Behind the Scenes of Your Mortgage
A mortgage can be seen as a stream of future cash flows. These cash flows are bought, sold, stripped, tranched and securitized in the secondary mortgage market. The secondary mortgage market is extremely large and very liquid.
From the point of origination to the point at which a borrower's monthly payment ends up with an investor as part of an mortgage-backed security (MBS), asset-backed security (ABS), collateralized mortgage obligation (CMO) or collateralized debt obligation (CDO) payment, there are several different institutions that all carve out some percentage of the initial fees and/or monthly cash flows.
Most mortgages are sold into the secondary mortgage market. In this article, we'll show you how the secondary mortgage market works and introduce you to its major participants.
SEE: Mortgage Basics
1. The Mortgage Originator
The mortgage originator is the first company involved in the secondary mortgage market. Mortgage originators consist of banks, mortgage bankers and mortgage brokers. One distinction to note is that banks and mortgage bankers use their own funds to close mortgages and mortgage brokers do not. Mortgage brokers act as independent agents for banks or mortgage bankers. While banks use their traditional sources of funding to close loans, mortgage bankers typically use what is known as a warehouse line of credit to fund loans. Most banks, and nearly all mortgage bankers, quickly sell newly originated mortgages into the secondary market.
However, depending on the size and sophistication of the originator, it might aggregate mortgages for a certain period of time before selling the whole package - it might also sell individual loans as they are originated. There is risk involved for an originator when it holds onto a mortgage after an interest rate has been quoted and locked in by a borrower.
If the mortgage is not simultaneously sold into the secondary market at the time the borrower locks the interest rate, interest rates could change, which changes the value of the mortgage in the secondary market and, ultimately, the profit the originator makes on the mortgage. Originators that aggregate mortgages before selling them should hedge their mortgage pipelines against interest rate shifts. There is a special type of transaction called a best efforts trade, designed for the sale of a single mortgage, which eliminates the need for the originator to hedge a mortgage. Smaller originators tend to use best efforts trades. (To learn more, see A Beginner's Guide To Hedging.)
In general, mortgage originators make money through the fees that are charged to originate a mortgage and the difference between the interest rate given to a borrower and the premium a secondary market will pay for that interest rate.
2. The Aggregator
Aggregators are the next company in the line of secondary mortgage market participants. Aggregators are large mortgage originators with ties to Wall Street firms and government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac. Aggregators purchase newly originated mortgages from smaller originators, and along with their own originations, form pools of mortgages that they either securitize into private label mortgage-backed securities (by working with Wall Street firms) or form agency MBSs (by working through GSEs). (To learn more about GSEs, see Profit From Mortgage Debt With MBS.)
Similar to originators, aggregators must hedge the mortgages in their pipelines from the time they commit to purchase a mortgage, through the securitization process, and until the MBS is sold to a securities dealer. Hedging a mortgage pipeline is a complex task due to fallout and spread risk. Aggregators make profits by the difference in the price that they pay for mortgages and the price for which they can sell the MBSs backed by those mortgages, contingent upon their hedge effectiveness.
3. Securities Dealers
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. Most Wall Street brokerage firms have MBS trading desks. Dealers do all kinds of creative things with MBS and mortgage whole loans. The end goal is to sell securities to investors. Dealers frequently use MBSs to structure CMO, ABS and CDO deals. These deals can be structured to have different and somewhat definite prepayment characteristics and enhanced credit ratings compared to the underlying MBS or whole loans. Dealers make a spread in the price at which they buy and sell MBS, and look to make arbitrage profits in the way they structure CMO, ABS and CDO deals.
Investors are the end users of mortgages. Foreign governments, pension funds, insurance companies, banks, GSEs and hedge funds are all big investors in mortgages. MBS, CMOs, ABS and CDOs offer investors a wide range of potential yields based on varying credit quality and interest rate risks.
Foreign governments, pension funds, insurance companies and banks typically invest in high-credit rated mortgage products. Certain tranches of the various structured mortgage deals are sought after by these investors for their prepayment and interest rate risk profiles. Hedge funds are typically big investors in low-credit rated mortgage products and structured mortgage products that have greater interest rate risk.
Of all the mortgage investors, the GSEs have the largest portfolios. The type of mortgage product they can invest in is largely regulated by the Office of Federal Housing Enterprise Oversight.
The Bottom Line
In a matter of weeks, maybe a month, from the time a mortgage is originated it can become part of a CMO, ABS or CDO deal. Few borrowers realize the extent to which their mortgage is sliced, diced and traded. The end user of a mortgage might be a hedge fund that makes directional interest rate bets or uses leveraged positions to exploit small relational pricing irregularities, or it might be the central bank of a foreign country that likes the credit rating of an agency MBS. On the other hand, it could be an insurance company based in Brussels, that likes the duration and convexity profile of a certain tranche in an ABS, CMO or CDO deal. The secondary mortgage market is huge, liquid and complex with several institutions that all take a slice of the mortgage pie.