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Demystifying the secondary mortgage market

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The secondary mortgage market is a massive marketplace of banks, investors and financial institutions that trades mortgages, servicing rights and mortgage-backed securities. While many homebuyers aren’t aware of it, the secondary mortgage market has a huge impact on how you get a mortgage, the rate you pay and the standards you must meet to do so.

While a lender may have initially gotten you a loan, in many cases today the lender doesn’t hold the loan. Instead, it sells the loan into the secondary mortgage market, where it may be sliced and diced into any number of mortgage-backed securities to satisfy investors’ needs.

Here’s how the secondary mortgage market works and who may actually own your home loan.

How the secondary mortgage market works

Most folks know how the basic mortgage process works. A borrower asks a bank for a loan, and the bank extends money to the homebuyer and keeps the loan on its books for the loan’s term. That’s Banking 101 — but it’s less often how things are done today in the mortgage market.

After making a loan, a bank often sells it in the secondary mortgage market, though the bank may retain the servicing rights. Many loans are sold to the government-sponsored enterprises Fannie Mae and Freddie Mac or other aggregators, which can repackage the loans as mortgage-backed securities, or MBS, or hold them on their own books and collect the interest from borrowers.

To be sold to the agencies, the loan must be “conforming” — that is, the loan must meet certain standards set by the agencies. These factors include:

  • A maximum loan amount of $510,400 (for 2020) in most U.S. states, though it is higher in others
  • The down payment relative to the size of the loan, typically at least 3 percent
  • The borrower’s credit score, usually at least 630 to 650
  • The borrower’s debt-to-income ratio, which should be no more than 41 percent

The demand for conforming loans helps push down the mortgage rates for borrowers who can meet the standards. Note that jumbo loans are not typically considered conforming loans.

The government agencies are one type of mortgage aggregator, but other large institutions (including the mortgage originator itself) may be aggregators and create their own MBS, too.

What are mortgage-backed securities?

Once aggregators buy mortgage loans, they can chop them up and repackage them into bonds called mortgage-backed securities.

Think of the mortgage as a kind of cash flow, with specific characteristics based on the loan. Aggregators can repackage these cash flows — typically thousands of mortgages in a single security — in different ways to create bonds that appeal to the investment needs of certain kinds of investors.

For example, mortgages can be sliced into tranches with varying degrees of safety — and the safer the bond, the lower its yield, usually. So, investors looking for a higher interest payment can buy somewhat riskier mortgage-backed securities, while those who must buy higher-rated bonds (such as insurance companies or public pension investors) can buy the safer tranches.

Investors looking for other traits, such as those based on risk or timing of cash flow, can find other MBS bonds to meet their specific needs. It’s a wide market offering a range of bonds.

Just like regular bonds, these mortgage-backed securities are graded by the rating agencies, including Standard & Poor’s, Moody’s and Fitch, which collect fees for their services.

Once the bonds have been created and rated, they are sold to investors, who may hold them for their own portfolios or sell them later in the secondary market. Banks themselves may also be buyers of MBS, which may offer more diversification than loans written only in their service area.

Why does the secondary mortgage market exist?

Congress created the secondary mortgage market in 1938 with the formation of Fannie Mae, which purchased FHA mortgages. Fannie Mae provided liquidity for originating lenders, who didn’t want to tie up their capital for long periods, and allowed them to generate more loans. With the ability to sell loans, banks could write more mortgages and encourage homeownership.

Freddie Mac was created by Congress in 1970 with similar goals to Fannie Mae.

Creating a completely new security from mortgages is a complex process, so why would the players involved in the mortgage market do this? The secondary market creates benefits for each economic player — borrowers, investors, banks/lenders, aggregators and rating agencies:

  • Borrowers – Borrowers who can qualify for a conforming loan benefit from potentially lower costs and greater access to capital and loans for longer periods of time.
  • Investors – Investors (including institutional players such as banks, pension funds, hedge funds and others) enjoy getting exposure to specific kinds of securities that better meet their needs and risk tolerance.
  • Banks/lenders – Lenders can move certain loans off their books, while retaining other loans that they’d prefer to have. It also allows them to efficiently use their capital, allowing them to generate fees for underwriting mortgages, selling the mortgage and then using their capital again to write a new loan. The lender may retain the right to service the mortgage, which can be a lucrative stream of fees as well. The bank may also benefit as an investor, too, by buying MBS that diversify its own assets.
  • Aggregators – Aggregators such as Fannie and Freddie earn fees from bundling and repackaging mortgages and structuring them with certain attractive characteristics.
  • Rating agencies – These firms generate sales by rating mortgage-backed securities and ensuring that they have specific traits and riskiness.

Because it allows lenders to slice up their mortgages, the secondary market also enables financial firms to specialize in various areas of the market. For example, a bank may originate a loan but sell it in the secondary market while retaining the right to service the mortgage.

As a loan originator, the bank underwrites the loan, processes the loan, funds the mortgage and closes the loan. It collects fees for these services and then may or may not hold the loan.

As a loan servicer, the bank receives a fee for processing the monthly payment, tracking loan balances, generating tax forms and managing escrow accounts, among other functions.

Even if the lender decides to originate the loan and hold it, it benefits by having an active and liquid secondary market, where it can sell its loans or servicing rights if it wanted or needed to.

In short, the market exists to create more efficiency and better meet the needs of the players.

Bottom line

There’s a lot going on behind the scenes of the mortgage market that borrowers may not be aware of. Because it purchases a huge portion of home loans, the secondary market drives a lot of the behavior in the primary market, such as the banks’ desire to write conforming loans. While you may continue to make your monthly payment to the bank that originated the loan, the money may actually be going to many different investors who own your mortgage or a slice of it.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Mortgage editor