Continued from Part 5.
The primary mortgage market still exists today; in fact, borrowers still find their mortgage originator or lender in the primary mortgage market. No one goes to Fannie Mae or Freddie Mac for purchase money. It’s the primary mortgage market that now has the option of selling originated mortgages to the secondary market. The primary and secondary mortgage markets are dependent upon each other and operate side-by-side.
The primary mortgage market consists of people and businesses wanting to borrow money and lenders and mortgage originators who are in the business of lending money and collecting origination fees. The distinction between a primary lender and a mortgage originator is that lenders keep most of the mortgage that they originate in-house and bear the interest rate and credit risk of the loans they originate. Mortgage originators focus on loan origination, rather than holding and managing loan portfolios, and typically sell a large percentage of the loans they originate to the secondary mortgage market. By selling mortgages to the secondary mortgage market, originators acquire new funds that can be used to originate additional mortgages. For their services, originators typically charge up front fees, paid at loan origination, rather than rely on an interest rate spread.
A mortgage banker is an example of a loan originator. The mortgage banking industry has grown-up with the secondary mortgage market and has replaced S & Ls as the common source for residential mortgage lending. Mortgage bankers raise capital though debt and equity issues, and certainly sell mortgages to the secondary mortgage market to raise capital. Mortgage bankers often retain the mortgage servicing rights ad collect the mortgage payments, keep records, and handle customer service for a servicing fee. Mortgage bankers are licensed by the state or states in which they conduct business.
Please do not confuse a mortgage banker with a mortgage broker. A mortgage broker is simply a matchmaker-just like a real estate broker, which introduces borrowers to lenders for a fee. A mortgage broker should be knowledgeable about local mortgage products and programs, but does not originate the mortgage nor do they put their own money at risk, as does a mortgage banker.
Mortgage originators have the option of selling their mortgages to the secondary mortgage market, typically Fannie Mae and Freddie Mac for conforming loans. A conforming loan meets the specific underwriting criteria required by the secondary mortgage market and does not exceed a maximum amount, also specified by the secondary mortgage market. In other words, a conforming loan is a loan that the secondary mortgage market would consider purchasing.
The secondary mortgage market purchases mortgages from every state in the country and has created essentially one national secondary mortgage market. Now large nationally diversified pools of mortgages are sold as packages that can be securitized and sold as investments. Credit risk of local borrowers is no longer concentrated in the mortgage portfolios of local lenders, but is spread among millions of MBS investors throughout the country and world.
Mortgage pooling provides tremendous liquidity to the mortgage markets where the local funds available for mortgage lending is constrained by the amount of local deposits. Now, growing and developing areas of the country, such as Utah and Arizona, with great demand for development funding have about the same access to mortgage money as relatively developed and “old money” areas of the country such as New York and Pennsylvania.
Fannie Mae and the secondary mortgage market offers insurance on their mortgage pools to reduce the pool’s overall credit risk to investors. Also, the servicing rights of these mortgages can be retained by the originator or serviced by mortgage bankers or other companies specializing in mortgage servicing, for a fee.
Wall Street investment banking firms can now purchase large pool of mortgages for the creation of mortgage-backed securities that they can offer their clients (savers) as investments. Mortgage-backed securities can be added to a saver’s portfolio and provide an element of diversification from stocks and bonds.
As of 2008, Fannie Mae and Freddie Mac owned or guaranteed approximately half of the $12 trillion mortgage market. Fannie Mae was one of the largest corporations in history in terms of assets. Many academics and practitioners would agree that the secondary mortgage market is a great financial innovation. Universities have students from all over the world coming to the US to study this market, as secondary mortgage market related topics have been the subject of many theses and dissertations. Fannie Mae and the government also touted studies showing that the secondary mortgage market has been responsible for decreasing mortgage interest rates, increasing mortgage market liquidity, and increasing the US homeownership rates to it’s highest levels in history.
So what went wrong? Why was Fannie Mae placed into conservatorship in September 2008? The next section focuses on a moral hazard and unintended consequences that brought this great system down.
Part 7 coming soon.
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