Real estate finance 2

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Financing Residential Real Estate

Lesson 3:

The Primary and Secondary Markets

Introduction

This lesson will cover:

primary vs. secondary mortgage markets
primary market lenders and funding of mortgage loans
sale of loans on secondary market
mortgage-backed securities
government-sponsored enterprises and their role in the mortgage industry

Introduction

Residential mortgage industry made up of:

financial institutions
private companies
government-sponsored enterprises
other investors

Two Mortgage Markets

Industry is divided into two “markets” that supply funds for mortgage loans.

Primary market: market where lenders make loans to home buyers.

Secondary market: market where lenders sell their loans to investors.

Primary Market

In primary market, home buyers apply for mortgage loans and lenders originate them.

Loan origination involves:

processing application
approval decision
funding loan

Primary Market

Primary market was originally local, made up
of community financial institutions.

More complicated now, due to developments
such as:

interstate banking
online lenders

Local model still useful in understanding
primary and secondary markets.

Primary Market

Local market is subject to real estate cycles.

Real estate cycles: periodic shifts in level of real estate activity (sales, loans).

Caused by changes in supply of and demand for:
real estate for sale
funds for mortgage lending

Real estate cycles

Primary Market

Local real estate cycles are affected by many factors, including:

economic forces
political events
social trends

These factors may be either local or national.

Factors affecting real estate cycles

Primary Market

At one time, local lenders couldn’t do much about real estate cycles in their communities.

Dealing with real estate cycles

Primary Market

They needed:

a source of extra funds to lend when
demand exceeded supply; and
a place to invest surplus funds when
supply exceeded demand.

Secondary market helped meet both needs.

Dealing with real estate cycles

Summary
Primary Market

Primary market
Loan origination
Real estate cycles

Secondary Market

Solution to primary market problems was secondary market, where mortgages secured by real estate all over U.S. are bought and sold.

Secondary Market

Secondary market activities:

buying and selling loans
buying and selling mortgage-backed securities

Secondary Market Activities

Like other investments, loans can be bought and sold.

Loan purchaser pays present value of right to receive payments from borrower.
Rate of return on loan compared with rate of return on other investments to determine present value.

Buying and selling loans

Buying and Selling Loans

Mortgage lenders may sell their loans to:

other lenders
government-sponsored enterprises:
created by federal government to establish strong secondary market for mortgage loans
often referred to as GSEs

Who buys loans?

Federal National Mortgage Association
(FNMA or “Fannie Mae”)
Federal Home Loan Mortgage Corporation (FHMLC or “Freddie Mac”)

Buying and Selling Loans

Government-sponsored enterprises

Lenders “package” similar loans together for sale to government-sponsored enterprise.

After sale, loans may be serviced by original lender or by another servicer.

Loan servicing: payment processing, collections, working with borrowers to prevent default.

Buying and Selling Loans

Government-sponsored enterprises

Secondary Market Activities

GSEs also issue mortgage-backed securities (MBS): investment instrument with mortgage
loans as collateral; a type of bond.

Investor returns are monthly payments
from GSE.
GSE passes borrowers’ payments
on to investors.

Mortgage-backed securities

Mortgage-backed Securities

Securitizing: buying mortgages, pooling them together, pledging pool as collateral, issuing securities.

Private-label mortgage-backed securities: securities issued by private firm rather than GSE.

Securitizing loans

Mortgage-backed Securities

Reasons investors prefer buying MBSs to buying actual mortgage loans include:

convenience
greater liquidity
can be purchased in relatively
small denominations

Advantages for investors

Functions of Secondary Market

Secondary market serves two important functions for real estate industry:

moderates adverse effects of real
estate cycles, providing some stability

makes funds available for mortgage
loans, promoting home ownership

Functions of Secondary Market

Availability of funds in primary market depends on secondary market.

Mortgage funds flow between the two markets.

Flow of mortgage funds

Functions of Secondary Market

Lender loans funds to buyer in primary market.
Lender sells mortgage to GSE
GSE pools mortgages and sells MBSs, freeing entity’s funds to buy more mortgages.
As GSE buys mortgages, more funds available for more loans in primary market.

Flow of mortgage funds

Functions of Secondary Market

If lender doesn’t sell loan on secondary market, loan is kept in portfolio.

Only small percentage of loans are kept in portfolio today.

Portfolio loans

Summary
Secondary Market

Secondary market
Government-sponsored enterprise
Loan servicing
Mortgage-backed securities
Securitizing
Portfolio loan

Secondary Market Entities

Government-sponsored enterprise (GSE):

created and supervised by federal
government
owned by private stockholders

Historical background

Historical Background

1938 – Created by federal government in response to Depression-era credit
problems. Authorized to buy FHA loans.

1948 – Also authorized to buy VA loans.
1968 – Reorganized as government-
sponsored enterprise.

Fannie Mae

Historical Background

1968 – Created as agency within HUD when Fannie Mae was privatized.

Wholly-owned government corporation.
Now securitizes FHA and VA loans.

Ginnie Mae

Historical Background

1970 – Created by Emergency Home
Finance Act as government-sponsored
enterprise.

Original purpose: to assist savings and loans hit hard in 1969 recession.
1970 act authorized both Freddie Mac and Fannie Mae to buy conventional loans.

Freddie Mac