How Does the Secondary Mortgage Market Work?

We’ve been hearing a lot about the secondary mortgage market in the news lately. This is mainly because it had a lot to do with the housing and subprime mortgage crisis that wrecked the U.S. economy.

But many consumers don’t know what the secondary mortgage market is or how it works. They think it has nothing to do with them, as a home buyer and consumer. In truth, it does affect you, because it influences the affordability of home mortgage loans and the willingness of lenders to make new loans. So in this lesson, I’ll give you a basic overview of the secondary mortgage market, and I’ll explain how it affects you as a home buyer.

Three Parts of the Mortgage Market

In a broad sense, there are three primary components of the mortgage market in this country. Here is how these key components relate to one another:

Part 1 – Primary Lenders — As the name implies, these are the lending institutions who make loans directly to consumers and businesses. For a long time, there was no such thing as a secondary mortgage market. There were only the primary lenders, who kept the loans they made as part of their in-house portfolio. But in the late 1930’s (think Great Depression), the secondary market came into existence … see next item.

Part 2 – Secondary Market —  Basically, it involves the buying and selling of mortgage-backed securities. The primary lender makes a loan directly to a consumer, and then they sell it off through the secondary market. The major players in the secondary mortgage market are Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Association), and Ginnie Mae (Government National Mortgage Association). These are all private companies who enjoy plenty of government support. The “touchy-feely” mission of these organizations is to make home loans more affordable to more Americans. The real mission of these organizations is to make unfathomable amounts of money.

Part 3 – Private Mortgage Insurance (PMI) Market — This is the third components of the secondary mortgage market, and it was created in response to the buying and selling (a.k.a. “recycling”) of mortgage loans that I explained above. When you buy and sell mortgage-backed securities, you conjure a certain amount of risk, mainly from default. Private mortgage insurance typically covers the top 20% of a home loan against borrower default (failure to pay). This is how you’re able to avoid PMI by making a down payment of at least 20% of the home’s value — it minimizes the risk for the primary lender and secondary buyers, so it makes PMI coverage unnecessary.

How the Secondary Market Affects Home Buyers

What happens on the secondary mortgage market has a direct effect on you, as a home buyer. For example, if Freddie Mac changes its guidelines on the types of mortgage loans it will buy, the primary lenders may adjust their underwriting procedures to keep pace with those guidelines. In turn, this will affect the qualifying criteria that you must meet in order to get approved for a loan.

The subprime mortgage crisis is a prime example of how the secondary market changes things on the primary lending front. In the 1990s and early 2000s, subprime loans were given out like candy. By the way, these were the high-risk loans given to “subprime” borrowers who did not qualify for the best interest rates (because of bad credit, no down payment, etc.). In the days before the secondary mortgage market existed, lenders would never make these kinds of loans, because they had to keep them in their own portfolios. But by selling the subprime loans through the secondary mortgage market, the lenders were able to “offload” the risk associated with those loans.

You know the rest of the history. This kind of “easy lending” led to the subprime mortgage crisis that devastated our economy. So today, the big players in the secondary mortgage market (like Freddie Mac) have changed their tune regarding subprime loans. They don’t want anything to do with them. So in turn, the primary lenders will no longer make these kinds of mortgage loans, because they know they cannot sell them off.

This is how the secondary mortgage market affects home buyers. It has a lot to do with the terms lenders are willing to offer, the interest rates they charge, their qualification criteria and more.