The mortgage industry is a bit like a game of hot potato. Most newly originated mortgages are quickly sold by lenders on the secondary mortgage market. Running parallel to the primary mortgage market, this secondary marketplace allows investors and lenders to buy and sell home loans and servicing rights. Lenders embrace it because it allows them to bulk up loan revenue.
Here's a look at 10 common questions people have about how the secondary mortgage market works.
1. How Did the Secondary Mortgage Market Evolve?
Secondary mortgage transactions aren't new, and have been around longer than most people probably realize. Congress actually created this market with the formation of Fannie Mae way back in 1938. By providing liquidly for originating lenders, the creation of secondary mortgage sales allowed lending institutions to free up capital that ultimately enabled them to offer more loans. That means that the secondary market directly increased the dream of homeownership for more people! The secondary loan market was further expanded with the creation of Freddie Mac in 1970.
2. Who Are the Typical Lenders in the Secondary Mortgage Market?
The core participants in the secondary mortgage market are mortgage originators (lenders), buyers, refinancing homeowners, and mortgage investors. Overall, any type of mortgage lender offering home loans can participate in the secondary mortgage market. Participating lenders create mortgages that can be used to sell servicing rights within the secondary market.
3. What Are the Benefits of Selling Mortgages?
The core purpose of the secondary mortgage market is to expand homeownership by making financing for home purchases more accessible. When lenders can generate capital through selling servicing rights, they have more money to lend to homebuyers. This creates a situation for:
- Maintaining lower mortgage rates.
- Allowing for uniform interest rates around the country.
- Making it possible for lenders to offer loans with longer terms.
- Making it possible for borrowers to refinance without penalty.
The simple way to look at the sale of a mortgage's servicing rights is that it allows the lender to replenish mortgage funds. A gain turns into a new mortgage for the next customer. In addition, the sale of loan rights removes some of the initial risk that the lender took on when approving the loan.
4. What Are the Risks of the Secondary Mortgage Market?
For lenders, exposure risks loom when entering the secondary mortgage market. This is especially true for smaller community banks that pivot from the broker role to the originator role in order to participate in the secondary market. Taking on an originator role places a lender under Ability-to-Repay (ATR) rules, Qualified Mortgage (QM) rules, and all other applicable Consumer Financial Protection Bureau (CFPB) lending rules. Yes, a lender remains partially liable under these rules even after selling a loan on the secondary market.
There are some situations where a lender could be required to buy back a loan that has been sold if it's determined that the lender failed to properly validate a borrower's ability to repay a mortgage, though that is less common currently. The big takeaway with risk is that a lender must use airtight underwriting and compliance policies when originating loans that will be passed on using the secondary mortgage market.
5. How Does the Secondary Mortgage Market Affect the Real Estate Market?
The secondary mortgage loan marketplace expands the real estate market by increasing the number of new loans that can be funded by lenders, thus allowing more people to access the home loan market. Without a secondary market that offers the opportunity to make money from selling loans, mortgage lenders would have too much capital tied up in existing mortgages to generously provide new mortgages. The secondary market also plays a big role in allowing for a combination of longer loan terms and stable interest rates.
6. What Role Do Fannie Mae and Freddie Mac Have in the Secondary Mortgage Market?
A big one. In short, the secondary mortgage market doesn't exist without Fannie and Freddie. That's because Fannie Mae and Freddie Mac are the primary aggregators of mortgages on the secondary market. Once these institutions purchase mortgages, they take one of two actions. The first action is to hold mortgages within their portfolios. The second is to package loans into investments called mortgage-backed securities.
7. What Is the Role of the Government in Selling Mortgages?
Freddie Mac and Fannie Mae are government-sponsored enterprises (GSEs) that play important roles in providing liquidity, stability, and affordability in the United States mortgage market. Their involvement in the secondary mortgage market directly provides liquidity for thousands of banks, mortgage companies, and other lending institutions.
By packaging mortgages into mortgage-backed securities, GSEs are able to attract investors that might not otherwise be interested in pouring capital into the mortgage sector. Fannie Mae and Freddie Mac also play an important role in helping to stabilize the mortgage market when broader stress and turmoil within the financial system create a crisis in the real estate market.
8. What Are Private-label Securities?
Standard mortgage-backed securities are issued with guarantees from GSEs. A security that is not guaranteed by a GSE is what's known as a private-label security. Also known as a non-agency security, a private-label security does not conform to the criteria for GSEs. They are instead issued by banks, bank subsidiaries, home builders, and general financial institutions.
9. What Impact Do Changes in the Secondary Mortgage Market Have on Mortgage Rates?
The core reason why the secondary market helps to keep interest rates low is that mortgage-backed securities are considered to be reliable investments. As a result, investors are happy to accept lower returns in exchange for great reliability. This translates to lower mortgage rates for borrowers.
Any fluctuations in the economy can impact how investors view mortgage-backed securities. Generally, Treasury bonds that are backed by the U.S. government serve as indicators for where interest rates might be headed. That's because Treasury bonds are considered the safest investments. Investors need to see that yields on mortgage-backed securities are higher than yields on intermediate-term Treasury bonds in order for mortgage-backed securities to be attractive. As a result, many investors view changes in Treasury yields as "clues" regarding where mortgage rates are headed.
10. How Does Selling Mortgages Affect the Availability of Financing for Homeowners?
A bustling secondary mortgage market allows lenders to get the capital they need to continue to lend to homeowners. When the secondary market constricts, lenders often have to tighten their belts when it comes to originating new loans. This tightening can come in the form of fewer loans, stricter terms, or higher interest rates.
Final Thoughts on the Secondary Mortgage Market
The secondary mortgage market is sometimes maligned as a "financial game." It's understandable for a new buyer to be confused about why their loan is now being serviced by an entity they've never heard of before. In reality, the dream of homeownership would disappear for millions without it, so in reality, the second mortgage market is a lifesaver that many don’t know anything about. Any lender seeking a way to recoup capital that can be used to expand lending needs to investigate how the secondary mortgage market fits into their internal loan life cycle.