In the mortgage world, the “primary” market encompasses direct interactions by borrowers and lenders. The “secondary” market is a phrase used to describe what happens after the loan is originated. Mortgage-backed securities (MBS), which play an important role in commercial and residential real estate markets, are the biggest part of the secondary market. These bonds, based on mortgages collateralized by homes, office buildings, shopping centers and hotels, account for hundreds of billions of dollars of commercial real estate financing. The world learned just how big this market had become during the Great Recession, when defaults on home loans cratered residential mortgage-backed securities and nearly brought down the global economy.
What Is the Secondary Mortgage Market
MBS are fixed income-securities, meaning bonds that are backed by commercial mortgages. They’re instruments that are used as a funding mechanism for mortgages. Investors buy these securities with the promise of receiving a pre-determined yield. The process of creating MBSs starts with lenders who originate loans to owners of commercial properties and homes. Lenders then package these loans into bonds and sell the bonds.
To give an analogy, picture a bucket that gets filled with mortgages as lenders write them. The investors who buy these buckets of bonds effectively fund the mortgages. The buyers are a community of sophisticated investors who value the diversification and predictability provided by MBS. The MBS market is divided into two sectors: commercial mortgage-backed securities (CMBS) are collateralized by loans on office buildings, shopping centers, warehouses and apartment buildings, while residential mortgage-backed securities (RMBS) are backed by home loans.
Primary vs Secondary Mortgage Market
In the primary mortgage market, lenders offer funding to borrowers. A borrower applies for a loan from a lender, and the lender originates the loan and pays it out to the borrower.
The secondary mortgage market comes into play once the borrower has been approved for a loan and the deal is closed. Then the lender chooses to retain the loan in its portfolio or to sell it on the secondary mortgage market.
The Primary Purpose of the Secondary Mortgage Market
The secondary mortgage market exists to increase lending liquidity, and also to provide steady returns to investors. Because lenders know that not all of their loans will stay on their books, they can originate more loans. And investors looking for predictable returns can buy MBS for their portfolios.
How Do You Sell a Loan on the Secondary Market
MBS loans typically come with fixed interest rates. These rates may or may not include an introductory interest-only payment period. These interest rates typically hover around the US Treasury swap rate plus the spread. Active mortgage originators have relationships with MBS investors and generally know what types of loans the investors target for purchase.
Generally, the borrower has no say in the sale of a loan on the secondary market. However, a new breed of CMBS product is known as single-asset single-borrower (SASB) loan. These deals package a single large loan – typically worth $200 million or more – to be sold to investors.
Who Are the Major Participants in the Secondary Mortgage Market
There are several types of investors that routinely buy MBSs.
- Institutional investors such as pension funds, insurance companies and hedge funds
- Foreign governments
- Government sponsored enterprises such as Fannie Mae and Freddie Mac
- Investment banks
The investors buy shares of the pooled mortgage loans that are securitized, and then earn a steady income from the regular mortgage payments made by borrowers. It’s worth nothing that individual investors don’t play a role here, although there are exchange-traded funds that let small investors in on the action.
How Do Mortgage Lenders Make Money in the Secondary Market?
Mortgage originators make money by collecting origination fees, and also from the spread the between the interest rate given to a borrower and the premium a secondary market will pay for that interest rate. Lenders also can collect revenue by keeping the servicing rights – that is, collecting monthly payments on behalf of the MBS investor.
Secondary Mortgage Market Example
If you’ve ever taken a home loan that was backed by mortgage giants Fannie Mae or Freddie Mac, you’ve probably been a player in the MBS market. Most residential mortgages issued in the United States are originated by lenders such as Rocket Mortgage and United Wholesale Mortgage, and then packaged and sold as RMBS.
In the CMBS market, many properties similarly are packaged and sold. Recent examples of properties financed by CMBS instruments include OKC Outlets, a 394,000-square-foot regional mall in Oklahoma City, and 95 Morton Street, a Manhattan office tower built in 1911 and with a tenant list that includes PayPal.
What Are Mortgage-Backed Securities
A mortgage-backed security is created when a bank or other financial institution pools together a group of loans and sells them off to investors as bonds. There’s also a type of MBS backed by only a single mortgage on a single property. The bonds are assigned ratings by such agencies as Moody’s and Standard & Poor’s.
An RMBS is made up of a pool of residential mortgages – typically hundreds or thousands of them packaged together. The securities can contain all of one type of mortgage or a mix of different types. They may contain mortgages with fixed rates, floating rates, adjustable rates and mortgages of varying credit quality. This variety helps reduce the risk of default.
The loans in a CMBS can be from different property types, locations, and even borrowers. But they all have one thing in common: they’re all backed by commercial real estate. That way, if any of the borrowers default on their loan, the investor still has the underlying property to collect as collateral.
The structure of CMBS can vary, but typically, the loans are divided into three parts, or tranches: senior, mezzanine, and equity. The different tranches are then sold to investors who are willing to take on different levels of risk. For example, an investor who wants a higher return might be willing to buy the equity tranche, while an investor who wants a lower-risk investment might buy the senior tranche.
Can You Control Which Market Your Loan Is In?
As a borrower, generally not. The RMBS machinery is mostly invisible to the borrower. The lender issues the mortgage, and then it’s up to the lender to determine whether to keep the loan in its portfolio, or to securitize and sell the mortgage. Compared to the RMBS market, the CMBS market gives a bit more say to borrowers – because of the better terms offered for securitized loans, borrowers are aware their loans are likely to be sold. If the loan is packaged as a single-property CMBS, the borrower may have even more involvement in the MBS packaging.
What Are the Benefits and Risks of the Secondary Mortgage Market
- MBS loans create liquidity in real estate markets. A bank might not want to make a loan in a specific location, or on a specific property type, or to a borrower with a particular credit profile. MBS creates a new borrowing option and additional opportunities for property owners. A bank that might say no to a loan it keeps on its balance sheet can instead originate the loan and then funnel it into the MBS market. The advantages are particularly evident in the RMBS market – because of the secondary market, U.S. homeowners can readily find financing with favorable terms.
- MBS adds transparency to mortgage markets. Because MBSs trade frequently, their values are transparent. As a result, these securities are an important pricing mechanism. Even lenders who originate commercial real estate loans to keep on their balance sheets look to the CMBS market to price loans.
- Favorable terms for lenders. CMBS loans typically offer more favorable interest rates than a borrower could secure with a traditional commercial loan. CMBS loans usually promise fixed interest rates, so the borrower isn’t subject to interest rate volatility over the life of the loan. CMBS deals also can offer more generous down payment terms. In general, CMBS loans offer a 75% loan-to-value ratio. This comparatively high leverage doesn’t bring correspondingly strict requirements about the borrower’s net worth and credit history.
What Are the Risks of the Secondary Mortgage Market
- Systemic risk. The complexity of MBS creates some difficult-to-quantify disadvantages. Systemic risk is the possibility that a financial crisis could affect all investments within the pool that underlies the MBS. This risk snowballed during the 2008 financial crisis. The second major danger is that of offloading the consequences to someone else. A loan originator might not care to look to closely at a borrower if the deal is soon to become someone else’s problem. While historical RMBS default rates averaged 2%, during 2009 this rate soared to 5%.
- Terms are inflexible. CMBS borrowers have little flexibility to respond to routine changes in their business, such as the loss of an important tenant. Say, for instance, that a borrower finances a property via a CMBS and then, two years later, loses a key tenant. To market the property to a replacement tenant, the owner must invest a significant sum in tenant improvements. CMBS gives the borrower no flexibility to repay the original loan and get a new loan to finance the unexpected expense.
- CMBS rules remain rigid even in a crisis. At the beginning to the Covid-19 pandemic, many property owners faced difficult times – lockdowns closed shopping centers, office buildings and hotels, and tenants struggled to pay rent. Property owners with traditional bank loans could negotiate with their lenders for concessions such as reduced rent or temporary forbearance. CMBS borrowers had no such flexibility – they owed their monthly payments, regardless of what else was going on in the global economy. Eventually, CMBS investors did allow some limited relief to borrowers affected by the pandemic, but the terms weren’t as broad as those granted elsewhere in the economy.
- Prepayment penalties. CMBS loans stipulate prepayment penalties. In other words, borrowers are penalized for paying off the loan early. These penalties are designed to protect investors, but they’re a disadvantage to borrowers. CMBSs impose prepayment penalties that can be 1% to 3% of the amount of the loan.