Picture yourself securing a loan to buy a new house. The financial institution provides you with the amount needed to acquire the residence, and you commit to repaying this sum over a specified duration. Meanwhile, the lender sells your loan to the secondary market, converting it into cash. This process allows the lender to increase its capital and extend loans to additional clients.
Once your mortgage is sold to the secondary market, several outcomes are possible. The purchaser might opt to retain your mortgage and receive the interest payments, or it could be combined with various other loans and converted into a mortgage-backed security. In the end, the lender’s choice regarding your mortgage does not affect you as a borrower.
Why does the secondary mortgage market exist?
Developing an entirely novel security from mortgages is a challenging endeavor, so what motivates the participants in the mortgage sector to pursue this? The secondary market offers advantages for all economic participants—such as borrowers, investors, banks/lenders, aggregators, and rating agencies.
The secondary market permits lenders to break down their mortgages, which in turn allows financial institutions to focus on different sectors of the market. For instance, a bank might originate a loan and later sell it on the secondary market while still keeping the servicing rights of the mortgage.
In the role of a loan originator, the financial institution handles the underwriting, processing, funding, and finalization of the loan. It charges fees for these various services and might choose to retain the loan or sell it thereafter.
In its role as a loan servicer, the bank earns a fee for handling the monthly payments, monitoring loan balances, producing tax documents, and overseeing escrow accounts, along with several additional tasks.
Regardless of whether the lender chooses to retain the loan it created, there is an advantage in having a vibrant and fluid secondary market that allows it to sell its loans or servicing privileges.
Pros and cons of the secondary mortgage market
The secondary mortgage market has its pros and cons, which are as follows:
Pros
- Lower costs: Through the secondary mortgage market, borrowers may experience reduced costs.
- Investors can pick and choose loans: Investors, which encompass institutions like banks, pension funds, and hedge funds, gain access to particular types of securities that align more closely with their requirements and risk preferences.
- It keeps money moving: Financial institutions have the ability to reassign specific loans while still holding onto others they wish to retain. This strategy enables them to utilize their capital effectively, earning fees from the mortgage underwriting process, selling the mortgage, and then reinvesting their capital to issue a new loan.
- Aggregators collect fees: Entities like Fannie Mae and Freddie Mac generate revenue by combining and reorganizing mortgages, then tailoring them with appealing features.
Cons
- It can come with risk: Investing in mortgage-backed securities carries significant risks. When borrowers fail to meet their loan obligations, investors may incur losses, potentially impacting the broader economy negatively.
- Impact on returns:Â The returns for investors may suffer if borrowers decide to refinance or repay their loans sooner than anticipated.
- Strict eligibility criteria: Government-sponsored enterprises (GSEs) impose rigorous standards on the kinds of loans they will back in the secondary market, which typically leads lenders to refrain from providing loans that fall outside these guidelines. Consequently, individuals with low credit ratings often find themselves ineligible for a loan, or if approved, are likely to encounter elevated interest rates.