Quintessential Considerations - Warehouse Lines of Credit

The world of finance can seem convoluted, perplexing, intricate, byzantine (and all the synonyms) to an outsider. Let’s be real, it is hard to navigate even for an insider. You hear technical terms in the news, on podcasts, and at dinner parties (don’t judge my social life!) and may feel an indescribable sense of “I should probably know this…”. So you do what you do best - you type it into Google. Unfortunately, that nudges you to take a leap of faith into a deeper web of despair and embedded links within embedded links…..

Here is my attempt at simplifying some financial jargon. I am offering a ‘top 5 things to know’ about each concept, but if you want to know more, refer to 6 Through Infinity below.

What is a Warehouse Line of Credit?

Tracking cash flow in a warehouse line of credit

At a high level, a warehouse line of credit is simply a loan given to companies (most often institutions that issue loans to borrowers like you and me). It is a way for said institutions to find capital to fund the loans they originate. Warehouse lines can have MANY different structures, terms, interest rates, and legal protections, but let’s try to understand the fundamental concept here:

Note: I will be using the term ‘borrower’ to refer to loan originators that are borrowing money from warehouse lenders. Consequently, I will be using the term ‘lender’ for the warehouse lenders.

1. Loans require collateral! Lenders need the reassurance that they will be paid back, and want recourse if a borrower defaults. So, here is what makes the warehouse structure elegant. (Remember note above: ‘borrowers’ here are companies that originate loans — auto loans, student loans, mortgages, anything really) Borrowers use their own loans as collateral for these lines of credit. Imagine a virtual ‘warehouse’ in which borrowers can store loans as ‘assets’. If the borrower doesn’t pay back the warehouse loan, she has to give up her ‘assets’. Loans should be thought of as assets because each loan is associated with a steady, monthly repayment of principal and interest which can be worth a lot!
2. Lenders have different processes in place to monitor the type and quality of loans that are being used as collateral. Not every loan is the same! A high-prime, secured, auto loan could be worth an 85% ‘advance rate’ (For every $1 of a high-prime loan warehoused, the lender will extend $0.85 of credit), while a more risky, subprime, unsecured loan may only generate a 60% advance rate (only $0.60 given to borrower for a $1 subprime loan in the warehouse). As an analogy — if you were taking out a regular loan, putting a fancy SUV down as collateral would get you a better rate than that dinky scooter. These terms are agreed upon during the negotiations for setting up the facility.
3. The repayment structure is the same as it is for any loan — monthly principal payments with interest. Unlike a loan, which you receive for a fixed amount, say $10,000, the warehouse facility offers a ‘capacity’ of, say $250,000,000. The borrower can use some or all of it - but in addition to the interest paid on the capacity used, a predetermined amount is also owed on the amount left ‘unused’. Let’s say in January, the borrower only needed $150,000,000 to fund loans. The borrower will then owe the lender x% interest for that $150,000,000 and y% for the remaining $100,000,000 for January. Money ain’t free!
4. Most warehouse lines are ‘revolving’. This means that the borrower can request funding up to that given capacity of $250,000,000 by putting assets (loans) in at any point. Using the example above, in January, the borrower added enough assets in the warehouse that she was able to withdraw $150,000,000. At the same time, remember that the borrower could have a different use for that loan - maybe she wants to sell the loan to a third-party? Maybe the loan was charged-off due to bad performance? She also has the ability to ‘remove’ an asset from the warehouse, in essence, repay the part of the loan attributed to that specific asset. So maybe in February, the borrower PAYS the warehouse lender $50,000,000 and withdraws the assets she wants.
5. Where do lenders get money from? Lenders usually issue commercial paper (short-term, unsecured promissory notes) to third-party investors to finance the warehouse lines of credit. As banks, they could also use their own capital, but through short-term financing from third parties, they can earn a levered return (at a very high level: using borrowed money to generate even higher returns).

6 Through Infinity: Warehouse Lending, Revolving Credit, Advance Rate, Commercial Paper, Levered Return