Why Are Loans Sold?
The Loan Secondary Market - Brief Overview
Today, having your home loan sold is a very common occurrence.
This creates liquidity in the market, which is actually good - and in the end provides you with a lower mortgage rate.
Let me explain - it used to be that banks could only loan money that they had from deposits. If the total of their checking and savings accounts totaled $100,000,000 - that's all they could loan. This is not good for many reasons, including a big problem if deposits are withdrawn!
So a secondary market was created for mortgages. This included the creation of Fannie Mae and Freddie Mac, which guarantee that they will buy a loan if it meets certain conditions.
This lets banks lend money, knowing that they can sell the loan if needed to replenish their cash reserves. Or just to keep their loan originators busy if they are out of cash to lend, but still need to write loans - or lay off employees.
Note: When you loan is sold, you are protected. Your loan terms cannot change once the loan is closed. You are protected by law. Please note that having your loan sold is not a reflection on you or your credit.
Contents Of This Article
The Secondary Marketing Function
Buying and Selling Mortgages
Why there is a Secondary Market
Mortgage Backed Securities
Why Interest Rates Are The Same Everywhere
Why Underwriting is Uniform
How the Secondary Market Reduces Costs
The Secondary Marketing Function
Secondary marketing is the general term used for pricing, buying, selling, securitizing, and trading residential mortgages. The market place is a highly sophisticated network of financial institutions and Wall Street firms that are linked together through real time communications.
Often the secondary market is compared to the stock or bond market, but it is not as formal or as well regulated. It is really an informal process of different financial institutions buying and selling home mortgages. Because it is a very large market place with thousands of people involved, some very positive things are accomplished for the good of the home buyer who is totally unaware of what is going on by people whose primary interest is making money.
Buying and Selling Mortgages
To understand the secondary market you must accept the concept that a home loan can be bought and sold. A loan is really two pieces of paper. First, there is the note which is the promise to pay a certain sum at a certain interest rate over a certain term to the lender. Secondly, there is the deed of trust which is the document that gives the lender the right to take the property if the payments under the note are not made as agreed.
These two pieces of paper together have a value because they represent an amount the borrower will pay back, interest income on the amount loaned to the borrower, and a right to the property as security for the loan.
The borrower agrees to make payments to any legitimate holder of the note. Therefore, if the lender transfers his loan to someone else the new holder can expect the borrower to continue to make the payments, much like a US Bond. Mortgages are like anything else, if you can transfer ownership someone will begin selling and somebody will begin buying.
Why There Is A Secondary Market
Imagine you are the president of a local credit union that makes home loans. On Tuesday, Mr. and Mrs. Johnson come into borrow $100,000 to buy a new home. You check their credit and approve them. They sign a note and deed of trust and you send $100,000 to closing. After the Johnson's, Mr. and Mrs. Anderson come in and borrow $100,000 to buy a home. Again you send the money to closing.
Then, the mayor of the town comes in to borrow $100,000 for a new home. Unfortunately, when you go back to the vault you discover that you do not have $100,000 cash available. Now you have two options, tell the mayor to wait until you get $100,000 in deposits or go out and raise the $100,000. The quickest way to raise $100,000 is to sell one of the loans that you made.
This cash shortage situation is not uncommon, so there is a network of individuals and financial institutions willing to purchase the $100,000 note and deed of trust. Using your contacts you quickly negotiate the sale of one of the loans to a Bank in New York. Your receive the $100,000 cash, make the loan to the mayor, and save your credit union from embarrassment.
You are serving the primary market - the home buyer. The Bank in New York then services your loan and is the secondary market for the mortgage.
Mortgage Backed Securities
Most fixed rate mortgages originated by primary lenders and mortgage brokers are sold in the secondary mortgage. The loans are aggregated with other fixed rate mortgages with similar characteristics, such as note rate, term, etc., and converted into mortgage backed securities and bonds. These mortgage backed securities become part of the larger capital markets which also includes government securities, corporate bonds and municipal bonds. The yields on mortgage backed securities track other capital market instruments with similar maturities. Generally, mortgage backed securities that include 30 year fixed mortgages track the yields on the 10 year maturity U.S government securities.
This is another way loans can be sold - in bulk.
Why Interest Rates Are The Same Everywhere
The same very simple example we used above can also show how the secondary market keeps interest rates from varying from one place to another - by much. There are sometimes location adjustments due to risk, or by lenders balancing their portfolio across geographies or loan term.
Suppose the loans are only for one year terms with principal and interest due at the end of the year. The Johnson's was at 8% (because it was earlier in the week and you were in a good mood) and you charged the Andersons 9% for their loan.
Now suppose when you call the Bank in New York to offer your loans for sale he says he is buying loans with an interest rate of 8.5%. Does that mean you can not sell him either of your loans? Of course not!
When the investor says 8.5% he is really saying that he wants $8,500 back at the end of the year for letting you use his money. If he buys your 8% loan he will receive $8,000 at the end of the year, $500 less than he wants. To compensate for that shortfall he will discount (this is what we mean when we talk about discount points) what he pays for the loan, instead of $100,000 he will give you $99,500.
That means that at the end of the year he will receive $8,000 interest and $100,000 principal (because the Johnson's are still required to pay $100,000 even if you did not sell it for that) which will be $500 more than he actually gave you for the note. Instead of getting interest payments of $8,500 he receives interest of $8,000 and principal payments of $500. It's still $8,500 in cash.
If you do not want to sell a loan for a "loss" of $500. You could shop around, however, the Bank in New York knows you can get quotes from many many different sources. He is not going to offer you a price that is out of line with what you will find from other investors.
Your alternative is to offer the investor the Anderson loan with an interest rate of 9%. In our simplified example, you would receive a bonus of $500 for selling him this loan. Because the investor knows that the national market is looking for a yield of 8.5% and he knows that you know that and you know other people who will buy the loan, to buy the loan he will pay you $100,500.
The reasoning for this price is the same as for the Johnson loan. At 9% he will receive $9,000 at the end of the year plus the $100,000 principal, if the market dictates that he should accept $8,500 (8.5%) then he must give you the $500 excess interest income or you will sell the loan to someone else.
So, how does the secondary market influence interest rates? By making you realize that if you had made the Johnson's a loan at the going rate of 8.5% interest instead of 8% you would not have faced a loss when you were forced to sell it. In the future, even if you do not think you will sell a loan you will be aware of the national market rate and try to make your loans at that rate if you really want business.
When you talk to mortgage brokers, what they may not tell you (and the loan officer on the phone may not know) is that they have almost identical rates. Sometimes brokers receive volume discounts from certain wholesalers, but usually their pricing is a little higher to begin with. The difference in the quoted rates is the profit, called Yield Spread Premium or Servicing Release Premium. This is a payment to the broker/lender for selling a loan with a higher rate.
Why Underwriting Standards Are Uniform
In order to sell loans to someone who does not know you, your market, or the borrower you must have underwriting standards and documentation that the investor can rely on.
Suppose you had given the Johnson's a loan based only on your long term relationship with them without documenting their income, credit, etc. The Bank in New York would feel that the risk was greater and charge a higher interest rate or not purchase the loan. After this experience, you would try to underwrite and include documentation that would make investors feel comfortable.
How The Secondary Market Reduces Costs
The secondary market increases the number of organizations that are able to originate home loans. Because the secondary market provides lenders money to make new loans by buying closed loans immediately, even relatively small companies can originate very large volumes of loans. This increases the competition among loan originators and forces lenders to keep interest rates and fees in line and as low as the secondary market will allow. Without the secondary market, a very few, extremely large institutions would control the housing finance market.
Fannie Mae and Freddie Mac
Fannie Mae is a private, shareholder-owned company that works to make sure mortgage money is available for people in communities all across America. Fannie Mae does not lend money directly to home buyers. Instead, Fannie Mae works with lenders to make sure they don't run out of mortgage funds, so more people can achieve the dream of homeownership.
Fannie Mae was created by Congress in 1938 to bolster the housing industry during the Depression. At that time, Fannie Mae was part of the Federal Housing Administration (FHA) and authorized to buy only FHA-insured loans to replenish lenders' supply of money.
Today, Fannie Mae operates under a congressional charter that directs them to channel our efforts into increasing the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and they are one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America.
The lenders with which Fannie Mae does business are part of the primary mortgage market -- the place where mortgages are originated and funds are loaned directly to borrowers. Primary market lenders include mortgage companies, savings and loans, commercial banks, credit unions, and state and local housing finance agencies.
Lenders sell mortgages into what's called the secondary market -- the place where mortgages are bought and sold by various investors. Secondary market investors include Fannie Mae, various pension funds, insurance companies, securities dealers, and other financial institutions.
Once a mortgage is originated, lenders have a choice. They can either hold the mortgage in their own portfolio or they can sell the mortgages to secondary market investors, such as Fannie Mae. When lenders sell their mortgages, they replenish their funds so they can turn around and lend more money to home buyers.
Currently, Fannie Mae buys mortgages up to a loan limit of $417,000. This is in keeping with Fannie Mae's mission to help more low-, moderate-, and middle-income people buy homes. Their loan limits are adjusted each year, in response to changes in housing affordability nationwide.
Second Fannie Mae issues what are known as Mortgage-Backed Securities (MBS) in exchange for pools of mortgages from lenders. These MBS provide the lenders with a more liquid asset to hold or sell. Fannie Mae MBS are highly liquid investments and are traded on Wall Street through securities dealers.
Traditionally, the lending portion of the mortgage industry has been made up of three tiers of participants. The local lenders, nation-wide lenders, and, above them, the federal lenders like Freddie Mac and Fannie Mae. Brokers sometimes work with, or for, local lenders, who often sell your loan "up-stream" to a nation-wide lender who in-turn may sell it to Freddie or Fannie. This is why many people experience their loan being sold, and sending their payment to another institution.