How The Secondary Mortgage Market Works In The United States
February 21st, 2009 by Michael Oliver
This is a very complex subject very few Realtors or loan officers can intelligently explain about how the mortgage markets work in the US. I try to learn anything and everything I can that relates to Tucson real estate so that I can serve my clients most effectively. The basis of this research I did to come across this very in depth article explaining the process was derived when a mortgage broker and I got into a differing of opinion on how things actually truly worked. (Just to let you know we were both right and the actual argument was about the actual percentage of mortgages held onto by the banks vs. the percentage sold off into the secondary markets.) This is the most current article I could find on the subject from The Federal Reserve Bank of Atlanta and is from 1999. Being that it took me over 30 minutes to find this info (and I know what I’m looking for) I figured this maybe interesting reading for those that want to understand the marketplace that exists for mortgages in the Unites States.
Actually this isn’t really the most interesting reading one could do (believe it or not) however if you want to be able to know more then 99.9% of people even in the real estate industry about the secondary mortgage markets read through this and you will I guarantee it. (However if you read the disclosure at the bottom of this blog you would conveniently see I never guarantee anything because I’m not smart enough to know when things are going to change and the average real estate professional can quickly and easily recite the intricate inner-workings of the US secondary mortgage markets on a whim…..I’m just going out on a limb and saying it won’t be any time soon.) With that lengthy and probably non-needed introduction here is the article explaining everything you would like to understand and comprehend about the mortgage markets secondary market:
Fannie Mae and Freddie Mac at Work in the Secondary Mortgage Market
by Michael Padhi, senior economic analyst
When financing home purchases, consumers deal primarily with their lenders at the time of obtaining mortgage loans and through the loans’ term. Behind the scenes, though, is a very important secondary market for mortgages, in which banks and other mortgage originators sell claims to the mortgage payments to third parties. This secondary market provides valuable liquidity to mortgage originators and, in turn, benefits consumers by expanding the availability of mortgages.
Among the most active participants in the secondary market are Fannie Mae and Freddie Mac, both of which are government-sponsored enterprises. In gaining a better insight into the secondary mortgage market, it is important to understand the functions of these organizations, their unique relationship to the government and how commercial banks use their services.
Getting to know Fannie, Freddie and Ginnie
Fannie Mae and Freddie Mac are the popular names for the Federal National Mortgage Association (FNMA), chartered by Congress in 1938, and the Federal Home Loan Mortgage Corp. (FHLMC), chartered in 1970.
While both Fannie Mae and Freddie Mac currently have similar charters, congressional mandates and regulatory structure, they were originally formed with different focuses. Fannie Mae was formed to support the secondary market for Federal Housing Administration loans after the Great Depression, while Freddie Mac was created to provide a secondary market for conventional mortgages during the severe credit crunch of 1969–70 in the thrift industry. Today both Fannie Mae and Freddie Mac deal with all types of depository institutions and conventional as well as government-insured mortgage loans.
As government-sponsored enterprises, Fannie Mae and Freddie Mac — which are both publicly traded companies — receive explicit and implicit government subsidies. This mix of private and public involvement means that these organizations need to fulfill a public mission as well as provide investors with acceptable rates of return.
The federal government maintains its ties to Fannie Mae and Freddie Mac by providing various explicit subsidies: a $2.5 billion line of credit with the Treasury, exemption from registration with the Securities and Exchange Commission, and exemption from state and local income taxes.
Though obligations of Fannie Mae and Freddie Mac are not backed by the full faith and credit of the federal government, investors have indicated that they believe the government would provide any support necessary to keep these companies solvent because of their public sponsorship and mission. Fannie Mae and Freddie Mac benefit from this implicit guarantee through lower funding costs: Investors in their stock, general obligations and mortgage-backed securities (MBSs) accept lower rates of return in exchange for perceived lower risk.
Ginnie Mae, spun off from the FNMA in 1968 as the Government National Mortgage Association (GNMA), performs a similar role to Fannie Mae and Freddie Mac. It differs in two major ways, however: Ginnie Mae’s securities are backed by the full faith and credit of the U.S. government, and Ginnie Mae may purchase only federally insured Federal Housing Administration and Veterans Administration nonconventional mortgages.
Fannie, Freddie and the secondary mortgage market
Loan originators free up more funds for making additional loans by selling mortgages to Fannie Mae, Freddie Mac and other purchasers in exchange for cash to possibly originate more loans. Fannie Mae and Freddie Mac either hold these purchased
loans in their own portfolios or sell them in the secondary market in the form of MBSs, which are obligations to the security holder of the principal and interest payments from a pool of mortgages, less certain fees. The creation of securities based on a pool of underlying assets such as mortgages is known as “securitization.”
Fully private companies also buy mortgages and create MBSs backed by mortgages insured against credit loss through various credit enhancements. Private issuers of MBSs play an important role by securitizing conventional mortgages that do not qualify — also known as nonconforming mortgages — for Fannie Mae’s or Freddie Mac’s programs. Typically, a nonconforming mortgage’s loan amount exceeds the maximum limit that Fannie Mae or Freddie Mac may purchase, which is currently $275,000 for a single-unit home sold in the continental United States.
Relationship to commercial banks
Commercial banks interact extensively with Fannie Mae and Freddie Mac as mortgage sellers, mortgage servicers, and investors in Fannie Mae and Freddie Mac debt securities and, to a very limited degree, equity securities.
Banks as sellers of mortgages. Banks benefit from selling their mortgages to Fannie Mae or Freddie Mac by receiving liquid funds that can be used to originate more loans. Banks are also able to reduce the credit and prepayment risks of a mortgage that has an uncertain future cash flow in exchange for less risky assets, like MBSs. This management of risk allows the bank to free up some capital for lending or investing while meeting capital adequacy standards.
In 1999, commercial banks and their mortgage company affiliates sold to nonaffiliated purchasers $41.7 billion in mortgages originated by homebuyers in Southeastern metropolitan areas. Of this amount, 29.3 percent were sold to Fannie Mae, 24.5 percent to Freddie Mac and 22.7 percent to Ginnie Mae. (To obtain more data on sales of mortgages, see www.ffiec.gov/hmda to download Home Mortgage Disclosure Act reports.)
Banks as servicers of sold mortgages. The servicing rights of mortgages sold to Fannie Mae and Freddie Mac can be retained by the originators, which have the facilities and the relationships with borrowers that allow them to service at a profit. Servicing a loan includes collecting the principal and interest from borrowers, monitoring delinquencies and executing necessary foreclosures. Contracts with Fannie Mae and Freddie Mac make up 62.5 percent of the outstanding principal of serviced mortgages by commercial banks. Ginnie Mae contracts constitute 19.2 percent.
The servicing agreements place the obligation to cover borrower defaults on either the servicer or the securitizer. Only a small percentage of Freddie Mac and Fannie Mae servicing agreements with U.S. commercial banks place this obligation on the bank servicers (4.2 percent), showing that an important motive for banks to sell mortgages is to reduce credit risk. Since the mid-1990s, commercial banks have securitized mortgages to overcome liquidity constraints, allowing them to greatly increase mortgage originations. The percentage of banks’ single-family mortgage loans to total assets has remained mostly constant at about 15 percent during this time even though total mortgage originations significantly increased, demonstrating the usefulness of securitization in overcoming liquidity constraints (see the chart).
U.S. Commercial Bank Mortgage Statistics
Source: FFIEC Consolidated Report of Condition and Income
Banks as investors in federal agency securities. Banks also sell mortgages to Fannie Mae or Freddie Mac for securitization and buy them back in the form of MBSs. In addition, banks hold general debt securities issued by these two agencies in their investment portfolios.
MBSs held by a bank are reported in two categories on commercial banks’ financial statements: pass-through MBSs and other MBSs. Pass-through MBSs are claims on principal, interest and any prepayments coming from pools of mortgages minus servicing and credit guarantee fees. Pass-through MBSs distribute prepayment risk uniformly across all bondholders. Prepayment risk is the probability that a mortgage loan will be paid off early, causing the investor to forgo the originally anticipated interest payments.
Other MBSs include collateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs), and stripped mortgage-backed securities (SMBSs). CMOs, most of which are structured as REMICs because of tax advantages, are collateralized by pass-through MBSs but redistribute prepayment risk among different classes or tranches of bonds. SMBSs are claims on either the principal-only or interest-only payments from the mortgage pool. (For more information on these MBS types, see section 4110.1 of the Federal Reserve’s Trading and Capital-Markets Activities Manual at www.federalreserve.gov/boarddocs/supmanual.)
Commercial bank holdings of all mortgage agency securities totaled $656 billion in 1999. This total investment as a percentage of total assets has remained steady at 10 to 12 percent since 1994. This constant portion of assets in mortgage agency securities being serviced, which occurred during a period when there was a significant increase in the amount of mortgage principal outstanding under servicing agreements, further demonstrates that banks sell mortgages in exchange for funds in order to originate more mortgages.
Fannie’s and Freddie’s secondary mortgage advantages
Fannie Mae and Freddie Mac dominate the secondary mortgage market because the government provides them with both implicit and explicit subsidies, helping these organizations to reduce their funding costs. Financial analysis of banks’ overall mortgage activities demonstrates that banks value the liquidity and reduction of credit risk resulting from the secondary mortgage market. Banks also value Fannie Mae and Freddie Mac as investment opportunities and invest a significant portion of their assets in these two institutions’ securities.