Secondary Mortgage Market: Definition, Function, and Impact
What Is Secondary Mortgage Market?
The secondary mortgage market is where existing mortgage loans and mortgage-backed securities (MBS) are bought and sold by investors. This crucial segment of the broader financial markets provides essential liquidity to the primary mortgage market, enabling lenders to originate more mortgage loans without holding them on their balance sheets until maturity. It functions by transforming illiquid individual mortgage loans into tradable securities through a process known as securitization.
History and Origin
Before the development of the secondary mortgage market, traditional financial institutions that originated mortgages often faced limitations on their lending capacity. They had to hold the loans on their books for their entire term, tying up significant capital. The Great Depression exposed vulnerabilities in this system, leading to widespread foreclosures and a lack of confidence in mortgage lending. To address these issues and promote homeownership, the U.S. government initiated a series of programs.20
A significant step was the establishment of the Federal National Mortgage Association (Fannie Mae) in 1938 as part of the New Deal, created to provide a reliable source of funding for housing by purchasing mortgages from lenders.18, 19 This allowed banks to free up capital and continue lending. In 1968, under the pressures of the Vietnam War, Fannie Mae was reorganized into a government-sponsored enterprise (GSE) and became a publicly traded company.17 Two years later, in 1970, the Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered by Congress to create competition for Fannie Mae and further expand the secondary mortgage market, particularly by working with smaller banks.14, 15, 16 Another key entity is the Government National Mortgage Association (Ginnie Mae), a government agency that guarantees payments on MBS backed by FHA and VA loans.13 These entities play a pivotal role in the secondary mortgage market by purchasing mortgage loans, pooling them, and issuing mortgage-backed securities (MBS) to investors, thereby attracting new sources of investment capital to the housing market.12
Key Takeaways
- The secondary mortgage market facilitates the buying and selling of existing mortgage loans and mortgage-backed securities.
- It provides essential liquidity to mortgage originators, enabling them to make more loans.
- Government-sponsored enterprises like Fannie Mae and Freddie Mac are major players, along with Ginnie Mae.
- The securitization process transforms individual mortgage loans into tradable securities, attracting a wide range of investors.
- It influences the availability and cost of mortgage credit, impacting housing affordability for borrowers.
Interpreting the Secondary Mortgage Market
The secondary mortgage market's health is often interpreted as a bellwether for the broader housing finance system and overall economic stability. A liquid and efficient secondary mortgage market indicates that mortgage originators can reliably sell their loans, replenishing their funds to issue new mortgages. Conversely, disruptions in this market can lead to a tightening of credit risk and higher mortgage interest rates for borrowers.
When the secondary market is functioning well, it signals that investors have confidence in the underlying mortgage assets and the structure of MBS. This confidence translates into a steady flow of capital into the housing sector, supporting home sales and construction. The pricing of MBS within this market also provides insights into market perceptions of prepayment risk and credit risk associated with the underlying mortgages.
Hypothetical Example
Consider "Sunshine Bank," a small community bank that has just originated $50 million in new home loans. If Sunshine Bank were to hold these loans on its books, its ability to make new loans would be limited until borrowers repaid their principal. This constraint would restrict its lending capacity and potentially slow local economic growth.
Instead, Sunshine Bank sells these mortgage loans to Fannie Mae or Freddie Mac in the secondary mortgage market. These GSEs then pool Sunshine Bank's loans with thousands of other similar loans from various originators. They then create mortgage-backed securities, which are debt instruments representing claims on the cash flows from these pooled mortgages. These MBS are then sold to institutional investors, such as pension funds or insurance companies, in the broader capital markets.
By selling its original loans, Sunshine Bank immediately receives cash, which it can then use to originate another $50 million in new mortgage loans. This continuous cycle, facilitated by the secondary mortgage market, ensures that capital flows efficiently from investors to borrowers, promoting a more dynamic and accessible housing market.
Practical Applications
The secondary mortgage market has several practical applications across the financial landscape:
- For Mortgage Lenders: It allows originators to offload mortgage loans from their balance sheets, freeing up capital to issue new loans and manage their risk management profiles. This continuous funding mechanism ensures a steady supply of credit for homebuyers.
- For Investors: It offers a diverse range of fixed-income investment opportunities through mortgage-backed securities and collateralized mortgage obligations (CMOs). These securities provide regular income streams from the underlying mortgage payments.11
- For the Economy: By expanding the pool of funds available for housing, the secondary mortgage market contributes to lower and more stable interest rates for mortgages, making homeownership more accessible to a broader population. The Federal Reserve, for instance, has historically purchased MBS to support market functioning and influence mortgage rates, especially during periods of financial stress.8, 9, 10
Limitations and Criticisms
While vital, the secondary mortgage market is not without limitations and has faced criticism, particularly highlighted during financial crises. A primary concern revolves around the potential for systemic risk if the underlying mortgage loans deteriorate in quality. The complexity of certain mortgage-backed securities, especially those with multiple tranches, can obscure the true level of credit risk embedded within them.
The 2008 financial crisis demonstrated how weaknesses in the secondary mortgage market, particularly the proliferation of subprime mortgages packaged into complex MBS without sufficient underwriting scrutiny, could lead to widespread instability. When housing prices declined and defaults surged, the value of these securities plummeted, leading to significant losses for investors and financial institutions.7 Federal entities like Fannie Mae and Freddie Mac, while designed to provide stability, also faced severe financial distress during this period, requiring substantial government intervention.6 The Financial Stability Oversight Council (FSOC) regularly reviews the secondary mortgage market, assessing potential risks to financial stability, particularly those associated with the dominant activities of Fannie Mae and Freddie Mac.5
Secondary Mortgage Market vs. Primary Mortgage Market
The distinction between the secondary mortgage market and the primary mortgage market lies in their respective functions. The primary mortgage market is where borrowers initially obtain mortgage loans from lenders, such as banks, credit unions, or mortgage companies. This is the "origination" phase, where the direct relationship between borrower and lender is established, and loan terms like interest rates and repayment schedules are set.
In contrast, the secondary mortgage market is where these originated mortgages are subsequently bought and sold. Once a lender in the primary market issues a loan, they can sell that loan to an entity in the secondary market (like Fannie Mae or Freddie Mac) or directly to institutional investors. This allows the primary market lender to free up capital, which can then be used to make new loans to other borrowers. Without the secondary market, primary market lenders would have limited funds and would likely need to charge higher interest rates to compensate for the long-term commitment of capital. The two markets are interdependent: a robust secondary market is essential for the efficient functioning and affordability of the primary market.
FAQs
What is the main purpose of the secondary mortgage market?
The main purpose of the secondary mortgage market is to provide liquidity to mortgage originators in the primary mortgage market. By purchasing existing mortgage loans, it allows lenders to free up capital to issue new loans, making mortgage credit more widely available and affordable.
Who are the main participants in the secondary mortgage market?
Key participants include government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, and government agencies like Ginnie Mae. Large institutional investors such as pension funds, insurance companies, and mutual funds are also significant buyers of mortgage-backed securities issued in this market.
What are mortgage-backed securities (MBS)?
Mortgage-backed securities (MBS) are investment products that represent claims on the cash flows from pools of mortgage loans. They are created through the process of securitization, where many individual mortgage loans are bundled together and then sold as a single security to investors.4
How does the secondary mortgage market affect borrowers?
The secondary mortgage market positively impacts borrowers by ensuring a continuous flow of funds for mortgages. This competition and efficiency generally lead to lower interest rates and more standardized mortgage products, making homeownership more accessible and affordable for a broader range of individuals.
Is the secondary mortgage market regulated?
Yes, the secondary mortgage market is subject to significant regulation, particularly given its systemic importance. Entities like the Federal Housing Finance Agency (FHFA) oversee Fannie Mae and Freddie Mac, while the Securities and Exchange Commission (SEC) regulates the issuance and trading of mortgage-backed securities. Various other government bodies, including the Department of the Treasury and the Federal Reserve, also monitor and influence this market to ensure financial stability.1, 2, 3