Many people wonder where the money comes from to originate mortgage loans.
How do banks and lenders have a seemingly unlimited supply of money to
loan for the next 30 years? Well, the short story is that the money comes
from Wall Street. Banks do not have piles of money sitting in their vault
just lying around until borrowers come in to ask for it. For every real
estate loan that banks finance, one of two things happen – they
retain and service the loan, or they sell the loan on the open market.
Banks originate two types of mortgages. They are known as “saleable”
and “portfolio” loans. Saleable loans are those scheduled
to be sold off to investors on Wall Street in the form of “mortgage-backed
securities.” These saleable loans are typically adjustable rate
mortgages or subprime loans, but ideally, a mortgage securitization trust
will consist of a balanced mix of both low-risk and high-risk notes. Loans
that have fixed rates, well-qualified borrowers, and low loan-to-value
ratios are considered low-risk and are deemed a portfolio loan. Banks
may choose to hold on to these types of loans, making money off of the
servicing and the interest earned.
While the market has dramatically changed since the financial crisis of
2008, the system to replenish money within the mortgage industry has pretty
much stayed the same. Lenders and brokers originate loans based on program
guidelines and sell those loans to secondary market investors. The investors
in these securities are primarily made up of investment trusts or institutional
financial companies. Loans that meet certain requirements may also be
purchased by government-backed agencies such as Freddie Mac, Fannie Mae,
or Ginnie Mae, who hold and service them.
Investment trusts operate as aggregators of loans. They create a securitization
trust that then “pools” hundreds of loans, sometimes with
diverse underwriting criteria, to create an investment rated security.
This pooling helps mitigate risk and provides a good rate of return to
individual investors. The loan pools, or trusts, are assigned to investment
firms who hold and service the account on behalf of the investors. The
investors in mortgage-backed securities usually earn a rate of return
that is far higher than that of traditional government or money market
bonds, making them in high demand.
Cycling the Money
The secondary market pools loans in securitization trusts and offers them
for purchase to Wall Street investment firms. Individual certificates
for the trust, similar to stock certificates, are sold to institutions
or individual investors. This provides for the capital supply to be replenished
for banks and other lending institutions that have established credit
lines, and as the cycle continues, that money goes back into the economy
in the form of new mortgages.
Lenders and brokers depend on the secondary market to purchase the loans
they originate so they can continue uninterrupted lending operations.
With the new rules and regulations established under Dodd-Frank, individual
errors or omissions in loan documentation can cause a closed loan to become
“unpurchasable,” leading to the inability to offload the loan
to investors. When this happens, it reduces the amount of capital that
is available to go back into mortgage lending. Besides the risk of carrying
excessive mortgage debt, if a bank or lender gets caught with too many
loans on their books, they may not be able to continue operations until
those loans are remedied and sold.
The buying and selling of mortgage securities is known as "mortgage
banking" and is the backbone that keeps the mortgage industry humming
along. Ensuring this market continues to operate normally, through common
sense oversight and regulation, is vital to maintaining a reliable mortgage industry.
Learn more abou the author, Melissa Martorella by reading her