Secondary Mortgage Market

The space where mortgages are bought and sold after they have been originated (buyer has bought the house and mortgage placed on it) is called Secondary Mortgage Market. It is secondary because the buyer is not affected and the interactions are between two unrelated parties to the original (or primary) transaction.

Why does Secondary Mortgage Market Exist?
The main reason is that Banks, especially the Mortgage Banks, are in the business of originating loans to borrowers and making money doing that. They want to originate more loans to as many buyers as possible and need funds for that. They could either way 10-15 years to get their funds back from the borrowers or sell the loans in Secondary Mortgage Market to get funds much more quickly and passing on the long-term returns (after skimming some from the top to compensate for their efforts) to appropriate investors who are willing to wait to get their principal investment back.

Some of the most common ways mortgages are bought and sold, and steps involved are:

1) Lender/Bank has originated the mortgage. It has the loan associated with the mortgage on its “books” – the loan is an asset on Bank’s Balance Sheet.

2) Lender either keeps that “whole” loan (mortgage goes with the loan) or sells it as a whole loan (ownership to all the future cash flows repaid by the borrower) to another Bank who would like to get that return built into the loan.

3) Another option is for the Bank to convert that loan into an MBS – Mortgage Backed Security. The loan is not “whole” anymore and the cash flows of several loans are pooled together into a Trust. These funds are then distributed to the investors who buy ownership in the Trust by buying bonds called MBS. This entitles them to some share of the cash flows generated by loans in the Trust.

4) There are three main paths taken to create MBSs
a. Agency/GSE MBS: GSEs are Government Sponsored Entities such as Fannie Mae and Freddie Mac. Now they are really GEs – Government Entities since they are in conservatorship of the Government Regulator. High risk loans (such as high LTV, Loan-to-Value) require some kind of credit enhancement before being placed into GSE MBSs. The Banks either sell their loans to GSEs, who guarantee the timely payment of Principal and Interest (P&I) and charge a fee for it, who in turn create “Agency MBS” and sell them to large investors or they “convert” the whole loans into Agency MBS buy simultaneously selling whole loans and then immediately buying MBS from GSEs for their portfolio.

b. Government/Ginnie MBS: Ginnie Mae is completely owned by the US Government and it buys loans from Banks that are credit protected by other Government entities such as FHA/VA. FHA has started playing a bigger and bigger role in the housing market ever since the collapse of the housing market as its rates and underwriting guidelines continued to be the same as before the crisis. So as others cut back on their business, more business flowed into FHA. As the loans are essentially backed by US Government, the default risk on the loans is completely eliminated for the investors.

c. Private Label MBS: These are high risk loans that are not backed by FHA/VA and not eligible to be bought or guaranteed by GSEs. Banks originate these higher return loans and package them themselves using some legal structures into various types of bonds (Private Label MBS). These bonds carry default risk in additional to normal interest rate risk to the investors. Investors therefore demand higher returns to invest in these types of securities. If the economics work out then these types of bonds are created and sold by Banks to willing investors to replenish their funds and make more loans to more buyers.

You can see the interaction of different parties in the graphic below: