© 2012 Rockwell Publishing Financing Residential Real Estate Lesson 3: The Primary and Secondary Markets

© 2012 Rockwell Publishing Introduction Residential mortgage industry made up of: financial institutions private companies government-sponsored enterprises other investors

© 2012 Rockwell Publishing Two Mortgage Markets Industry is divided into two “markets” that supply funds for mortgage loans. Primary market: market where lenders make loans to home buyers. Secondary market: market where lenders sell their loans to investors.

© 2012 Rockwell Publishing Primary Market In primary market, home buyers apply for mortgage loans and lenders originate them. Loan origination involves: processing application approval decision funding loan

© 2012 Rockwell Publishing Primary Market Primary market was originally local, made up of community financial institutions. More complicated now, due to developments such as: interstate banking Internet lenders Local model still useful in understanding primary and secondary markets.

© 2012 Rockwell Publishing Primary Market Local market is subject to real estate cycles. Real estate cycles: periodic shifts in level of real estate activity (sales, loans). Caused by changes in supply of and demand for: real estate for sale funds for mortgage lending Real estate cycles

© 2012 Rockwell Publishing Primary Market Local real estate cycles are affected by many factors, including: economic forces political events social trends These factors may be either local or national. Factors affecting real estate cycles

© 2012 Rockwell Publishing Primary Market At one time, local lenders couldn’t do much about real estate cycles in their communities. Dealing with real estate cycles

© 2012 Rockwell Publishing Primary Market They needed: a source of extra funds to lend when demand exceeded supply; and a place to invest surplus funds when supply exceeded demand. Secondary market helped meet both needs. Dealing with real estate cycles

© 2012 Rockwell Publishing Secondary Market Solution to primary market problems was secondary market, where mortgages secured by real estate all over U.S. are bought and sold.

© 2012 Rockwell Publishing Secondary Market Secondary market activities: buying and selling loans buying and selling mortgage-backed securities

© 2012 Rockwell Publishing Secondary Market Activities Like other investments, loans can be bought and sold. Loan purchaser pays present value of right to receive payments from borrower. Rate of return on loan compared with rate of return on other investments to determine present value. Buying and selling loans

© 2012 Rockwell Publishing Buying and Selling Loans Mortgage lenders may sell their loans to: other lenders secondary market agencies Created by federal government to establish strong secondary market for mortgage loans. Who buys loans?

© 2012 Rockwell Publishing Federal National Mortgage Association (FNMA or “Fannie Mae”) Federal Home Loan Mortgage Corporation (FHMLC or “Freddie Mac”) Government National Mortgage Association (GNMA or “Ginnie Mae”) Buying and Selling Loans Secondary market agencies

© 2012 Rockwell Publishing Lenders “package” similar loans together for sale to secondary market agency. After sale, loans may be serviced by original lender or by another servicer. Loan servicing: payment processing, collections, working with borrowers to prevent default. Buying and Selling Loans Secondary market agencies

© 2012 Rockwell Publishing Secondary Market Activities Secondary market agencies also issue Mortgage-backed securities (MBS): investment instrument with mortgage loans as collateral; a type of bond. Investor returns are monthly payments from secondary market agency. Agency passes borrowers’ payments on to investors. Mortgage-backed securities

© 2012 Rockwell Publishing Mortgage-backed Securities Securitizing: buying mortgages, pooling them together, pledging pool as collateral, issuing securities. Private-label mortgage-backed securities: securities issued by private firm rather than secondary market agency. Securitizing loans

© 2012 Rockwell Publishing Mortgage-backed Securities Reasons investors prefer buying MBSs to buying actual mortgage loans include: convenience greater liquidity can be purchased in relatively small denominations Advantages for investors

© 2012 Rockwell Publishing Functions of Secondary Market Secondary market serves two important functions for real estate industry:  moderates adverse effects of real estate cycles, providing some stability  makes funds available for mortgage loans, promoting home ownership

© 2012 Rockwell Publishing Functions of Secondary Market Availability of funds in primary market depends on secondary market. Mortgage funds flow between the two markets. Flow of mortgage funds

© 2012 Rockwell Publishing Functions of Secondary Market Lender loans funds to buyer in primary market. Lender sells mortgage to secondary market agency. Agency pools mortgage and sells MBSs, freeing agency funds to buy more mortgages. As agency buys mortgages, more funds available for more loans in primary market. Flow of mortgage funds

© 2012 Rockwell Publishing Functions of Secondary Market If lender doesn’t sell loan on secondary market, loan is kept in portfolio. Only small percentage of loans are kept in portfolio today. Portfolio loans

© 2012 Rockwell Publishing Secondary Market Agencies Government-sponsored enterprise (GSE): created and supervised by federal government owned by private stockholders Historical background

© 2012 Rockwell Publishing Historical Background 1938 – Created by federal government in response to Depression-era credit problems. Authorized to buy FHA loans – Also authorized to buy VA loans – Reorganized as government- sponsored enterprise. Fannie Mae

© 2012 Rockwell Publishing Historical Background 1968 – Created as agency within HUD when Fannie Mae was privatized. Wholly owned government corporation. Managed and liquidated mortgages bought by FNMA before change-over. Now securitizes FHA and VA loans; helps finance urban renewal and housing projects. Ginnie Mae

© 2012 Rockwell Publishing Historical Background 1970 – Created by Emergency Home Finance Act as government-sponsored enterprise (GSE). Original purpose: to assist savings and loans hit hard in 1969 recession act authorized both Freddie Mac and Fannie Mae to buy conventional loans. Freddie Mac

© 2012 Rockwell Publishing Secondary Market Agencies As GSEs, Fannie Mae and Freddie Mac were given some advantages over ordinary private corporations. Exempted from certain types of taxes. Not subject to certain SEC registration and disclosure requirements. GSE status

© 2012 Rockwell Publishing Secondary Market Agencies GSEs were also given special responsibilities and limitations. Restricted by charter to investment in residential mortgage assets (mortgages and mortgage-backed securities). Required to meet annual affordable housing goals. GSE status

© 2012 Rockwell Publishing Secondary Market Agencies Ginnie Mae started first MBS program in Offered guaranteed securities backed by pools of FHA and VA loans. Fannie Mae and Freddie Mac followed with securities backed by conventional loans. MBS programs

© 2012 Rockwell Publishing Secondary Market Agencies 1980s: Congress removed certain restrictions on mortgage-backed securities. Made them more competitive with corporate bonds. Fueled expansion of secondary market. MBS programs

© 2012 Rockwell Publishing Secondary Market Agencies Investors can buy MBSs: directly from issuing agency on Wall Street, through securities dealers Direct purchases typically made by large investors such as insurance companies or pension funds. MBS programs

© 2012 Rockwell Publishing Secondary Market Agencies MBS issued by secondary market agency is guaranteed by agency. Investor receives full payment from agency even if borrowers default on some loans in pool. Guaranty fees and servicing fees subtracted before payments passed on to investors. MBS programs

© 2012 Rockwell Publishing Secondary Market Agencies Lender who wants to sell loan to Fannie Mae or Freddie Mac must: comply with agency’s underwriting rules when qualifying loan applicant use uniform loan documents If lender violates agency rules, may be required to buy loan back from agency. Standardized underwriting

© 2012 Rockwell Publishing Secondary Market Agencies Underwriting guidelines and uniform documents are quality control to ensure loans purchased by secondary market agencies meet minimum standards. Inspires investor confidence. Strongly influences primary market lenders. Standardized underwriting

© 2012 Rockwell Publishing Secondary Market Agencies Prime loan: loan made to borrower with A credit rating. Subprime loan: loan made to less creditworthy borrower. At one time, Fannie Mae and Freddie Mac bought only prime loans. Subprime loans didn’t meet their standards. GSEs and subprime loans

© 2012 Rockwell Publishing Secondary Market Agencies In 2005 Fannie Mae and Freddie Mac began buying subprime loans. Primarily A-minus loans: top layer of subprime market. Encouraged by government, to help meet affordable housing goals. GSEs and subprime loans

© 2012 Rockwell Publishing Secondary Market Agencies Before current crisis, analysts credited Fannie Mae and Freddie Mac with: increasing home ownership rates reducing mortgage interest rates improving underwriting practices providing mortgage lenders with access to global capital markets GSEs and the economic crisis

© 2012 Rockwell Publishing GSEs and the Economic Crisis Before current crisis, critics argued: claims of Government Sponsored Enterprises’ benefit to public exaggerated GSEs too large, with too much power over mortgage industry GSEs limited opportunities for other investors and enterprises GSEs not run well (2003/04 accounting scandals) Criticism before crisis began

© 2012 Rockwell Publishing GSEs and the Economic Crisis By 2007, 1/3 of Fannie Mae and Freddie Mac’s new purchases and guaranties involved riskier loans. As subprime crisis unfolded, house prices dropped and foreclosure rates rose sharply. Caused GSEs’ stock prices to plunge, further undermining their financial stability. On the brink of insolvency

© 2012 Rockwell Publishing GSEs and the Economic Crisis Housing and Economic Recovery Act of 2008 (HERA) created new independent regulatory agency to oversee GSEs. Federal Housing Finance Agency (FHFA). September 2008: to prevent economic consequences of GSE failure, FHFA placed both agencies in conservatorship. Essentially a government takeover. Conservatorship

© 2012 Rockwell Publishing GSEs and the Economic Crisis Terms of GSE conservatorship: top management replaced voting power of shareholders and directors terminated to maintain solvency of GSEs, government would: buy securities from GSEs buy billions of dollars of stock in each GSE Conservatorship

© 2012 Rockwell Publishing GSEs and the Economic Crisis Federal Housing Finance Agency also announced plans to reduce size of Fannie Mae and Freddie Mac over several years. Conservatorship

© 2012 Rockwell Publishing GSEs and the Economic Crisis Ginnie Mae securities have always been backed by “full faith and credit” of U.S. government. Ginnie Mae is government agency. Investors won’t lose invested capital in economic crisis. Federal guaranty

© 2012 Rockwell Publishing GSEs and the Economic Crisis But securities issued by Fannie Mae and Freddie Mac didn’t carry government guaranty. GSE’s private guaranty ensured only that investors would receive timely payment in spite of borrower default. No protection against financial crisis affecting GSEs themselves. Guaranty usually worthless if guarantor bankrupt. Federal guaranty

© 2012 Rockwell Publishing GSEs and the Economic Crisis However, investors believed government would feel obligated to intervene if Fannie Mae or Freddie Mac became insolvent. Investors viewed GSE mortgage-backed securities as carrying implicit government guaranty. Federal guaranty

© 2012 Rockwell Publishing GSEs and the Economic Crisis After conservatorship announced, government confirmed federal guaranty. GSEs were “too big to fail.” Default on payments to MBS investors could have drastic effect on national economy. Federal guaranty