10 Real Estate Finance - Chapter 3: The Secondary Mortgage Market
Buying Loans
A real estate loan is essentially an investment just like stocks and bonds. The lender (whether a lending institution or private party) is the investor. The lender commits its funds to the purchase or construction of a home, expecting a return in the form of interest payments. And just like other investments, real estate loans can be bought and sold.
Issuing Mortgage-Backed Securities
A security (e.g., stocks and bonds) is a fancy word for an investment instrument. Mortgage-backed securities are simply investment instruments that have mortgages as collateral. A secondary market agency creates mortgage-backed securities by buying a large number of mortgage loans, pooling them together, and pledging the pool as collateral for the securities. The securities are sold to investors, who receive a return on their investment in the form of periodic payments (usually monthly) from the agency. Mortgage-backed securities can be easily traded. The secondary market agency obtains the funds to make payments to the investors from the borrowers' repayment of the mortgage loans that back the securities. Often the securities involve a guaranty so that the investor will receive the full monthly payment from the secondary market agency, whether or not payment has been collected from all of the borrowers.
Primary Mortgage Market
As I mentioned in a previous chapter, the mortgage market has a two-tiered structure. At the first level is the primary mortgage market, where lenders underwrite loans to borrowers seeking to purchase real property. Most home purchase loans are made by one of these types of primary lenders: Savings and loan associations Commercial banks Savings banks Mortgage bankers Credit unions Private lenders
Conforming to Standards
As we learned in the last chapter, a loan that meets Fannie Mae and Freddie Mac standards is known as conforming loan. The benefit of a conforming loan is that it can be sold in the secondary market. So, the creation of Fannie Mae and Freddie Mac (and the secondary market) helped usher in a standardization of mortgages. Lenders now had an incentive to create more conforming loans. That way, if the lender needed to liquidate their real estate loans, they could quickly turn around and sell them on the secondary market.
CMOs vs. CDOs
Asset-backed securities are the basic form of mortgage-backed securities. They are a pool of mortgages that are securitized by Wall Street. Collateralized debt obligations (CDOs) and collateralized mortgage obligations (CMOs) are a little bit different. They both look similar on the outside (as in, they are pools of risky and non-risky mortgages, divided by risk). But while CMOs are backed by mortgages, CDOs are backed by mortgages plus other debts.
Higher Mortgage Availability
Because GSEs work to increase mortgage availability, they are also doing their part in keeping interest rates down. GSEs act as financial intermediaries to assist lenders and borrowers in housing and agriculture. And because of this, GSEs are together the largest financial institutions in the U.S.
Behind the Scenes
Buyers have a right to know who their loan has been sold to. Whenever a loan is sold, the borrower must receive notice within 30 days. The borrower won't see any real change on their end, and they will continue making payments. So, even if a mortgage is sold by the lender, the buyer isn't really affected.
Reconstruction Finance Corporation
Congress created the Reconstruction Finance Corporation, or RFC in 1932. The RFC's purpose was to build confidence in the economy. One way they did this was by creating a mortgage company to sell and buy FHA and VA loans, making them more appealing to lenders/mortgage originators. And you might be familiar with the mortgage company that the RFC created...
Farmer Mac
Farmer Mac is a secondary market for agricultural loans and not a direct lender — they assure that attractively-priced mortgages are readily available. When a consumer is planning to purchase or refinance an agricultural property or a business serving a rural constituency, it's to their advantage to work with a lender who offers a variety of options, including loans that qualify for Farmer Mac's long-term fixed-rate funding. Like Fannie Mae and Freddie Mac, Farmer Mac also buys and pools loans to create mortgage-backed securities. Farmer Mac guarantees these securities as well.
Public vs. Private
GSEs are a weird mix of both public and private. They are created by the government, and exist for public use, but are privately owned. Confusing, right? Yes, very. Don't get it twisted, though — they are accountable first and foremost to the stockholders and investors, not the government or the public. So every decision a GSE makes is for the sake of the stockholders and investors. They see it as their fiduciary responsibility.
Ginnie Mae: The Government Has Its Back
I'm gonna reiterate this one more time for those of you sitting way, way in the back of the virtual classroom: Ginnie Mae is different from Fannie Mae and Freddie Mac because Ginnie has the U.S. government on their side. Their mortgages are backed by the government, unlike Fannie Mae and Freddie Mac. Ginnie Mae doesn't have an investment portfolio of mortgages and MBSs, which means no CMO/CDO subprime scary loans hanging out. Liability for the mortgages falls on the banks that create the mortgages, which makes Ginnie Mae less responsible for what happens if someone is delinquent on their house payments, but they also give banks the benefit of securitization. For Fannie Mae and Freddie Mac, the banks pass responsibility onto them, putting them at higher risk. And now onto something a little more rural...
It's Fannie Mae!
In 1938, the Federal National Mortgage Association (FNMA), or Fannie Mae, was created by the RFC. Fannie Mae is a government-sponsored enterprise (GSE) that purchases FHA and VA loans, as well as conventional, conforming loans. Fannie Mae packages the mortgages they buy and sells them as mortgage-backed securities to investors (we'll talk more about that in just a second!).
A Little History of the Secondary Mortgage Market
Let's back it up for just a second right now. How did we get this system of primary and secondary markets in the first place? Well, the the secondary mortgage market came about as a byproduct of the Great Depression. Because of the economic devastation, many homeowners were having trouble making their mortgage payments, resulting in widespread foreclosure. Because of this, Congress created a secondary market for mortgages, where the actual mortgages could be sold by lenders and bought by investors. This is known as mortgage liquidity. This worked to create more confidence in the mortgage market.
Mortgage Originator
Let's start with the mortgage originator. As we talked about earlier in this chapter, mortgage originators are either mortgage banks (who supply their own funds) or mortgage brokers (who do not supply their own funds). Mortgage bankers use what's called a warehouse line of credit, which is just a fancy way to say a line of credit given to mortgage bankers for the purpose of creating mortgages.
Non-Conforming Loans
Loans that do not fit Fannie Mae or Freddie Mac guidelines are called non-conforming loans. MBS pools can also be made of non-conforming loans. These loans are usually bought by hedge funds or private investors or someone who wants to take a bigger risk with their investments. A single MBS may have any number of investors, similar to how a stock would have many owners.
Determining the Value
Many factors determine the value of a loan. Especially important is the degree of risk associated with the loan. A lender may sell mortgage loans directly to another lender in a different part of the country or to one of the secondary market agencies. The agency may, in turn, use those mortgages to create mortgage-backed securities (MBSs).
Securities Dealers
Next we have the securities dealers. They usually come in after the MBSs have been created because they buy the MBSs. The reason they do this is to sell these MBSs to investors, but in order to do this they create asset-backed securities (ABS), collateralized debt obligation (CDO), and collateralized mortgage obligation (CMO). Don't worry, we're about to talk about all these strange new acronyms.
The Aggregator
Now let's talk about the aggregator (which only sounds like a really terrible superhero). Aggregators are next level originators. Not only do they originate loans, but they also purchase newly-originated loans from smaller originators. Aggregators work with government-sponsored enterprises, such as Freddie Mac and Fannie Mae, and create mortgage pools that they can turn into mortgage-backed securities (MBSs).
Freddie Mac
The Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac, was created as part of the Emergency Home Finance Act of 1970. Like Fannie Mae, it is a government-sponsored enterprise (GSE). The focus for Freddie Mac is on buying conventional loans from depository institutes (although it also purchases VA and FHA loans). Buying loans from depository institutions encourages further lending by returning working capital back to the banks, and essentially means the loans are insured by the U.S. government.
Securitization
The GSEs fund their operations through the act of securitization. Securitization in the secondary mortgage market is the act of pooling of mortgages together to be sold to third-party investors as a packaged mortgage-backed security (MBS).
Ginnie Mae (Owned by the government)
The Government National Mortgage Association (GNMA), or Ginnie Mae, was created in 1968 as an offshoot of Fannie Mae. Fannie Mae continued its operation in the secondary mortgage market, concentrating on its portfolio liquidity by buying and selling loans, staying governmentally chartered, but becoming a privately-funded company. When Fannie Mae became a privately-funded company, Ginnie Mae took over the housing assistance and support programs under the Department of Housing and Urban Development (HUD), which is where Ginnie Mae's focus still is today. So, Ginnie Mae's mission is to expand affordable housing financing. They do this by ensuring that lenders have the funds and stability to provide loans to customers. Unlike Fannie Mae and Freddie Mac, Ginnie Mae is not a GSE and is still wholly owned by the United States Government.
The Investor
The last party involved is the investor. These include insurance companies, banks, pension funds, foreign governments, hedge funds, and government-sponsored enterprises. Investors choose investments based on their amount of risk and prepayment penalties. For example, a hedge fund will probably be looking for something more risky, while a pension will want something much less risky.
Mortgage Brokers
The mortgage brokers act as independent agents for the mortgage bankers, but in the end, both of these entities end up selling back these mortgages into the second market very quickly upon origination. The reason for the quick turnaround time in selling the loan is so the loan can be sold before the interest rate changes.
Origination Fees and Interest Rates
The mortgage originators make their money through the origination fees and the difference between the borrower's interest rate and the premium paid by the secondary market for that interest rate.
The Simple Version
The secondary mortgage market can be a little confusing. But it's still important to know about! To help, I'll bring it down to a small scale so you can see the necessity of the secondary mortgage market: There are 20 people looking to take out a mortgage. Each of these homebuyers needs to borrow $100,000 to afford their home. But the bank they want to use only has $1 million to lend out. Because of this, the bank can only give loans to 10 homebuyers. The government has an interest in keeping the housing market healthy. So, once the bank lends out their $1 million, Fannie Mae (or Freddie Mac) will buy the promissory notes from bank. The bank now has their $1 million again and can originate more loans to the remaining homebuyers. And remember, the bank has to create conforming loans, or else they can't be purchased by a GSE. Okay, so Fannie Mae just bought 10 mortgages. Through securitization, they will package those 10 mortgages together into an MBS and sell it to third-party investors. The third-party investors now hold the notes to the loans. The investors will receive interest payments.
The Secondary Mortgage Market
The secondary mortgage market is the place where mortgages are bought and sold. So, the mortgages are created in the primary mortgage market, then the primary lender sells them off into the secondary mortgage market, where they are bought by investors. Investors can be government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, or they can be private investors. FHA, VA, and conforming conventional loans are all eligible to be packaged and sold on the secondary mortgage market.
Major Players in the Secondary Mortgage Market
The three major players in the secondary mortgage market are: Fannie Mae - Federal National Mortgage Association (FNMA) Freddie Mac - Federal Home Loan Mortgage Corporation (FHLMC) Ginnie Mae - Government National Mortgage Association (GNMA)
The Difference Between Fannie & Freddie
Today, the only significant difference between Fannie Mae and Freddie Mac is the size of the financial institutions from which they purchase their mortgage loan bundles. Fannie Mae deals with larger commercial banks, whereas Freddie Mac works with the smaller "thrift" banks.
Secondary Market Activities
When it comes down to it, all of these secondary market agencies engage in two main activities: Buying loans Issuing mortgage-backed securities What does that look like? Glad you asked.
The Difference Between Ginnie, Fannie, & Freddie
Whereas Ginnie Mae deals exclusively with FHA, VA, and other government-supported mortgage loans, Fannie Mae (since the 1970s) and Freddie Mac (always) engage primarily in conventional conforming mortgage loans. Another difference between these three is that Ginnie Mae guarantees the timely payment of mortgages with the backing of the U.S. government, but it does NOT issue mortgage-backed securities in its own name. In contrast, Fannie Mae and Freddie Mac issue and guarantee MBS collateralized by the mortgage loans or hold mortgage loans and MBS in their portfolios. In other words, Freddie Mac and Fannie Mae's loans are guaranteed by Freddie Mac and Fannie Mae, but Ginnie's loans are guaranteed by the U.S. government. This is an important distinction to make, but one that makes sense when you remember that Freddie Mac and Fannie Mae are government-sponsored, while Ginnie Mae is government-owned!
Major Participants
Who are the major participants in the secondary market? As always, a great question, Mustafa. Before we dive in, let's talk about the people who work behind the scenes creating mortgages. There's a lot that goes into getting a client a home mortgage, and a lot of folks who make it happen: The mortgage originator The aggregator Securities dealers Investors
The Need for Liquidity
Why is selling off the mortgages they originate so attractive to lenders? Well, let's consider what would happen if they didn't do this. When do banks make all their money back? When the loan is paid off. In the case of a fully-amortized 30-year mortgage, this means that the lender's money is out of their reach for the better part of 30 years! Selling the mortgages on the secondary market allows the overhead of the note to rest with investors who are comfortable having their money "out there" for a long period. This in turn allows the banks to reload on capital, which means they can go and originate more loans. The secondary mortgage market keeps lenders lending, which is what they do best.
Chapter 3 Key Terms
✏️ primary mortgage market: the market in which loans are originated/created/funded by the lender ✏️ secondary mortgage market: the market in which already-existing mortgages are sold and re-sold to investors