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The availability of funds in the primary market depends to a large extent on the existence of secondary markets. First, mortgage funds are given to the homebuyer by a lending institution in the primary market. The mortgage is then sold to a secondary market agency, which in turn can sell it to other investors as mortgage-backed securities. Mortgage-backed securities come in two general types: bond-type securities and pass-through securities. Bond-type securities have a longer duration, pay interest semi-annually, and provide for repayment on a specified date. Passing securities, which are more common, pay interest and principal payments on a monthly basis. Some types of pass-through securities pay even when payment is not collected from the borrower.
Because a primary lender sold the mortgage, the lender can take the money from the sale and make a second mortgage loan, then sell that new loan in the secondary market, and the cycle continues. Secondary market agencies may pool the mortgages they have purchased to create mortgage-backed securities, which they then sell to investors. As the secondary market agency sells mortgage-backed securities to investors, it now has more money to buy more mortgages. It can then pool more mortgage-backed securities to resell to investors, and the cycle continues.
The market is able to function as it does because standardized underwriting criteria are used to qualify borrowers and assets. A mortgage will only be purchased by the secondary market if the primary market lender conforms to the underwriting standards of the secondary market. Since lenders want to sell their loans, they must adhere to the underwriting standards of those agencies. The three largest secondary market agencies are Fannie Mae, Freddie Mac, and Ginnie Mae. Therefore, a conforming loan is usually a loan that conforms to Fannie Mae’s underwriting guidelines. Private companies such as hedge funds and investment banks also participate in the flow of mortgage funds by purchasing mortgage-backed securities. The recent credit meltdown and economic downturn were partly caused by the buying and selling of mortgage-backed securities. Investors borrowed incredible amounts of money and leveraged themselves so dramatically that when the value of mortgage-backed securities went down, it was enough to cause massive liquidity problems for companies and many went out of business. (Bear Stearns, Merrill Lynch, etc.). Unfortunately, many of the same dynamics that led to the financial collapse are still in play today. The secondary market still exists with Fannie Mae (influenced by taxpayer money) now buying up to 99% of all loans originated in the United States.
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