Question

Explain how the Mortgage Secondary Market (Securitization) Works. Make sure to include the major plays and size of the secondary market, the pros and cons, Mortgage characteristics, and 3 types of Mortgage Backed Securities. Should we continue to have Frannie and Freddie? What should the role of our government be in securing them?

Answer 1

In simple words, the secondary mortgage market is a market place where lenders and investors come together for buying/selling home loans as well as service rights.

It majorly consist of three players: Mortgage originators, Mortgage Aggregators and Investors

The way it works: In an economy, population always follows an increasing trend and this triggers the demand for more houses which in turn creates more requests for house loans. The main providers of the loans are the banks/credit unions and they are termed as the mortgage originators. Now, whenever an individual plans to buy a home, he/she approaches these banks for home loans. The banks in turn keep any collateral as mortgage and provide the loan to the individual. This is basically the primary mortgage market.

Considering lending as one of the important component of bank’s business, it needs to continuously provide loans. But, if the bank keep on giving loans to different individuals one after the another, then it will drain away all its money and will have too much loan assets. In order to replenish these loan amounts, the mortgage originators will sell the loans to aggregators such as Fannie Mae and Freddie Mac in secondary market. These aggregators aggregate loans from different originators and use the secondary market to resell these loans. But, aggregators do not sell them directly, they make them mortgage backed securities and sell them to investors such as the pension funds, insurance companies or hedge funds.

                                                                                                                                                           

Pros: >> Secondary market helps all the banks and the borrowers to do the business in home loan sector. Otherwise few big banks having huge capital base can only do the business by charging high interest rate. Moreover, this will also become difficult for individual home loan borrowers to pay off their loans at such high interest rates.

>> It helps to increase the consumer spending in an economy which boosts the growth of economy in turn.

Cons: >> Secondary mortgages are risky in nature. Because of risk, the investors often tend to charge high interest rates and fees from the aggregators, who in turn increase the rates for the originators. In this way, investors in the secondary markets play an important role in driving the interest rates up and down.

>> From the perspective of the home loan borrower, if at any point of time, they fail to repay the loan, then at foreclosure their homes (the mortgaged collateral) is taken away from them as the secondary market involves securitization of mortgage. But, this might not be the case for an unsecured market.

Mortgage characteristics:

• Only secured loans can be issued against a mortgage
• Only immovable properties can be used as mortgage
• Mortgage is not a transfer of actual possession, but only transfer of interest of the property
• On repayment of the loan, the interest of the mortgaged property is given back to the borrower. On the other hand, on failure to repay, the actual possession is taken away from the borrower

There are three types of Mortgage backed securities: Pass-Throughs, Collateralized Mortgage Obligations, Mortgage Backed Bond

Pass-Throughs: These are basically trusts whose responsibility is to collect the mortgage payment from the originators and then pass them through to the investors. Major types are Adjustable-rate-mortgage and Fixed-rate-mortgage

Collateralized Mortgage Obligations: It has multiple pools of mortgages repackaged and bundles together to be sold as investment. It consists of several tranches with individual credit ratings depending on their risk profile

Mortgage Backed Bond: These are safe investments with comparatively low rate of return. Whenever a borrower takes a loan, the originator keeps a mortgage for it. This loan is then sold to the aggregator along with the mortgage. The aggregator in turn issues a bond backed by the mortgage given by the borrower. This bond is then bought by the investor, who receives its yield from the loan repayment installments paid by the borrower.

Fannie Mae and Freddie Mac are basically mortgage aggregators. These two are government sponsored entities which have a significant contribution in secondary mortgage market. Though in 2008, these two organizations undertook excessive risk which led to the subprime debt crisis. Though this incident questioned Fannie and Freddie’s existence, but considering the economic situation till date, it is necessary for the government to retain them.

Role of the government: During sub-prime debt crisis, when Fannie and Freddie were facing huge financial crisis, the US government had bailed out the two organizations in order to revive them and keep the house loan market functioning. But in near future, it is advisable for the government to privatize Fannie and Freddie by selling their shares. The government can only act as a guarantee to these organizations as this will not give them the opportunity to take utmost risk for the purpose of boosting their stock price.