How the American Mortgage Machine Works

Creators are probably the most familiar actors to investors. They sit at the forefront of the process and in many cases deal directly with borrowers. But, for a mortgage with typical terms and size, they are not usually the player owning the loan.

One of the main reasons is the unique system of support for taxpayers in the US real estate market, through government-sponsored companies. Fannie Mae FNMA 1.27%

and Freddie Mac FMCC 0.87%

buy loans from originators, secure them and resell them to investors as agency mortgage securities. Thus, in turn, the economy of many originators is ultimately based on the volume of loans they produce and sell through Fannie or Freddie. This business model also avoids loan risk and requires less capital, which is attractive to investors.

But selling loans is quite complicated. To get anyone else interested in buying or negotiating loans negotiated by third parties, a lot of things have to happen to commodify a 30-year mortgage. Developers sell mainly in standardized sets of mortgages that are arranged in half-point interest rate deposits, such as 2.5% or 3%. Investors buy cuts in these funds in the form of securitization.

This fee is not the same as what the borrower pays. A 3% mortgage could end up in a 2% reserve. This is because in order to further standardize the loan, some parts of the interest are used to pay for other processing services. One part is for Fannie or Freddie, to cover their base cost to secure the mortgage, in addition to various adjustments based on the individual mortgage. Another piece is for a service administrator, who manages the borrower’s collection, who then pays the investors, the tax authorities, and so on.

In exchange for this current of long-term tariffs, maintenance services assume certain risks. On the one hand, when interest rates are lowered, mortgages are refinanced more and prepaid in advance, leading to the loss of these payment flows by administrators. Providers also cover some missed payments before the mortgage is defaulted. In an economy where many people lack payments, this can bite. The increase in deferred payments during the pandemic, for example, fell sharply on maintenance services.

Lenders may also need to use private mortgage insurance if the value-for-loan ratio is too low for a guarantor, perhaps because the borrower decreases by less than 20%. Borrowers can pay this fee directly or indirectly through a higher mortgage rate.

Even after paying for the service and credit risk, an originator may not always have a predictable sale price for each mortgage. Mortgage rates or relative prices between deposits may move during the long closing period, but borrowers like to “block” the rates offered. There is a huge market for future mortgage delivery, known as the TBA market, or “To Be Announced,” which is used to effectively cover this interest rate risk for lenders. But it comes at a cost that can vary depending on how long the protection lasts.

An emerging technology component of the business uses data and analysis to synchronize the rate offered on a mortgage with how it could be covered and sold, says Vishal Garg, CEO of Better, a digital home ownership company. “You can be a much better market participant by matching the demand of end investors with the consumer,” he says. “A traditional loan officer can’t contemplate every scenario.”

Originators have some natural counterparties that assume interest rate risk. Demand from investors such as real estate investment trusts in mortgages, informed about the economic cost that can be financed, helps drive up prices.

A great way to manifest type risk is the speed at which people prepay in advance. This, in turn, can affect what investors are willing to pay, because the securities derived from these mortgages have essentially a shorter life. Thus, even when originators enjoy the benefits of volume when many people are refinancing, they could earn less by selling mortgages. Of course, when the Federal Reserve buys mortgages and when rates of other fixed-income assets are so low, the profits of originators who sell mortgages can continue to be quite large.

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

Write to Telis Demos to [email protected]