A consortium of independent mortgage bankers is pressuring the government to allow Fannie Mae and Freddie Mac to expand their activities into “warehouse lending.” Any policy that aims to reinflate the housing bubble is bad news, but this is more than that.
Independent mortgage banks rely on warehouse lending because, unlike big commercial banks, they usually don’t have their own capital to lend. An independent mortgage bank draws on a warehouse line of credit to make mortgage loans with borrowed money. The bank packages these loans, sells them to investors, repays the warehouse lender, and keeps the rest of the proceeds. Large banks and other financial institutions have curtailed their warehouse-lending operations in response to the financial crisis, and this represents a threat to the mortgage bankers’ business model.
But is that such a bad thing? The consortium of bankers, which calls itself the Warehouse Lending Project, points out on its website that the number of active warehouse lenders has fallen from more than 115 in 2005 to fewer than 30 today. But the site fails to mention that in 1996, there were only around 40 active warehouse lenders. The recent decline represents a return to the pre-bubble norm.
Warehouse lending took off during the housing bubble because lenders wanted in on the profits to be made in risky subprime, alt-A, and second mortgages. Wall Street’s appetite for subprime-mortgage-backed securities was unquenchable, and mortgage bankers developed a number of clever ways to keep originating such mortgages even after they ran out of credit-worthy borrowers. All you needed in order to get a loan, former mortgage banker Mike Garner told NPR last year, was “a credit score and a pulse.”
In retrospect, it’s easy to see how lending standards completely deteriorated in this environment. An article by Stanley Street on the rise of warehouse lending in the March 2006 issue of Mortgage Banking noted that the institutions rushing into warehouse lending were drawn by the high margins to be found in subprime mortgages, but they were ill equipped to manage the associated risks. Street wrote that “warehouse lenders are responsible for ensuring the integrity of their collateral. As a result, [they] must implement more complex processes and more detailed oversight of their product portfolios.” But that never happened. No one was paying attention to the quality of the loans.
The same banks that offered warehouse lines of credit often turned around and bought the finished product — the mortgage-backed securities. Tom Lindmark, a former banker with a background in real estate, says, “In the boom years the banks looked to the third-party originators to be their sales force.” The big commercial banks like Bank of America and Wells Fargo provided the financing on the front end and bought the securities on the back end, but the independent mortgage banks actually made the loans. The problem with this business model was that it outsourced due diligence to third parties that didn’t have skin in the game. They were under enormous pressure to keep making loans with other people’s money, so many let their standards slide.
This heedless expansion of credit is what led to the glut of consumer debt that has now exploded into a full-blown financial crisis. The contraction of warehouse lending is a natural correction to the excesses of the bubble years. Big commercial lenders are rightly wary of again outsourcing their mortgage-lending activities to the independent guys. Mortgage origination is returning to the traditional banking sector, where large banks put their own capital at risk. That is a trend we should welcome.
The last thing we should want is for the government to allow Fannie and Freddie to plunge into warehouse lending. Now that Fannie and Freddie have been seized by the government, the taxpayer is on the hook for all of their losses. The government should be winding down their portfolios, not expanding them. Turning them into warehouse lenders would subsidize the very business model that got us into the mess we are in today.
– Stephen Spruiell is an NRO staff reporter.