BLOG VIEW: Mortgage bankers have long enjoyed the benefits of leverage via warehousing facilities. In fact, residential mortgage banking may be the most highly leveraged industry in America. Almost all warehouse lines allow at least 15 times the net worth in actual debt outstanding, and many companies have combined facilities that represent far more than this in terms of funding capacity. The high quality and liquidity of the mortgage loan collateral makes this possible. Competition between banks has resulted in incredibly favorable pricing on warehouse facilities. Abundant and cheap warehouse facilities have almost become an entitlement in the minds of many mortgage bankers.
Is this too much of a good thing? Perhaps. Let me explain.
Warehousing leverage has allowed a lot of mortgage companies to post eye-popping return on equity over the years, particularly in the environment prior to the financial crisis when folks tended not to retain a lot of earnings in their companies. There was no incentive to do so, as counterparties didn't demand it (as they should have), and so owners distributed well in excess of the amounts necessary to pay taxes. To be blunt, even marginal operators could do quite well with earnings relative to capital simply because the leverage provided by their warehouse lines bailed them out.
In our experience, most successful mortgage bankers know how to drive loan volume but have never really thought much about utilizing leverage other than warehouse lines, much less having a complete capital plan for their companies – yet they should.
In recent years, the game has changed, as counterparties (government-sponsored enterprises, investors and warehouse lenders) have upped the ante on required capital and liquidity, and companies retaining mortgage servicing rights (MSRs) face a liquidity shortfall due to foregone servicing release premiums. And the pipeline hedging programs that are so common these days also put demand on liquidity, due to timing issues on pair-offs and margin calls. Finally, quite a few larger firms are seizing the current opportunity to expand their origination operations by adding retail branches or through wholesale and even correspondent channels.
What are the options for adding the necessary capital to fuel these activities? The most likely options are as follows:
- ‘Friends and family’ loan (F&F);
- MSR financing;
- Mezzanine capital placement; and
- Equity issuance.
For some mortgage bankers, particularly small firms, F&F money may realistically be the only option. However, our observation is that business is business and is best kept separate from close personal or family relationships. If F&F is the only option, our guidance is to hire a good lawyer and document the deal as if with a third party.
Particularly for those mortgage companies retaining a high percentage of the MSRs they create each month, the need for cash can be significant. The gain on sale recorded when MSRs are capitalized may result in healthy-looking GAAP earnings, but again, this is a non-cash entry. We are now observing quite a few firms that have the ability to generate loan volume and, thus, additions to their MSR portfolios that outpace their ability to add liquidity through retained earnings.
The first solution is to obtain MSR credit facilities, if possible, as this is the cheapest leverage available. To date, funding sources have been limited and terms are not nearly as homogeneous as warehousing. Our firm has partnered with Customers Bank to create true long-term MSR financing with a duration closely matching the asset and other terms that maximize the leverage while minimizing margin call risk and other negatives. We were able to get quite a few of these facilities in place for clients in 2014, and we are busy assisting other folks in the first quarter of this year.
Although MSR financing arrangements may represent the cheapest way to address liquidity, other avenues of adding cash may be available and necessary. For one thing, the advance rate on MSR facilities is not likely to exceed 60% of fair value. Further, for firms with less than approximately $10 million in net worth, MSR financing is likely not available at present. Finally, even the largest independent mortgage firms may need to add to their capital stack to convince their existing MSR lender to add capacity to their line. We believe the best alternative for such companies will be adding mezzanine capital, either subordinated debt or preferred stock. Although more expensive than MSR debt, mezzanine capital is still far cheaper than equity and, thus, should be accretive.
Mezzanine capital is also likely the best alternative for mortgage bankers needing capital for expanding loan origination channels, including acquisitions. We believe there are significant opportunities for such growth in the current marketplace as consolidation of the industry continues apace.
Issuing new equity (common stock) or selling a portion of previously issued shares is likely the last alternative mortgage bankers will want to consider in scenarios where the existing ownership wishes to remain in control. In our experience, there tends to be a significant divide between what mortgage bankers think their shares are worth and what sophisticated investors are willing to pay.
Some of this is just human psychology (‘I worked hard to build this company, and it is pretty!’), but the real issue is typically that sellers have an idea of best-case pricing on sales of entire companies and don't realize that non-control investments just don't price out the same way. Non-control investors rarely are willing to pay much if any premium over book value, which results in immediate dilution of current owners – expensive new capital indeed. Nonetheless, this can be a viable alternative, particularly if the new partner brings skills or contacts valuable to the firm.
Capital raises don't happen in just a few weeks, so don't delay – get started on your capital plan now.
David Fleig is president and CEO of MorVest, an investment firm focused on providing capital and strategic solutions to mortgage bankers.
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