Secondary Mortgage Markets

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Secondary Mortgage Market

The market for buying and selling mortgages. After a bank makes a mortgage loan to a client, it may choose to sell the loan to another party, which reduces its risk of non-payment; this transaction is based on the same concept as accounts receivable financing. Often, these mortgages are re-packaged together as mortgage-backed securities.

Secondary Mortgage Markets

Markets in which mortgages or mortgage-backed securities are bought and sold.

“Whole Loan” Markets Versus Securities Markets: Secondary mortgage markets are of two general types. “Whole loan” markets involve the sale of mortgages themselves, sometimes on a loan-byloan basis but more often in blocks. Such markets, which arose in the U.S. soon after World War II, primarily involve the one-time sale of newly originated mortgages to traditional mortgage lenders.

In the 1970s, markets also developed in mortgage-backed securities issued against pools of mortgages. Instead of selling, e.g., $50 million of whole loans, the loans are segregated in a pool and $50 million of securities are issued against the pool. These securities are actively traded after the initial issuance, and they are attractive to investors that would not ordinarily hold mortgages, such as pension funds or mutual funds.

Mortgage-backed securities always have some kind of “credit enhancement,” or guarantees of payment beyond the promises of the individual mortgage borrowers. The most important of the guarantors are Ginny Mae, Fanny Mae, and Freddie Mac (see below).

Impact on Interest Rates: Secondary markets reduce mortgage interest rates in several ways. First, they increase competition by encouraging the development of a new industry of loan originators. Called different names in different countries (in the U.S. they are called “mortgage companies” or “mortgage banks”), they all have in common that they require little capital and tend to be aggressive competitors.

Absent secondary markets, the only institutions originating mortgage loans are those with the capacity to hold them permanently, termed “portfolio lenders.” In small communities especially, borrowers may be at the mercy of one or a few local banks or savings and loan associations. The entry of mortgage companies that can sell into the secondary market breaks up these local fiefdoms, much to the benefit of borrowers. The development of whole loan markets in the U.S. is largely responsible for the growth of this industry.

Secondary markets also increase efficiency by encouraging a specialization of lending functions that reduces costs. Portfolio lenders typically do everything connected to originating and servicing loans, even though they may do some things quite inefficiently. Secondary markets, in contrast, create pressures to break functions apart and price them separately, and this imposes a discipline on mortgage companies to concentrate on what they do best. Many mortgage companies have ceased servicing loans, for example, because they can do better selling the servicing to companies that specialize in that function.

In addition, conversion of mortgages into mortgage-backed securities permits a better distribution of the risk of holding fixed-rate mortgages (FRMs). As one example, depository institutions don't want to take the risk of funding long-term assets with short-term liabilities. But they can originate FRMs, convert them to securities, and sell the securities to pension funds, which have long-term liabilities.

Mortgage-backed securities also are “liquid” while mortgages themselves are not. This means that in most cases mortgage-backed securities can be sold for full value within the day whereas selling the same amount of mortgages could take weeks. Because most investors value liquidity and are willing to accept a lower yield to get it, converting illiquid mortgages to liquid securities puts downward pressure on the rates charged to borrowers.

Widening the Market: Secondary markets have also vastly expanded the size of the borrower pool. Portfolio lenders generally restrict their loans to “A-quality” borrowers, in large part because of regulatory concerns about their safety and soundness. Secondary markets, in contrast, can access investors who are prepared to hold risky loans

if the price is right. The result has been the emergence of the socalled “sub-prime market” and a new category of borrowers—borrowers who previously had recourse only to family, friends, home sellers, and loan sharks.

Shopping Complexities: The downside of secondary markets from a borrower's perspective is that shopping for a mortgage becomes more complex. The secondary market is largely responsible for market nichification, which makes it difficult for a borrower to determine whether a price quote applies to his or her particular deal, and price volatility, which makes it risky to compare a price quote on Monday  with  one  from  another  loan  provider  on  Tuesday. Nichification and volatility underlie several common scams perpetrated on borrowers by loan providers. See Mortgage Scams and Tricks/ Scams by Loan Providers.

Ginny Mae: The mortgage-backed security market was begun in 1970 by Ginny Mae, a wholly-owned agency of the federal government. The agency guaranteed the payments on securities issued by lenders against pools of FHAand VAmortgages. This program makes money for the Treasury and has been relatively free of controversy.

Fannie Mae and Freddie Mac: These firms are “government-sponsored enterprises” (GSEs), which means that they are privately owned, but receive support from the federal government and assume some public responsibilities. The two GSEs today are among the largest corporations in the world and are highly controversial.

Operations: The GSEs purchase “conforming” mortgages from the lenders that originate them. They hold some, which are funded by issuance of debt. The remainder are “securitized”—sold in the form of securities that the GSEs guarantee.

Conforming mortgages are those that meet the underwriting requirements of the agencies and are no larger than the largest loan the GSEs are allowed by law to purchase. In 2003 the maximum was $322,700. It is raised every year in line with increases in home prices. Conforming mortgages account for roughly 80% of the conventional (non-FHA/VA) home loan market.

Government Support: The major support the GSEs receive from the Federal Government is a special claim for government assistance in the event they ever get into financial trouble. This claim is grounded on their right to borrow from the U.S. Treasury, and on their history—both were public institutions before they became privately owned. As a result, investors consider the notes they issue and the mortgage securities they guarantee almost as good as securities issued by the federal government itself.

Absence of Competitors: The GSEs have no competitors in the conforming loan market. Because of their government backing, the GSEs can sell notes and securities at a lower yield than any strictly private secondary market firm. This gives them a monopoly—or rather a duopoly, since there are two of them—in the market in which they operate.

The GSEs do have emulators, however, in the non-conforming market. While the cast of players changes, at any one time there are usually 15 or more strictly private firms that purchase non-conforming loans and securitize them in much the same way as the GSEs.

Why the Special Treatment? The government did not select the two firms for special treatment. Both the GSEs began as government entities and the major objective in privatizing them (while retaining government support) was to encourage development of a private secondary market. The other firms arose later, based on the GSE model, so that objective was achieved.

While logic might dictate that the special treatment is no longer required, it has continued. The GSEs are unwilling to give it up and they have become so powerful politically that they have managed to thwart the several attempts that have been made to take it away.

The Public Stakes: If you are a potential borrower eligible for a conforming loan, your interest rate will probably be about 3/8% lower than it would be absent the GSEs. This reflects their relatively low funding costs, part of which is passed through to borrowers.

In addition, if you are a low or low-to-moderate-income borrower and/or reside in an underserved area, you might find a loan through a GSE. As part of their public responsibility, the GSEs commit to purchase specified numbers of such loans. How many would not be made without the GSEs, however, is not clear.

As a taxpayer, on the other hand, you have a cause for concern. The low borrowing costs of the GSEs are based on implicit government backing for their $3 trillion-plus of debt and guarantees. If the GSEs ever have a financial disaster, the government will have to bail them out and tax payers will be on the hook for the cost.

A few years ago Congress gave responsibility for monitoring the safety and soundness of GSEs to the Department of Housing and Urban Development (HUD). However, very few informed observers believe that HUD is up to the task.

A Way Out: It is possible to gradually reduce the risk of a financial disaster by removing government support without hurting investors who have relied on that support. This could be done by revoking the credit lines the GSEs now have with the Treasury and providing an explicit federal guarantee of all debt and GSE guarantees outstanding on the date the credit line is revoked. An explicit guarantee on the old claims would prevent any repercussions in the financial markets, yet put the markets on notice that new ones are not guaranteed. Over time, the volume of guaranteed claims would gradually decline.

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