How the American Mortgage Machine Works

The initiators are probably the most well-known actors for investors. They are at the forefront of the process and in many cases deal directly with borrowers. But for a mortgage on typical terms and size, it is usually not the player who holds the loan.

One of the main reasons is the unique system of taxpayer support in the US housing market, through government funded businesses. Fannie Mae FNMA 1.27%

and Freddie Mac FMCC 0.87%

buy loans from originators, guarantee them and resell them to investors in the form of mortgage agency securities. So, in turn, the economy of many originators is ultimately driven by the volume of loans they produce and sell through Fannie or Freddie. This business model also avoids loan risk and requires less capital, which makes it attractive to investors.

But selling loans is quite complicated. To get anyone interested in buying or trading third-party loans, it takes a lot to trivialize a 30-year mortgage. Originators mainly sell in standardized pools of mortgages that are organized in installments of half an interest rate point, like 2.5% or 3%. Investors buy portions of these pools in the form of securitization.

This rate is not the same as the rate paid by the borrower. A 3% mortgage could end up in a 2% pool. Indeed, to further standardize the loan, part of the interest is used to pay for other processing services. Part is for Fannie or Freddie, to cover their base cost of securing the mortgage, plus various adjustments based on the individual mortgage. Another element is a managing agent, who manages the collection from the borrower and then pays out to investors, tax authorities, etc.

In return for this sustainable stream of fees, directors bear certain risks. On the one hand, when interest rates fall, more mortgages are refinanced and prepaid early, causing managers to lose those payment streams. The servers also cover some missed payments before a mortgage actually goes into default. In an economy where a lot of people are missing out on payments, that can bite. The surge in payment deferrals during the pandemic, for example, hit managers hard.

Originators may also have to resort to private mortgage insurance if the loan-to-value ratio is too low for a guarantor, perhaps because the borrower is putting less than 20%. Borrowers can pay these fees directly or indirectly through a higher mortgage rate.

Even after paying for service and credit risk, an originator still can’t count on a predictable selling price for every mortgage. Mortgage rates or relative prices between funds may change during the long closing period, but borrowers like to “lock in” the offered rates. There is a huge market for future mortgage delivery, known as the TBA, or “to be announced” market, which is used to effectively hedge this rate risk for lenders. But this entails a cost which may vary depending on the duration of the protection.

An emerging technology component of the business is using data and analytics to synchronize the rate offered on a mortgage with how it might be hedged and sold, says Vishal Garg, managing director of Better, a home equity investment company. digital property. “You can be a much better player in the market by matching the demand of end investors and the consumer,” he says. “A traditional loan officer cannot envision all scenarios.”

The originators have natural counterparties who take the interest rate risk. The demand of investors like mortgage real estate investment trusts, informed by how they can finance themselves cheaply, contributes to pricing.

One of the main manifestations of interest rate risk is the speed at which people pay in advance. This in turn can affect what investors are willing to pay, as the securities derived from these mortgages essentially become of shorter duration. So even though originators reap the benefits of volume when many people refinance, they can earn less by selling mortgages. Of course, when the Federal Reserve buys mortgage-backed securities and the rates on other fixed income assets are so low, the profits of originators selling mortgages can remain quite large.

Savvy investors will understand how market changes would affect their portfolios.

Write to Telis demos at [email protected]