How the American Mortgage Machine Works

The initiators are probably the most well-known investors for investors. They are at the forefront of the process and in many cases have direct contact with borrowers. But for a mortgage with typical terms and size, they are usually not the player who ultimately owns the loan.

An important reason is the unique system of taxpayer support in the US housing market, through government-sponsored companies. Fannie Mae FNMA 1.27%

and Freddie Mac FMCC 0.87%

buy loans from originators, guarantee them and resell them to investors as mortgage lenders. So in turn, many originators’ economies are ultimately determined by the volume of loans they produce and sell through Fannie or Freddie. This business model also avoids credit risk and requires less capital, making it attractive to investors.

But selling loans is quite complicated. To get someone else interested in buying or trading loans negotiated by third parties, there are many things that need to be done to trade a 30-year mortgage. Originators primarily sell in standardized pools of mortgages divided into half-point interest rates, such as 2.5% or 3%. Investors purchase segments of these pools in the form of a securitization.

That rate is not the same as what the borrower pays. A 3% mortgage can end up in a 2% pool. That’s because to further standardize the loan, some of the interest goes to other transformation services. Part is for Fannie or Freddie, to cover their basic costs to guarantee the mortgage, plus various adjustments based on the individual mortgage. Another part is for a servicer, who handles the collection from the borrower and then pays it out to investors, tax authorities, and so on.

In exchange for this sustained flow of fees, servicers bear certain risks. First, when interest rates fall, more mortgages are refinanced and prepaid, leaving servicers to lose those payment flows. Servicers also cover some missed payments before a mortgage actually defaults. In an economy where many people miss payments, that can be a bit of a hit. For example, the increase in payment deferments during the pandemic was hard for servicers.

Initiators may also need to take advantage of private mortgage insurance if the loan-to-value ratio is too low for a guarantor, perhaps because the borrower is putting in less than 20%. Borrowers can pay this fee directly, or indirectly through a higher mortgage interest.

Even after paying for maintenance and credit risk, a client still cannot always count on a predictable selling price for every mortgage. Mortgage rates or the relative pricing between buckets may change during the long closing period, but borrowers like “locks” on offered rates. There is a huge market for future mortgage delivery, known as the TBA market, or “To Be Announced,” which is used to effectively hedge that interest rate risk to lenders. But there are costs that can vary depending on the length of the protection.

An emerging technology part of the business is using data and analytics to sync the rate offered on a mortgage with how it can be hedged and sold, explains Vishal Garg, CEO of Better, a digital home ownership company. “You can become a much better market participant by matching end-investor demand with consumers,” he says. “A traditional credit executive cannot consider all scenarios.”

Originators have a number of natural counterparties who assume interest rate risk. The demand from investors like real estate investment mortgage branches, based on how cheaply they can finance themselves, is helping to drive pricing.

An important way in which interest rate risk manifests itself is the speed with which people pay in advance. This, in turn, can affect what investors are willing to pay because securities derived from those mortgages essentially have a shorter life. So even if originators take advantage of the benefits of volume when many people refinance, they can make less money selling mortgages. Of course, when the Federal Reserve buys mortgage bonds and interest rates on other fixed-income assets are so low, the originators’ profit in selling mortgages can remain quite high.

Savvy investors will understand how changes in the market will affect their portfolios.

Write to Telis Demos at [email protected]