Secondary Mortgage Market: What it is and how it Works
Key takeaways:
- Investors purchase and sell mortgage-backed securities, or bundled packages of numerous individual loans, on the secondary mortgage market, a financial marketplace.
- Although you, as the buyer, are not directly involved in it, the secondary market affects the cost and availability of mortgages.
- If you obtain a mortgage, you may be required to repay your lender over the following 15 or 30 years.
- Many banks and lenders create mortgages to resell to other investors.
Many homebuyers need to be made aware of the size and operation of the secondary mortgage market. Despite this, the secondary market significantly impacts both your ability to obtain a mortgage and the cost of that loan.
What is the secondary mortgage market?
Investors can purchase and sell securitized mortgages on the secondary mortgage market. Securitized mortgages are bundled together into large-group loans. Mortgage lenders create loans and sell them on the secondary market. Investors who buy those loans are granted the right to collect the outstanding balance.
The risk and potential return of mortgages determine their value on the secondary market, just like in any other securities market. People with lower credit scores pay higher interest rates partly because higher-risk loans have to provide higher returns.
Primary vs. Secondary Mortgage Market
Lenders offer mortgages to borrowers in the primary mortgage market. For instance, you are engaging in the primary mortgage market if you visit a few banks and your neighborhood credit union to obtain a mortgage quote.
There are no borrowers in the secondary mortgage market. Instead, it's where lenders offer investors loans they have created.
How the Secondary Mortgage Market Works
Even though they may keep the servicing rights, lenders typically sell the loans they originate in the secondary mortgage market. Numerous lenders offer loans to other aggregators or government-sponsored enterprises (GSEs), such as Freddie Mac and Fannie Mae. These aggregators can hold the loans on their books, collect interest from borrowers, or repackage them as mortgage-backed securities (MBS).
The loan must be "conforming"—that is, it must adhere to specific requirements established by the Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie—to be sold to the GSEs. Among these are:
- Most markets have a maximum loan amount of $766,550 (for 2024); however, in some pricey areas, it can be as much as $1,149,825.
- The down payment, which is usually at least 3% of the loan amount
- The credit score of the borrower, typically between 620 and 650
- The debt-to-income (DTI) ratio of the borrower, which is ideally 36 percent or less
When borrowers can meet the requirements, the demand for conforming loans contributes to a decrease in mortgage rates. It should be noted that jumbo loans with higher loan amounts do not qualify as conforming loans.
1. A borrower takes out a loan
A mortgage, also known as a conforming loan, is a loan obtained by a homebuyer from a lender. The lender retains the buyer's mortgage and promises to pay it back at a predetermined interest rate while the buyer purchases the property with cash.
2. The lender sells the loan to an aggregator
A mortgage aggregator, such as Fannie Mae or Freddie Mac, which purchases two-thirds of all mortgages in the United States, buys the loan from the lender. By selling the mortgage note, the lender receives cash and can use that money to write another loan. The lender may retain the right to service the mortgage for which it is paid.
Since the aggregator paid cash for the loan, it now belongs to them, so the lender waives any principal or interest payments.
3. The aggregator combines the loans to create mortgage-backed securities.
The aggregator purchases conforming loans repeatedly, accumulating hundreds or thousands of mortgages throughout the United States. Subsequently, these loans are packaged, or "securitized," into mortgage-backed securities (MBS). It could combine 1,000 mortgages into a single MBS series. Like a mutual fund that invests in numerous companies, purchasing an MBS carries a lower risk than buying a single mortgage due to its many mortgages.
MBS can be organized into a wide range of investment products by aggregators, who can subsequently sell "shares" in these products. They might produce a spectrum of bonds, from highly safe to somewhat risky, with higher payouts for more difficult notes and lower payouts for safer bonds. Additionally, they might arrange the MBS bond payments in a way that appeals to specific investors. For example, certain MBS may only pay investors interest, while others may pay principal or a combination.
An aggregator may keep the servicing rights for the mortgages and, if it has acquired those rights, either service or sell the underlying loans to a third party.
4. Investors purchase securities.
Investors, including insurance companies, mutual funds, pension funds, and other income-oriented investors, can purchase the MBS from the aggregator. The money that the aggregator gets is used to purchase additional mortgage notes for potential future repackaging. The MBS is then given to the investor, who may keep it and make money off it (from the mortgage payments) or sell it to another investor afterward.
The investor receives payment when the MBS matures. The investor can then buy another MBS or invest this money elsewhere.
Example of the secondary mortgage market
Assume you decide to buy a new house with a mortgage. You agree to repay the lender over a predetermined period in exchange for them providing you with the money to buy the property. However, the lender sells your mortgage to the secondary market to raise funds on the back end. As a result, the lender now has more capital to lend to more borrowers.
After it is sold to the secondary loan market, your mortgage may experience a few different outcomes. It could be packaged with other home loans and pledged as a mortgage-backed security, or the buyer could choose to hold it and collect interest. As a borrower, you are unaffected by the lender's decision regarding your mortgage.
History of the secondary mortgage market
With the establishment of Fannie Mae in 1938, which bought FHA mortgages, Congress established the secondary mortgage market. Since originating lenders wanted to avoid committing their capital for extended periods, Fannie Mae gave them the liquidity they needed to produce more loans. Banks could write more mortgages and help more people become homeowners if they could sell loans.
Congress established Freddie Mac in 1970 with similar objectives to those of Fannie Mae: to act as a market-maker, or a ready buyer and seller of mortgages, to incentivize lenders to provide loans to individuals, safe in the knowledge that they can always be repaid.
Banks (or other institutions, such as savings and loan associations and credit unions) usually held the loans they originated on their books before establishing the secondary mortgage market. Therefore, if you obtained a mortgage from a local bank, that bank remained the owner of the mortgage until you paid it off in full or refinanced. When assessing risk, the regional bank's needs and whether it had space in its loan book for your type of loan were considered. You might only be able to obtain a mortgage if it did, and you could not get a loan from any of the other local banks.
However, with the development of the secondary market, a bank can use more space in its loan book for your loan. It could take on the role of the loan's originator before selling it to an aggregator or another interested business. However, those outside parties wished to confirm that banks weren't merely writing bad loans; they could sell them to others. Consequently, the need arose for uniform lending standards, which gave rise to the conforming mortgage.
These days, even if a local lender doesn't want to hold the mortgage, those who can meet conforming loan standards can find funding for their mortgage thanks to the secondary mortgage market.
Who is involved in the secondary loan market?
The secondary loan market involves several parties, such as:
- Mortgage loan originators (MLOs): MLOs create loans in close collaboration with borrowers. They might decide to sell these loans on the secondary mortgage market.
- Aggregators: Government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac, buy mortgages from lenders and repackage them into securities sold on the secondary market. Aggregators can also be MLOs.
- Investors: On the secondary market, investors purchase mortgage-backed securities. Investors receive returns when borrowers pay back their loans.
- Homeowners: These transactions do not directly involve homeowners. Nevertheless, they remain crucial since their loans are bought and sold on the secondary real estate market.
What is the purpose of the secondary mortgage market?
Given how difficult it is to create an entirely new security out of mortgages, why would the participants in the mortgage market take this action? The secondary market benefits all parties involved in the economy: investors, banks and lenders, aggregators, rating agencies, and borrowers.
The secondary market enables lenders to segment their mortgage portfolios, allowing financial firms to focus on different market segments. A bank might, for instance, originate a loan and sell it on the secondary market, yet it still has the right to handle mortgage servicing.
As the originator, the bank underwrites, processes, funds, and closes the loan. After payment for these services, the loan may or may not be kept.
The bank is compensated for its services as a loan servicer, which includes processing monthly payments, monitoring loan balances, producing tax forms, and overseeing escrow accounts.
Lenders gain from having an active and liquid secondary market where they can sell their loans or servicing rights, even if they choose to hold onto the original loan.
Pros and Cons of the Secondary Mortgage Market
There are several benefits and drawbacks associated with the secondary mortgage market.
Pros
- Cheaper costs: Because of the secondary mortgage market, borrowers may be able to save money.
- Lending options are available to investors: Investors are exposed to securities that better suit their needs and risk tolerance, including institutional players like banks, hedge funds, and pension funds.
- Maintains cash flow: Lenders can remove some loans from their records while keeping others they would rather keep. Additionally, it enables them to use their capital effectively, earning fees for the underwriting of mortgages, selling the mortgage, and then repurchasing capital to write another loan.
- Fees are collected by aggregators. Aggregators like Fannie and Freddie can charge fees by repackaging, bundling, and arranging mortgages with particular alluring features.
Cons
- Investing in mortgage-backed securities can be hazardous. Investors risk losing money if borrowers don't make loan payments, and the economy may suffer.
- Impact on returns: If a borrower refinances or repays their loan earlier than anticipated, this could also hurt investors' returns.
- Tight eligibility requirements: Lenders typically will only issue loans within these parameters because GSEs have strict guidelines about what kinds of loans they'll guarantee in the secondary market. Because of this, borrowers with low credit scores may not be able to get a loan at all, or if they do, their interest rates will be higher.
The bottom line on the secondary mortgage market
The secondary market influences many aspects of the primary market, including the banks' willingness to underwrite loans since they buy a sizable share of home loans. Even though you may still be paying your monthly installments to the bank that first obtained the loan, the funds go to several different investors who either fully or partially own your mortgage.
