The New Mortgage Landscape
The process of taking out a mortgage and the people with whom borrowers interact may not have undergone much change according to the borrowers point of view. However, the same cannot be said about the lenders point of view. The business of mortgage lending has changed completely in the previous 30 years or so. Earlier, there used to be one bank performing a variety of functions when loans were made. However, in the previous years all that has changed. This article will describe the new financial landscape and contrast it with the old financial landscape.
The Old Mortgage Landscape
The old mortgage world was pretty simple. There was a person who needed money to buy a house and then there was an institution (usually a bank) that was willing to lend the money to buy that house. The borrower would make monthly repayments of the loan over the next few years and then the loan got settled one day.
This simple world had a problem. The problem was that if the bank gave a mortgage loan to one person, they could expect to be repaid in full only after 30 years or so. Hence, for the next 30 years a portion of that money would always remain locked. Hence, the bank will not have that money to make new loans. Therefore the amount of mortgage loans that a bank could make was limited. This was an impediment to the existing political climate which wanted more and more home ownership and therefore wanted the banks to make as many mortgages as possible.
To solve this problem the new financial landscape was created. The new landscape was far more complicated. On one side there was the borrower whereas on the other side instead of there being a single institution i.e. the bank, there came to be a team of institutions. This article will describe the new arrangement in detail.
The bank that made the actual mortgage loan came to be known as the originator. This is because they would not hold the mortgage on their books for very long. Instead, they would simply sell the mortgages at a discount to other institutions. The liability of the bank was then over and they would be flush with cash to make more loans! Hence, the problem of the old financial landscape could be solved using this new arrangement. However, this new arrangement required several different types of players. The roles of some of them have been listed in this article.
Since the originator of the loan was no longer required to hold the loan for the entire tenure, banks were not the only people that could offer mortgages. A number of individuals who could raise some capital joined the business of making mortgages. They were called mortgage brokers. They were essentially doing the same function as the banks. The only difference being that they were not as big as the banks or were not subject to the same amount of regulatory checks. As long as the borrowers complied with certain criteria, they were free to make their loans which they could later sell off to the secondary mortgage market. The mortgage brokers themselves were a part of the primary mortgage market.
Since mortgages last for decades, they need to be serviced too. There are people that will be late on their monthly payments, the others will have queries about how the interest rates reset and so on. Hence, there is an organization required to answer these queries and perform the customer service and collections end of the business.
These tasks came to be performed by independent third party agencies called mortgage servicers. They were in the service industry and therefore were not a part of the secondary or primary mortgage market. However, since they were formed after the decentralization of the functions of the banks, they are often referred to as being part of the secondary mortgage market.
The secondary mortgage markets are based on the role of the underwriters. They are pivotal for the secondary market to function efficiently. This is because they buy the mortgages from the primary market. Then they securitize these loans. This means that if they buy a $95 loan from the market, they will create 100 $1 securities and sell them against the $95 loan. By doing so, they make a $5 profit. However, they have to underwrite these securities i.e. they have to guarantee to some extent that these loans will be paid off in due course of time. The values of their guarantees are different. Based on the value of their guarantees as well as the loan mix underlying the securities, these securities are priced in the open market. The underwriters basically define the secondary mortgage markets and therefore are undoubtedly a part of the secondary mortgage markets.
Special Purpose Entities
The investment banks wanted to steer clear of the additional liability that mortgage defaults would produce. Hence for every issuance of securities, they would create a special purpose entity. The purpose of this entity was to buy the mortgage securities from the investment banks and sell them to investors. It needs to be noted that the special purpose entities were selling these securities and not the banks. Hence, the banks had limited liability in these transactions.
Credit Rating Agencies
As we mentioned earlier, the value of the securities is largely based on who is guaranteeing them. Now, how do the investors know whose guarantee is worth what? For this purpose, credit rating agencies started venturing into the mortgage business. These agencies would rate the creditworthiness of the various investment banks, quasi government agencies and other special agencies who were issuing securities. Based on the ratings issued by these agencies, the value of the bonds would change.
The investors are finally the people who buy these securities from the open market. They could be individuals like you and me. Alternatively, they could be pension funds, municipal funds, insurance companies and so on.
In essence these are the people that are lending money to the borrower. They give their money to the underwriter who then gives it to the bank who then gives it to the borrower. Everyone else is only an intermediary holding the money for some time and slicing and dicing the mortgages. The real transaction is between the investors and the borrower. Also, since there is an active market for these securities, these securities are highly liquid and investors can exchange them for cash in an instant!
In the last three decades or so, the business of mortgage underwent a complete transformation. From being liquidity strapped and a long term business, it became a fast moving dynamic business. However, the roots of this business model were flawed as we shall see in the next article.
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