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  1. Lesson 2: The Primary and Secondary Markets

  2. 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

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

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

  5. 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.

  6. 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.

  7. 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.

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

  9. Primary Market Local 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:

  10. Primary Market Local 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.

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

  12. Local Market Real estate cycles • 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.

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

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

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

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

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

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

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

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

  21. Real Estate Cycles Supply and demand • Previously, local lenders couldn’t do much about real estate cycles in communities. • Local lenders needed: • a source of extra funds to lend when demand exceeded supply; and • a place to invest surplus funds when supply exceeded demand.

  22. Primary Market Primary market Origination Real estate cycles Disintermediation

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

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

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

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

  27. Secondary Market Buying and selling loans • 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.

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

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

  30. 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”).

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

  32. 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.

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

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

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

  36. Secondary Market Agencies 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.

  37. Secondary Market Agencies Mortgage-backed securities • 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.

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

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

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

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

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

  43. 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.

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

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

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

  47. Funds given to home buyer by lender in primary market. • Mortgage sold to secondary market agency.

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

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

  50. Secondary Market Functions of 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.