concern is that billions and even trillions of dollars of such mortgages that have already been originated would not perform as expected, this would cause a ripple effect throughout the market.

Well, this is exactly what happened. Securitizations as a whole have not been performing as originally forecasted and the investor demand to purchase these securitizations has diminished substantially. This halt in securitzation results in a clog of assets sitting on warehouse lines that now have nowhere to go, hence the banks ceasing new fundings.

This has forced many mortgage banks (even some of the biggest), to completely cease all new mortgage origination. They are also being required to liquidate the loans they hold on the books and due to the lack of liquidity in the market, there are only a few bidders and the prices being paid for these loans are at very steep discounts.

It should take about 6-12 months to weed out which companies will remain in business and which will have to shut down, but I will make a forecast that the number of lenders to “implode” will increase two-fold over the next year.

Portfolio- Can you say liquidity?

There are very few lenders that do not utilize warehouse lines or participate in the securitization marketplace. For a long time, these portfolio lenders have been the big losers in the mortgage space by not taking advantage of cheap leverage capital from other banks. Now, however, these lenders may end up being the only ones with any liquidity to actually close and fund loans in the interim until this mess works itself out.

Most portfolio lenders operate as a fund or partnership whereby their investment capital is committed for an extended period of time. Portfolio lenders may also have warehouse lines, however, these warehouse lines are typically also committed in a matching duration of the investment capital. This secures the portfolio lender ongoing capital, regardless of market conditions.

As portfolio lenders are seeking higher returns than the prime mortgage market, they are typically geared more towards the true sub-prime and hard money space. These portfolio lenders may end up being the only outlet for the low-fico and low-LTV loans on a go-forward basic.

Too many lenders who have relied solely upon the trickle down demand from foreign investors, that flowed through Wall Street and their warehouse lines, are now facing the unavoidable reality that the liquidity well has run dry - at least for the time being. Batten down the hatches and find yourself a good portfolio lender, this storm's going to be here for a while...