Primary and secondary loan markets
Before I tackle explicating OFHEO’s damning report on the Fannie Mae scandal, and in the spirit of the one-room schoolhouse, here’s a primer on loan origination and the primary and secondary markets.
1. The primary market: origination and placement
Origination is the process of making a new loan, but since the originator (often a mortgage broker) has expertise but lacks money, typically these originators immediately place the loan with a capital source (usually called an ‘investing lender’).
First get a big pile of cash?
Most originators who have no capital of their own enter into loan correspondent relationships with various lenders; these may be open or exclusive, and exclusivity may be geographic, programmatic, or otherwise.
Even after selling the loan, the originator normally retains a loan servicing responsibility (and often a top-loss position). This whole cycle is called the primary mortgage market.
A loan as a financial creature: its life-cycle
Like other financial instruments, a loan is a legal, economic, and intellectual creation: it is conceived, born, lives, matures, and eventually expires.
1. Conception. Mortgage bankers invent new loan types and offer them to the public.
2. Birth: origination. A loan is originated when a particular customer (home buyer, let’s say) borrows money from an ‘originating lender’ and signs agreements (loans, mortgages, security agreements) to repay it.
3. Life. The borrower makes monthly payments to a loan servicer who remits them to the lender.
4. Maturity. Over time, the borrower pays down principal even as the property (typically) appreciates, so the ratios (loan-to-value or LTV, debt service coverage, loan payment-to-income) evolve, and the loan is said to be maturing.
5. Expiration. The loan is either fully retired (that ecstatic moment when you tear out the last mortgage payment stub), or more commonly prepaid (usually but not always via a refinancing).
Where do investing lenders get their capital?
In the good old pre-World-War-II days of localized finance, lenders were deposit-takers, who collected money from the community, paying interest for it, of course — called credit unions, savings and loans, or banks. These lenders held on to their loans.
That’s why Bonnie and
(How quaint!)
When the depositors panicked, and they are sometimes wont to do, the banks suffered a cash run, and to meet its depositors’ demands, it had to call the loans. Credit stopped dead, and the economy crashed.
“My life isn’t worth living if the bank’s run out of cash.”
In any marketplace with substantial origination activity, investing lenders eventually run out of cash (called liquidity) even though they may have an excellent, diversified portfolio of soundly performing loans. They would thus like to sell those loans to another investor so they can recoup their cash and make money loans.
Enter the secondary market.
2. The secondary market: securitization
In the secondary mortgage market, a primary-market lender (who owns a portfolio of loans that it or its loan correspondents originated) sells a portfolio of performing loans to a new investing lender. It can do this in either of two ways:
1. Direct placement. The primary lender simply sells the ‘whole loan’ (or a pool of loans) to a single buyer or consortium (sometimes called a loan syndicate). This is a no-fuss-no-muss transaction where the buying group simply takes over the primary lender’s position. But of course, the buying group now has the risk of the loans’ defaulting, and the primary lender generally has no ongoing liability. Transactions such as these tended to be inefficient, or backed up by early forms of strong credit enhancement (e.g. FHA mortgage insurance).
2. Securitization. Instead of selling the loan directly, the primary lender borrows money from the secondary market investing lender. It does so by issuing a new bond (the new security) on its own name, and pledging the pool of loans as collateral.
Some are more secure than others.
The most visible example is a state housing finance agency, which issues its own bonds that are backed up by a pool of individual property mortgage loans, plus additional collateral (e.g. cash, guarantees, assignments or pledges) to strengthen the issue’s creditworthiness.
I think I can enhance your worthiness.
Securitization is much more flexible: the issuer, being a stronger credit, normally gets a lower interest rate (and hence makes a rate spread). The issuer can add collateral, change payment terms, and add features (e.g. rate reset, mandatory or discretionary calls of the outstanding issues) that give the issuer flexibility to cope with changing market conditions and borrower behavior. Further, securitization enables aggregation — multiple similar loans can be bundled together and sold in Great Big Blocks, reducing transaction costs per loan.
If you get past Tranche C, you’ve probably gone too far.
Securitization becomes even more sophisticated and effective when the flows are divided into an issue in multiple tranches (imaginatively called Series A, Series B, and so on), each with its own terms, collateral, and priority. By slicing the whole loan into distinctive parts and then selling each to the buyer who most values just that part, the aggregate effect can be — should be — to add value versus a direct placement of the whole loan.
Make sure you use every part.
Still, securitization is more complex, and riskier for the securitizing issuer ….
