What is the Secondary Mortgage Market?

Understanding the secondary market for real estate is crucial for new would-be-buyers and investors alike. With that in mind, below is an answer to the fundamental question “What is the secondary mortgage market?” Keep reading to learn how the secondary mortgage market works, who the major players are in recycling capital, and how you, as the consumer, can be affected by market fluctuations.

Key takeaways

By the end of this article, you will know that:

1. A secondary mortgage market is a marketplace where existing mortgages are bought and sold by investors who are not the originators or the payers of these mortgages.
2. The secondary market allows mortgage lenders to sell their notes quickly, giving them cash to issue further loans. This means greater availability of mortgages for buyers.
3. Government-sponsored agencies like Fannie Mae and Freddie Mac, along with banks, loan acquisition firms and investors are the largest participants in the secondary market.

What is the secondary mortgage market?

To start, even though lenders issue mortgages to homeowners, they rarely keep the debt in-house. Instead, the loans are sold off shortly after closing to loan aggregators like Fannie Mae and Freddie Mac or a private institution like Amerinote Xchange. The lenders are paid in exchange for those loans and they use those funds to provide mortgages to further borrowers.

Once the loan aggregators buy the loans, they bundle them with other mortgages that have a similar risk level. Those bundles are known as mortgage-backed securities (MBS). The mortgage-backed securities are then sold in the market to investors like governments, pension funds, insurance companies and hedge funds.

While the main focus here will be the secondary loan market, it’s worth noting that other types of debt are also sold in secondary markets as well. Auto loans, credit card debt, and student loan debt are all packaged and sold in this way. In particular, so are U.S. Treasury bills, bonds, and notes, which have an effect on all interest rates.

History of the secondary mortgage market

During the Great Depression, the U.S. government stepped in to support a struggling housing market. In 1938, the Federal National Mortgage Association, more commonly known as Fannie Mae, was established. This government entity bought mortgages from lenders, enabling them to issue more loans and thus help revive the housing market.

The landscape of the secondary mortgage market changed further in the late 1960s with the creation of the Government National Mortgage Association (Ginnie Mae) in 1968. Ginnie Mae introduced the first mortgage-backed securities, which had a government guarantee of principal and interest payments. This innovation made these securities much safer for investors, which in turn made funds more readily available for lending.

Another key development came in 1970 when Fannie Mae was privatized, and Freddie Mac was created to provide some competition in the market. Freddie Mac specifically aimed to help smaller banks by buying their mortgages, thereby enhancing their ability to lend.

These steps led to a dynamic secondary mortgage market that not only helped standardize and lower borrowing costs but also made homeownership achievable for a larger segment of the American population. However, the system was not without flaws, as evident during the 2007-2008 financial crisis. This crisis highlighted significant risks and led to major reforms aimed at improving the stability and transparency of the secondary mortgage market. 

How the secondary mortgage market works

• Origination of mortgages: Initially, mortgages are created in the primary market when a homebuyer applies for and obtains a mortgage from a lending institution like a bank. This is the direct lending phase where the borrower and lender finalize the loan terms.
• Selling the mortgages: After the mortgage is issued, lenders often sell these loans to entities in the secondary market. The reason lenders sell mortgages is to free up their capital, allowing them to offer loans to more borrowers without needing excessive amounts of on-hand capital.
• Aggregation into MBS: Once the mortgages are sold to secondary market players, they are often bundled together with other similar loans to create mortgage-backed securities. These securities are then sold to investors. By pooling many mortgages, these securities diversify the risk associated with any single loan.
• Impact on liquidity and rates: The continuous flow of capital from the sale of these securities back into the lending market helps maintain liquidity, enabling lenders to offer competitive mortgage rates. This liquidity is crucial, especially in times of economic downturn, to keep the housing market stable.
• Market regulation and oversight: Regulatory bodies oversee the secondary mortgage market to ensure that it operates smoothly and transparently. This oversight is designed to prevent the kind of risk-taking that led to the 2008 financial crisis, ensuring that lending standards and security structuring are maintained responsibly.

Who are the major participants in the secondary mortgage market?

To get a more in-depth understanding of how secondary marketing works, it’s important to take a look at the major participants in this cycle, as well as the role that each one plays in moving capital:

Banks

Before the mortgage secondary market was established, banks had to wait a long time before they were repaid for a mortgage, typically 15 to 30 years. This meant that fewer financial institutions had enough capital to write mortgage loans, and as a result, potential homebuyers had a harder time finding mortgage lenders.

Today, selling mortgage loans allows banks to recoup the cost of lending and to use the proceeds to fund new loans. This increases the amount of capital available for lending, making it easier for borrowers to find the money they need.

Government-sponsored enterprises (GSEs)

Fannie Mae was originally created by Congress in 1938 to bring liquidity and affordability to the mortgage market. However, in order to more successfully fund these efforts, the government privatized the agency with the passage of the Federal National Mortgage Association Charter Act in 1968. It also did the same with Freddie Mac once the agency was created in 1970.

Now that they are privatized, these agencies bundle home loans into mortgage-backed securities, which are then sold. By packaging these mortgage-backed securities — and guaranteeing the timely payment of their principal and interest — these agencies are able to attract investors and expand the pool of funds available for housing.

Private mortgage note acquisition firms

Beyond Fannie Mae and Freddie Mac, there are many private loan acquisition firms that perform the same role as loan aggregators. Fannie Mae and Freddie Mac have strict standards for the loans that they will buy. Private firms can and do buy the Fannie and Freddie “fallouts,” as they are called. This means loans that don’t fit Fannie and Freddie’s purchase criteria.

However, private mortgage note buyers are able to assume a greater level of risk. They are able to help lenders exit their investments on both conforming and non-conforming loans in order to recycle their capital in an expedient way.

Investors

The last group of participants in this cycle are the investors. For their part, investors can buy into mortgage-backed securities in a few different ways:

Pass-through securities

With pass-through securities, the investors receive a share of all the principal and interest payments received by their pool of mortgage loans as the borrowers make payments to the issuers. Each mortgage pool typically has a five-to-30 year maturity, but there is a certain amount of risk involved because some mortgages will be paid off early.

Collateralized Mortgage Obligation (CMO)

Collateralized mortgage obligations aim to minimize that prepayment risk by grouping mortgages into several tranches based on their risk levels. The tranches are then sold similarly to shares. Since each tranche has a different maturity date and size, bonds with monthly coupons are issued against them. The coupons entitle their holders to monthly principal and interest rate payments.

Stripped mortgage securities

With stripped mortgage securities, investors are paid either the principal or the interest on the loan. The market value of a principal-only stripe can vary widely based on interest rates. Whereas, an interest-only stripe strictly pays interest based on the outstanding principal amount of the loan. As mortgages amortize and prepayments are made, the value of an interest-only strip declines.

Secondary mortgage market example

Consider a scenario where a couple, the Smiths, obtain a mortgage from their local community bank to buy their first home. This loan origination occurs in the primary mortgage market where direct financing is provided to borrowers. After closing the loan, the community bank seeks to free up its capital to finance more home purchases for other customers. To achieve this, the bank sells the Smiths’ mortgage to a larger institution in the secondary mortgage market, such as Fannie Mae.

Once Fannie Mae acquires the mortgage, it combines this loan with thousands of others to create a diversified pool of mortgages. These pools are then structured into mortgage-backed securities (MBS), which are sold to investors around the world, including mutual funds, insurance companies, and pension funds. These investors are attracted by the predictable income generated from mortgage payments, backed by Fannie Mae’s guarantee of principal and interest. Through this process, the secondary mortgage market recycles capital back into the primary market.

What is the difference between primary and secondary mortgage market?

In the primary mortgage market, the initial transactions happen. This is where borrowers apply for and obtain mortgage loans directly from lenders like banks, credit unions, or mortgage companies. The primary market is all about the direct interaction between borrowers and financial institutions to secure funding for buying a home.

Once these loans are secured and funded, they often don’t stay with the original lender. Instead, they frequently move to the secondary mortgage market. This is where existing mortgage loans are bought and sold between lenders and investors. Large institutional players like Fannie Mae and Freddie Mac are major participants in this market. They buy large numbers of mortgages, bundle them into mortgage-backed securities, and then sell them to investors. The secondary market thus provides liquidity to the primary market lenders, enabling them to offer more loans to new borrowers.

So, while the primary market deals with the creation of the loans, the secondary market deals with the trading of these already existing loans. 

Why is there a secondary market for mortgages?

• Liquidity for lenders: By selling mortgages they’ve originated to entities in the secondary market, lenders are able to regain the capital they used to fund those loans. This replenishment of their funds allows them to issue new loans to other borrowers, keeping the cycle of lending active and continuous.
• Risk distribution: The secondary market helps distribute the risk associated with mortgage loans. When loans are sold from the original lenders to investors or institutions like Fannie Mae and Freddie Mac, the risk of default is spread out. This distribution makes the system more resilient and less vulnerable to localized economic downturns that might affect borrowers’ ability to repay loans.
• Stabilization of mortgage rates: By providing a steady flow of capital into the mortgage market, the secondary market helps stabilize mortgage rates. This stability is crucial for maintaining affordability in the housing market, as it helps keep rates more consistent and predictable for borrowers.
• Investment opportunities: The secondary market also creates opportunities for investors. Mortgages, when bundled into mortgage-backed securities, become accessible investment options. These securities offer returns based on mortgage payments and can be attractive for different types of investors, contributing to a dynamic financial market.

How does the secondary mortgage market affect consumers?

When private investors bring mortgage loans into the secondary market, competition and risk become much bigger factors. If you have a lower credit score, for example, the lender will perceive lending to you as a greater risk than lending to someone who has a higher score. As a result, you will likely be charged higher rates and fees in order to attract investors.

In fact, depending on the strength of your financial profile, you may not be able to get a mortgage through traditional means at all. In the wake of the 2008 recession, Fannie Mae and Freddie Mac tightened their lending standards more than ever before, boxing some would-be-home-buyers out entirely.

In light of that, many Americans have turned to seller-backed financing that offers looser qualifying requirements. However, since many private lenders don’t want to wait 15 to 30 years to see returns, they end up selling mortgage notes to private buyers, who then package the notes for the secondary markets.

Cons of the secondary mortgage market

• Complexity and opacity: The process of bundling mortgages into securities and selling them can be complex and difficult to understand. This complexity was one of the factors that contributed to the 2007-2008 financial crisis. The lack of transparency and understanding of mortgage-backed securities can lead to significant systemic risks.
• Increased volatility: The secondary market can introduce more volatility into the financial system, particularly if the market for mortgage-backed securities fluctuates significantly. This can affect the stability of financial institutions and the broader economy.
• Focus on quantity over quality: There is a risk that the desire to create more mortgage-backed securities can lead lenders to lower their lending standards, issuing more loans with a higher likelihood of default. This was another critical issue during the financial crisis, where an emphasis on volume led to poor quality loans being made and subsequently bundled into securities.
• Dependency on large entities: The secondary mortgage market relies heavily on large government-sponsored enterprises like Fannie Mae and Freddie Mac. This dependency can pose risks if these institutions face financial difficulties, potentially leading to broader economic impacts.

The bottom line

At its core, the answer to the question “what is the secondary mortgage market?” is simple. The secondary market for mortgages allows more Americans to become homeowners. By giving lenders the opportunity to sell their existing loans, it provides them with the liquidity they need to keep lending.

However, not all loans can reach secondary markets through traditional channels. In those cases, private lending can provide an effective solution.

If you are thinking about using seller-financing or private lending to accomplish your goals, contact us to see how we can help.

Frequently Asked Questions

What happens in a secondary mortgage market?

In a secondary mortgage market, the originator of a loan (the lender) sells on the rights to that loan to an intermediary, such as Fannie Mae or Freddie Mac, or a loan acquisitions company, which then bundle these loans according to level of risk and sell these bundles on to investors.

How do investors make money in the secondary mortgage market?

In the most general terms, investors make money in the secondary mortgage market through the spread (difference) between what they paid for the note, and what the note pays out in principal and interest over time.

Who regulates the secondary mortgage market?

In the U.S., the Federal Housing Finance Agency (FHFA) regulates the activities of Fannie Mae and Freddie Mac, as well as the banks that are part of the Federal Home Loan Bank (FHLB) System, which provides a steady stream of capital to mortgage lenders. The Consumer Financial Protection Bureau (CFPB), created in the wake of the 2008 foreclosure crisis, is responsible for enforcing rules against unfair, deceptive or abusive behavior by mortgage lenders.

DISCLAIMER: This is not an offer to sell securities. Any person, entity, or organization must first be qualified by the company and read all the offering documents and attest to reading and fully understanding such documents. Amerinote Xchange and its affiliates are not licensed securities dealers or brokers and as such, do not hold themselves to be. This presentation should be construed as informational and not as an advertisement soliciting for any particular purpose. All securities herein discussed have not been registered or approved by any securities regulatory agency in accordance with the Securities Act of 1933 or any state securities laws.