Mortgage Market Flashcards
Since this chapter is all about sources of funds, you know we’ll be learning about where people seek and find real estate financing options. This is the primary mortgage market: the market in which mortgage lenders and borrowers come together to negotiate and create new mortgages. The various businesses that meet this consumer need for mortgages are called loan originators.
In the first part of this chapter, we will go over some of the different primary market players. Some of these parties are dedicated lenders and some are simply organizations that play a significant role in providing funds for real estate purchases.
We will discuss:
Savings and loan associations
Commercial banks
Life insurance companies
Retirement programs
Credit unions
Mortgage bankers and brokers
Real estate investment trusts
Private lenders
Primary Mortgage Market
Let’s begin with a look at savings and loan associations, or, S&Ls.
Savings and loan associations, also known as thrift lenders, were originally established by the government for the purpose of offering long-term, single-family home loans. For a long time, most conventional mortgage lending was done by the savings and loan industry. The idea was that S&L banks would fund mortgages with deposits from savings accounts.
Today, S&Ls are much like commercial banks and offer a wide variety of financial services. However, S&Ls are chartered by the government and must meet the qualified thrift lender (QTL) test to retain that charter and receive benefits from the Federal Home Loan Bank System. At least 70% of an S&L’s assets must be housing-related (for example: home mortgages, home equity loans, and mortgage-backed securities) for it to be considered a qualified thrift lender.
Savings and Loan Associations
Now that you know about savings and loan associations in the mortgage world, let’s move on to good ol’ fashioned banks.
Commercial banks provide financial services to the general public and businesses. This ensures stability, both economic and social, and sustainable economic growth.
Commercial banks are the largest source of investment funds in the United States. They offer demand, time, and savings deposits. Most of the mortgages created by commercial banks are sold to buyers on the secondary market. Still, some mortgages may be kept as portfolio loans.
Portfolio Lenders
While the majority of conventional loans are purchased by secondary market buyers, a portfolio lender (sometimes called a boutique lender) does not sell loans on the secondary market. Portfolio lenders are usually a bank or other institution that originates mortgage loans and then keeps the debt in a portfolio of loans.
Since portfolio lenders do not have to meet the underwriting guidelines required by secondary market buyers, their approvals are usually a bit more flexible for customers. However, since portfolio lenders are faced with more risk from servicing these loans, they will typically charge borrowers prepayment fees and higher interest.
Intermediation and Disintermediation
Intermediation is the name for the process of creating a go-between in the economic process. Think of it as “cutting in the middle-man.” In the financial system, commercial banks are the intermediaries – they collect and hold much of the funds that move between the government and consumers.
So, intermediation in the financial world would be an action that creates a flow of the economy’s money into banks. Disintermediation is when money is flowing out of the banks. A sudden and large disintermediation would cause a run on a bank that could create a financial crisis, as occurred during the stock market crash preceding the Great Depression.
Commercial Banks
There are thousands of insurance companies in the United States. I’m sure you made a payment to at least one of them this month!
Customers make payments (also called premiums) to the insurance company in exchange for a policy. The payments are usually made monthly or annually.The insurance company then has the responsibility to pay for specific, predetermined costs incurred by individuals, governments, or businesses as necessary.
If insurance companies simply pooled all their customers’ payments, left those funds sitting around, and paid all the claims out of this pool, they wouldn’t be as profitable as they are. They put those premiums to work by investing them.
Investing Premiums
Life insurance companies have the challenge of investing customer payments to ensure they will have funds available to satisfy claims and withdrawals when customers make claims on or withdrawals from their policies. As a result, many life insurers invest in a collection of long-term assets, including mortgages.
You see, because life insurance is a long-term plan, life insurance companies can afford to invest in long-term assets like mortgages. The majority of their real estate exposure comes in the form of financing commercial, multifamily real estate investments.
In many of America’s biggest cities, life insurance companies rank in the top 10 commercial real estate lenders.
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Life Insurance Companies
Many seniors have seen their monthly incomes, heavily dependent on Social Security and limited pension plan payouts, plummet following retirement. Yet on paper, they look relatively comfortable financially. They’ve got growing IRA and 401(k) retirement account balances, perhaps swelling from stock market gains. They often have solid equity in their homes, good credit scores, and at least modest savings.
But if these same people apply for a refinancing or a new mortgage to buy a home, suddenly they’re told they don’t look so great. They often can’t qualify under the debt-to-income standards required for today’s post-recession underwriting. Those rules sometimes set the bar for total household debt-to-income too high for retirees who have low income and are still making payments on auto loans, credit cards, home equity lines of credit, and other debts.
Using Retirement Funds to Purchase Real Estate
There are options, though! Seniors may be able to use income from their 401(k), IRA, and other retirement assets to qualify for the mortgage loan they want.
That, in turn, might open the door to a money-saving refinancing (with a lower interest rate) or to the purchase of a new house or condo that fits their needs. Many people downsize to a smaller home after they have retired and their children have moved out of the house.
Top credit officials at Freddie Mac, the giant federally controlled mortgage investment company, said that a “little known” policy revision now allows seniors and others to use certain retirement account balances to supplement their income for underwriting purposes — without actually tapping those balances or drawing down cash.
The bottom line is this: If a debt-ratio problem is preventing a senior from getting a new, low-interest-rate mortgage and they’ve got substantial untapped retirement funds, that might help qualify them on income.
An elderly couple standing close together in front of a house with a sold sign next to it.
Investing with Retirement Funds
Some seniors have made the decision to become real estate investors themselves. Some of these investors have made good profits by buying homes that aren’t in good cosmetic condition, doing the rehab, and then renting or reselling for their own account. It’s important for an investor to be knowledgeable about the market and to be able to make good estimates of the total they will have to invest in the property (for both the purchase and repairs) and the amount they will be able to sell it for.
Everyone’s financial circumstances are different, and some people like the option of growing their retirement savings by investing in real estate. They can do this by using money that has already been placed in a self-directed retirement account. A self-directed IRA is a retirement account that allows for alternative investments (like real estate) that traditional IRAs do not.
This investment method is generally more popular when the economy is in a recovery or expansion phase, since that indicates more bargains available in the real estate market. As the market picks up, there is opportunity for significant gains on an investment.
Retirement Programs
If you’re not a member of a credit union, you have probably met someone who is. And that person is probably very adamant about the virtues of credit unions.
A credit union is a financial cooperative that is created to serve its members’ needs, not for profit. Some other names for credit unions include cooperative banks, credit associations, and people’s banks.
Credit unions provide essentially the same services as banks. These services include:
Checking and savings accounts
Loans and home mortgages
Online banking and bill payment
There are a few reasons why your buyer clients may want to use a credit union for financing rather than a bank. The buyer may be attracted to the lower rates, flexible qualification standards, and a better chance of staying with the originating lender.
Credit Unions
Mortgage Banks
Mortgage companies aren’t bothered with a lot of the services that banks and credit unions provide, like savings and checking accounts. They’re specialized mortgage-making machines! They receive money to fund these mortgages from a variety of sources. Often it is borrowed from a warehouse lender or from one of the financial institutions that provide them with capital.
The money is then used to fund mortgages for their clients. A mortgage banker’s primary business is to earn the fees associated with loan origination.Mortgage bankers (which are not necessarily individual people, and can be called mortgage companies) are NOT depository institutions. They function more in the role of intermediaries rather than a source of lending capital. Mortgage banks control the greatest share of the primary lending market.
They manage capital, not from personal deposits, but from large investors such as insurance companies and retirement funds. Mortgage companies will also borrow money from commercial banks to finance loans.
A tiny house-shaped figurine balanced atop one of several stacks of coins.
Mortgage Brokers
A mortgage broker (not to be confused with a mortgage banker) is a licensed professional who originates mortgage loans that are financed by one of several lenders the broker works with. Many mortgage brokers deal exclusively with the residential home loan process, so they are highly specialized and can be beneficial in several ways to potential buyers.
The easiest way to differentiate a mortgage broker from a mortgage banker is that “brokers are broke-r.” I don’t mean to say that they are broke (au contraire!), but you can think of them as broke in the sense that they have no money of their own to loan out for mortgages. Mortgage brokers don’t fund loans. They simply bring lenders and borrowers together and are paid a commission for doing so.
Mortgage Banks and Brokers
A real estate investment trust (REIT) is a registered company that owns and operates commercial real estate. (Typically, these companies must meet special federal rules to get a pass-through tax status.) Most REITs trade on the major stock exchanges, so have plenty of investors who can take advantage of the benefits of owning real estate, such as hedging against inflation, by buying and selling shares in REITs.
There are many options out there for willing investors. Deciding which REITs to purchase works much the same way as deciding how to maximize one’s own cash flows. The investor must evaluate the market and examine the benefits and risks each company takes in its investments.
You may be wondering what the appeal of a REIT is. Well, many investors like REITs because they allow them to invest in real estate but avoid some of the hassles and risks involved with traditional real estate investment (such as going out and buying a duplex to rent out to tenants). The investor who chooses a REIT doesn’t have to go out and find a house, apartment complex, or a plot of land to buy.
Real estate investment trusts take away some of those challenges that make old fashioned real estate investment difficult. The majority of REITs are traded on the stock market, have diverse holdings, and can be liquidated quickly if the investor desires to do so.
Put simply, REITs allow investors to mitigate some risk by spreading their ownership interest across all the properties the REIT owns.
Real Estate Mortgage Trusts (REMT)
A real estate mortgage trust (REMT) is a type of REIT that buys and sells real estate mortgages instead of real property. Real property is the house. The mortgage is the loan.
REMTs make income via origination fees, interest, and profits from buying and selling mortgages.
Real Estate Investment Trusts (REITs)
Seller Financing
It’s not a very common type of financing, but when we talk about private lenders in real estate, seller financing comes to mind.
Sellers have the option to provide all the financing for the person who is buying their home. Other times, the seller will supplement the financing the buyer obtains from an institutional lender. Sellers can be an especially important source of financing (and a more common source) when institutional loans are difficult to obtain, particularly in times of high interest rates.
The interest rate on a savings account is usually very low compared to other places a person could keep their money. Sometimes the seller can earn a higher yield on their money by leaving it in the property and becoming the lender in the transaction.
The process of seller financing can be an option if the home is free and clear of liens and there is no mortgage on it. The owner of the home can, in a sense, take the bank’s place and finance the home for the buyer.
A typical amount for a down payment to the seller is about 20-25%. After that, monthly payments are scheduled through an amortized worksheet. The owner may also require an escrow account for taxes and insurance. There are processing companies that the owner can hire for the loan servicing so everything is tracked and documented properly.
2 people holding onto the same stack of one hundred dollar bills.
Borrowing from Friends and Family
Private individual financing is not limited to the seller of the property. Some buyers get financing by tapping into the “bank” of family and friends. If a borrower is having a hard time obtaining traditional financing, this type of loan can be a win-win for both the borrower and the lender of the money.
The borrower wins when they get the cash they need, and the private lender wins by earning interest at a rate equal to or higher than the yields they could have gotten by investing their money elsewhere.
Rights of the Borrower and Lender
Both the borrower and the private lender have rights. The big safety net for the private lender is that they can foreclose if the borrower defaults on the loan. Still, the borrower retains the same rights they would have with a more traditional loan. If a homebuyer got financing from a friend, their friend/lender couldn’t foreclose without the same justification a traditional lender would need. That means they can’t foreclose on the house for a personal reason, like being mad at the borrower for not attending their New Year’s Eve party.
As a lender, they still have to follow the foreclosure laws of the state. The note will define the actions that can be considered a default.
Down Payment Gifts
Homebuyers are more likely to get help with their down payment (in the form of gift funds that don’t have to be repaid) than they are to finance the whole loan through a friend or relative.
Some homebuyers receive the down payment amount (or a portion of it) as a gift from relatives. This is allowed no matter what type of loan the buyer is using, including conventional and government loans. However, there is a maximum amount set for gift funds, and that maximum may vary by loan type.
Gifts are acceptable for primary residences (and sometimes second homes), but not investment properties.
Private Lenders
In the United States, we have a two-tiered mortgage market, the primary and secondary market.
Primary Mortgage Market
At the first level of the mortgage market’s two-tiered structure is the primary mortgage market, where lenders underwrite loans to borrowers seeking to purchase real property.
Remember from the last few screens that most home purchase loans are made by one of these types of primary lenders:
Savings and loan associations
Commercial banks
Mortgage bankers
Credit unions
Private lenders
The Secondary Mortgage Market
The second tier of the two-tier system is the secondary mortgage market. The secondary market is where mortgages are bought and sold.
So, to reiterate:
The mortgage is originated in the primary mortgage market. The lender gives the borrower money and the borrower promises to repay the lender.
The lender sells the mortgage on the secondary mortgage market. Now the borrower needs to pay back whoever the lender sold the mortgage to.
Are you wondering who buys these mortgages from the lender? A lot of the time the buyer is a government-sponsored enterprise (GSE), such as Fannie Mae and Freddie Mac, or they can be private investors. I’ll spend the rest of this chapter explaining exactly how this works.
Remember when I said a promissory note promises to pay anyone who holds the note – even if it’s not the lender? This is what I was talking about.
A chart comparing the features of the primary and secondary market.
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The Two Mortgage Markets
The secondary mortgage market hasn’t always been a staple of the American mortgage market. Remember when I talked about all the financial shakeup that happened as a result of the Great Depression? The secondary mortgage market was another by-product of that era. Because of the economic devastation, many homeowners were having trouble making their mortgage payments, resulting in widespread foreclosure.
To help combat this, Congress created what’s known as a secondary market for mortgages, where the actual mortgages could be sold by lenders and bought by investors.
But how did the creation of a secondary market help improve the economic situation for homebuyers and lenders?
The Problem of Illiquidity
Without a secondary market for mortgages, mortgages are a simple two-way street: A lender lends money to a buyer, then the buyer pays the lender back with interest. But once the lender lends their funds to the borrower, the lender has to wait years in order to realize a profit. And if enough people want to take out a mortgage with a lender, the lender would end up emptying the vaults and not having any funds left for future borrowers.
In this world, mortgages are illiquid. This means that the lender cannot easily convert that mortgage to cash. In other words, they are stuck with that mortgage for years. In this same world it makes sense that lenders would want loans with shorter terms and higher interest rates. Remember in the previous chapter when I talked about what mortgages used to look like? Short five-year terms and interest-only payments. They looked like that in part because lenders could not afford to give out a large sum of money and then wait 30 years to make the money back.
A Liquid World
A more sustainable system for the lender would be to originate the mortgage, and then immediately sell the mortgage to someone else (an investor or investors). That way, they have money to continue loaning and they don’t have to worry about sitting on that mortgage and waiting for the payments to come trickling in. The mortgage payments would be paid to the investor who bought the mortgage.
This system is also beneficial for borrowers. The lender is going to turn around and sell the loan right after they originate it, so it doesn’t matter as much to them if it’s a 30-year loan or not. With longer loan terms, borrowers could find much more favorable monthly payments.
And that’s exactly what the secondary market made possible. The freedom to sell mortgages easily is known as mortgage liquidity. And once lenders had the power of mortgage liquidity, both the lender and the borrower got a boost of confidence in the mortgage market.
The Need for a Secondary Mortgage Market
A Little History of the Secondary Mortgage Market
So, when exactly did the secondary market come into existence? And what does it look like? As I said, the Great Depression was the catalyst for the change, but it took an act of Congress to build the foundation of this new system.
Reconstruction Finance Corporation
Congress created the Reconstruction Finance Corporation, or RFC, in 1932. The RFC’s purpose was to build confidence in the economy. One way they did this was by creating a mortgage company to sell and buy FHA and VA loans, making them more appealing to lenders/mortgage originators.
And you might be familiar with the mortgage company that the RFC created…
Fannie Mae
In 1938, the Federal National Mortgage Association (FNMA), or Fannie Mae, was created by the RFC.
Fannie Mae is a government-sponsored enterprise (GSE) that purchases FHA and VA loans, as well as conventional, conforming loans. Fannie Mae packages the mortgages they buy and sells them as mortgage-backed securities to investors (we’ll talk more about that in just a second!).
Freddie Mac
The Federal Home Loan Mortgage Corporation (FHLMC), or Freddie Mac, was created as part of the Emergency Home Finance Act of 1970. Like Fannie Mae, it is a government-sponsored enterprise.
The focus for Freddie Mac is on buying conventional loans from depository institutes (although it also purchases VA and FHA loans). Buying loans from depository institutions encourages further lending by returning working capital back to the banks, and essentially means the loans are insured by the U.S. government.
The Difference Between Fannie & Freddie
Today, Fannie Mae and Freddie Mac are completely independent of each other. They have the same business model and often compete with each other.
The only significant difference between Fannie Mae and Freddie Mac is the size of the financial institutions from which they purchase their mortgage loan bundles.
Fannie Mae deals with larger commercial banks, whereas Freddie Mac works with the smaller “thrift” banks. Fannie buys from the big boys, Freddie buys from the little guys.
To make it easier to package and sell loans on the secondary market, Fannie Mae and Freddie Mac have certain standards for the loans they buy. A loan that meets these standards is known as a conforming loan.
The most well-known guideline is the size of the loan, which as of 2021 was generally limited to $548,250 for single-family homes in the continental US. Other guidelines include the borrower’s loan-to-value ratio (which is affected by the size of the down payment), debt-to-income ratio, credit score and history, documentation requirements, etc.
So, the creation of Fannie Mae and Freddie Mac (and the secondary market) helped usher in a standardization of mortgages. Lenders now had an incentive to create more conforming loans. That way, if the lender needed to liquidate their real estate loans, they could quickly turn around and sell them on the secondary market.
Conforming to Standards
Intermediaries
GSEs act as financial intermediaries to assist lenders and borrowers in housing and agriculture. And because of this, GSEs are together the largest financial institutions in the U.S.
Remember, in finance, intermediation is the middle man in the transaction. The GSEs are the link between the loan providers and the investors who purchase the packaged loans. And in doing so, they are acting as intermediaries.
What Is a Government-Sponsored Enterprise, Exactly?
I’m glad you should ask, Anthony. Government-sponsored enterprises occupy a unique middle ground between the government and the market.
GSEs are a weird mix of both public and private. They are created by the government, and exist for public use, but are privately owned. Confusing, right? Yes, very.
Simply put, a government-sponsored enterprise is a type of financial services corporation created by the United States Congress with the goal of enhancing the flow of credit to targeted sectors of the economy.
More confusingly put, government-sponsored enterprises have been privately owned but publicly chartered; others, such as the Federal Home Loan Banks, are owned by the corporations that use their services. GSE securities carry NO explicit government guarantee of creditworthiness, but lenders grant them favorable interest rates, and the buyers of their securities offer them high prices. This is partly due to an “implicit guarantee” that the government would not allow such important institutions to fail or default on debt.
Don’t get it twisted, though — GSEs are accountable first and foremost to the stockholders and investors, not the government or the public. So every decision a GSE makes is for the sake of the stockholders and investors. They see it as their fiduciary responsibility.
Government Sponsored Enterprises
Another major player in the secondary market is the Government National Mortgage Association (GNMA), or Ginnie Mae. It was created in 1968 as an offshoot of Fannie Mae.
Fannie Mae continued its operation in the secondary mortgage market, concentrating on its portfolio liquidity by buying and selling loans, staying governmentally chartered, but becoming a privately funded company.
When Fannie Mae became a privately funded company, Ginnie Mae took over the housing assistance and support programs under the Department of Housing and Urban Development (HUD), which is where Ginnie Mae’s focus still is today.
So, Ginnie Mae’s mission is to expand affordable housing financing. They do this by ensuring that lenders have the funds and stability to provide loans to customers.
Unlike Fannie Mae and Freddie Mac, Ginnie Mae is not a GSE and is still wholly owned by the United States Government. Instead of being government-sponsored, Ginnie Mae is considered a government-owned enterprise.An outline of the United States overlain with a one-dollar bill.
A Government-Owned Enterprise
I’m gonna reiterate this one more time for those of you sitting way, way in the back of the virtual classroom: Ginnie Mae is different from Fannie Mae and Freddie Mac because Ginnie has the U.S. government on their side. Their mortgages are backed by the government, unlike Fannie Mae and Freddie Mac.
Liability for the mortgages falls on the banks that create the mortgages, which makes Ginnie Mae less responsible for what happens if someone is delinquent on their house payments, but also gives banks the benefit of securitization.
For Fannie Mae and Freddie Mac, the banks pass responsibility onto them, putting them at higher risk.
Ginnie Mae
