Behind the scenes of your mortgage

You may see your mortgage as the loan that helped you buy your home. But investors see a mortgage as a stream of future cash flows. These cash flows are bought, sold, stripped, tranched, and securitized in the secondary mortgage market. Because most mortgages end up for sale, the secondary mortgage market is extremely large and very liquid.

From the point of origination to the point at which a borrower’s monthly payment ends up with an investor as part of a mortgage-backed security (MBS), asset-backed security (ABS), collateralized mortgage obligation (CMO) or collateralized debt obligation (CDO) payment, there are several different institutions that all carve out some percentage of the initial fees and/or monthly cash flows.

In this article, we’ll show you how the secondary mortgage market works and introduce you to its major participants.

The mortgage originator is the first company involved in the secondary mortgage market. Mortgage originators consist of retail banks, mortgage bankers and mortgage brokers. While banks use their traditional sources of funding to close loans, mortgage bankers typically use what is known as a warehouse line of credit to fund loans. Most banks, and nearly all mortgage bankers, quickly sell newly originated mortgages into the secondary market.

One distinction to note is that banks and mortgage bankers use their own funds to close mortgages and mortgage brokers do not. Rather, mortgage brokers act as independent agents for banks or mortgage bankers, putting them together with clients (borrowers).

However, depending on its size and sophistication, a mortgage originator might aggregate mortgages for a certain period of time before selling the whole package; it might also sell individual loans as they are originated. There is risk involved for an originator when it holds onto a mortgage after an interest rate has been quoted and locked in by a borrower. If the mortgage is not simultaneously sold into the secondary market at the time the borrower locks the interest rate, interest rates could change, which changes the value of the mortgage in the secondary market and, ultimately, the profit the originator makes on the mortgage.

Originators that aggregate mortgages before selling them often hedge their mortgage pipelines against interest rate shifts. There is a special type of transaction called a best efforts trade, designed for the sale of a single mortgage, which eliminates the need for the originator to hedge a mortgage. Smaller originators tend to use best efforts trades.

In general, mortgage originators make money through the fees that are charged to originate a mortgage and the difference between the interest rate given to a borrower and the premium a secondary market will pay for that interest rate.

Aggregators are the next company in the line of secondary mortgage market participants. Aggregators are large mortgage originators with ties to Wall Street firms and government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac. Aggregators purchase newly originated mortgages from smaller originators, and along with their own originations, form pools of mortgages that they either securitize into private-label mortgage-backed securities (by working with Wall Street firms) or form agency mortgage-backed securities (by working through GSEs).

Similar to originators, aggregators must hedge the mortgages in their pipelines from the time they commit to purchasing a mortgage, through the securitization process, and until the MBS is sold to a securities dealer. Hedging a mortgage pipeline is a complex task due to fallout and spread risk. Aggregators make profits by the difference in the price that they pay for mortgages and the price for which they can sell the MBS backed by those mortgages, contingent upon their hedge effectiveness.

After an MBS has been formed (and sometimes before it is formed, depending upon the type of the MBS), it is sold to a securities dealer. Most Wall Street brokerage firms have MBS trading desks. Dealers on these desks do all kinds of creative things with MBS and mortgage whole loans; the end goal is to sell them as securities to investors. Dealers frequently use MBSs to structure CMO, ABS, and CDOs. These deals can be structured to have different and somewhat definite prepayment characteristics and enhanced credit ratings compared to the underlying MBS or whole loans. Dealers make a spread in the price at which they buy and sell MBS, and look to make arbitrage profits in the way they structure the particular CMO, ABS, and CDO packages.

Investors are the end-users of mortgages. Foreign governments, pension funds, insurance companies, banks, GSEs and hedge funds are all big investors in mortgages. MBS, CMOs, ABS, and CDOs offer investors a wide range of potential yields based on varying credit quality and interest rate risks.

Foreign governments, pension funds, insurance companies and banks typically invest in highly rated mortgage products. Certain tranches of the various structured mortgage deals are sought after by these investors for their prepayment and interest rate risk profiles. Hedge funds are typically big investors in mortgage products with low credit ratings and structured mortgage products that have greater interest rate risk.

Few borrowers realize the extent to which their mortgage is sliced, diced, and traded. In a matter of weeks, maybe a month, from the time a mortgage is originated it can become part of a CMO, ABS, or CDO. The end-user of a mortgage might be a hedge fund that makes directional interest rate bets or uses leveraged positions to exploit small relational pricing irregularities, or it might be the central bank of a foreign country that likes the credit rating of an agency MBS.

On the other hand, it could be an insurance company based in Brussels attracted by the duration and convexity profile of a certain tranche in an ABS, CMO or CDO deal. The secondary mortgage market is huge, liquid and complex with several institutions all eager to consume a slice of the mortgage pie.