© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 3: The Primary and Secondary...

© 2012 Rockwell Publishing

Financing Residential Real Estate

Lesson 3:

The Primary and Secondary Markets


Introduction

Residential mortgage industry made up of:financial institutionsprivate companiesgovernment-sponsored enterprisesother investors


Two Mortgage Markets

Industry is divided into two “markets” that supply funds for mortgage loans.

Primary market: market where 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 applicationapproval decisionfunding loan


Primary Market

Primary market was originally local, made up of community financial institutions.

More complicated now, due to developments such as:

interstate bankingInternet lenders

Local model still useful in understanding primary and secondary markets.


Primary Market

Local market is subject to real estate cycles.

Real estate cycles: periodic shifts in level of real estate activity (sales, loans).

Caused by changes in supply of and demand for:real estate for salefunds for mortgage lending

Real estate cycles


Primary Market

Local real estate cycles are affected by many factors, including:

economic forcespolitical eventssocial trends

These factors may be either local or national.

Factors affecting real estate cycles


Primary Market

At one time, local lenders couldn’t do much about real estate cycles in their communities.

Dealing with real estate cycles


Primary Market

They needed: a source of extra funds to lend when

demand exceeded supply; and a place to invest surplus funds when

supply exceeded demand.

Secondary market helped meet both needs.

Dealing with real estate cycles


Secondary Market

Solution to primary market problems was secondary market, where mortgages secured by real estate all over U.S. are bought and sold.


Secondary Market

Secondary market activities:buying and selling loansbuying and selling mortgage-backed

securities


Secondary Market Activities

Like other investments, loans can be bought and sold.

Loan purchaser pays present value of right to receive payments from borrower.

Rate of return on loan compared with rate of return on other investments to determine present value.

Buying and selling loans


Buying and Selling Loans

Mortgage lenders may sell their loans to:other lenderssecondary market agencies

Created by federal government to establish strong secondary market for mortgage loans.

Who buys loans?


Federal National Mortgage Association (FNMA or “Fannie Mae”)

Federal Home Loan Mortgage Corporation (FHMLC or “Freddie Mac”)

Government National Mortgage Association (GNMA or “Ginnie Mae”)

Buying and Selling LoansSecondary market agencies


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

After sale, loans may be serviced by original lender or by another servicer.

Loan servicing: payment processing, collections, working with borrowers to prevent default.

Buying and Selling LoansSecondary market agencies


Secondary Market Activities

Secondary market agencies also issue Mortgage-backed securities (MBS):investment instrument with mortgage loans as collateral; a type of bond.

Investor returns are monthly payments from secondary market agency.

Agency passes borrowers’ payments on to investors.

Mortgage-backed securities


Mortgage-backed Securities

Securitizing: buying mortgages, pooling them together, pledging pool as collateral, issuing securities.

Private-label mortgage-backed securities: securities issued by private firm rather than secondary market agency.

Securitizing loans


Mortgage-backed Securities

Reasons investors prefer buying MBSs to buying actual mortgage loans include:

conveniencegreater liquiditycan be purchased in relatively

small denominations

Advantages for investors


Functions of Secondary Market

Secondary market serves two important functions for real estate industry:

moderates adverse effects of real estate cycles, providing some stability

makes funds available for mortgage loans, promoting home ownership



Availability of funds in primary market depends on secondary market.

Mortgage funds flow between the two markets.

Flow of mortgage funds



Lender loans funds to buyer in primary market.

Lender sells mortgage to secondary market agency.

Agency pools mortgage and sells MBSs, freeing agency funds to buy more mortgages.

As agency buys mortgages, more funds available for more loans in primary market.

Flow of mortgage funds



If lender doesn’t sell loan on secondary market, loan is kept in portfolio.

Only small percentage of loans are kept in portfolio today.

Portfolio loans


Secondary Market Agencies

Government-sponsored enterprise (GSE): created and supervised by federal

governmentowned by private stockholders

Historical background


Historical Background

1938 – Created by federal government in response to Depression-era credit problems. Authorized to buy FHA loans.

1948 – Also authorized to buy VA loans.1968 – Reorganized as government-

sponsored enterprise.

Fannie Mae



1968 – Created as agency within HUD when Fannie Mae was privatized.

Wholly owned government corporation. Managed and liquidated mortgages

bought by FNMA before change-over. Now securitizes FHA and VA loans;

helps finance urban renewal and housing projects.

Ginnie Mae



1970 – Created by Emergency Home Finance Act as government-sponsored enterprise (GSE).

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

1970 act authorized both Freddie Mac and Fannie Mae to buy conventional loans.

Freddie Mac



As GSEs, Fannie Mae and Freddie Mac were given some advantages over ordinary private corporations.

Exempted from certain types of taxes.Not subject to certain SEC registration

and disclosure requirements.

GSE status



GSEs were also given special responsibilities and limitations.

Restricted by charter to investment in residential mortgage assets (mortgages and mortgage-backed securities).

Required to meet annual affordable housing goals.

GSE status



Ginnie Mae started first MBS program in 1970.

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

Fannie Mae and Freddie Mac followed with securities backed by conventional loans.

MBS programs



1980s: Congress removed certain restrictions on mortgage-backed securities.

Made them more competitive with corporate bonds.

Fueled expansion of secondary market.

MBS programs



Investors can buy MBSs:directly from issuing agencyon Wall Street, through securities

dealers

Direct purchases typically made by large investors such as insurance companies or pension funds.

MBS programs



MBS issued by secondary market agency is guaranteed by agency.

Investor receives full payment from agency even if borrowers default on some loans in pool.

Guaranty fees and servicing fees subtracted before payments passed on to investors.

MBS programs



Lender who wants to sell loan to Fannie Mae or Freddie Mac must:

comply with agency’s underwriting rules when qualifying loan applicant

use uniform loan documents

If lender violates agency rules, may be required to buy loan back from agency.

Standardized underwriting



Underwriting guidelines and uniform documents are quality control to ensure loans purchased by secondary market agencies meet minimum standards.

Inspires investor confidence.Strongly influences primary market

lenders.

Standardized underwriting



Prime loan: loan made to borrower with A credit rating. Subprime loan: loan made to less creditworthy borrower.

At one time, Fannie Mae and Freddie Mac bought only prime loans.

Subprime loans didn’t meet their standards.

GSEs and subprime loans



In 2005 Fannie Mae and Freddie Mac began buying subprime loans.

Primarily A-minus loans: top layer of subprime market.

Encouraged by government, to help meet affordable housing goals.

GSEs and subprime loans



Before current crisis, analysts credited Fannie Mae and Freddie Mac with:

increasing home ownership ratesreducing mortgage interest ratesimproving underwriting practicesproviding mortgage lenders with access

to global capital markets

GSEs and the economic crisis


GSEs and the Economic Crisis

Before current crisis, critics argued:claims of Government Sponsored

Enterprises’ benefit to public exaggerated

GSEs too large, with too much power over mortgage industry

GSEs limited opportunities for other investors and enterprises

GSEs not run well (2003/04 accounting scandals)

Criticism before crisis began



By 2007, 1/3 of Fannie Mae and Freddie Mac’s new purchases and guaranties involved riskier loans.

As subprime crisis unfolded, house prices dropped and foreclosure rates rose sharply.

Caused GSEs’ stock prices to plunge, further undermining their financial stability.

On the brink of insolvency



Housing and Economic Recovery Act of 2008 (HERA) created new independent regulatory agency to oversee GSEs.Federal Housing Finance Agency

(FHFA).September 2008: to prevent economic

consequences of GSE failure, FHFA placed both agencies in conservatorship.Essentially a government takeover.

Conservatorship



Terms of GSE conservatorship:top management replacedvoting power of shareholders and

directors terminatedto maintain solvency of GSEs,

government would: buy securities from GSEs buy billions of dollars of stock

in each GSE

Conservatorship



Federal Housing Finance Agency also announced plans to reduce size of Fannie Mae and Freddie Mac over several years.

Conservatorship



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

Ginnie Mae is government agency.Investors won’t lose invested capital in

economic crisis.

Federal guaranty



But securities issued by Fannie Mae and Freddie Mac didn’t carry government guaranty.

GSE’s private guaranty ensured only that investors would receive timely payment in spite of borrower default.

No protection against financial crisis affecting GSEs themselves.

Guaranty usually worthless if guarantor bankrupt.

Federal guaranty



However, investors believed government would feel obligated to intervene if Fannie Mae or Freddie Mac became insolvent.

Investors viewed GSE mortgage-backed securities as carrying implicit government guaranty.

Federal guaranty



After conservatorship announced, government confirmed federal guaranty.

GSEs were “too big to fail.”Default on payments to MBS investors

could have drastic effect on national economy.

Federal guaranty

© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 3: The Primary and Secondary...

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