Financing Residential Real Estate Lesson 2: The Primary and Secondary Markets

Introduction In this lesson, we will cover: primary and secondary mortgage market loan origination and financing mortgage-backed securities standardized underwriting secondary market agencies and their role in the mortgage industry

Introduction The residential mortgage industry is made up of: financial institutions, private companies, agencies, and other investors.

The Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans.

The Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans. Primary market Market in which lenders make loans to home buyers.

The Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans. Primary market Market in which 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 the application, approval decision, and funding the loan.

Primary Market Primary market originally a local market, made up of community financial institutions. Local market

Primary Market Primary market originally a local market, made up of community financial institutions. Today, the primary market is much more complicated, in part due to: Local market

Primary Market Primary market originally a local market, made up of community financial institutions. Today, the primary market is much more complicated, in part due to: interstate banking, Internet lenders, and other developments. Local market

Local Market Local real estate markets and the availability of funds are affected by real estate cycles. Real estate cycles

Local Market Local real estate markets and the availability of funds are affected by real estate cycles. Real estate cycle = periodic changes in real estate activity, such as active periods followed by slumps. Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: local conditions, Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: local conditions, national economic forces, Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: local conditions, national economic forces, political events, Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: local conditions, national economic forces, political events, social trends, Real estate cycles

Local Market Local real estate cycles are affected by several factors, including: local conditions, national economic forces, political events, social trends, and disintermediation. Real estate cycles

Real Estate Cycles Disintermediation = when depository institutions lose funds to higher-yielding investments. Disintermediation

Real Estate Cycles Disintermediation = when depository institutions lose funds to higher-yielding investments. Depositors withdraw funds from savings accounts and put them in higher yield investments. Disintermediation

Real Estate Cycles Previously, local lenders couldnt do much about real estate cycles in communities. Local lenders needed: 1.a source of extra funds to lend when demand exceeded supply; and 2.a place to invest surplus funds when supply exceeded demand. Supply and demand

Summary Primary Market Primary market Origination Real estate cycles Disintermediation

Secondary Market Solution to local market problems: the secondary market.

Secondary Market Solution to local market problems: the secondary market. Secondary market = National market where mortgages secured by real estate are bought and sold.

Secondary Market Secondary market activities: Buying loans Issuing mortgage-backed securities Activities

Secondary Market A loan is an investment that can be bought and sold. A loan purchaser pays present value of right to receive payments from borrower. Buying and selling loans

Secondary Market A loan is an investment that can be bought and sold. A loan purchaser pays present value of right to receive payments from borrower. Present value = comparison between rate of return on loan and rate of return on other investments. Buying and selling loans

Secondary Market Lenders sell mortgage loans to: other lenders, Buying and selling loans

Secondary Market Lenders sell mortgage loans to: other lenders, and secondary market agencies. Buying and selling loans

Secondary market agencies include: Federal National Mortgage Association (FNMA or Fannie Mae), Federal Home Loan Mortgage Corporation (FHMLC or Freddie Mac), and Government National Mortgage Association (GNMA or Ginnie Mae).

Secondary Market Agencies Ginnie Mae is a government agency within the U.S. Department of Housing and Urban Development (HUD).

Secondary Market Agencies Ginnie Mae is a government agency within the U.S. Department of Housing and Urban Development (HUD). Fannie Mae and Freddie Mac are government- sponsored enterprises, chartered by Congress and supervised by HUD.

Secondary Market Agencies Lenders package similar loans together for sale to a secondary market agency.

Secondary Market Agencies Lenders package similar loans together for sale to a secondary market agency. Loans must meet quality standards of the purchasing agency.

Secondary Market Agencies Secondary market agencies also issue mortgage- backed securities (MBS). Mortgage-backed security = investment instrument with pools of mortgage loans as collateral. Mortgage-backed securities

Secondary Market Agencies Secondary market agencies also issue mortgage- backed securities (MBS). Mortgage-backed security = investment instrument with pools of mortgage loans as collateral. Investor returns are monthly payments from secondary market agency. Mortgage-backed securities

Secondary Market Agencies Investors prefer MBSs to actual mortgage loans for several reasons: more liquid than mortgages; can be purchased in small denominations; are guaranteed by the issuing agency. Mortgage-backed securities

Mortgage-Backed Securities Guaranties Agency subtracts guaranty fee before passing payments to investor. Guaranties

Mortgage-Backed Securities Guaranties Agency subtracts guaranty fee before passing payments to investor. A servicing fee is deducted for the lender servicing the loan. Guaranties

Loan servicing includes: processing payments, dealing with collection problems, and working with borrowers to prevent default.

Mortgage-Backed Securities MBSs can be purchased directly from Fannie Mae, Ginnie Mae, or Freddie Mac when first issued. MBS trading

Mortgage-Backed Securities Private firms also buy and pool mortgage loans and issue securities called private label mortgage- backed securities. Private-label securities

Mortgage-Backed Securities Private firms also buy and pool mortgage loans and issue securities called private label mortgage- backed securities. These firms are often subsidiaries of: investment banks, financial institutions, or home builders. Private-label securities

Secondary Market The secondary market serves two important functions for real estate industry: 1. Makes funds available for mortgage loans, promoting home ownership. 2. Moderates adverse effects of real estate cycles, providing measure of stability. Functions of secondary market

Secondary Market Availability of funds in the primary market depends on the secondary market. Mortgage funds flow between the two markets. Functions of secondary market

1.Funds given to home buyer by lender in primary market.

2.Mortgage sold to secondary market agency.

1.Funds given to home buyer by lender in primary market. 2.Mortgage sold to secondary market agency. 3.Agency pools mortgages and sells as MBS, which frees agency funds to purchase more mortgages.

1.Funds given to home buyer by lender in primary market. 2.Mortgage sold to secondary market agency. 3.Agency pools mortgages and sells as MBS, which frees agency funds to purchase more mortgages. 4.As agencies buy more mortgages, more funds are available for primary market lenders to make more loans.

Secondary Market If a lender doesnt sell a loan on the secondary market, it is kept in portfolio. Only a small percentage of loans are kept in portfolio today. Functions of secondary market

Secondary Market Loans sold to secondary market agency must comply with agencys underwriting rules. Standardized underwriting

Secondary Market Loans sold to secondary market agency must comply with agencys underwriting rules. Apply when qualifying loan applicants. Standardized underwriting

Secondary Market Loans sold to secondary market agency must comply with agencys underwriting rules. Apply when qualifying loan applicants. Agencies have uniform application forms, appraisal forms and mortgage documents. Standardized underwriting

Secondary Market Loans sold to secondary market agency must comply with agencys underwriting rules. Apply when qualifying loan applicants. Agencies have uniform application forms, appraisal forms and mortgage documents. If lender violated agency rules, lender may be required to buy loan back from agency. Standardized underwriting

Secondary Market Guidelines and uniform documents are a quality control system to ensure the quality of loans purchased by secondary market agencies. Standardized underwriting

Secondary Market Guidelines and uniform documents are a quality control system to ensure the quality of loans purchased by secondary market agencies. Inspires investor confidence. Standardized underwriting

Secondary Market Guidelines and uniform documents are a quality control system to ensure the quality of loans purchased by secondary market agencies. Inspires investor confidence. Strongly influences primary market lenders. Standardized underwriting

Summary Secondary Market Secondary market Secondary market agency Mortgage-backed securities Guaranties Private-label securities In portfolio

Secondary Market Agencies Fannie Mae Created in 1938 by federal government in response to Depression-era credit problems. Original purpose to provide secondary market for FHA-insured loans. Historical background

Secondary Market Agencies Fannie Mae 1948 – authorized to buy VA-guaranteed loans. Historical background

Secondary Market Agencies Fannie Mae 1948 – authorized to buy VA-guaranteed loans – reorganized as a private corporation owned by stockholders. Historical background

Secondary Market Agencies Fannie Mae 1948 – authorized to buy VA-guaranteed loans – reorganized as a private corporation owned by stockholders. HUD retains limited authority over it as a government-sponsored enterprise (GSE). Historical background

Government-sponsored enterprise Created and supervised by the federal government. Owned by private stockholders.

Secondary Market Agencies Ginnie Mae Created as an agency in HUD when Fannie Mae was changed into a private corporation. A wholly owned government corporation that managed and liquidated mortgages bought by Fannie Mae before the change-over. Historical background

Secondary Market Agencies Ginnie Mae Created as an agency in HUD when Fannie Mae was changed into a private corporation. A wholly owned government corporation that managed and liquidated mortgages bought by Fannie Mae before the change-over. Today: buys FHA and VA loans, and helps finance urban renewal and housing projects. Historical background

Secondary Market Agencies Freddie Mac Created in 1970 by the Emergency Home Finance Act. Historical background

Secondary Market Agencies Freddie Mac Created in 1970 by the Emergency Home Finance Act. Like Fannie Mae, it is a government-sponsored enterprise. Historical background

Secondary Market Agencies Freddie Mac Created in 1970 by the Emergency Home Finance Act. Like Fannie Mae, it is a government-sponsored enterprise. Original purpose: to assist savings and loan associations hit hard in 1969 recession. Historical background

Secondary Market Agencies MBS Programs Ginnie Mae started first MBS program in Offered guaranteed securities backed by pools of FHA and VA loans. Historical background

Secondary Market Agencies MBS Programs Ginnie Mae started first MBS program in Offered guaranteed securities backed by pools of FHA and VA loans. Fannie Mae and Freddie Mac followed suit. Historical background

Secondary Market Agencies MBS Programs Ginnie Mae started first MBS program in Offered guaranteed securities backed by pools of FHA and VA loans. Fannie Mae and Freddie Mac followed suit. In 1980s, Congress removed restrictions to make securities more competitive. Historical background

Secondary Market Agencies Fannie Mae and Freddie Mac (the GSEs) buy conventional loans, as well as FHA and VA loans. GSE status gives them certain advantages and restrictions. Agencies today

Secondary Market Agencies Restrictions/responsibilities of GSEs GSEs restricted by charter to investment in residential mortgage assets. Required to meet affordable housing goals set by HUD. Must promote programs to help provide affordable home financing and rental housing. Agencies today

Secondary Market Agencies Office of Federal Housing Enterprise Oversight (OFHEO) is an independent agency in HUD. Created in 1992 and funded by assessments on GSEs. Financial oversight

Secondary Market Agencies Office of Federal Housing Enterprise Oversight (OFHEO) is an independent agency in HUD. Created in 1992 and funded by assessments on GSEs. Conducts examinations of GSEs. Financial oversight

Secondary Market Agencies Office of Federal Housing Enterprise Oversight (OFHEO) is an independent agency in HUD. Created in 1992 and funded by assessments on GSEs. Conducts examinations of GSEs. Requires GSEs to maintain capital to survive severe economic crisis. Financial oversight

Secondary Market Agencies Office of Federal Housing Enterprise Oversight (OFHEO) is an independent agency in HUD. Created in 1992 and funded by assessments on GSEs. Conducts examinations of GSEs. Requires GSEs to maintain capital to survive severe economic crisis. Prohibits excessive compensation. Financial oversight

Secondary Market Agencies GSEs are exempt from state and local taxes. Advantages of GSEs

Secondary Market Agencies GSEs are exempt from state and local taxes. Still required to pay federal taxes. Advantages of GSEs

Secondary Market Agencies GSEs are exempt from state and local taxes. Still required to pay federal taxes. Exempt from SEC disclosure/registration requirements. Advantages of GSEs

Secondary Market Agencies GSEs are exempt from state and local taxes. Still required to pay federal taxes. Exempt from SEC disclosure/registration requirements. Each GSE has limited back-up line of credit with U.S. Treasury. Advantages of GSEs

Secondary Market Agencies Mortgage-backed securities issued by GSEs (Freddie Mac and Fannie Mae) dont have government guaranty. Private guaranty only ensures investors will receive timely payment. No protection against financial crisis affecting GSEs themselves. Guaranties

Secondary Market Agencies However, investors believe government would feel obligated to intervene should GSEs fail. Investors therefore view GSE securities as having implicit government guaranty. Guaranties

Secondary Market Agencies Ginnie Mae securities are backed by full faith and credit of U.S. government. Investors wont lose capital in financial crisis. Guaranties

Secondary Market Agencies Many mortgage industry analysts credit Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; Public benefits from GSEs

Secondary Market Agencies Many mortgage industry analysts credit Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; reducing mortgage interest rates; Public benefits from GSEs

Secondary Market Agencies Many mortgage industry analysts credit Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; reducing mortgage interest rates; enabling lenders to offer larger variety of mortgage loan products; Public benefits from GSEs

cutting down the time and cost involved in obtaining a mortgage; making underwriting practices in industry sounder and fairer; and provide mortgage lenders access to global capital markets as a source of funds.

Secondary Market Agencies Critics argue GSEs are too large and have too much power over mortgage industry. They claim: GSEs limit opportunities for other investors and enterprises; Public benefits from GSEs

Secondary Market Agencies Critics argue GSEs are too large and have too much power over mortgage industry. They claim: GSEs limit opportunities for other investors and enterprises; public benefits from GSEs are exaggerated; and Public benefits from GSEs

Secondary Market Agencies Critics argue GSEs are too large and have too much power over mortgage industry. They claim: GSEs limit opportunities for other investors and enterprises; public benefits from GSEs are exaggerated; and point to 2004 Fannie Mae accounting scandal as reason to rein GSEs in. Public benefits from GSEs

Summary Secondary Market Agencies Fannie Mae Ginnie Mae Freddie Mac OFHEO MBS programs Guaranties