Secondary Mortgage Market: Pros, Cons, Role in the Financial Crisis
Why Your Bank Sells Your Mortgage, and How That Helps You
The proceeds give the banks new funds to offer more mortgages. Before the secondary market was established, only larger banks had the deep pockets tie up funds for the life of the loan, commonly for 15 to 30 years. As a result, potential homebuyers had a more difficult time finding mortgage lenders.
Since there was less competition between lenders, they could charge higher interest rates.
The 1968 Charter Act solved this problem by creating Fannie Mae, and Freddie Mac two years later. These government-sponsored enterprises buy bank mortgages and resold them to other investors. The loans aren't resold individually. Instead they are bundled into mortgage-backed securities. Their value is secured, or backed, by the value of an underlying bundle of mortgages.
Before the subprime mortgage crisis, the two owned or guaranteed 40 percent of all U.S. mortgages. As Lehman Brothers, Bear Stearns and other banks were capsized by mortgage-backed securities and other derivatives during the 2008 financial crisis, private banks exited the mortgage market en masse. As a result, Fannie and Freddie became responsible for nearly 100 percent, basically holding together the entire housing industry. Read more about How Fannie Mae and Freddie Mac Created the Subprime Mortgage Crisis.
Banks only started returning to the secondary market in 2013. Even so, they are still holding onto 27 percent of mortgages issued in 2014, the highest level in a decade. There are three reasons for this:
- Fannie and Freddie raised their guarantee fees from 0.2 percent of the loan amount to 0.5 percent. As a result, many banks find it's cheaper to hold onto the safest loans.
- Banks are making more "jumbo" loans, which exceed Fannie and Freddie's loan limits and therefore are uninsurable by them. The percent has risen from 14 percent of all originations in 2013 to 19 percent in 2014.
- Banks are making fewer loans to only the most credit-worthy customers. The total dollar amount of residential mortgages fell 2.7 percent between 2012 and 2014. During that same time period, their total assets grew 7.6 percent. (Source: ”Banks Keeping Their Loans Close to Home”, John Carney, The Wall Street Journal, March 23, 2015. )
Other Secondary Markets
There are also secondary markets in other kinds of debt, as well as stocks. Finance companies bundle and resell auto loans, credit card debt, and corporate debt. Stocks are sold on two very famous secondary markets, the New York Stock Exchange and the NASDAQ. Here's more on the primary market for stocks, called the Initial Public Offering.
Most important is the secondary market for U.S. Treasury bills, bonds and notes. Demand for these Treasuries affect all interest rates. Here's how. Treasury notes, backed by the U.S. government, are the safest investment in the world. Therefore, they can offer the lowest yield. Investors who want more return, and are willing to take on more risk, will buy other bonds, such as municipal or even junk bonds.
When demand for Treasuries is high, then interest rate yields can be low for all debt. When demand for Treasuries is low, then interest rates must rise for all debt on the secondary market. For more, see Relationship Between Treasury Notes and Mortgage Interest Rates.
As confidence returns in the secondary mortgage market, it returns to all secondary markets. In 2007, auto and credit card securities were at $178 billion, but plunged to just $65 billion by 2010.By 2012, they had recovered to $100 billion, according to Standard & Poor's. (Source: “How an Obscure Bond Play Could Help Consumers," Ian Salisbury, Marketwatch, August 25, 2012.)
Why is this secondary market returning? Large investors are now more willing to take a chance with securitized loans from reputable banks because Treasury note yields are at 200-year lows.
That means the quantitative easing by the Federal Reserve helped restore functioning in the financial markets. By buying U.S. Treasurys, the Fed forced yields lower and made other investments look better by comparison.
The result? Banks now have a market for the securitized loan bundles. This gives them more cash to make new loans.
How the Secondary Market Affects You
The return of the secondary market is especially great if you need a car loan, new credit cards or even a business loan. If you've applied for a loan recently and were turned down, try again. Unless, of course, your credit score is below 720. In that case, your first step is to repair your credit. Here are some great free tips to repair your credit yourself.
It's also great for economic growth. Consumer spending generates nearly 70 percent of the U.S. economy, as measured by gross domestic product. In 2007, a lot of consumers used credit card debt to shop. After the financial crisis, they either cut back on debt, or were denied access by panicked banks. A return of securitization means investors and banks are less fear driven. Consumer debt is rising, boosting economic growth. For recent statistics, see How Does Your Credit Card Debt Compare to the Average?