Christy Moss, CMB, and Ken Logan, CMB: Reps and Warrants Relief Key to IMB Liquidity Strategies

Christy Moss, CMB, is Head of Sales and Marketing with FormFree, Atlanta; she can be reached at cmoss@formfree.com. Ken Logan, CMB, is Principal of Logan Build Serve, Canton, Ga.; he can be reached at Ken@loganbuildserve.com.

Our industry’s historic boom cycle promises to keep lenders on their toes well into 2021, creating growth opportunities that could catapult some to new heights of market dominance and even to IPOs. That said, there is more to spinning today’s volume into gold than efficiently originating high quality loans. For independent mortgage banks, the name of the game is liquidity. Lenders with an eye and a taste for transformative growth are equally attentive to their liquidity strategies, including how their origination practices impact liquidity now and after the current cycle ends.

Specifically, one key aspect of liquidity management relates to the “come from behind” type risks. One of the largest of these unexpected claims on cash has historically been repurchase and indemnification demands, most particularly directly and indirectly from the GSEs, and usually months or even years after loans are sold into the secondary market.

Following GSE guidance around reps and warrants relief opportunities is one cost-effective and significant way to mitigate this potentially business-ending risk. Typically viewed as a path to mitigating loan manufacturing risk, reps and warrants relief also creates a ripple effect of benefits to lenders, allowing them to protect and maximize their financial resources for the future.

The good news is that, today, lenders have an array of investor-approved data validation tools at their fingertips for key underwriting elements including asset, employment, income and collateral valuation. When used as required by investors, these tools allow lenders to receive reps and warrants relief that significantly reduces that “come from behind” risk, and just as importantly, frees them to lean into long term growth.

Although the upside of reps and warrants relief may seem minimal in an environment of heightened loan volume and credit quality, industry veterans, investors and warehouse lenders know that any degree of residual risk tolerated by a lending business is its Achilles Heel. That’s why reps and warrants relief can be a significant liquidity management tool, powerfully affecting a lender’s liquidity on four mission critical fronts: loan loss reserves, warehouse lines, strategic opportunities and overall business valuation.

Exploring these in greater detail helps make the case why mortgage lenders, and IMBs in particular, should focus on expanding their book of business protected by reps and warrants relief.

First, every time a lender manufactures a loan unqualified for reps and warrants relief, they must shave off some profit and put it in a bucket for the possibility that something fails, and the investor may eventually come knocking to require a buyback. As lenders increase their book of business with reps and warrants relief, they also decrease the percentage of their required loan loss reserves.

Remember, loan loss reserves are meant to be sequestered resources – essentially a bucket of cash with a sign saying, “Don’t Touch.” No matter the need, loan loss reserves are supposed to be funded reserves for future claims, with that amount of cash effectively “off limits” for other uses. An unfunded reserve account is practically useless when it’s actually needed in the future.

Since on balance sheet loan loss reserves are meant to be legitimately analyzed and adjusted regularly, some warehouse lenders rightfully discount reported unrestricted cash by the amount of the under-funded loan loss reserves for covenant compliance calculations. This recognizes the simple reality that if, and when, a repurchase claim has to be paid, cash has to be wired out to clear that claim, which would clearly have to come from unrestricted cash on hand at the time. More than one lender has gone out of business in the past because of overwhelming repurchase demands they couldn’t pay.

Lenders that increase their rep and warrant relief are decreasing their loan loss reserves set aside, allowing them to put more operating capital back into their business. With that additional unrestricted capital, they can hire more staff, invest in technology, engage in strategic transactions and/or improve their pricing to be even more competitive.

After minimizing loan loss reserves, the second element of a lender’s liquidity equation impacted by reps and warrants relief is maximizing their warehouse lender relationship. The lifeblood of a broad majority of IMBs, warehouse line capacity dictates a lender’s capacity to fund their current operation and also handle spikes in volume. When warehouse lenders see that an IMB’s prior loan production has components of meaningful reps and warrants relief, they are more willing to extend incremental capacity to the lender because the “come from behind” risk is reduced.

For example, if a mortgage lender requests a $25 million warehouse line increase this month, the likelihood that the warehouse lender will agree is influenced by their perception of the mortgage lender’s risk. Even though the mortgage lender may be somewhat tight on cash because of the current production environment, warehouse providers tend to be more likely to extend their line knowing that the IMB will have less future risk on loans that have reps and warrants relief.

Additionally, in terms of current liquidity and using the line effectively, whether set for purchase by the GSEs or aggregators, investors will generally purchase loans off warehouse lines quicker because they don’t have to go back and revalidate or manage that credit risk. The reps and warrants relief has taken that off the table for them.

Thus, by using investor-approved tools to validate borrower and collateral data, lenders that minimize these risks can not only retain more operating capital but also leverage their warehouse line capacity more effectively as needed.

A third facet of lenders’ liquidity management strategies impacted by prioritizing reps and warrants relief is the pursuit of specific growth options. As most IMBs are experiencing their highest volume and profits ever in 2020, many will seek to capitalize on their success by exploring IPOs, looking to be acquired and/or make strategic acquisitions of their own to gain further scale that will be a key to success when this current volume surge subsides. Understandably, they are trying to make these highly strategic moves while at the top of their game.

Smart money buyers, however, know volumes will drop at some point and firms with lower “come from behind” contingent liabilities are always much more attractive and worth a higher valuation. This alone is a very smart reason to explore any tools that can reduce this historically significant valuation risk.  

Lenders may avoid a few origination hurdles today by disregarding reps and warrants relief options, but the cascading effects have an impact on liquidity that can limit a lender’s growth options at key times. Like right now.

One of lenders’ most productive liquidity strategies is simply to manage their risk. And one of the ways to mitigate this risk is to originate with reps and warrants relief as the goal. When lenders manage their risk appropriately, they improve their liquidity position, putting themselves in a better position to seize the opportunities offered by future market shifts.

If a lender is still on the fence about the importance of reps and warrants relief, they need to ask themselves: 1) would my business benefit from having more funds tied up in loan loss reserves; 2) would my business be able to handle a further spike in volume with its current warehouse line capacity; and 3) would my business financials look better if we produced some incremental volume today, but had a riskier book of business in the future in exchange?

Lenders with an eye and a taste for growth opportunities, and the wisdom to achieve it, know the answer to each of those questions is no.

To summarize, reps and warrants relief emerged in response to our industry’s focus on loan quality, with the desired effect of raising standards across the board. The net result has been that every player in the chain cares about the risks that lurk in loans originated without qualifying for reps and warrants relief.

Lenders now have several tools available to improve liquidity and improve their strategic opportunities by securing reps and warrants relief on as many loans as possible.  Getting in the habit of using those tools can be a significant boost to your long-term liquidity and competitive advantage.

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)