The Mortgage Funds Flow: Your Local Bank for Mortgage-Backed Securities
The availability of funds in the primary market is highly dependent on the existence of secondary markets. First, the mortgage funds are loaned to a home buyer by a lender in the primary market. The mortgage is then sold to a secondary market agency who, in turn, can sell it to other investors in the form of mortgage-backed securities. Mortgage-backed securities are divided into two general types: bond-type securities and transferable securities. Bond-type securities are long-term, pay interest semi-annually and are repaid on a specified date. The most common transferred securities pay interest and principal payments on a monthly basis. Some types of transferred securities pay even if the payments are not collected from the borrower.
Because a primary lender sold the mortgage, the lender can take the money it receives from the sale and make another home loan, then sell that new loan to the secondary market and continue the cycle. The secondary market agency can bundle the mortgages it buys to create mortgage-backed securities, which it then sells to investors. As the secondary market agency sells the mortgage-backed securities to investors, it now has more funds to buy more mortgages. You can then create more pools of mortgage-backed securities to sell back to investors, and the cycle continues.
The marketplace can work the way it does because standardized underwriting criteria are used to rate borrowers and property. The secondary market will only buy a mortgage if the primary market lender complies with the secondary market underwriting rules. Since lenders want to sell their loans, they must follow the underwriting standards of those agencies. The top three agencies in the secondary market are Fannie Mae, Freddie Mac, and Ginnie Mae. Therefore, a conforming loan is typically a loan that conforms to Fannie Mae’s underwriting guidelines. Private companies such as hedge funds and investment banks also participate in the flow of mortgage funds by purchasing mortgage-backed securities. The recent credit crisis and economic downturn were due in part to the buying and selling of mortgage-backed securities. Investors borrowed incredible amounts of money and were so dramatically leveraged that when the value of mortgage-backed securities fell, it was enough to create huge liquidity problems for companies and many closed (Bear Stearns, Merrill Lynch, etc. ). Unfortunately, many of the same dynamics that caused the financial collapse are still at work today. The secondary market still exists with Fannie Mae (infused with taxpayer money) now buying up to 99% of all loans originated in the United States.