The Secondary Mortgage Market: What Happens to Your Mortgage After You Close?

Fun fact: your mortgage lender—the bank or company that granted you your loan—probably isn’t cashing your mortgage payment check each month. That’s because almost immediately after you closed on your loan, they turned around and sold it. With the housing bubble that caused the recession still on everyone’s mind, it’s more important now than ever for home buyers to know how the system works—and how it went so wrong. What many homeowners and buyers don’t realize is that there’s an entire secondary mortgage market where the lender becomes a seller. Here are the basics to help you understand how that market influences the primary mortgage industry and the rest of the economy.

What is the Secondary Market for Mortgages? 

Once you close your loan, your bank takes it to a marketplace, where a variety of investors can purchase it. Sometimes, the final purchaser is lined up before you even close and the paperwork at your signing includes a statement as to who they will be. The largest investors by far are Fannie Mae and Freddie Mac, two corporations that are owned by the United States government. They were designed to provide backing on the secondary market for low-income and very-low-income home purchases, and they have expanded under the Obama administration to take on more and more purchases. There are other investors on the secondary mortgage market, and often those investors will purchase the loan and bundle it together with other loans into a fund called a mortgage-backed security, or MBS for short.

Understanding How Mortgage-Backed Securities Work

If your mortgage is bundled into an MBS fund, the investor or investment entity that created it then sells out shares of the fund to other investors in the same way they might sell shares of a mutual fund or a company’s stock. Investors then buy the shares of the fund knowing that as the loans are paid, a portion of the returns (a.k.a. your interest payment) comes back to them. How large a portion depends on several factors, including how many shares of the security they bought, how many mortgages are bundled into the security, and how many of those loans are performing as expected. The reason why such a large number of mortgages are bundled together? Reduced risk. After all, if more mortgages are part of the fund, then when a few have repayment difficulties, that relatively small number is outweighed by the larger number of still-performing mortgages and the fund as a whole remains profitable. For this reason, MBSs were, historically, one of the most secure investments available.

MBS Funds and the Financial Meltdown

Many homeowners are rightly wary about mortgage-backed securities on the secondary mortgage market in light of what happened with the financial meltdown of 2007-2008. Here’s how it worked: private equity investors grouped higher- and lower-risk mortgages in separate categories, called tranches. They then sold these without disclosing the risks of investing in a particular tranche to the investors. In fact, during this period, investors were rarely told about the tranches, leading to situations where investors were misled about the risks. When these funds began to fail, it affected many of the investors involved, and for many, it was the first time they fully realized which risk category their investment had fallen into. The results are history.

MBS Funds in Today’s Secondary Mortgage Market 

After the financial meltdown, the Obama Administration unveiled a comprehensive plan for reforming the mortgage market, one that put Freddie Mac and Fannie Mae front and center. The plan sought to achieve a few key changes to the market:

• To use the government-backed corporations to underwrite mortgages and provide stability, so ordinary people could purchase with confidence again.
• To expand the programs to cover most American home purchases in the short term.
• To use FHA measurements to ensure that housing was being provided to low-income and extremely-low-income families who qualify.
• To stabilize the market so banks could continue to offer mortgage loans with confidence.
• To eventually scale back these programs as the private equity market regains strength, BUT
• To fund all of the programs’ commitments for the duration of the loans they underwrite.

As a result of these clear policy goals, today’s secondary mortgage market is dominated by Freddie Mac and Fannie Mae, who acquire around 90 percent of all new mortgages between them. MBS funds do still play a role in the marketplace, especially when it comes to jumbo loans, commercial real estate loans, and mortgages that do not meet Fannie Mae and Freddie Mac requirements. As time goes on, they are also growing in popularity again, and the new regulations on their structure and constitution have restored some consumer confidence in their use.