Many people wonder where the money comes from to originate mortgage loans. How do banks and lenders have a seemingly unlimited supply of money to loan for the next 30 years? Well, the short story is that the money comes from Wall Street. Banks do not have piles of money sitting in their vault just lying around until borrowers come in to ask for it. For every real estate loan that banks finance, one of two things happen – they retain and service the loan, or they sell the loan on the open market.
Many people wonder where the money comes from to originate mortgage loans. How do banks and lenders have a seemingly unlimited supply of money to loan for the next 30 years? Well, the short story is that the money comes from Wall Street. Banks do not have piles of money sitting in their vault just lying around until borrowers come in to ask for it. For every real estate loan that banks finance, one of two things happen – they retain and service the loan, or they sell the loan on the open market.
Banks originate two types of mortgages. They are known as “saleable” and “portfolio” loans. Saleable loans are those scheduled to be sold off to investors on Wall Street in the form of “mortgage-backed securities.” These saleable loans are typically adjustable rate mortgages or subprime loans, but ideally, a mortgage securitization trust will consist of a balanced mix of both low-risk and high-risk notes. Loans that have fixed rates, well-qualified borrowers, and low loan-to-value ratios are considered low-risk and are deemed a portfolio loan. Banks may choose to hold on to these types of loans, making money off of the servicing and the interest earned.
While the market has dramatically changed since the financial crisis of 2008, the system to replenish money within the mortgage industry has pretty much stayed the same. Lenders and brokers originate loans based on program guidelines and sell those loans to secondary market investors. The investors in these securities are primarily made up of investment trusts or institutional financial companies. Loans that meet certain requirements may also be purchased by government-backed agencies such as Freddie Mac, Fannie Mae, or Ginnie Mae, who hold and service them.
Investment trusts operate as aggregators of loans. They create a securitization trust that then “pools” hundreds of loans, sometimes with diverse underwriting criteria, to create an investment rated security. This pooling helps mitigate risk and provides a good rate of return to individual investors. The loan pools, or trusts, are assigned to investment firms who hold and service the account on behalf of the investors. The investors in mortgage-backed securities usually earn a rate of return that is far higher than that of traditional government or money market bonds, making them in high demand.
Cycling the Money
The secondary market pools loans in securitization trusts and offers them for purchase to Wall Street investment firms. Individual certificates for the trust, similar to stock certificates, are sold to institutions or individual investors. This provides for the capital supply to be replenished for banks and other lending institutions that have established credit lines, and as the cycle continues, that money goes back into the economy in the form of new mortgages.
Lenders and brokers depend on the secondary market to purchase the loans they originate so they can continue uninterrupted lending operations. With the new rules and regulations established under Dodd-Frank, individual errors or omissions in loan documentation can cause a closed loan to become “unpurchasable,” leading to the inability to offload the loan to investors. When this happens, it reduces the amount of capital that is available to go back into mortgage lending. Besides the risk of carrying excessive mortgage debt, if a bank or lender gets caught with too many loans on their books, they may not be able to continue operations until those loans are remedied and sold.
The buying and selling of mortgage securities is known as “mortgage banking” and is the backbone that keeps the mortgage industry humming along. Ensuring this market continues to operate normally, through common sense oversight and regulation, is vital to maintaining a reliable mortgage industry.
