Imagine obtaining financing to purchase a new home. The bank gives you the funds necessary for the purchase, and you agree to pay back this amount within an agreed timeline. In the meantime, the bank transfers your loan to the secondary market, turning it into liquid assets. This transaction enables the lender to boost its capital and issue loans to more customers.
After your mortgage is transferred to the secondary market, various scenarios can unfold. The buyer may choose to keep your mortgage and collect the interest, or they could bundle it with other loans to create a mortgage-backed security. Ultimately, the lender’s decision concerning your mortgage doesn’t impact you as a borrower.
Why does the secondary mortgage market exist?
Creating a completely new security based on mortgages is no easy task. So, what drives those involved in the mortgage industry to engage in this process? The secondary market provides benefits to everyone involved-including borrowers, investors, banks or lenders, aggregators, and rating firms.
In the secondary market, lenders can disassemble their mortgage loans, enabling financial entities to concentrate on various market segments. For example, a financial institution could initially create a loan and subsequently sell it within the secondary market, all the while retaining the right to manage the loan’s servicing.
As a loan originator, the financial entity manages the steps of underwriting, processing, funding, and closing the loan. It levies charges for these distinct services and may opt to keep the loan or sell it afterward.
As a loan servicer, the bank receives compensation for managing monthly payment collections, tracking loan balances, generating tax statements, maintaining escrow accounts, and performing a variety of other responsibilities.
No matter if the lender decides to keep the loan it has issued, having a dynamic and active secondary market provides a benefit, enabling the sale of its loans or servicing rights.
Pros and cons of the secondary mortgage market
The advantages and disadvantages of the secondary mortgage market can be outlined as follows:
Pros
- Lower costs: Borrowers can benefit from lower expenses via the secondary mortgage market.
- Investors can pick and choose loans: Entities such as banks, pension funds, and hedge funds fall under the category of investors, allowing them to obtain specific kinds of securities that better match their needs and tolerance for risk.
- It keeps money moving: Financial organizations can transfer certain loans while maintaining ownership of others they prefer to keep. This approach allows them to optimize their capital use, generating income from the mortgage underwriting phase, disposing of the mortgage, and subsequently reinvesting their funds to create a new loan.
- Aggregators collect fees: Organizations such as Fannie Mae and Freddie Mac create income by merging and restructuring mortgages, subsequently enhancing them with attractive characteristics.
Cons
- It can come with risk: Putting money into mortgage-backed securities comes with considerable dangers. If borrowers do not fulfill their loan responsibilities, investors could face financial setbacks, which might adversely affect the overall economy.
- Impact on returns: If borrowers choose to refinance or pay off their loans earlier than expected, it could negatively impact the returns for investors.
- Strict eligibility criteria: Enterprises backed by the government, known as GSEs, set strict criteria for the types of loans eligible for support in the secondary market. This often results in lenders avoiding loans that do not adhere to these standards. As a result, those with poor credit scores frequently discover they cannot obtain a loan, or if they do manage to secure one, they face significantly higher interest rates.