financing residential real estate lesson 2: the primary and secondary markets

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.



Primary market

Market in which lenders make loans to home buyers.



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


Today, the primary market is much more complicated, in part due to:

Local market

Primary Market


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 conditions,

Real estate cycles

Local Market


local conditions,

national economic forces,

Real estate cycles

Local Market


local conditions,


political events,

Real estate cycles

Local Market


local conditions,


political events,

social trends,

Real estate cycles

Local Market


local conditions,


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 couldn’t 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.


Secondary Market

Lenders sell mortgage loans to:

other lenders,


Secondary Market

Lenders sell mortgage loans to:

other lenders, and

secondary market agencies.


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).


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.


Lenders “package” similar loans together for sale to a secondary market agency.


Lenders “package” similar loans together for sale to a secondary market agency.

Loans must meet quality standards of the purchasing agency.


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 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.



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

Guaranties

Agency subtracts guaranty fee before passing payments to investor.

Guaranties


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.


MBSs can be purchased directly from Fannie Mae, Ginnie Mae, or Freddie Mac when first issued.

MBS trading


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

Private-label 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.


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.



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 doesn’t sell a loan on the secondary market, it is kept in portfolio.

Only a small percentage of loans are kept in portfolio today.


Secondary Market

Loans sold to secondary market agency must comply with agency’s underwriting rules.

Standardized underwriting

Secondary Market


Apply when qualifying loan applicants.


Secondary Market



Agencies have uniform application forms, appraisal forms and mortgage documents.


Secondary Market



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.


Secondary Market

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


Secondary Market


Inspires investor confidence.


Secondary Market


Inspires investor confidence.

Strongly influences primary market lenders.


Summary

Secondary Market

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


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


Fannie Mae

1948 – authorized to buy VA-guaranteed loans.



Fannie Mae


1968 – reorganized as a private corporation owned by stockholders.



Fannie Mae


1968 – reorganized as a private corporation owned by stockholders.

HUD retains limited authority over it as a government-sponsored enterprise (GSE).


Government-sponsored enterprise

Created and supervised by the federal government.

Owned by private stockholders.


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.



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.



Freddie Mac

Created in 1970 by the Emergency Home Finance Act.



Freddie Mac


Like Fannie Mae, it is a government-sponsored enterprise.



Freddie Mac


Like Fannie Mae, it is a government-sponsored enterprise.

Original purpose: to assist savings and loan associations hit hard in 1969 recession.



MBS Programs

Ginnie Mae started first MBS program in 1970.

Offered guaranteed securities backed by pools of FHA and VA loans.



MBS Programs



Fannie Mae and Freddie Mac followed suit.



MBS Programs



Fannie Mae and Freddie Mac followed suit.

In 1980s, Congress removed restrictions to make securities more competitive.



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


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


Office of Federal Housing Enterprise Oversight (OFHEO) is an independent agency in HUD.

Created in 1992 and funded by assessments on GSEs.

Financial oversight




Conducts examinations of GSEs.

Financial oversight





Requires GSEs to maintain capital to survive severe economic crisis.

Financial oversight





Requires GSEs to maintain capital to survive severe economic crisis.

Prohibits excessive compensation.

Financial oversight


GSEs are exempt from state and local taxes.

Advantages of GSEs



Still required to pay federal taxes.

Advantages of GSEs




Exempt from SEC disclosure/registration requirements.

Advantages of GSEs




Exempt from SEC disclosure/registration requirements.

Each GSE has limited back-up line of credit with U.S. Treasury.

Advantages of GSEs


Mortgage-backed securities issued by GSEs (Freddie Mac and Fannie Mae) don’t have government guaranty.

Private guaranty only ensures investors will receive timely payment.

No protection against financial crisis affecting GSEs themselves.

Guaranties


However, investors believe government would feel obligated to intervene should GSEs fail.

Investors therefore view GSE securities as having implicit government guaranty.

Guaranties


Ginnie Mae securities are backed by “full faith and credit” of U.S. government.

Investors won’t lose capital in financial crisis.

Guaranties


Many mortgage industry analysts credit Fannie Mae and Freddie Mac with:

dramatically increasing home ownership rates;

Public benefits from GSEs




reducing mortgage interest rates;





reducing mortgage interest rates;

enabling lenders to offer larger variety of mortgage loan products;


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.


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 are exaggerated; and

point to 2004 Fannie Mae accounting scandal as reason to rein GSEs in.


Summary


Fannie Mae Ginnie Mae Freddie Mac OFHEO MBS programs Guaranties

financing residential real estate lesson 2: the primary and secondary markets

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