How the American mortgage car works

The originators are probably the best known players for investors. They stand in front of the process and, in many cases, deal directly with the borrowers. But for a mortgage with typical terms and sizes, these are not usually the player who ultimately holds the loan.

One major reason is the unique system of supporting taxpayers in the US real estate market through government-sponsored businesses. Fannie Mae FNMA 1.27%

and Freddie Mac FMCC 0.87%

buy loans from initiators, guarantee them and resell them to investors as agency mortgages. So, in turn, the economy of many initiators is ultimately determined by the volume of loans they produce and sell through Fannie or Freddie. This business model also avoids the risk of borrowing and requires less capital, which makes it attractive to investors.

But selling loans is quite complicated. In order for anyone else to be interested in buying or trading third-party loans, a lot of things have to happen to sell a 30-year mortgage. The initiators sell mainly in standardized groups of mortgages, which are organized in half-point interest cups, such as 2.5% or 3%. Investors buy slices of these funds in the form of a securitization.

This rate is not the same as the one paid by the debtor. A 3% mortgage could reach a 2% fund. This is because in order to further standardize the loan, parts of the interest are paid for other processing services. One part is for Fannie or Freddie, to cover the basic cost of securing the mortgage, plus various adjustments based on the individual mortgage. Another piece is for a servicer, who manages the collection from the borrower, then pays to investors, tax authorities and so on.

In return for this long-term toll flow, service providers bear certain risks. First, when interest rates fall, more mortgages are refinanced and prepaid earlier, causing service agents to lose these payment flows. Service agents also cover some missed payments before a mortgage is defaulted. In an economy where many people are missing out on payments, this can bite. The increase in deferred payments during the pandemic, for example, has fallen sharply on service providers.

Initiators may need to use private mortgage insurance if the loan-to-value ratio is too low for a guarantor, perhaps because the borrower falls less than 20%. Borrowers can pay this fee directly or indirectly through a higher mortgage rate.

Even after paying for service and credit risk, an initiator still cannot always count on a predictable selling price for each mortgage. Mortgage rates or the relative price between buckets may move during the long closing period, but lenders like to “block” the rates offered. There is a huge market for the future delivery of mortgages, known as the TBA or ‘To Be Announced’ market, which is used to effectively cover the risk rate for creditors. But it bears a cost that can vary depending on the duration of protection.

An emerging technology component of the company uses data and analysis to synchronize the rate offered on a mortgage with how it could be covered and sold, explains Vishal Garg, CEO of Better, a digital property company. “You can be a much better market participant by matching the demand of the final investor with the consumer,” he says. “A traditional loan officer can’t look at all the scenarios.”

The originals have some natural counterparties that assume the interest rate risk. Demand from investors, such as mortgage investment trusts, informed by how cheap they can finance themselves, helps drive up prices.

A great way to show the tariff risk is the speed with which people pay in advance. In turn, this can affect what investors are willing to pay, as the securities derived from these mortgages become essentially shorter. So, even if the initiators enjoy the benefits of volume when many people refinance, they could earn less when they sell mortgages. Of course, when the Federal Reserve buys mortgages and when rates for other fixed-income assets are so low, the start-up profits from the sale of mortgages can remain quite high.

Smart investors will understand how changes in the market would affect their portfolios at home.

Write to Telis Demos at [email protected]