The mortgage market is made up of two segments: the primary mortgage market and the secondary mortgage market.
Many home buyers are only aware of the primary mortgage market because it’s the one they engage with directly. However, lenders participate heavily in both markets. Without the support of the secondary mortgage market, lenders wouldn’t be able to extend nearly as many mortgages as they do today.
So, how does the secondary loan market work? Below, we’ll review what it is, its history, and its many benefits.
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What is the Secondary Mortgage Market?
The secondary mortgage market is where mortgages go after they’ve passed through the primary mortgage market. In the secondary mortgage market, loans are bought and sold between lenders and investors. Their ultimate goal? Provide a reliable source of money, so that some of the risk associated with the primary mortgage is alleviated and they can continue to lend.
Let’s break it down. Here’s how these two segments of the mortgage market work:
- Primary mortgage market — In the primary mortgage market, aspiring home buyers apply for mortgages from lenders. Lenders review their applications and determine which applicants fit their lending criteria. If a home buyer’s mortgage application is approved, their lender will originate their loan, enabling them to purchase a home. All mortgages are originated in the primary mortgage market.
- Secondary mortgage market — In the secondary mortgage market, mortgage lenders can sell their newly-originated mortgages to investors in the form of mortgage-backed securities (MBSs).1 MBSs work similarly to traditional bonds. By selling their mortgages, lenders can recoup some of their capital and use it to fund additional mortgages.
Most homeowners never know if their mortgage is being bought and sold on the secondary market. Fortunately, it doesn’t impact their borrowing experience either way.
How Mortgages Move Through the Secondary Market
To clarify how the secondary mortgage market works, we need to take a look at how a mortgage moves through it step-by-step:
- The mortgage gets sold on the secondary market — After originating a mortgage loan, a lender can either choose to keep it on their books or sell it on the secondary market. If the lender decides to sell the mortgage, they’ll most likely sell it to a government-sponsored enterprise (GSE) aggregator, like Fannie Mae or Freddie Mac.
- The mortgage gets bundled into an MBS — If sold to an aggregator, the mortgage will get bundled into an MBS with other mortgages that have the same interest rate and loan term.
- The MBS is sold in shares to investors — Investors can buy shares of this MBS and enjoy steady returns from it for the duration of the loan term. These returns are derived from the home buyers’ monthly mortgage interest payments.
- The mortgage gets serviced by the original lender — The lender who originated the mortgage will continue servicing it throughout its lifetime. This service may include collecting monthly payments, tracking the balance, and creating tax forms. For this work, lenders get to keep all of the associated servicing fees, though they’ll pass on the interest payments to the investors.
As you can see, mortgages pass through many hands in the secondary market. They benefit each party in different ways, which we’ll discuss in greater detail below.
Why Was the Secondary Mortgage Market Created?
The secondary mortgage market hasn’t always existed. Before its emergence in the 1930s, mortgages were a lot more expensive and hard to come by.2 That’s because they had:
- Costly down payments — Lenders often required down payments of 20 to 40 percent.3
- Short loan terms — The average mortgage loan term was between one and seven years.
- Interest-only payments — Monthly mortgage payments usually only consists of interest. The principal had to be repaid all at once at the end of the (very short) loan term.
These tricky loan terms presented major obstacles for many home buyers. Only the wealthy could comfortably afford mortgages.
Lenders set these types of terms because they had to finance each mortgage for the full loan term all on their own. Most lenders couldn’t afford to tie up their capital for 15 to 30 years at a time. Only large banks had enough capital to do this.
The Emergence of the Secondary Mortgage Market
After the stock market crash of 1929, the government decided to revamp the mortgage market. Their goal was to make mortgages more affordable and accessible to the average home buyer.
The problem? Mortgages with longer loan terms and smaller down payments are much riskier for lenders. To solve this problem, the government created Fannie Mae to buy FHA-backed mortgages from lenders, mitigating their capital constrictions.4 Thanks to the creation of Fannie Mae, lenders could now recover some of their capital and put it towards new mortgages.
And with that, the secondary mortgage market was created.
The Impact of the 2008 Subprime Mortgage Crisis
Up until the subprime mortgage crisis of 2008, private investors were very active in the secondary mortgage market.5 Once millions of homeowners started defaulting on their mortgages, these private investors paid the price. In turn, they stopped buying MBSs.
This forced the federal government to step in and buy more mortgages going forward. After 2008, the government-owned over 90% of U.S. mortgages.6
It wasn’t until 2013 that investors started dipping their toes in the secondary mortgage market again. They felt comfortable doing so because lenders had tightened up their underwriting requirements. These stricter requirements reduced the chance of a 2008-like crisis happening again.
The Major Players in the Secondary Mortgage Market
Now that you know how the secondary mortgage market works and why it was created, let’s take a look at how each of its participants benefits from it:
- Homebuyers — Homebuyers aren’t directly involved in the secondary mortgage market, but it wouldn’t exist without them. They are the first players within this market, whether they know it or not. Homebuyers benefit from the secondary mortgage market because it has made affordable mortgages more widely available – lowering down payments and lengthening loan terms – and making mortgages easier to pay back.
- Lenders — Lenders are the cornerstone of the secondary mortgage market, since they underwrite, originate, and service mortgages. They also get to decide which mortgages to sell to investors. Lenders benefit greatly from the secondary mortgage market since it offers them much-needed liquidity. With more available capital, they can originate even more mortgages, multiplying their servicing fees and making affordable homeownership a reality for more home buyers.
- MBS aggregators — Lenders usually sell their mortgage loans to the major GSE aggregators, Fannie Mae, and Freddie Mac. If a lender wants to sell one of their mortgages to Fannie Mae or Freddie Mac, their loans must meet certain criteria. Fannie Mae and Freddie Mac earn fees for their aggregation services. Lenders can also bundle their mortgages into MBSs and sell them to private investors. In this case, their mortgages won’t need to meet Fannie Mae or Freddie Mac’s standards.
- Investors — The final participants in the secondary market are investors. MBS investors often include hedge funds, insurance companies, pension funds, banks, and the federal government.Since MBSs are grouped by their interest rate and loan term, investors can select specific securities that meet their return requirements and risk tolerances.
However, investors aren’t just passive shoppers. They’ve also played an important role in driving up mortgage underwriting standards since 2008. Lenders know they must vet their borrowers with care if they want to sell their mortgages on the secondary loan market down the line.
Investors are also part of the reason why borrowers with lower credit scores receive higher interest rates. While riskier, these borrowers’ mortgages offer a more lucrative return to investors who are willing to take the risk.
As you can see, the secondary mortgage market exists for good reason. It benefits nearly every participant involved.
The Value of the Secondary Mortgage Market
The secondary mortgage market is a crucial part of the real estate system and it offers many notable benefits, including:
- Increasing access to affordable mortgages by freeing up lenders’ capital
- Improving mortgage terms
- Allowing lenders to take riskier loans off their books, enhancing their risk management
- Providing investors with an opportunity to earn steady returns
- Keeping money moving throughout the mortgage market
- Maintaining greater stability in the real estate system
The only downside of the secondary mortgage market is that it has made it harder for homebuyers with poor credit to qualify for mortgages. They simply present too much risk to investors.
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1 Investopedia. Mortgage-Backed Security (MBS).
2 CBO. Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market.
3 PrepAgent. What is the Secondary Market?
4 Federal Housing Finance Agency. Fannie Mae and Freddie Mac.
5 Center For American Progress. The 2008 Housing Crisis.
6 SmartAsset. Everything You Need to Know about the Secondary Mortgage Market.