Forward flow arrangements: a viable alternative to warehouse financing structures as a means of funding mortgage loan origination?

IN BRIEF...

One of the key decisions for any new entrant to the mortgage lending market is how to fund the crucial early phase of origination. Without the backing of deep-pocketed investors able to provide the capital needed to originate and service a sizeable volume of mortgage loans, new originators have traditionally opted for warehouse financing as a preferred method of funding. A notable recent trend, however, has been the emergence of forward flow arrangements as offering a viable alternative. This note looks at some of the features of both forward flow and warehouse financing structures from the perspective of a new originator and considers why forward flow is gaining traction.

Even though forward flow arrangements tend to be quite bespoke and done privately, it is possible to offer an insight into some common structures and terms that have recently been observed. Whilst the following commentary enters on mortgage lending, most of the principles can be applied (with tailoring) to the funding of other assets such as receivable flows and financial assets.

STRUCTURAL OVERVIEWS

In terms of structure, a forward flow arrangement typically involves an outright purchase by the funder of loans that are advanced by an originator in accordance with eligibility criteria. Beneficial and economic interest in the loans are transferred to the funder on day one with legal interest only tending to pass following trigger events linked to the originator’s or servicer's performance and creditworthiness. This phased transfer of legal and beneficial title to the mortgage assets is consistent with securitization and warehouse financing transactions where receivables are sold to the special purpose vehicle (SPV)without initially notifying the underlying debtors. In fact, from a customer's perspective, there is very little difference between the loan being funded by way of forward flow compared to a warehouse structure or refinanced by way of securitization.

The funder in a forward flow typically funds 100 percent of the loans which meet the eligibility criteria, thereby not requiring the originator to commit its own funds or involve a junior funder. The prospect of being able to kick-start origination without using its own funds is likely to be appealing to new originators and their shareholders. Funds are typically advanced to the originator as often as weekly or fortnightly and can be sized according to the originator’s pipeline meaning that they can track the originator's speed of growth and any seasonal fluctuations. The originator is' pre-funded' with the amounts needed to complete on its pipeline, often with an additional buffer to smooth out any unexpected changes. As soon as a loan is originated, which may be daily, it is sold and transferred to the funder and related security is assigned, at which point the loan sits on the funder's balance sheet.

Warehouse financing on the other hand typically involves the provision of a loan or variable funding note by a single lender or small group of funders on a limited recourse basis to a special purpose vehicle and secured on a portfolio of assets acquired by the SPV from the originator in accordance with eligibility criteria.

Funders in a warehouse financing typically fund a proportion of the loans based on a borrowing base calculation, which can often be complex - this leaves the balance to be funded by the originator via a subordinated loan or note or by a junior funder. Drawdowns generally occur less frequently than under a forward flow and are invariably in larger minimum amounts. Warehouse financings are often structured with a revolving period, allowing for loans and related security to be sold and transferred by the originator to the SPV on a recurring basis during that period. A senior facility also usually allows the SPV to manage its level of borrowing and costs by voluntary prepaying loans or notes as required, subject to prepayment tees or break costs. Once acquired by the SPV, the loans provide security for the repayment of the warehouse line and liabilities of other secured creditors.

TYPES OF FUNDER

From a funder's perspective, the on-balance sheet nature of forward flow can mean that they are better suited to non-bank entities able to commit a portion of their balance sheet without the same regulatory capital implications as would apply to bank funders. The bespoke nature of forward flow facilities can also prove potentially challenging. That said, forward flow arrangements can present an opportunity for bank and non-bank funders alike to benefit from an existing lending platform and quickly deploy capital into different markets and asset classes. It is perhaps not a surprise then that we are seeing increasing numbers of forward flow transactions at a time when platforms are a significant and growing distribution channel; according to the FCA's recent Investment Platforms Market Study, the market has doubled since 2013 from E250 billion to E500 billion of assets under administration.

RISK ALLOCATION

Forward flow and warehouse financing transactions have distinct risk profiles, which reflect the key difference between the structures: forward flow being asset purchase arrangements and warehouse financings being asset backed lending arrangements.

Forward flow involves the transfer of the economic interest in, and the credit risk of, the mortgage assets to the funder - usually subject to limited rights of recourse against the originator. The funder buys the newly originated loans at par together with an origination fee or premium, and in return assumes the performance risk of the portfolio and any resulting upside or downside. The fact that the ultimate credit risk of the assets sits with the funder has a bearing on provisions within the documents- such as the limitations that may apply to the originator’s liability in the event that asset level representations and warranties are breached. In short, origination risk generally remains with the originator while credit risk generally shifts to the funder.

Warehouse financings by contrast tend to see a more balanced allocation of risk between originator and funder. Both funders and originators look to the performance of the mortgage assets for their economic return: for the funders, this is their receipt of interest and principal (in addition to arrangement, commitment or other fees); and for originators, their receipt of interest and principal on the subordinated loan or notes as well as any residual value in the mortgage assets once the funding transaction ends. This different allocation of risk between the parties will again have a bearing on the negotiation.

ECONOMICS FOR THE ORIGINATOR

The economics for the originator vary considerably between the two structures. A forward flow enables an originator to use the funder's balance sheet to originate loans in return for receiving origination and servicing fees. Origination fees will often be a percentage of the initial principal advance of the mortgage loan with an additional percentage payable as deferred consideration if the mortgage assets satisfy performance targets. Servicing fees will usually be a percentage of the outstanding principal balance with higher fees applying to the servicing of defaulted or delinquent assets. For the funder, the yield is likely to be higher than if they were to provide aware house line given the greater credit risk being taken on.

A warehouse financing by contrast enables the originator to borrow against a pool of loans to fund new origination for which the funder will charge fees and interest. Borrowing costs of a warehouse facility will depend on a number of factors. For example, for funders subject to regulatory capital requirements, having the senior loan or notes rated will tend to result in lower capital charges which may feed through to cheaper borrowing costs. Obtaining ratings on the senior loan or notes will however have to be weighed up against the time and costs associated with the rating process. In addition to borrowing costs, the originator will also need to have the necessary capital available to fund a subordinated loan or note in order to bridge the funding gap and (depending on the regulatory status of parties) also satisfy risk retention requirements. The absence of risk retention requirements in a forward flow structure will be a major selling point from a new originator's perspective.

The funder (in the case of a forward flow) and originator (in the case of a warehouse financing) can use the transactions as a stepping stone to a public market refinancing of the loans and an opportunity to potentially access cheaper funding. The transition to a securitization or other ABS transaction will likely prove easier from aware house given the architecture and documentation involved but remains an achievable exit option for funders of a forward flow too.

FOCUS ON THE UNDERLYING ASSETS

A key similarity between the transaction types is (not surprisingly) the focus on the underlying assets - including the manner in which mortgage loans are brokered, underwritten, originated, serviced and how they perform.

These areas will be the subject of extensive legal, commercial and operational due diligence at the outset and will also influence the representations and warranties given by the originator as to its business and the underlying loans. Funders in either structure are likely to require a granular level of reporting to monitor performance of the assets, in addition to audit rights allowing them to take a closer look at the performance of the key business functions and processes. They are also likely to want tight controls over the origination and servicing of the mortgage assets, including consent rights with respect to changes to the eligibility criteria or amendments or waivers of terms of the underlying mortgage contracts.

The servicing of the mortgage assets will also be a key area of concern for funders - this is particularly the case in a forward flow context or where regulated mortgage assets are being funded, given the possible ramifications for failing to comply with consumer credit and mortgage laws and regulations such as the CCA or MCOB. Originators should also expect detailed covenants and warranties in relation to the servicer and standby or back-up servicing arrangements to be required. Funders will also want to ensure that all documents of title in relation to purchased loans are clearly held on the funder's or (in the case of warehouse structures) the SPV's behalf and that all solicitors’ valuers and insurers acknowledge the funder's or SPV's beneficial interest in the assets going forward. Issues with either the primary or backup servicing arrangements are likely to lead to a 'stop purchase event' and bring a halt to the purchase arrangements until the issues with the existing servicer have been resolved or adequate replacements appointed.

The underlying loans will usually be the subject of ongoing portfolio testing to ensure that they comply with performance measures and concentration limits. A test failure will usually relieve the funder, on a forward flow, of any commitment to purchase further loans or, on a warehouse financing, lead to either an early amortization or acceleration of the senior loan or notes. Clearly, the early termination of funding arrangements will greatly impact the originator and its ability to service customers and so needs to be looked at closely during the negotiation. Other events leading to early termination of funding arrangements may include: change of control, loss of key persons, continuing breaches of covenants or warranties, the originator or servicer's loss of any regulatory authorizations which could affect the enforceability and collectability of the mortgage assets and insolvency-related events.

RECOURSE TO THE ORIGINATOR

A focus of negotiation between the parties will be the extent to which the originator remains responsible for any issues that arise in relation to the mortgage assets post-closing.

Originators in both transaction types will be expected to give detailed warranties on the mortgage assets including that the loans complied with all eligibility criteria on the date of their sale to the funder or SPV. The granularity of these warranties will be similar between the transactions and will be tailored to the specific mortgage assets involved.

Where loan warranties are found to have been breached, for example where the loan did not meet one of the eligibility criteria, the funder or SPV will often have the ability to require the originator to repurchase the affected loans. The types and materiality of the breaches that lead to a repurchase will be a point for commercial discussion. Particularly in a forward flow context, the originator will be keen to ensure that immaterial breaches are not used as away of enabling the funder to force a repurchase. Other repurchase rights may be negotiated and can include repurchases triggered by unauthorized amendments to underlying loan contracts or where loans have been originated or obtained in a fraudulent manner - positions that are also common in warehouse financings.

It is often the case that the ability of the funder to have recourse to the originator, either by requiring a repurchase or having a claim for breach of warranty, will be more limited on a forward flow transaction. For example, the originator’s liability may be subject to time and monetary limits and not cover change of law and certain other risks. Having sold loans to the funder, the originator will want to minimize any potential future claims or liabilities, particularly given its more limited economic return.

A warehouse facility by contrast may allow an originator to voluntarily repurchase loans where conditions are satisfied- for example, where doing so would help to remedy a portfolio test failure or allow the originator to refinance the loans on the public markets. This gives the originator added flexibility in the way that the assets are managed.

PRACTICALITIES OF GETTING THE DEAL DONE

A key factor for a new originator will be the cost and speed of executing the transaction.

In terms of initial and ongoing costs, forward flow is likely to be a more cost-effective option than a typical warehouse financing. A forward flow transaction will typically involve fewer third-party service and professional advisers given its less structured nature and absence of asp. There will also be fewer documents to draft and negotiate, which should help to keep down cost. The expense of establishing a warehouse facility may also sometimes be driven up by the funder's requirement to have the senior loan or notes rated, listed or cleared for regulatory capital, tax or liquidity purposes.

The speed of execution across the two transaction types will largely depend on the engagement and cooperation of the parties and level of due diligence that the funder needs to undertake on the originator, including for example on its underwriting and servicing policies and procedures.

CONCLUSION

Forward flow arrangements offer a viable means of raising funding for early stage mortgage loan origination. The right partnership between originator and funder can enable an originator to utilize the funder's balance sheet to start or increase its mortgage lending, whilst enabling the funder to leverage the originator's existing lending platform to quickly deploy funds into different markets and asset classes.