Your mortgage may be seen as the financing that enabled you to purchase your house. However, mortgages are seen as a stream of future cash flows by investors. In the secondary mortgage market, these cash flows are purchased, sold, stripped, tranched, and securitized. The secondary mortgage market is particularly big and liquid since most mortgages are eventually sold.
There are several different institutions that all carve out some portion of the initial fees and/or monthly cash flows from the point of origination to the point at which a borrower’s monthly payment ends up with an investor as part of a mortgage-backed security (MBS), asset-backed security (ABS), collateralized mortgage obligation (CMO), or collateralized debt obligation (CDO) payment.
We’ll explain how the secondary mortgage market operates, explain why lenders and investors engage in it, and introduce you to its key players in this post.
The four types of mortgage market players include:
- The mortgage originator
- The aggregator
- The securities dealer
- The investor
1. The Mortgage Originator
The first business active in the secondary mortgage market is the mortgage originator. Retail banks, mortgage bankers, and mortgage brokers are examples of mortgage originators. Mortgage bankers often utilize what is known as a warehouse line of credit to finance loans, while banks typically use their regular sources of financing to finalize loans. Newly created mortgages are swiftly sold into the secondary market by the majority of banks and almost all mortgage bankers.
One difference to be made is that, in contrast to mortgage brokers, banks and mortgage bankers utilize their own money to complete mortgages. Instead, they serve as unbiased representatives for banks or mortgage bankers, connecting them with customers (borrowers).
However, a mortgage originator may aggregate mortgages for a while before selling the whole package, or it may sell individual loans as they are created, depending on its size and complexity. When an originator stays onto a mortgage after an interest rate has been offered and locked in by a borrower, there is risk associated. The value of the mortgage in the secondary market and, ultimately, the profit the originator gets on the mortgage, might alter if the mortgage is not concurrently sold into the secondary market at the same moment the borrower locks the interest rate.
Mortgage originators that pool loans before selling them often insure their pipelines against changes in interest rates. For the selling of a single mortgage, there is a unique sort of transaction called a best efforts deal that does away with the necessity for the originator to hedge a mortgage. Best efforts transactions are often used by smaller originators.
The costs required to initiate a mortgage and the difference between the interest rate provided to a borrower and the premium a secondary market would pay for that interest rate are the two main ways that mortgage originators often generate income.
2. The Aggregator
The following business in the list of secondary mortgage market players is an aggregator. Large mortgage originators known as “aggregators” have connections to Wall Street corporations and GSEs like Fannie Mae and Freddie Mac. Aggregators acquire freshly originated mortgages from smaller originators and combine them with their own originations to create pools of mortgages, which they then either securitize into agency mortgage-backed securities or private-label mortgage-backed securities (by cooperating with Wall Street companies) (by working through GSEs).
Aggregators must hedge the mortgages in their pipelines, much like originators, from the moment they agree to buying a mortgage through the securitization process until the MBS is sold to a securities dealer. A mortgage pipeline’s hedging is a challenging job because of spread and fallout risk. Depending on how well their hedges work, aggregaters benefit from the difference between the price they pay for mortgages and the price at which they can sell the MBS backed by those mortgages.
3. The Securities Dealers
An MBS is sold to a securities dealer after it has been constituted (and sometimes earlier, depending on the kind of MBS). Most brokerage houses on Wall Street have MBS trading desks. MBS and mortgage entire loans are used in a variety of inventive ways by dealers at these desks with the intention of selling them as securities to investors. MBSs are often used by dealers to structure CMOs, ABSs, and CDOs. In contrast to the underlying MBS or entire loans, these transactions may be designed to have distinct and defined prepayment characteristics as well as higher credit ratings. When buying and selling MBSs, dealers charge a spread, and they try to benefit from arbitrage by structuring specific CMO, ABS, and CDO packages.
4. The Investors
Mortgages are ultimately used by investors. Large investors in mortgages include foreign governments, pension funds, insurance firms, banks, GSEs, and hedge funds. Based on varied levels of credit quality and interest rate risk, MBS, CMOs, ABSs, and CDOs provide investors with a broad range of possible returns.
Banks, insurance firms, pension funds, and foreign governments often invest in highly rated mortgage products. These investors are looking for certain tranches of the different structured mortgage agreements due to their prepayment and interest rate risk profiles. Hedge funds often invest heavily in structured mortgage products with higher interest rate risk and mortgage products with poor credit ratings.
The GSEs have the biggest portfolios out of all the mortgage investors. The Office of Federal Housing Enterprise Oversight controls a substantial portion of the mortgage products that investors are permitted to purchase.
Why Do Banks Sell Mortgages?
Mortgages are sold by banks primarily for two reasons: profitability and liquidity.
In order to comply with legally required cash reserve requirements and to have funds accessible for account holders and customers, banks must maintain cash reserves. By releasing their cash via the sale of mortgages, banks may better manage withdrawals and provide applicants with loans, including additional mortgages. Additionally, it removes the danger of default off their books.
Selling mortgages creates cash immediately while also removing obligations from the balance sheet. Not simply fast money, but also a faster profit. On the loans they sell, banks get commission payments right away. In contrast, the bank takes decades to collect the mortgage interest it earns throughout the course of your loan.
In a nutshell, it is more lucrative to sell loans than to cling onto them. By issuing a mortgage and then collecting interest on it for many years, banks may profit. However, they may increase their profits by creating a mortgage, selling it (while receiving a fee), and then creating more mortgages, selling them, and so forth.
Banks may sometimes just sell the mortgage debt, or the loan principle, but retain the rights to the mortgage servicing, which allows them to continue collecting the borrower’s payments. However, they often sell the full mortgage, including the servicing rights as well as the debt.
Why Do Investors Buy Mortgages?
Mortgages (or mortgage-backed securities) are purchased by investors for the same reason they purchase the majority of debt securities: income. Specifically, consistent monthly revenue from the interest the loan created (or whichever way the mortgage owner makes their payments).Institutional investors that offer recurrent payments to account holders and customers, such pension plans, insurance annuity firms, and mutual funds, may find the regularity of this income to be enticing.
Especially if they are agency mortgage-backed securities, the majority of mortgage-backed securities are seen to have excellent credit quality, often more than that of corporate bonds (that is, guaranteed by the government or government-sponsored agencies such as Ginnie Mae, Fannie Mae, or Freddie Mac).In spite of this, mortgage-backed securities have offered yields that are greater than those of other low-risk bonds, such as Treasury bonds with a similar maturity.
Mortgages may be purchased by other investors to diversify their portfolios and asset allocation. Purchasing mortgages offers a little real estate play.
The Bottom Line
Few borrowers are aware of how much their mortgage gets exchanged and divided up. A mortgage may join a CMO, ABS, or CDO in a couple of weeks after it is created. The final user of a mortgage might be a hedge fund that employs leveraged positions to take advantage of minor relational pricing abnormalities or directional interest rate wagers, or it could be a foreign central bank that appreciates the agency MBS’s credit rating.
On the other hand, it may be a Brussels-based insurance firm drawn to the length and convexity of a particular tranche in an ABS, CMO, or CDO transaction. There are several institutions willing to take a piece of the secondary mortgage market, which is large, liquid, and complicated.
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