That’s an easy one, right? I got my mortgage from Fred’s bank downtown. They hold my mortgage. I know. I filled out my paperwork there and that’s where I send my payment (we’ll get back to this is a sec).
And to a large degree, most of us don’t really care. We probably did a bit of rate-shopping before we bought, and we went to a local office for signing, where we sign over 1,000 documents. Did you read them all?
But, once we’ve signed, we close on our home, move in, and then make payments for the rest of our lives.
Payments
On my first home mortgage, I got a nice little payment book with 360 coupons. I tore one out each month, wrote a check for the amount on the coupon, tucked them both in an envelope, stamped it, addressed it to my local bank office, and dropped it in the mail.
On more recent mortgages in this century, I set up autopay.
And these days, there is often a company in between us and the bank known as a mortgage servicer who receives and processes the payments. This leaves the bank to do banking work and lets a service provider deal with the mundane work of processing payments.
Selling Mortgages
Who the heck would buy a mortgage, and what even is that?
The creative folks in the investment community, in their never-ending search to make a buck, came up with a nifty product called a Mortgaged Backed Security (MBS for short).
Simply put, lenders, like your local bank, package up a bundle of mortgages, and sell them to investors.
Investors
Why would an investor buy my loan?
Well, an investor probably is not interested in buying your loan and your $2,500 a month payment. But package up a few hundred loans, with a much larger monthly payment, and now you’re talking.
This isn’t all that different from buying a bond. An investor who buys a bond, or a Mortgaged Backed Security, is looking to acquire a regular income stream.
For a corporate bond, that income stream comes from regular interest payments from the bond issuer. So, if I buy a 5% Walmart bond for $1,000, Walmart pays me 5% of the face value per year until the bond matures. At maturity, payments stop and I get my initial purchase ($1,000) back.
Same-ish for a Mortgaged Backed Security. As an investor, I buy a security which is a package of loans. All the loans make monthly payments which provide the cashflow to the investor. Though unlike a bond, I’m getting a bit of my principal back each month in the mortgage payments.
Risks
And just like when we buy a corporate or government bond, there are risks for the investor.
What if some of the mortgage holders miss a payment? That reduces the monthly cashflow.
What if a mortgage holder declares bankruptcy and walks away? We, the investors, may be left holding the bag.
Like corporate and government bonds, the mortgages are rated, and the issuing financial institutions perform their own due diligence before issuing a loan – remember all the questions we answered and the bank statements and w-2s we had to provide??
Financial Institutions
What’s in it for them? Why would Fred’s bank sell my mortgage?
Fred makes money every time he writes a mortgage for a customer. But Fred can’t write an unlimited number of mortgages. Pesky government regulations require Fred to hold reserves to cover the mortgages in case someone doesn’t make a payment, or defaults on their mortgage.
But if Fred sells the mortgage, or better yet, a package of mortgages, he moves that liability to someone else which allows him to write more mortgages and make more money.
Key Players
These packages of mortgages, the Mortgaged Backed Securities, are traded on a secondary market. There are a few big players involved.
Fannie Mae – Federal National Mortgage Association (FNMA)
Sounds like a middle aged spinster who spends her day in the barn chasing cats…but no, Fannie Mae is a government-sponsored-enterprise (GSE) that was established around the time of the great depression to help Americans buy homes. As you may recall, money was tough to come by at the time.
Fannie Mae doesn’t provide loans, but it does buy loans on the secondary market. It holds some, and sells others as Mortgaged Backed Securities, but it guarantees principal and interest payments to Mortgaged Backed Security buyers. This helps keep mortgage rates low and stable.
Freddie Mac – Federal Home Loan Mortgage Corporation (FHLMC)
Freddie is Fannie’s cousin. He’s also a GSE. He was created in the 1970’s when more liquidity was needed in the mortgage market.
Both Fannie and Freddie have started out as GSEs, have become independent public companies, and then returned to GSE status during the financial melt-down in 2008. We’ll talk about this in a sec, but essentially, due to the housing and mortgage crisis, Fannie and Freddie needed a bail-out and the US Government stepped in.
Fannie and Freddie have since more than paid back the American taxpayers and have become profitable. There has been talk of them being privatized, but nothing solid yet.
Ginnie Mae – Government National Mortgage Association (GNMA)
Ginnie is a slightly different model. Ginnie is a wholly owned Government corporation within the US Department of Housing and Urban Development.
Ginnie was established in the late 1960s to provide guaranteed loans (backed by the full faith and credit of the US Government) in 4 key areas.
- Federal Housing Administration (FHA) — primary for first-time, low/moderate-income buyers (99% of FHA single-family mortgages flow into Ginnie Mae MBS).
- Department of Veterans Affairs (VA) — for veterans and eligible service members.
- USDA Rural Development — for rural homebuyers.
- HUD Office of Public and Indian Housing — for public/tribal housing programs.
Trouble
This all sounds great. What could go wrong?
Greed.
For those who owned homes in the 2005 – 2007 timeframe, you probably got something in the mail regularly telling you to unlock the equity in your home. Home prices were skyrocketing. Every day the price of my home increased on Zillow.
Time to refinance and buy that 2nd home or speedboat.
NINJA
This was also the time of the NINJA loan. No Income, No Job, No Assets, No Problem!!!
Seriously. Home prices were rising so quickly, there was no risk in buying a house. Lenders weren’t worried because if the borrower defaulted, they’d get the home back and depending on how much time had gone by since the original loan, the home could have doubled in value.
Write as many loans as you can. Don’t worry. House prices will go up forever.
Secondary Market
So, the secondary market for mortgages had been around for quite a while. At least since Fannie started out in the 1930s.
For years, it had been a dependable market. Very conservative banks and financial institutions wrote mortgages for people who could prove they could afford the payments, and then these mortgages were packaged and sold on the secondary market.
And Mortgaged Backed Securities sold by Fannie and Freddie were guaranteed.
By the way, Fannie and Freddie weren’t doing the NINJA thing.
But, financial institutions that were writing NINJA loans were packaging their loans into Mortgaged Backed Securities and a fun new security called a Collateralized Debt Obligation (CDO). No one really understood what a CDO was. There were Pools and Tranches of debt which made it seem even cooler and more enticing.
Experienced investors, even a lot of old conservative financial institutions that should have know better, bought these hand over fist.
Uh Oh
This worked out fantastically well and everyone got rich.
And then housing prices dropped.
Home owners who stretched to buy their dream house and were now paying exorbitant interest rates (on their NINJA loan) for a home that was worth half of what they paid for it made the decision to leave the keys on the kitchen table and walk away.
As this happened over and over again, the payments on those CDOs dried up. If people aren’t paying their mortgage, that cashflow is gone. And the asset (homes) backing that CDO are worth a fraction of what they had been. This caused the CDOs to become basically worthless.
Wrap Up
So, the 2008 financial crisis came about because of some craziness in the housing market that cause opportunists to try and capitalize by creating new and exciting securities that seemed the same as the ones that had been around for 100 years, but in truth, were much riskier.
It worked out poorly – for the entire planet.
But, as fun and exciting as that story is, there is a lesson here.
Our mortgage has likely been sold. Fred’s Bank probably doesn’t hold it anymore and it is likely being serviced by a 3rd party. But for us as homeowners, we may have to send our payment to someone else, but it really makes no difference.
The packaging and selling is great for us though. It provides liquidity.
If Fred can package and sell loans and get them off of his books, that allows him to write more loans without increasing his capital reserves. As more banks like Fred write more loans, interest rates stay (relatively) low. And it’s easier for us to get a loan.
And then there’s Freddie, Fannie and Ginnie. They play a huge role in keeping the home loan market stable and available.