This is an article I ran across that simplified the explanation of the function and operation of the secondary mortgage market. It was sent out from an account executive and apparently the information is attributable to the VP of Mortgage Production for a local bank (though I can't find the person's name or company). Overall it is a simple and concise explanation.
In years past a borrower would visit their local Savings & Loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage was paid off. What the bank needed was a way to sell the loans it made, freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, FNMA and GNMA were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage-Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBSs know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (Verification of Employment), willing to repay (credit report) the debt, has the cash to close (Verification of Deposit), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.
During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% N/O/O (Non-Owner Occupied, or a fancy way of saying an investment property) with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006.
Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetites for this risk has waned. To attract investors in this environment, rates had to increase substantially.
Loans sold to GNMA or FNMA remain largely untouched in the recent credit rout because the investment qualities of the loans are well known. The foreclosure and delinquency rates are well within acceptable standards lending support to these products as their interest rates have fallen in the recent weeks.
The recent rapid rise in rates not directly tied to FNMA/GNMA is an example of the pendulum swinging too wide. The fact remains that a qualified borrower is a good investment from a bondholder perspective. In a typical interest rate market, jumbo loans (loans in excess of the conforming limit) with proper documentation carry a yield about 1/4 higher than similar conforming products. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current subprime issue will determine when that change occurs.
As always, I am here to help educate and inform you throughout this turbulent time. If I can be of assistance in any manner, please don't hesitate to contact me.
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