The Mortgage Markets
Understanding Mortgage Backed Securities (MBSs) necessitates a basic understanding of mortgages, the mortgage markets and their related terminology. Mortgages are loans generally backed by real estate that carry a specified repayment date, and periodic interest and principal payment obligations.
Usually, the borrower signs a note, representing the actual amount of debt and terms of repayment, and also signs a mortgage, which is the borrower’s agreement to give his property as collateral, and when recorded against the property, acts as a lien on the collateral. The mortgagee is the lender, and the mortgagor is the borrower.
In most jurisdictions, a lender may foreclose the mortgaged property if certain conditions principally, non-payment of the mortgage loan – apply. Subject to local legal requirements, the property may then be sold. Any amounts received from the sale (net of costs) are applied to the original debt.
In some jurisdictions, mortgage loans are non-recourse loans: if the funds recouped from sale of the mortgaged property are insufficient to cover the outstanding debt, the lender may not have recourse to the borrower after foreclosure. In other jurisdictions, like Florida, for example, the borrower remains responsible for any remaining debt.
Before the internet, most mortgage businesses were divided into three channels–retail, wholesale and correspondent. The retail channel deals directly with borrowers where mortgages are originated. The wholesale channel consists of entities who obtain loans from mortgage brokers that originate loans. The correspondent channel is similar to the wholesale channel, except that correspondent lenders generally do not hold their loans, but resell them.
In the retail channel, mortgage brokers generate about 50% of all loans. They have access to a variety of lenders and often offer the most choice in loan programs. Brokers assist the consumer in completing the application and loan selection process and direct them to suitable lenders to fund the mortgage. Mortgage brokers are paid a fee by the borrower or the lender when a loan closes. As the name implies, a mortgage broker is not a lender.
In the wholesale channel, loans are channeled from brokers and bought by lenders. Correspondent lenders are similar to mortgage bankers in their ability to make a decision whether to extend you a loan and fund it with their own money, and they recruit mortgage brokers to sell their lending products.
However, as soon as your loan is closed, it is usually sold to another lender, the ‘funding lender’, with which the correspondent lender has a business relationship. If a correspondent lender makes mortgage loans available from one source of funds, they may be functioning as the exclusive agent of the funding lender. Correspondent lenders do have a risk that brokers don’t, which is that the funding lender can force a correspondent to buy back a loan if it doesn’t meet the funding lender’s guidelines.
Generally, mortgage brokers don’t use the word ‘broker’ in their company name. Many financial institutions currently operate as both lenders and brokers. For example, on some loans a mortgage company may act as a lender, on other loans – as a broker, or they may act as a lender in their home state and broker loans in some other states.
Mortgage Lending in the Internet Age
The internet brought significant change to the three traditional channels of mortgage lending.
Large online companies like LendingTree and Ditech are not lenders or even brokers, but call themselves administrators or consultants, receiving a fee from lenders for mortgage leads. Many mortgage companies pay other websites a small fee for each lead they generate. These affiliate sites range from individual enterprises to mid-size marketing businesses, but they all sell information to lead aggregators, rather than distributing them to mortgage lenders directly.
In some cases loan applicant details are sold and then resold among some of these affiliate websites in an effort to make more money. The point is that the borrower often does not know what channel of the market they are dealing with, unless they are dealing directly with the retail lender who will originate and own their loan, which is not the norm today.
The mortgage market is where funds are borrowed. The primary market provides the actual loan to a borrower, and the secondary market creates liquidity for the primary market by purchasing loans from lenders. The original lender is known as the mortgage originator. Upon issuance of the loan, the mortgage originator has two choices–keep or sell the loan. If the mortgage originator chooses to sell the loan, then the secondary market is where the mortgage will be sold to either the GSEs or private companies. These buyers are known as conduits, who operate in the secondary market to provide liquidity to the primary market. Upon the purchase of the loan by the conduit, the mortgage originator now has more loanable funds to make more home loans in the primary market.
There are two kinds of mortgages, conventional and nonconventional. A conventional loan is basically any kind of lender agreement that’s not backed in full by the Veterans Administration or protected by the FHA (the Federal Housing Administration).
Other so-called conventional loans include conforming loans. Basically, these are arrangements that meet stipulations set forth by Fannie Mae and or Freddie Mac, two of the largest mortgage trading companies. For example, current Fannie Mae guidelines for conforming loans put the maximum price for a conventional, conforming loan at just over $417,000 for a single-family home.
While Fannie Mae and Freddie Mac don’t actually approve or disapprove of loans, they buy and sell mortgages. Lenders enjoy signing up borrowers with conforming loans, since they can later sell these loans to Fannie Mea or Freddie Mac to get funds for other investments.
Nonconforming loans – instruments which don’t meet Fannie Mae or Freddie Mac qualifications are also considered conventional. Non-conforming loans have no set guidelines and vary widely from lender to lender. In fact, lenders often change their own non-conforming guidelines from month to month.
Another category of loans, jumbo loans, falls outside of Fannie Mae eligibility but is also considered conventional. A jumbo loan is a loan that’s too large to be eligible to be traded by the two main loan purchasers.
A conventional loan is also known as a prime loan, and is exactly what it sounds like. It’s the “I’ve got all my ducks in a line” loan. If you have good credit when you go into your local bank to apply for a mortgage, you are applying for a conventional loan. A conventional, or conforming, loan is one not insured by the Federal Housing Administration (FHA) or guaranteed by the Veterans Administration (VA).
A non-conventional loan, also know as sub-prime, has greater exceptions than a conventional loan.
Lower credit scores, higher debt ratios, less money down, being late on rent or mortgage payments: these are all situations where a bank might have denied an application. But a sub-prime lender will allow some, if not all of these exceptions, and still give an approval to a loan application. Sub-prime lenders have opened the door to people who might never have been able to own a home in the past. These subprime, non-conventional loans are granted according to strict loan qualification criteria such as credit score, income-to-debt ratio and other requirements.
Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.
According to the Department of the Treasury, “Subprime lending refers to loans to borrowers who have weakened credit histories. The characteristics of a subprime borrower typically include a history of paying debts late, personal bankruptcy filings, or a high debt service-to-income ratio. These borrowers, therefore, pose a higher risk of default than do traditional borrowers at banking institutions.
A subprime lending program is the regular or targeted acquisition, through origination or purchase, of loans to subprime borrowers that will be held in portfolio or accumulated for resale.” Subprime borrowers typically display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Such loans have a higher risk of default than loans to prime borrowers.
Although most home loans do not fall into this category, subprime mortgages proliferated in the early part of the 21st century. About 21 percent of all mortgage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, according to John Lonski, chief economist for Moody’s Investors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market.
Next: The Subprime Mortgage Crisis: Understanding the Meltdown