Secondary Mortgage Market

What Is the Secondary Mortgage Market?

The secondary mortgage market is a marketplace where home loans and servicing rights are bought and sold between lenders and investors. A large percentage of newly originated mortgages are sold by the lenders who issue them into this secondary market, where they are packaged into mortgage-backed securities and sold to investors such as pension funds, insurance companies, and hedge funds.

The secondary mortgage market is extremely large and liquid, and helps to make credit equally available to all borrowers across geographical locations.

Secondary Mortgage Market Explained

Several players participate in the secondary mortgage market: mortgage originators, mortgage aggregators (securitizers), and investors.

When a person takes out a home loan, the loan is underwritten, funded, and serviced by a financial institution, usually a bank. Known as mortgage originators, banks use their own funds to make the loan, but they can't risk eventually running out of money, so they often will sell the loan on the secondary market to replenish their available funds, so they can continue to offer financing to other customers. Depending on its size and sophistication, a mortgage originator might aggregate mortgages for a certain period of time before selling the whole package; it might also sell individual loans as they are originated.

The loan or loans is often sold to large aggregators. The aggregator then distributes thousands of similar loans in a mortgage-backed security (MBS). After an MBS has been formed (and sometimes before it is formed, depending upon the type of the MBS), it is sold to a securities dealer. This dealer, often a Wall Street brokerage firm, further package the MBS in various ways and sell it to investors, who are often seeking income-oriented instruments. These investors don't get control of the mortgages, but they do receive the interest income from the borrowers' repayments.

History of the Secondary Mortgage Market

Before the secondary market was established, only larger banks had the extensive funds necessary to provide the funds for the life of the loan, usually for 15 to 30 years. Because of this, potential homebuyers had a more difficult time finding mortgage lenders. Because there was less competition between mortgage lenders, they were able to charge higher interest rates. 

The 1968 Charter Act solved this problem by creating Fannie Mae and Freddie Mac, which actually started operating two years later. These government-sponsored enterprises functioned as aggregators, able to buy bank mortgages and resell them to other investors. Instead of reselling the loans individually, they were bundled into mortgage-backed securities, which means their value is secured or backed by the value of the bundle of underlying loans. 

Competition and Risk on the Secondary Mortgage Market

Competition and risk are always part of the game when private investors bring mortgage loans onto the secondary mortgage market because the private investors begin to drive mortgage rates and fees. This means if you have a low credit score and seek a loan, you can be perceived as risky, so they can charge higher rates and fees.  

After the subprime mortgage crisis, individual investors grew unwilling to risk their capital on mortgage-backed securities with low rates. The federal government then had to step in to fill the void in the secondary mortgage market. This stopped rates from skyrocketing to a place where hardly anyone could afford to own a home.