Hello Realtors and Real Estate Professionals! Before reading this article make sure you read part 1 ” Realtor’s Guide to Mortgages in the Financial Markets Part 1″ , to make sure you obtain the proper base of understanding, on how wall street affects mortgages and ultimately – Real Estate!
Most experienced realtors and mortgage professionals, that have worked with financing in the past, have a basic understanding of how the mortgage process works (unfortunately it takes more than a snap of the fingers to make the money appear in time for closing!). There are many intricacies and details that occur during the mortgage process from the moment the mortgage application is taken until the investor who will own the mortgage note, begins servicing it.
To understand the current process we need to look back at how originating a mortgage was done in the past. A typical mortgage transaction involved a local bank which will be originating the mortgage loan and will hold it as part of their portfolio, for the entire life of the loan. In this system, rejections were many and approvals were few; because the bankers had to be very careful in assessing the risk profile of each loan, since they will be the ones incurring the loss in the case the loan goes belly up. This old system was very selective and posed a great risk for the financial institutions given the loan portfolios were made up of similar loans in the same geographical area. in an economic downturn in the area may cause many of their loans to go into default at once.
As technology improved and globalization became more apparent, financial markets became more sophisticated and new techniques were developed to offload concentrated loan portfolio risks. This is where wall street began to dip their fingers into the mortgage loan market. The process of securitization, which basically groups pools of assets and are sold in wall street as a security. Essentially, pools of mortgages with specific risk profiles (Certain FICOs, loan amount, loan terms, property types, etc) were packaged together and sold as “Mortgage Backed Securities”. So if I wanted to invest in the mortgage market, I would be ablet o buy a Mortgage Backed Security (Bond) with a certain risk profile that pay a fixed return (and occasionally dividends).
This securitization allowed flexibility around the country, so that a downturn in an industry or region would only affect a small portion of the mortgages in the portfolio. Mutual funds and pension funds seeking a steady and safe return, began to own mortgages as an investment. The price of the mortgage backed securities is inverse to the mortgage rates; meaning, the higher the price of the security the lower the mortgage rate.
Investors were a bit reluctant at first; they argued that if banks were no longer servicing the mortgages originated, then the lending standards worsened and these mortgages became more risky. To address this concern, the “Government Sponsored Enterprises” of Fannie Mae, Freddie Mac and Ginnie Mae were created; these institutions were placed in order to ensure a standard in mortgage loan approvals were in place and in turn protect the investors and ensuring the loans in their portfolios were of quality. additionally, these agencies insured their loans so it removed nearly all the risk to the investors. In essence, when loans are underwrite to, say Freddie Mac guidelines, investors know there is a certain underlying credit quality for the mortgage backed security being purchased; even if the borrower defaults on their mortgage, the investor will be repaid in full.
In essence; mortgage backed securities are simply bonds made up of pools of mortgages backed by Fannie Mae, Freddie Mac, or Ginnie Mae; these are traded ina manner very similar to Treasury bonds. Over the past few decades the market cap for th MBS market has grown significantly, now comparable to the Treasury market. Investors receive payments based on the amount of interest and principal paid by the borrowers (consumers) who guarantee th emortgage note. The main difference between the Mortgage backed security and other types of fixed income investments (bonds) is that the borrowers have the option to prepay a mortgage. This is something you don’t like happening as an investor because you are unable to collect the expected interest throughout the life of the loan.
To summarize, the loan is originated, then sold to one of the GSEs (Fannie , Freddie or Ginnie) and finally securitized and sold as a Mortgage Backed Security to hungry investors in Wall Street!
Although an important factor that will influence mortgage rates is mortgage backed security prices (the higher the prices the lower the rates); there are many other factors that affect mortgage rates and the real estate industry as a whole. Stay tuned for Part III of this series, where I will telling you about the important factors!