The secondary mortgage market allows banks to repackage and sell mortgages as securities to institutional investors. These investors include large pension funds, insurance companies, hedge funds, and the federal government. In turn, the buyers of the bank's mortgage investment products will often repackage and sell the mortgages securities to smaller investors.
Secondary Market and Banks
By packaging and selling mortgages or house notes that they write, the bank can remove these items from their balance sheets. Also, the proceeds from selling the mortgages to a second party give banks new funds to lend to more borrowers. Before the secondary market was established, only larger banks had the deep pockets to tie up funds for the life of the loan—typically for 15 to 30 years. As a result, potential homebuyers had a difficult time finding mortgage lenders. Because there was less competition, lenders could charge higher interest rates.
Fannie and Freddie and Secondary Mortgages
The 1968 Federal National Mortgage Association Charter Act tried to solve this problem by privatizing Fannie Mae and Freddie Mac. These government-sponsored enterprises (GSE) were tasked with creating access to affordable mortgages. To fund these efforts, Fannie and Freddie buy bank mortgages and resold them to other investors. The loans aren't resold individually. Instead, they are bundled into mortgage-backed securities (MBS). The value of the MBS is secured—or backed—by the value of the underlying bundle of mortgages.
The 2008-2009 subprime mortgage crisis saw the two entities owning or guaranteeing 44% of all U.S. mortgages by the end of 2009. This portfolio amounted to nearly US$4.8 trillion as it teetered on the brink of default.
Other financial institutions like Lehman Brothers and Bear Stearns were capsized by mortgage-backed securities and other derivatives during the 2008 financial crisis. There was a rush to the exits as private banks exited the mortgage market en masse. As a result, Fannie and Freddie became responsible for almost 90% of home loans. The two GSEs were basically holding together the entire housing industry. This large holding hazard was how Fannie Mae and Freddie Mac were implicated in the subprime mortgage crisis.
Other Types of 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, student loan debt, and corporate debt.
Stocks are sold on two very famous secondary markets, the New York Stock Exchange and the NASDAQ. The primary market for stocks, called the initial public offering, involves a company’s first time offering part ownership to the public through shares of stocks.
Most important is the secondary market for U.S. Treasury bills, bonds, and notes. Demand for Treasurys affects all interest rates. Treasury bonds, backed by the U.S. government, are the safest investment in the world—they are used for calculations where a risk-free investment is needed. They also offer a low yield. Investors who want more return, and are willing to take on more risk, will buy other bonds, such as municipal, corporate, foreign, or even junk bonds. When demand for Treasurys is high, then interest rate yields can be low for all debt. When demand for Treasurys is low, then interest rates must rise for all debt on the secondary market.
There is a direct relationship between Treasury bonds and mortgage interest rates. When yields on Treasury bonds rise, so do interest rates on fixed-rate mortgages. Since fixed-income financial products compete for the notice of the “safe returns” investor, these all need to keep their returns on par with each other.
Growth in Confidence
As confidence returns in the secondary mortgage market, it returns to all secondary markets. Ian Salisbury of Marketwatch.com mentions this in his August 25, 2012 article, “How an Obscure Bond Play Could Help Consumers." Salisbury states that 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 the Standard & Poor's Financial Services LLC.
Large investors are now more willing to take a chance with securitized loans from reputable banks because Treasury bond yields are at all-time 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.
Banks now have a market for securitized loan bundles. This ready market gives them more cash to make new loans.
How the Secondary Market Affects You
The return of the secondary market is especially useful for you if you need a car loan, new credit cards, or a business loan. If you've applied for a loan recently and were turned down, now is a good time to try again. But if your credit score is below 720, you will have to repair your credit.
It's also great for economic growth. Consumer spending generates almost 71% of the U.S. economy, as measured by gross domestic product (GDP). In 2007, a lot of consumers used credit card debt to shop. After the financial crisis, they either cut back on debt or lost credit from panicked banks, which denied them access. A return of securitization means investors and banks are less fear-driven. Consumer debt is rising, boosting economic growth.