The Secondary Mortgage Market

Chapter Four: The Secondary Mortgage Market

Overview of Learning Objectives

  • Understand the development of the secondary mortgage market.
  • Explain the process of securitization.
  • Compare various secondary market enterprises.

Structure of the Mortgage Market

  • The mortgage market consists of a two-tiered structure:
    1. Primary Mortgage Market: Where lenders underwrite loans to borrowers.
    • Main types of primary lenders:
      • Savings and loan associations
      • Commercial banks
      • Mortgage bankers
      • Credit unions
      • Private lenders
    1. Secondary Mortgage Market: Where existing mortgages are bought and sold.

Secondary Mortgage Market Mechanics

  • The home mortgage process:
    1. A mortgage is originated in the primary mortgage market: the lender provides funds, and the borrower agrees to repay.
    2. Lender sells the mortgage in the secondary mortgage market.
    3. The borrower must then pay the entity that purchased the mortgage.

Purpose of the Secondary Mortgage Market

  • The secondary market helps increase liquidity in the mortgage system.
  • Illiquidity issue:
    • Without a secondary market, lenders face challenges due to waiting long periods for repayment.
    • Often leads to short-term, high-interest loans being favored by lenders.
  • Introduction of mortgage liquidity allows lenders to originate mortgages and sell them promptly, providing immediate funds for additional financing.
  • This promotes favorable terms for borrowers through longer loan durations and lower monthly payments.

Historical Context of the Secondary Mortgage Market

  • The Great Depression catalyzed the development of the secondary mortgage market due to economic turmoil, which caused widespread foreclosures.
  • Congress established the Reconstruction Finance Corporation (RFC) in 1932 to bolster confidence in the economy.
  • Fannie Mae was created in 1938 to manage and purchase FHA and VA loans, promoting wider mortgage access.
  • Freddie Mac was established through the Emergency Home Finance Act of 1970, focusing on the secondary market for conventional loans from depository institutions.

Comparison of Major Secondary Mortgage Market Enterprises

  • Fannie Mae (FNMA):
    • Focuses on larger commercial banks.
    • Buys conventional, FHA, and VA loans, and sells them as mortgage-backed securities (MBS).
  • Freddie Mac (FHLMC):
    • Works primarily with smaller thrift banks.
    • Similar business model to Fannie Mae but structured around smaller lending institutions.
  • Conforming Loans:
    • Loans meeting specific standards for packaging and selling on the secondary market.
    • Standard features include size limits (e.g., $484,350 for single-family homes as of 2019).
  • Ginnie Mae (GNMA):
    • A state-owned enterprise distinct from Fannie Mae and Freddie Mac, focused on FHA and VA loans.
    • Ginnie Mae guarantees timely mortgage payments but does not issue MBS in its name.
  • Farmer Mac:
    • Focuses on agricultural loans, established after the farm crisis in the 1980s.
    • Functions similarly to other GSEs, purchasing and securitizing agricultural loans.

Major Functions of the Secondary Mortgage Market

  • Main activities include:
    1. Buying Loans:
      • Real estate loans are considered investments similarly to stocks and bonds.
      • Secondary mortgage market agencies typically buy large numbers of loans.
    2. Issuing Mortgage-Backed Securities (MBS):
      • MBS are financial instruments backed by mortgages, resembling equity investments in mortgage portfolios.

Securitization Process

  • Definition: The pooling of mortgage loans to sell as securities.
  • Through securitization, secondary market agencies can package mortgages together and pledge them as collateral for the securities sold to investors.
  • Investors receive returns in the form of periodic payments based on the underlying mortgage repayments.
  • Often includes a guarantee of full payment by secondary market agencies, providing security to investors.

Types of Loans

  • Conforming Loans: Adhere to Fannie Mae and Freddie Mac standards.
  • Nonconforming Loans: Do not meet GSE guidelines; usually purchased by hedge funds or private investors willing to take on higher risk.

Participants in the Secondary Mortgage Market

  • Mortgage Originators: Entities that create mortgages, either lenders or brokers.
  • Aggregators: Purchase loans from smaller originators and work with GSEs to create mortgage pools for MBS.
  • Securities Dealers: Buy MBS after creation and sell to investors; engage in creating asset-backed securities (ABS), collateralized mortgage obligations (CMO), and collateralized debt obligations (CDO).
  • Investors: Comprise various institutions such as banks, hedge funds, and pension funds, choosing investments based on risk tolerance.

Case Study: Sarah's Mortgage Journey

  • Scenario:
    • Sarah agrees to pay $200,000 for a home, using $50,000 as a down payment and borrowing $150,000.
    • The First Bank of Aesopal provides the mortgage with a fixed rate of 4.7% over 30 years.
    • The loan is packaged and sold to Fannie Mae, which then securitizes it for investors.
    • Sarah pays her mortgage and is able to pay more than the minimum due, leading to early repayment.

Conclusion: Importance of the Secondary Mortgage Market

  • The secondary mortgage market plays a crucial role in ensuring liquidity for banks, enabling continuous financing for home loans.
  • Key Takeaway: The smooth functioning of the secondary mortgage market allows lenders to maintain lending activity, directly supporting homebuyers like Sarah in obtaining mortgages without undue delay or burdens.