Today I wanted to write up a brief explanation of how mortgage backed securities worked. I was going to provide a graphical flow map so you could try and make sense out of the secondary market (ie. where your mortgage goes off to live and work after you’ve signed the papers). But, before I dove into Photoshop for an hour, I took a quick run through what was already available on the net. I found a great image from a wonderful post by Noah Rosenblatt on urbandigs.com. His post provides a more detailed look at the secondary market, so check it out if you want to read more. So now with a great graphic, let’s get going.
Step 1-2: Let’s consider a fake bank for our example, Bank123, and let’s say it has been selling mortgages in the Raleigh area all quarter. Bank123 has amassed quite a few loans and is ready to package them up for re-sale. Why would they sell their mortgages?- I don’t get it. [[ Think about what your mortgage actually is – it’s a promissory note that states that you’ll repay the bank $x over a certain time period at a certain %rate. If you simply paid your mortgage for 30 years without taking any cash out and without refinancing, you’d be paying almost double what you borrowed. Here’s a quick example – a 30yr fixed rate mortgage for $200k at 5%. If you paid it off completely over the course of 30 years, you’d be paying a little over $185,500 in interest – meaning you’re borrowing $200k and paying back about $386.5k. ]] So your mortgage turns out to be quite a valuable long term investment that the bank has created. But in order for Bank123 to keep providing mortgages, they’ll need some more money to lend. Look at all those loans they’ve provided this quarter (step1). If we say, for example, that all those mortgages are $200k loans, then they’ve given out about $3.8million. So, to get new capital to lend, and to hedge some risk with regards to these loans defaulting, Bank123 needs to pool and sell them.
Step 3-4: “So who’s going to buy these pools of loans?” – you must be asking by now. It depends – it could be Fannie Mae or Freddie Mac or it could be a large bank. The buyer, let’s say Fannie in this example, takes a solid look at the pool and chops it up into different pieces called tranches. You’ll see in step 3 the different layers from AAA to b/b. A super simplistic way of looking at this is to consider all the loans in that pool – they’re all different loan types, amounts, and have different risk levels. Fannie considers what’s what and then sells these tranches as securities – the riskier tranches are expected to have better returns but are a much higher risk, and vice versa for the AAA rated section. These securities are then bought up by investors and that’s that. Depending on what your investor puts your money into, there’s is a chance, albeit small, that you own part of your mortgage as an investment.
A very simple view of the secondary market and how your mortgage becomes an investment security. It also provides some insight to how the secondary market affects you. Let’s say for example that Fannie Mae decides it’s changing its buying guidelines for loans. To make sure their loans are still marketable, the primary market players (your local banks/brokers/other lenders) adjust their underwriting criteria so their newly originated loans meet Fannie’s new guidelines. This in turn affects the criteria that you must meet to qualify for a loan. The old ‘from the top down’ effect. This is what happened to sub-prime loans – at one point Fannie and Freddie were buying – then when problems started to arise, they ceased buying activities for these types of loans – now they’re pretty much off the market. I’ll leave things here for now, maybe we’ll look back into the credit crisis and the secondary market at some other time. Thanks for reading and I hope everyone enjoyed their long holiday weekend.
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