We’re seeing early indicators of a shakeup over cash-poor private lenders. Now’s the time to secure your reserves.

Liquidity refers to the liquid assets available to a lender; basically, how easily and quickly they can access cash or cash equivalents to meet their short-term obligations. For a lender, maintaining liquidity is critical for several reasons.

First, it impacts operational efficiency. Lenders need cash on hand to fund new loans and cover operational costs. Insufficient liquidity can disrupt the ability to process and fund loans efficiently.

It is important to consider, for example, how insufficient lender liquidity could directly impact borrowers. A lender with liquidity issues might struggle to process and fund new loans promptly, leading to delays in disbursing funds as it pertains to rehab or construction draw requests.

This disruption could result in borrowers waiting longer than expected for their reimbursement of project costs/outlay, potentially causing them to miss important deadlines or financial opportunities. If the lender’s liquidity issues become severe, they may be forced to impose a stricter credit box, terms, or higher interest rates, further affecting borrowers’ access to affordable financing. The worst case is if the lender becomes completely insolvent, forcing them out of business, leaving existing borrowers without the ability to access or control funds and borrowers with closing deadlines scrambling to find a new lending partner.

Second, adequate liquidity allows lenders to manage risk better by providing a buffer against unexpected financial stress or market fluctuations.

Third, regulatory compliance is another reason liquidity is important. Some states that require lenders to maintain a license to transact certain types of loans may also require a minimum net worth. For example, California finance lender licensees must have a net worth of $25,000. An Arizona mortgage bankers license requires $250,000. Although this is not, strictly speaking, business liquidity (currently, there is no such stipulation), lenders should be aware of any analogous conditions.

Fourth, lenders with strong liquidity can take advantage of market opportunities, offer competitive rates, and react swiftly to changes in demand.

Liquidity, Risk, And Loan Buyback Issues

Different types of lenders interact with liquidity in various ways, each facing unique challenges and risks. Letís look at each type of lender in terms of liquidity needs and risks.

MORTGAGE LOAN BROKER AND THIRD≠PARTY ORIGINATOR (TPO).
Mortgage loan brokers and TPOs typically do not fund loans themselves. Instead they facilitate the process between borrowers and lenders; therefore, their liquidity needs are less about having cash to fund loans and more about maintaining enough capital to manage operational expenses and potential contingencies.

Brokers and TPOs rely on their partner lenders to provide the necessary funds. Hence, their liquidity impact is somewhat indirect; however, their ability to operate effectively can be influenced by the liquidity of the lenders they work with.

Since brokers and TPOs typically do not fund loans themselves, their risk is more about ensuring that the loans they originate are sold to lenders without issues. However, they may face reputational risks if the loans they originate are problematic.

CORRESPONDENT LENDER AND TABLE FUNDER LENDER.
Correspondent lenders and table funders either use a larger lenderís funds or provide their own capital at closing and then sell the loan to larger investors or aggregators. They need to maintain liquidity to fund loans before they can sell them, manage operational costs, and handle any delays in selling the loans.

If a correspondent lender struggles with liquidity, they might face challenges in funding loans promptly, which can affect their relationships with brokers and borrowers.

Correspondent lenders and table funders are at risk if they are unable to sell the loans quickly or the risk of loan buybacks if the loans they sell to investors do not meet the agreed-upon criteria or have underwriting deficiencies. Liquidity problems can exacerbate this risk if they struggle to handle buybacks financially or manage loan portfolios effectively.

DIRECT LENDER, BALANCE SHEET LENDER, AND WHOLE LOAN SELLER (GAIN ON SALE).
Direct lenders use their own capital to fund loans and hold them on their balance sheet until they are sold or repaid. They need significant liquidity to fund loans directly and manage their balance sheet effectively.

Direct lenders with robust liquidity can manage their loan portfolio better, offer competitive terms, and absorb market shocks. Conversely, those with liquidity problems might struggle with loan funding and servicing, potentially impacting their market position.

Direct lenders who sell to secondary markets or aggregators face the risk of buybacks if the loans they originate have underwriting or compliance issues. High liquidity can help mitigate this risk by allowing the lender to manage the impact of buybacks better, whereas liquidity constraints can make buybacks more financially stressful.

WHOLE LOAN PURCHASER.
Whole loan purchasers buy entire loans from other lenders or correspondents. They need liquidity to acquire loans and hold them until they are securitized or otherwise monetized.

For whole loan purchasers, liquidity is crucial for making timely purchases and managing their loan portfolio. Insufficient liquidity can hinder their ability to acquire new loans and affect their operational efficiency.

Whole loan purchasers are at risk if the performing loans they buy default or experience other quality issues. Subject to the contract between the purchaser and the original lender, the original lender may be required to buy back the loan. If the original lender is unable or unwilling to complete the buyback or the loan falls outside the buyback parameters, the purchaser may incur extensive legal fees and other costs. Additionally, there may be risks associated with a nonperforming loan that is packaged in a securitization or other secondary market resales. Adequate liquidity is essential for managing such risks and absorbing any financial impact.

Institutionally Backed Lenders Versus Balance Sheet Lenders

Institutionally backed lenders, who often handle large volumes of loans, face unique challenges.

Institutionally backed lenders typically have access to significant capital and can handle high volumes. However, the pressure to maintain liquidity (e.g., institutions may require lenders to have “skin in the game” against what they are willing to advance) and meet volume targets can lead to increased risks if they fail to manage underwriting standards or if market conditions change rapidly.

Balance sheet lenders, on the other hand, are lenders who rely on their own balance sheets and, therefore, may have fewer volume pressures but still need significant liquidity to manage their loan portfolios. They might face less immediate pressure but must manage their liquidity and risk exposure carefully to ensure long-term stability.

Misidentification Or Irresponsible Marketing

There are potential harms when lenders inaccurately market themselves as direct lenders using primarily their own in-house capital while maintaining little direct liquidity.

MISINFORMATION AND TRUST ISSUES.
If you market yourself as a direct lender but are primarily using third-party capital, borrowers may be misled about the stability and reliability of your lending operations. This can erode trust in your business and, more broadly, in the lending community as a whole.

IMPACT ON BORROWERS.
When borrowers believe they’re dealing with a direct lender, they might expect a higher level of service and financial stability. If youíre actually dependent on external capital, you might face challenges in meeting these expectations, especially if there are delays or issues with the funding source.

INCREASED RISK OF DISRUPTION.
Relying heavily on external capital with little of your own liquidity can make your operations vulnerable to disruptions if your funding sources face issues or withdraw support. This can lead to sudden changes in loan terms, delays, or even the inability to honor commitments, harming borrowers and potentially damaging your reputation.

REGULATORY AND LEGAL RISKS.
Funds that sell loans should be aware they have an obligation to disclose that they may sell loans. That being said, currently, there are otherwise no requirements to disclose to whom funds sell loans or how much of their capital originates from external sources.

LONG-TERM INDUSTRY IMPACT.
If such practices become widespread, they can undermine confidence in the private lending industry as a whole. Borrowers and investors may become wary of lending institutions, which could hinder the growth and stability of the industry. Accurate representation and transparency are crucial for maintaining the integrity and trustworthiness of the lending sector.

In summary, inaccurately marketing yourself as a direct lender when you’re reliant on external capital can lead to trust issues, borrower dissatisfaction, operational risks, regulatory challenges, and long-term damage to the industry’s reputation. For the betterment of the lending community, it is imperative we responsibly brand and act authentically in accordance with who we are and the degree to which we are capitalized to support our credit decisions.

Liquidity And Accountability

Although there isn’t an industry standard, “go-to” formula, or calculation on sufficient liquidity against obligations, you should proactively consider inquiring with both current and anticipated banking, credit facility, and/or family office relationships you may have on what liquidity reserves versus overall loan volume they recommend or are most comfortable with. The key is to remain humble and mindful that growth or scalability should not trump careful planning against risk. With any growth, the risk increases, so regularly recalibrating your “worst-case” scenario can help ensure you are not caught unaware even during periods of rapid scale.

Ask yourself: Am I prepared to buy back, hold, and service more than X% of my ill-performing portfolio? If the answer is no, you should prioritize raising more capital or capping your volume to where you can preserve your business and reputation despite losses.

For those more on the reactive side, there are some notable signs of liquidity imbalance. Increased delays in processing or funding your loans, tightening loan terms or raising interest rates, a drop in loan quality or an uptick in defaults, or frequently needing to access emergency funding or sell assets at a loss all indicate liquidity concerns are impacting your overall operations and accountability.

Liquidity is a fundamental aspect of lending, affecting various types of lenders in distinct ways. Each lender business faces unique liquidity-related challenges and risks, especially concerning loan buybacks. Institutional pressures and balance sheet constraints also play a significant role in managing liquidity and maintaining accountability. Understanding these dynamics is essential for lenders to navigate their operational environments effectively and manage the inherent risks of the lending industry.

Beyond these considerations, we also need to continue having open conversations around liquidity, accountability, and what best practices look like. Up to this point, it’s been every lender for themselves, but it doesn’t have to be, nor should it be, as the stakes grow higher and potential negative outcomes increase if lenders continue originating volume absent of adequate checks and balances.