When you go to a bank or lending facility to finance your home with a mortgage loan, you and the lender are doing business on what is referred to as the primary mortgage market. There is also a secondary market where the lender will recoup the funds they lent to you through third-party investors. These investors are responsible for driving interest rates and the underwriting standards. In fact they have a bigger impact on these factors than the original lender of the mortgage. If you are considering obtaining a mortgage loan, having a basic understanding of the secondary marketing of these loans is important.
The mortgage plan that has been laid out by President Barack Obama relies on the secondary mortgage market's health.
When your mortgage loan is funded by a bank or lending facility, it will be pooled with other, similar mortgages, that have the same rate and the same term, for example a 30 year fixed mortgage at 4.25 percent. Larger lenders will create a pool of their loans that fit these criteria and smaller lenders will typically join in a pool with one another. The group of loans that is created will then be packaged as a mortgage backed security, or MBS, and then sold to a waiting investor. The largest of these third-party investors are Freddie Mac and Fannie Mae. These lenders provide the guidelines for how the loans they buy are underwritten. A pool of the loans that meet the guidelines set out by Freddie and Fannie are sold, in whole, to the entity that is backed by the government.
The MSB Pools are also able to be comprised of loans that do not fit the Freddie Mac or Fannie Mae guidelines, including jumbo loans. The MSBs that contain these types of loans are then bought by private investors or by hedge funds. It is very common that single MBS have a number of different investors, much like stocks have many different owners.
The purchase of MBSs by private equity parties was extremely common prior to the fall of the mortgage market in 2007 and 2008. However, since that time private equity funding has been almost completely missing from the actual secondary mortgage market.
When a group of mortgage loans are purchased on the secondary mortgage market by a private investor, the mortgage fees and rates are driven by the risk and the competition. For loans that are considered risky, for example those that go to borrowers with low or poor credit scores, higher fees and rates are applied in order to be appealing to investors.
The mortgage rates find balance between what a certain borrower can pay and what the community of investors is willing to accept as a return on their investment. After the mortgage crisis, individual investors became unwilling to chance their capital on a mortgage backed security that contained a low rate. This is when the Federal Government stepped in to fill up the gap that occurred in the secondary mortgage market, which helped to prevent the rates from increasing to a level where no one would be able to afford home ownership. Currently, the government is still working on exiting the secondary mortgage market, finding it difficult as private investors are still hesitant to take the risk that these investments present.