Do Secondary Mortgage Markets Help Borrowers?
October 7, 1999, revised April 2, 2003
"In a recent column you said that there was no serious downside to borrowers from having their loans sold, but you didn't point to any upside to the practice, either…Don't loan sales raise costs, and don't borrowers end up paying all the costs?"
True, loan sales involve transaction costs, which ultimately must be borne by borrowers. But these transactions costs are more than offset by the greater competition and reductions in other mortgage costs that result from secondary markets.
Largely because of secondary markets, a knowledgeable and creditworthy home-buyer in the US pays a rate only modestly higher than that charged to the US Government. The rate spread between home mortgages and Government bonds is lower in the US than anywhere else in the world, with the possible exception of the UK and Denmark, which also have secondary mortgage markets.
Secondary mortgage markets are of two general types. "Whole-loan" markets involve the sale of mortgages themselves, sometimes on a loan-by-loan basis but more often in blocks. Such markets, which arose in the US soon after World War II, primarily involve the one-time sale of newly originated mortgages to traditional mortgage lenders.
In the 1970s, markets also developed in mortgage-backed securities issued against pools of mortgages. Instead of selling, e.g., $50 million of whole loans, the loans are segregated in a pool and $50 million of securities are issued against the pool. These securities are actively traded after the initial issuance, and they are attractive to investors that would not ordinarily hold mortgages, such as pension funds or mutual funds.
Secondary markets reduce mortgage interest rates in several ways. First, they increase competition by encouraging the development of a new industry of loan originators. Called different names in different countries (in the US they are called "mortgage companies" or "mortgage banks"), they all have in common that they require little capital and tend to be aggressive competitors
Absent secondary markets, the only institutions originating mortgage loans are those with the capacity to hold them permanently, termed "portfolio lenders". In small communities especially, borrowers may be at the mercy of one or a few local banks or savings and loan associations. The entry of mortgage companies who can sell into the secondary market breaks up these local fiefdoms, much to the benefit of borrowers. The development of whole loan markets in the US is largely responsible for the growth of this industry.
Secondary markets also increase efficiency by encouraging a specialization of lending functions that reduces costs. Portfolio lenders typically do everything connected to originating and servicing loans, even though they may do some things quite inefficiently. Secondary markets, in contrast, create pressures to break functions apart and price them separately, and this imposes a discipline on mortgage companies to concentrate on what they do best. Many mortgage companies have ceased servicing loans, for example, because they can do better selling the servicing to companies who specialize in that function.
In addition, conversion of mortgages into mortgage-backed securities permits a better distribution of the risk of holding fixed-rate mortgages. Historically, depository institutions were well positioned to originate mortgage loans but if the loans were long-term and had fixed-rates, they were not well positioned to hold them because their deposits were short-term. Many pension funds, in contrast, were well positioned to hold long-term investments but were not equipped to originate and service mortgages. The development of markets in mortgage-backed securities eliminated this impasse.
Mortgage-backed securities also are "liquid" while mortgages themselves are not. This means that in most cases mortgage-backed securities can be sold for full value within the day whereas selling the same amount of mortgages would take 4 to 8 weeks. Because most investors value liquidity and are willing to accept a lower yield to get it, converting illiquid mortgages to liquid securities puts downward pressure on the rates charged to borrowers.
In addition to generating downward pressures on mortgage interest costs, secondary markets also tend to eliminate regional rate differences. At the turn of the century, the Census of Housing showed mortgage rates to be about 2% higher in the western states than in the east. By the 1950s, however, the differential was down to 1/4%, largely because of the development of secondary markets. Today, regional differentials are negligible.
Secondary markets have also vastly expanded the size of the borrower pool. Portfolio lenders generally restrict their loans to "A-quality" borrowers, in large part because of regulatory concerns about their safety and soundness. Secondary markets, in contrast, can access investors who are prepared to hold risky loans if the price is right. The result has been the emergence of the so-called "subprime market" and a new category of borrowers from institutions -- borrowers who previously had recourse only to family, friends, home sellers and loan sharks.
But secondary markets have had a downside. In secondary market trading, investors price every loan, borrower, property and transaction characteristic that affects risk or cost. This fine pricing is then transferred to the primary market where borrowers get their loans. The result is "nichification", which increases the difficulty of shopping for the best price (see What Market Niche Are You In?).
Secondary markets also are volatile -- prices change frequently. Volatility is also transferred to the primary market, and increases the difficulty borrowers have in shopping competing sources (see How to Avoid Lapsed Prices).
"In a recent column you said that there was no serious downside to borrowers from having their loans sold, but you didn't point to any upside to the practice, either…Don't loan sales raise costs, and don't borrowers end up paying all the costs?"
True, loan sales involve transaction costs, which ultimately must be borne by borrowers. But these transactions costs are more than offset by the greater competition and reductions in other mortgage costs that result from secondary markets.
Largely because of secondary markets, a knowledgeable and creditworthy home-buyer in the US pays a rate only modestly higher than that charged to the US Government. The rate spread between home mortgages and Government bonds is lower in the US than anywhere else in the world, with the possible exception of the UK and Denmark, which also have secondary mortgage markets.
Secondary mortgage markets are of two general types. "Whole-loan" markets involve the sale of mortgages themselves, sometimes on a loan-by-loan basis but more often in blocks. Such markets, which arose in the US soon after World War II, primarily involve the one-time sale of newly originated mortgages to traditional mortgage lenders.
In the 1970s, markets also developed in mortgage-backed securities issued against pools of mortgages. Instead of selling, e.g., $50 million of whole loans, the loans are segregated in a pool and $50 million of securities are issued against the pool. These securities are actively traded after the initial issuance, and they are attractive to investors that would not ordinarily hold mortgages, such as pension funds or mutual funds.
Secondary markets reduce mortgage interest rates in several ways. First, they increase competition by encouraging the development of a new industry of loan originators. Called different names in different countries (in the US they are called "mortgage companies" or "mortgage banks"), they all have in common that they require little capital and tend to be aggressive competitors
Absent secondary markets, the only institutions originating mortgage loans are those with the capacity to hold them permanently, termed "portfolio lenders". In small communities especially, borrowers may be at the mercy of one or a few local banks or savings and loan associations. The entry of mortgage companies who can sell into the secondary market breaks up these local fiefdoms, much to the benefit of borrowers. The development of whole loan markets in the US is largely responsible for the growth of this industry.
Secondary markets also increase efficiency by encouraging a specialization of lending functions that reduces costs. Portfolio lenders typically do everything connected to originating and servicing loans, even though they may do some things quite inefficiently. Secondary markets, in contrast, create pressures to break functions apart and price them separately, and this imposes a discipline on mortgage companies to concentrate on what they do best. Many mortgage companies have ceased servicing loans, for example, because they can do better selling the servicing to companies who specialize in that function.
In addition, conversion of mortgages into mortgage-backed securities permits a better distribution of the risk of holding fixed-rate mortgages. Historically, depository institutions were well positioned to originate mortgage loans but if the loans were long-term and had fixed-rates, they were not well positioned to hold them because their deposits were short-term. Many pension funds, in contrast, were well positioned to hold long-term investments but were not equipped to originate and service mortgages. The development of markets in mortgage-backed securities eliminated this impasse.
Mortgage-backed securities also are "liquid" while mortgages themselves are not. This means that in most cases mortgage-backed securities can be sold for full value within the day whereas selling the same amount of mortgages would take 4 to 8 weeks. Because most investors value liquidity and are willing to accept a lower yield to get it, converting illiquid mortgages to liquid securities puts downward pressure on the rates charged to borrowers.
In addition to generating downward pressures on mortgage interest costs, secondary markets also tend to eliminate regional rate differences. At the turn of the century, the Census of Housing showed mortgage rates to be about 2% higher in the western states than in the east. By the 1950s, however, the differential was down to 1/4%, largely because of the development of secondary markets. Today, regional differentials are negligible.
Secondary markets have also vastly expanded the size of the borrower pool. Portfolio lenders generally restrict their loans to "A-quality" borrowers, in large part because of regulatory concerns about their safety and soundness. Secondary markets, in contrast, can access investors who are prepared to hold risky loans if the price is right. The result has been the emergence of the so-called "subprime market" and a new category of borrowers from institutions -- borrowers who previously had recourse only to family, friends, home sellers and loan sharks.
But secondary markets have had a downside. In secondary market trading, investors price every loan, borrower, property and transaction characteristic that affects risk or cost. This fine pricing is then transferred to the primary market where borrowers get their loans. The result is "nichification", which increases the difficulty of shopping for the best price (see What Market Niche Are You In?).
Secondary markets also are volatile -- prices change frequently. Volatility is also transferred to the primary market, and increases the difficulty borrowers have in shopping competing sources (see How to Avoid Lapsed Prices).