The Explanation of Mortgages : From the beginning of time......
I wanted to share on how mortgages work, how they are sold on the secondary market, and the reason why some of these companies are closing their doors.
We have seen some major changes in the lending industry, more so than ever before. What we need to do is stay positive, focused, and move forward. But at the same time, explain to the consumer what is happening in the market today, educating everyone on the ins and outs of what a mortgage is and how it works.
Just a few days ago, Kurt Jackson gave us some insight on what happened to American Home Mortgage. And then Bob Mitchell gave us a better look and understanding on the Secondary Marketing and how this could have affected American Home Mortgage and other companies like it.
What I want to explain here is how these loans are delivered and where they end up which as you can see, sometimes can affect the companies that are on the front line. **I might be leaving some things out just to make this easier to understand. I might not include all terms.**
The secondary market can be a twisting ball of confusion at times because of how it is broken down. Here is a diagram of the mortgage market process by DiPasQuale and Wheaton from the Urban Economics and Real Estate Markets research.
The secondary market can be broken down into 2 groups. The "whole loan" and the "mortgage-backed securities" market. You also have bonds backed by loans, but that is for another topic. You need to read Kurt Jackon's article listed above in order to get a better idea of how this works.
- The whole market is where mortgages are sold in blocks of mortgages, sometimes as a loan by loan basis, depending on the need. These are usually sold to investors who want to make money from the interest. Why are loans sold as blocks? I might have 10 loans sitting on my warehouse line, eight of which are very good performing A paper loans. Two of them might not be so great, a little riskier. I want to put them all together, as a block, so the investor will buy all of them, taking a chance, because they have 80% that are very good.
- Mortgage-backed securities are where you have specific insurers such as Fannie Mae, Freddie Mac, and Ginnie Mae who have guarantees over promises of other investors. This is usually a more efficient and lower cost of financing in comparison to the other options. These individuals are what is called "pools of money". Your Ginnie Mae pool is for FHA loans which are backed by the government. The other two are for conventional usage.
These pools are based on default risk which is credit risk and interest rate exposure. There is another risk that is factored into this which is the prepayment risk which is called the redemption risk. So many don't understand that it costs lenders that service these loans money when someone refinances. Why? Because they are losing the higher interest of return and because there were initial costs that went into this loan that is now lost. It doesn't hurt the loan officer, but it certainly hurts the banks and the market.
The part that is not understood by so many is that there are other players behind these pools of loans. These could be private investors that will dissect a loan and buy and sell it in pieces, depending on the loan itself. Just like when a company buys junk cars, there goal is to sell pieces of the car, which could bring a larger income than selling the whole car itself. This is what happens on the secondary market. These are basically called securities that attract other investors who would not want to hold onto a whole loan.
What becomes even more confusing is that there is some sort of food chain to this. But it works backwards, as shown in the diagram, working from left to right. Which gets back to when I say investors dissect loans. I will keep this short so as not to confuse you. This is where the subprime market came into play. These would be consider B or C loans within the market. These loans carry more risk but investors are willing to split them up and sometimes place them into the A group, which is normally your good performing loans that have less risk with good credit. When these companies start to close shop per se, they need to be bought up in the market. This is when someone who usually buys A paper ends up buying that B loan and tries to sell it in pieces. This is what ends up driving prices. The video below is from what Mike Mueller shared in his article Asking the Question.
I hope all of this gives you a better understanding of how mortgages work, how they are sold on the secondary market, and the reason why some of these companies are closing their doors. And for another breakdown in layman's terms, Brian Brady wrote : The Mortgage Tax Act of 2007
