The inside line on warehouse lending.

THE INSIDE LINE ON Warehouse Lending

With more and more new companies being added to the roster of
mortgage lenders, and with demand for warehouse credit lines growing, we
decided an assessment of warehouse lending was in order. We initially
set out to determine why so many small, new mortgage companies were
having difficulty establishing credit lines. The investigation took us
through a maze of procedures and regulations.

The inquiry involved contacting 14 warehouse lenders from various

parts of the country. Unfortunately, most of them requested that the
discussions be kept confidential because they did not want to reveal
their specific requirements. This article is a compilation of those
discussions and what was gleaned from them.

Representatives of the following warehouse banks were interviewed:

First Bank National Association, Minneapolis; First Collateral Services,
Walnut Creek, California; First Fidelity Bank N.A., Newark, New Jersey;
First Interstate Bank of Denver; First National Bank of Chicago; First
National Bank of Louisville; First Pennsylvania Bank N.A., Philadelphia;
Greenwich Capital Financial, Inc., Irving, Texas; Marine Midland Bank N.A., Buffalo; MidAtlantic
National Bank, Edison, New Jersey and Peoples
Westchester Savings Bank, Hawthorne, New York.

The experience of these companies as warehouse lenders is

categorized as follows: five had under five years, five had ten to
twenty-five years and one had more than twenty-five years. The total
number of warehouse customers they serve ranges widely: one has less
than fifteen customers, three have fifteen to twenty-five customers,
four have twenty-six to forty, two have more than forty and the
remaining lender declined to identify its customer count. In one
warehouse lender's attempt to locate banks with which to
participate, the lender was able to identify only fifty other lenders in
this field. Other interview participants confirmed that warehouse
lending is done on a limited scale.

Warehousing is defined as the extension of a short-term, secured

line of revolving credit from a financial institution to a mortgage
banker that enables a mortgage banker to fund and inventory loans until
they are delivered to a permanent investor. Other terms that substitute
for warehouse lending include asset-backed lending, inventory financing and revolving credit. An
expanded definition includes other types of
short-term arrangements. Some warehouse lenders provide "within
line allocations" that allow a portion of the credit line to be
used for servicing acquisition loans, repurchasing facilities,
foreclosure processing, principal and interest advances on modified
pass-through securities, construction financing, commercial paper
back-ups or general working capital needs. In addition, there are some
warehouse lenders who offer custodial and deposit/cash management
services.
Background

Following World War II, the housing industry entered a boom period
that brought mortgage bankers into the limelight as a major force in
mortgage finance. However, because of the industry's limited
capital positions, warehousing was developed as an alternative means to
support the consumer's need for financing. Initially, warehousing
was done with FHA and VA loans and lenders required fully documented
loan packages prior to funding.

Historically, warehouse lenders followed the negotiable instruments body of law. Subsequently, the
Uniform Commerical Code (UCC) was
utilized to govern warehousing practices and procedures. During the
transition, the lack of continuity between the two sets of legal
requirements left some lenders in unsecured positions, because they did
not control the collateral or have the proper documentation. In
addition, the secondary market became a more significant factor; its
volatility in the 1970s and early 1980s increased warehouse
lenders' risks.

These events caused a re-evaluation of the industry's

warehouse lending structure as lenders implemented procedures to comply
with the UCC. As a result, methods were developed for stricter control
of the collateral and the funds advanced. Before these changes, a
mortgage banker could deliver the collateral to a take-out investor and
then send the funds to the warehouse bank. The new UCC procedures
eliminated the mortgage banker's control over these items. No
longer would the mortgage banker be the middle man; instead, the

warehouse bank and the take-out investor would deal directly with each
other. The lender's control over these functions remains a vital
concern today, because some warehouse banks view the return of the
collateral documents to the mortgage banker as moving them from a
secured to an unsecured lending position.

Types of arrangements
There are three types of short-term, secured lending. Direct
warehousing is the extension of credit on a loan-by-loan basis from a
lender to a mortgage banker. Participations involve a direct (or lead)
warehouse bank soliciting other lenders to participate in the credit
arrangement once the direct bank has reached its legal or policy lending
limit. Each participating bank investigates the mortgage banker (as well
as the lead bank's operational capacity to handle the collateral
and quality control procedures). If the review is satisfactory, a
participation agreement is entered into with the lead bank. Participants
deal directly with the lead bank, not the mortgage banker. A third type
of lending is warehouse pooling or syndication. Under this arrangement,
several warehouse lenders provide credit to the mortgage banker who
individually negotiates a price with each bank. One bank is appointed
the agent (or lead) bank for the collateral, and each bank receives a
pro rata interest in the entire collateral pool. Almost all the lenders
we interviewed engaged in participations and pooling.

Interest rate risk is the warehouse lender's primary risk, but

inadequate loan documentation, delinquencies, foreclosures and the

mortgage banker's potential for cash flow problems pose additional

risks. The cushion between the mortgage banker and the warehouse lender
is the mortgage banker's net worth; most lenders use it to
determine leverage ratios.

Management of the credit line is important because the mortgage

banker's capital position is usually small compared to his credit
needs. The early 1980s provided many examples of poorly managed mortgage
banking operations that became fatalities, as capital dissipated during
periods of rapid and severe interest rate fluctuations. To protect
themselves, most warehouse lenders require evidence of a take-out
commitment prior to funding, thus ensuring that a line advance will be
paid down without relying on the mortgage banker's capital.

To minimize risks, a warehouse lender looks at delinquency and

foreclosure statistics, the mortgage banker's market positions and
operating results (over several quarters), changes in senior management,
the company's growth, changes in marketable loans and compliance
with the warehouse agreement. Excessive delinquencies are among the
indicators that the warehouse lender uses to identify potential
problems.

The customer

Not surprisingly, warehouse lenders want to deal with financially

sound, profitable companies with competent, experienced management that

originate quality loans and prudently market them. Many require mortgage
bankers to service as well as originate loans.

The focus for the initial review of the

mortgage banker's
operation is its management. This is
done through an examination of the
principals' resumes, and the company's
history and financial
information to identify its capital base
and financial performance.
Usually, three years of audited financial statements are required to
determine if consistent, increasing profitability exists.

Seventy-three percent of the warehouse lenders we polled require

three years of audited financials; yet one required none. Minimum net
worth requirements ranged from $250,000 to $2.5 million; again, one had
no minimum requirements.

If this phase of the review is satisfactory, the mortgage

banker's list of references is checked to assess the firm's
reputation and determine whether or not the referenced relationships
have been satisfactorily maintained. Evidence of applicable operating
licenses, insurance coverages and agency approvals also are obtained,
and a UCC search may be conducted to identify any existing encumbrances.
Upon completion of this step in the customer assessment, most warehouse
lenders perform an on-site interview with management to review the

mortgage banker's operation. Such visits and discussions help

develop a feel for quality and build trust. Several of the lenders we
talked with indicated they conduct quarterly or even monthly on-site
visits to examine such things as: earning trends, balance sheet ratios,
servicing portfolio growth, delinquency ratios, other credit lines,
position reports and the age and liquidity of the warehouse inventory.
This analysis is deemed important to help the lender gain an
understanding of the mortgage banker's approach to risk management
and secondary marketing. The absence of real estate owned and unsalable mortgage products serve
as indications that the mortgage banker is
generating quality loans. Another quality control measure is a review of
the mortgage banker's take-out investors. All lenders we polled
reserve the right to approve these investors.

One of the final functions is the leverage calculation. It is done

to separate hard assets from intangible assets, while simultaneously
giving the mortgage banker credit for his servicing portfolio. The
primary leverage ratios are: total available lines plus liabilities,
divided by tangible net worth, and total available lines plus
liabilities, divided by tangible net worth plus the net present value of
the servicing portfolio. Standard ratios range from 10:1 to 25:1 for the
first calculation and from 10:1 to 15:1 for the latter. Variations are
allowed depending on the mortgage banker's product line and
approach to secondary market risk.

The mortgage banker's capital base helps determine the size

and cost of the warehouse line. Cash flow projections help identify
peaks in the mortgage banker's lending cycle. This is important
because the warehouse line must accommodate the mortgage banker's
highest production levels. The mimimum lines of the majority of the
lender group we polled ranged from $1 to $3 million; one had a $20
million minimum and two others had no specific minimums. Maximum line
extensions usually ranged from $13 million to $75 million, with one
lender at $200 million and another having no maximum.

Overall, trust and knowledge of the mortgage banker are the

warehouse lender's primary concerns. Doing business with a mortgage
banker who speculates on the market usually results in adjustments to
the credit decision. In addition, such items as the mortgage
banker's markets, the size of his servicing portfolio and
compensating balances are factors that can influence the warehouse
lender's approval process.

Most of the warehouse lenders we spoke with use the prime rate plus
a margin to determine their lending rates. Others use certificates of
deposits, the London Interbank Offered Rate (LIBOR) or cost-of-funds
indices plus a margin. The warehouse lenders we interviewed set margins
ranging from 0 to 2.5 percent. Although most of them did not charge
warehouse line fees, some indicated that commitment, non-usage and
custodial fees could be applicable. Occasionally, these are assessed to
encourage usage and to compensate the bank for making the credit
facility available. Some lenders give credit for escrow balances and

allow a buydown of the rate.

Documentation

Once a mortgage banker is approved, the following documentation is

needed to establish the warehouse line: a warehouse line agreement, a
master note and/or security agreement, UCC-1 financing statements,
corporate resolutions and personal guarantees, if possible.

The collateral securing a line of credit should have a market value

in excess of the funds borrowed, so that if a default occurs, the sale
of the collateral will be sufficient to satisfy the outstanding credit
line.

The original loan package - credit and appraisal documentation - is

the collateral. (The funding package usually consists of a note,
mortgage or deed of trust, assignment, evidence of various insurance
coverages and a take-out commitment letter.) Some warehouse lenders do
"wet funding" advances made solely on receipt of copies of the
funding package documents. The majority of the warehouse lenders we
surveyed, approximately 55 percent, did "wet funding"
advances: the original documents are forwarded with the completed
package. Regardless of when the funding documents are received, the note
must have a blank signed endorsement and a blank assignment must be
filled out in recordable form. Most warehouse lenders believe it is
impractical to record every mortgage assignment; as such, blank

assignments are required. Recording an assignment is done only in the

event of a default.

One- to four-family residential loans are normally warehoused an

average of 45 to 65 days. It is an obvious benefit to the mortgage
banker to move his inventory out as quickly as possible to free up his
credit capacity. Furthermore, all of our lender sources have maximum
periods that a loan can be warehoused. Most range from 70 to 180 days;
extremes in both directions were 30 to 360 days.

Funding

All warehouse lenders require a funding package containing a

minimum loan documentation prior to an advance. A list of these
documents is normally specified in the warehouse agreement. In addition,
some agreements stipulate that advances are approved only on loans with
take-out commitments. Documentation required for an advance usually
includes the mortgage note, a certified copy of the mortgage or deed of
trust and an assignment. Although almost all lenders require evidence of
the take-out commitment and a bailee letter, others require some or all
of the following: a title policy, trust receipt, UCC filings,
truth-in-lending disclosures, HUD-1, evidence of agency guarantee or
insurance, hazard and flood insurance and the mortgagors's loan
application. Some lenders provide advance request forms that must be
submitted along with the funding package.

According to the legal interpretations of some lenders, the UCC

stipulates that a bank has 21 days to take possession of a mortgage note
from the day of funding. In addition, there is a second 21-day period
that extends from the time the mortgage note is delivered to the
take-out investor until the investor submits the purchase funds or
returns the note. These lenders believe that they have a secured
interest in the mortgage during both of these periods. Of course, if the
note is not delivered, the advance is considered unsecured. Most of the
warehouse lenders we interviewed remit advance funds to the mortgage
bankers or the settlement agent.

Under the terms of one program, funding could be provided to the

settlement agent at the time of loan closing or borrowings could be made
based on a whole loan repurchase line of credit. A repurchase line
involves the delivery of a security to a dealer with an agreement to
repurchase it on a specified date. Upon receipt of the security, the
deal wires the haircut proceeds to the mortgage banker who in turn pays
down his line of credit. A "haircut" is the discount from 100
percent funding; it can be a percentage of the face value of the
mortgage or the take-out commitment price. Most lenders advance funds
using a haircut. Our warehouse lender group had haircuts between 0 and
10 percent with 2 percent being the norm. One lender requires a 25
percent haircut on foreclosures that occur.

Document custodian
Most warehouse lenders act as their own document custodians while

others use a third-party bank as the custodian for their line of

collateral. Automated tracking systems are utilized to monitor the
status of the required legal documents including investor take-outs.

Furthermore, some warehouse agreements have specific instructions

for delivery of the mortgage notes and other loan documents. They may
stipulate the means of delivery and the types of institutions to which
the documents can be delivered.

Various information is required by most warehouse lenders on a

regular basis. Pipeline, position and aging reports can be required
weekly or monthly; delinquency reports may be requested monthly or
quarterly. Annual audited financial statements are typically required,
although a few of the lenders we spoke with require financial
information as often as monthly. Warehouse lenders require prompt
notification of significant events involving changes in management
ownership, legal proceedings and similar material changes.

Warehouse lenders normally produce several reports on the lines

they have extended; they may focus on profitability, usage and
collateral tracking reports. These reports sometimes are distributed to

their line customers.

It seems relatively clear after this brief inquiry why

some

mortgage bankers are unable to obtain warehouse lines. A basic

understanding of the risks and variables involved - those of changing
interest rates, obtaining the collateral and extending credit to new or
poorly capitalized firms are among those that come to mind - lead some
basic conclusions about this area of the business. Knowledge, extensive
experience, a solid reputation and signficant net worth are major
prerequisites for securing a warehouse line of credit.

With mortgage companies continually entering and leaving the

market, a lack of tight guidelines and controls could result in
substantial losses to a warehouse lender if a mortgage banker were to
close his doors. To understand the restrictive environment of warehouse
lending - which we are told will continue - just look at the risks that
lenders take in regard to wet fundings. Nowhere else is the importance
of a trusting relationship with experienced management more prevalent
than in this scenario. A warehouse lender is putting full faith and
credit in his mortgage bankers by advancing funds on copies of mortgage
documents. This is one of many instances where the warehouse lender is
relying on the mortgage banker's track record and experience as
critical factors in the relationship. However, these items do not carry
tangible monetary value. Because most mortgage bankers have limited
capital, the warehouse lender is required to assume significant risks.

So, relationships are the key to warehousing. The success of a

warehouse lender's program depends not only on providing credit at
a competitive price, but also on providing prompt and quality service

for credit and non-credit services. A few "extras," we were

told, include notifying mortgage bankers regarding fraudulent or problem
take-out investors and facilitating the sale of a mortgage banker's
servicing. Warehouse lending is indeed a relationship business.

The bottom line appears to be that for the small, inexperienced mortgage banker looking for a
warehouse line of credit, the prospects
are dim. However, two of the warehouse lenders we interviewed indicated
they consider start-up shops if the principals have strong backgrounds.
The lenders we polled stressed the importance of the mortgage
banker's careful, dedicated involvement throughout his business
dealings - a good reputation is a must. Although there are wholesalers
who will table funds for these originators, the capabilities of a
warehouse line would probably be welcomed by most originators. They
should establish their banking relationships with this in mind and as
they grow, their banker should become an even more important part of
their overall operation. After an originator has repeatedly proven his
"worth," it is likely that a warehouse lender ultimately will
go out on the credit limb for him.

Thomas S. LaMalfa is president of Asset Backed Capital Research,

Inc.., Cleveland.

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