In recent years the demand for capital in the mortgage industry has increased significantly, as the GSEs, investors and warehouse lenders have upped the ante on required capital and liquidity, and companies retaining mortgage servicing rights face a liquidity shortfall due to foregone service release premium.
While arrangements to finance MSRs 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 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(s) 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. While 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. A term of five or more years and a stated interest rate plus some sort of contingent performance obligation would provide a lender with an enhanced yield should future operating results or MSR portfolio performance exceed agreed benchmarks.
Pipeline hedging programs almost universally in place these days also place a 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 correspondent channels.
Short of selling out to a parent with deep pockets, the avenues available by which to add the capital necessary to fuel these activities, the sources for funding are limited.
For some mortgage bankers, particularly small firms, loans from friends and family might realistically be the only option. Business is business and is best kept separate from close personal or family relationships, but if friends and family loans are the only option, 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. 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.
To the extent possible, obtaining MSR credit facilities is the cheapest leverage available. To date, funding sources have been limited and terms are not nearly as homogeneous as warehousing. When differentiating between providers, obtain a facility that permits draw down of funds as needed over a year or longer and avoid facilities that mature in one or just a few years in favor of a longer term loan that better matches the duration of your MSR asset. Also take care to review margin call provisions and seek some cushion before a cash payment to address loan to value would be required.
Issuing new equity (common stock) or selling a portion of previously issued shares is generally the last alternative mortgage bankers 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, 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, if the new partner also brings skills or contacts valuable to the firm, this can be a viable alternative.
Mortgage bankers have long enjoyed the benefits of leverage provided by their warehouse lines, but for many, adding additional sources of leverage has become increasingly important. The first step is to develop a sophisticated multi-year capital plan that projects future balance sheets (and therefore liquidity demands) in addition to future income statements.
David Fleig is president and CEO of MorVest Capital LLC.