Printable Lesson Materials

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1 Printable Lesson Materials Print these materials as a study guide These printable materials allow you to study away from your computer, which many students find beneficial. These materials consist of two parts: graphic summaries of the content and a multiple choice quiz. Graphic Summaries This portion of your printable materials consists of dozens of frames that summarize the content in this lesson. The frames are arranged on the page to make it easy for you to study the material and add your own notes from your textbook or the online course. Quizzes Many students learn best from sets of questions, and this multiple choice quiz allows you to focus your review of the material to important topics Rockwell Institute NE 20th Street Bellevue, WA

2 Financing Residential Real Estate Lesson 3: The Primary and Secondary Markets Introduction In this lesson, we will cover: the distinction between the primary and secondary mortgage markets how primary market lenders get funds to make mortgage loans sale of loans on the secondary market mortgage-backed securities the secondary market agencies and their role in the mortgage industry Introduction The residential mortgage industry is made up of: financial institutions, private companies, government-sponsored enterprises, and other investors.

3 The Two Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans. The Two Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans. Primary market Market where lenders make loans to home buyers. The Two Mortgage Markets The industry is divided into two markets that supply funds for mortgage loans. Primary market Market where lenders make loans to home buyers. Secondary market Market where lenders sell their loans to investors.

4 Primary Market In primary market, home buyers apply for mortgage loans and lenders originate them. Loan origination involves: processing the application, approval decision, and funding the loan. Primary Market Primary market was originally local, made up of community financial institutions. More complicated now, due to developments such as: interstate banking Internet lenders Local model still useful in understanding primary and secondary markets. Primary Market Real estate cycles Local market is subject to real estate cycles. Real estate cycles = Periodic shifts in level of real estate activity (sales, loans).

5 Primary Market Real estate cycles Local market is subject to real estate cycles. Real estate cycles = Periodic shifts in level of real estate activity (sales, loans). Caused by changes in supply of and demand for: real estate for sale, and funds for mortgage lending. Primary Market Factors affecting real estate cycles Local real estate cycles are affected by many factors, including: economic forces political events social trends These factors may be either local or national. Primary Market Dealing with real estate cycles At one time, local lenders couldn t do much about real estate cycles in their communities.

6 Primary Market Dealing with real estate cycles They needed: 1. a source of extra funds to lend when demand exceeded supply; and 2. a place to invest surplus funds when supply exceeded demand. Primary Market Dealing with real estate cycles They needed: 1. a source of extra funds to lend when demand exceeded supply; and 2. a place to invest surplus funds when supply exceeded demand. Secondary market helped meet both needs. Summary Primary Market Primary market Origination Real estate cycles

7 Secondary Market Solution to primary market problems: the secondary market. Secondary market = National market where mortgages secured by real estate all over the U.S. are bought and sold. Secondary Market Secondary market activities: Buying and selling loans Buying and selling mortgage-backed securities Secondary Market Activities Buying and selling loans Like other investments, loans can be bought and sold. Loan purchaser pays present value of right to receive payments from borrower. Rate of return on loan compared with rate of return on other investments to determine present value.

8 Buying and Selling Loans Who buys loans? Mortgage lenders may sell their loans to: Other lenders Secondary market agencies Buying and Selling Loans Secondary market agencies Federal National Mortgage Association (FNMA or Fannie Mae ) Federal Home Loan Mortgage Corporation (FHMLC or Freddie Mac ) Government National Mortgage Association (GNMA or Ginnie Mae ) Created by federal government to establish strong secondary market for mortgage loans. Buying and Selling Loans Secondary market agencies Lenders package similar loans together for sale to a secondary market agency.

9 Buying and Selling Loans Secondary market agencies Lenders package similar loans together for sale to a secondary market agency. After sale, loans may be serviced by original lender or by another servicer. Loan servicing = Payment processing, collections, working with borrowers to prevent default. Secondary Market Activities Mortgage-backed securities In addition to buying loans, secondary market agencies also issue mortgage-backed securities. Secondary Market Activities Mortgage-backed securities In addition to buying loans, secondary market agencies also issue mortgage-backed securities. Mortgage-backed security (MBS) Investment instrument with mortgage loans as collateral; a type of bond.

10 Secondary Market Activities Mortgage-backed securities In addition to buying loans, secondary market agencies also issue mortgage-backed securities. Mortgage-backed security (MBS) Investment instrument with mortgage loans as collateral; a type of bond. Investor returns are monthly payments from secondary market agency. Secondary Market Activities Mortgage-backed securities In addition to buying loans, secondary market agencies also issue mortgage-backed securities. Mortgage-backed security (MBS) Investment instrument with mortgage loans as collateral; a type of bond. Investor returns are monthly payments from secondary market agency. Agency passes borrowers payments on to investors. Mortgage-backed Securities Securitizing loans Securitizing = Buying mortgages, pooling them together, pledging the pool as collateral, issuing securities. Private-label mortgage-backed securities = Securities issued by a private firm rather than a secondary market agency.

11 Mortgage-backed Securities Advantages for investors Reasons investors prefer buying MBSs to buying actual mortgage loans include: convenience greater liquidity can be purchased in relatively small denominations Functions of the Secondary Market Secondary market serves two important functions for the real estate industry: 1. Moderates adverse effects of real estate cycles, providing some stability. 2. Makes funds available for mortgage loans, promoting home ownership. Functions of the Secondary Market Flow of mortgage funds Availability of funds in the primary market depends on the secondary market. Mortgage funds flow between the two markets.

12 Functions of the Secondary Market Flow of mortgage funds 1. Lender loans funds to home buyer in primary market. Functions of the Secondary Market Flow of mortgage funds 1. Lender loans funds to home buyer in primary market. 2. Lender sells mortgage to secondary market agency. Functions of the Secondary Market Flow of mortgage funds 1. Lender loans funds to home buyer in primary market. 2. Lender sells mortgage to secondary market agency. 3. Agency pools mortgage with others and sells MBSs to investors, which frees agency funds to buy more mortgages.

13 Functions of the Secondary Market Flow of mortgage funds 1. Lender loans funds to home buyer in primary market. 2. Lender sells mortgage to secondary market agency. 3. Agency pools mortgage with others and sells MBSs to investors, which frees agency funds to buy more mortgages. 4. As agency buys more mortgages, more funds are available for primary market lenders to make more loans. Functions of the Secondary Market Portfolio loans If a lender doesn t sell a loan on the secondary market, the loan is kept in portfolio. Only a small percentage of loans are kept in portfolio today. Summary Secondary Market Secondary market Secondary market agency Loan servicing Mortgage-backed securities Securitizing Private-label securities Portfolio loan

14 Historical background Fannie Mae 1938 Created by federal government in response to Depression-era credit problems. Authorized to buy FHA loans Also authorized to buy VA loans Reorganized as a governmentsponsored enterprise. Historical background Government-sponsored enterprise (GSE) Created and supervised by the federal government. Owned by private stockholders. Historical background Ginnie Mae 1968 Created as an agency within HUD when Fannie Mae became a private corporation. Wholly owned government corporation. Managed and liquidated mortgages bought by Fannie Mae before the change-over. Now buys FHA and VA loans, helps finance urban renewal and housing projects.

15 Historical background Freddie Mac 1970 Created by Emergency Home Finance Act as a government-sponsored enterprise. Original purpose: to assist savings and loans hit hard in 1969 recession act authorized both Freddie Mac and Fannie Mae to buy conventional loans. GSE status As government-sponsored enterprises, Fannie Mae and Freddie Mac were given some advantages over ordinary private corporations: Exempted from certain types of taxes. Not subject to certain SEC registration and disclosure requirements. GSE status GSEs were also given special responsibilities and limitations: Restricted by charter to investment in residential mortgage assets (mortgages and mortgage-backed securities). Required to meet annual affordable housing goals.

16 MBS programs Ginnie Mae started first MBS program in Offered guaranteed securities backed by pools of FHA and VA loans. Fannie Mae and Freddie Mac followed with securities backed by conventional loans. MBS programs 1980s: Congress removed certain restrictions on mortgage-backed securities. Made them more competitive with corporate bonds. Fueled expansion of secondary market. MBS programs Investors can buy MBSs: directly from the issuing agency, or on Wall Street, through securities dealers. Direct purchases typically made by large investors such as insurance companies or pension funds.

17 MBS programs MBS issued by a secondary market agency is guaranteed by the agency. Investor receives full payment from agency even if borrowers default on some loans in the pool. Guaranty fees and servicing fees subtracted before payments passed on to investors. Standardized underwriting Lender who wants to sell loan to Fannie Mae or Freddie Mac must: Standardized underwriting Lender who wants to sell loan to Fannie Mae or Freddie Mac must: comply with agency s underwriting rules when qualifying loan applicant, and

18 Standardized underwriting Lender who wants to sell loan to Fannie Mae or Freddie Mac must: comply with agency s underwriting rules when qualifying loan applicant, and use uniform loan documents. Standardized underwriting Lender who wants to sell loan to Fannie Mae or Freddie Mac must: comply with agency s underwriting rules when qualifying loan applicant, and use uniform loan documents. If lender violated agency rules, may be required to buy loan back from agency. Standardized underwriting Underwriting guidelines and uniform documents are a quality control system to ensure that loans purchased by secondary market agencies meet or exceed minimum standards.

19 Standardized underwriting Underwriting guidelines and uniform documents are a quality control system to ensure that loans purchased by secondary market agencies meet or exceed minimum standards. Inspires investor confidence. Strongly influences primary market lenders. GSEs and subprime loans Prime loan Loan made to borrower with A credit rating. Subprime loan Loan made to less creditworthy borrower. GSEs and subprime loans Prime loan Loan made to borrower with A credit rating. Subprime loan Loan made to less creditworthy borrower. At one time, Fannie Mae and Freddie Mac bought only prime loans. Subprime loans didn t meet their standards.

20 GSEs and subprime loans In 2005 Fannie Mae and Freddie Mac began buying significant numbers of subprime loans. Primarily A-minus loans: top layer of subprime market. Encouraged to do so by government, to help meet affordable housing goals. GSEs and the economic crisis Before current crisis, many industry analysts credited Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; GSEs and the economic crisis Before current crisis, many industry analysts credited Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; reducing mortgage interest rates;

21 GSEs and the economic crisis Before current crisis, many industry analysts credited Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; reducing mortgage interest rates; making underwriting practices sounder and fairer; and GSEs and the economic crisis Before current crisis, many industry analysts credited Fannie Mae and Freddie Mac with: dramatically increasing home ownership rates; reducing mortgage interest rates; making underwriting practices sounder and fairer; and providing mortgage lenders with access to global capital markets. GSEs and the Economic Crisis Criticism before crisis began Before current crisis, critics argued: claims about how much GSEs benefited public were exaggerated;

22 GSEs and the Economic Crisis Criticism before crisis began Before current crisis, critics argued: claims about how much GSEs benefited public were exaggerated; GSEs were too large and had too much power over mortgage industry; GSEs and the Economic Crisis Criticism before crisis began Before current crisis, critics argued: claims about how much GSEs benefited public were exaggerated; GSEs were too large and had too much power over mortgage industry; GSEs limited opportunities for other investors and enterprises; and GSEs and the Economic Crisis Criticism before crisis began Before current crisis, critics argued: claims about how much GSEs benefited public were exaggerated; GSEs were too large and had too much power over mortgage industry; GSEs limited opportunities for other investors and enterprises; and GSEs weren t being run well (2004 accounting scandals).

23 GSEs and the Economic Crisis On the brink of insolvency By 2007, almost one-third of Fannie Mae and Freddie Mac s new purchases and guaranties involved riskier loans. As subprime crisis began to unfold, house prices dropped and foreclosure rates rose sharply. Caused GSEs stock prices to plunge, further undermining their financial stability. GSEs and the Economic Crisis Conservatorship Housing and Economic Recovery Act of 2008 (HERA) created new independent regulatory agency to oversee GSEs. Federal Housing Finance Agency (FHFA) September 2008: to prevent economic consequences of GSE failure, FHFA placed both agencies in a conservatorship. Essentially a government takeover. GSEs and the Economic Crisis Conservatorship Terms of GSE conservatorship: Top management replaced. Voting power of shareholders and directors terminated. To maintain solvency of GSEs, government would: buy securities from the GSEs, and buy up to $100 billion of stock in each GSE.

24 GSEs and the Economic Crisis Conservatorship Federal Housing Finance Agency also announced plans to reduce size of Fannie Mae and Freddie Mac over several years. GSEs and the Economic Crisis Federal guaranty Ginnie Mae securities have always been backed by full faith and credit of U.S. government. Ginnie Mae is a government agency. Investors won t lose their invested capital in an economic crisis. GSEs and the Economic Crisis Federal guaranty In contrast, securities issued by Fannie Mae and Freddie Mac didn t carry a government guaranty. A GSE s private guaranty ensured only that investors would receive timely payment in spite of borrower default. No protection against financial crisis affecting the GSEs themselves. Guaranty usually worthless if guarantor bankrupt.

25 GSEs and the Economic Crisis Federal guaranty However, investors believed government would feel obligated to intervene if Fannie Mae or Freddie Mac became insolvent. GSEs and the Economic Crisis Federal guaranty However, investors believed government would feel obligated to intervene if Fannie Mae or Freddie Mac became insolvent. Investors therefore viewed GSE mortgage-backed securities as carrying implicit government guaranty. GSEs and the Economic Crisis Federal guaranty After conservatorship announced, government confirmed federal guaranty. GSEs were too big to fail. Default on payments to MBS investors could have drastic effect on national economy.

26 Summary Fannie Mae Ginnie Mae Freddie Mac Government-sponsored enterprise Guaranties Subprime loan A-minus loan Federal Housing Finance Agency Conservatorship

27 Real Estate Finance Lesson 3 Cumulative Quiz 1. Reliable Savings Bank accepts deposits and originates loans for the purchase of homes. Reliable operates in the: A. money market B. primary market C. secondary market D. tertiary market 2. A private investor purchases real estate loans from lenders throughout the country and pools them together to serve as collateral for mortgage-backed securities. This occurs in the: A. money market B. primary market C. secondary market D. tertiary market 3. The economy is booming in Happyville and the population is growing. A potential problem for local lenders might be that: A. fewer people will be able to afford to buy houses because of increasing prices B. residents will save more, meaning that the lenders may have surplus deposited funds C. there aren't enough funds on deposit to meet the increased demand for new loans D. there isn't enough demand for loans, meaning deposited funds will go uninvested 4. The phenomenon of occurs when investors remove funds from savings accounts and place them in competing investments that may offer higher returns. A. disintegration B. disintermediation C. dislocation D. remediation 5. A secondary market agency may do all of the following except: A. buy loans B. originate loans C. package loans as securities D. sell loans 2009 Rockwell Publishing 1

28 6. Which of the following is a secondary market agency? A. Federal Deposit Insurance Corporation B. Federal National Mortgage Association C. Federal Reserve Bank of San Francisco D. Western Federal Savings and Loan 7. Which of the following is NOT an advantage that mortgage-backed securities have over the direct purchase of mortgage loans? A. Securities are guaranteed by the issuing agency B. Securities are more liquid than mortgages C. Securities do not include servicing fees D. Securities may be purchased in smaller denominations 8. An investment bank purchases mortgage loans and sells mortgage-backed securities to investors. These would be known as: A. commercial securities B. convertible securities C. nonconforming securities D. private-label securities 9. What important function does the secondary market serve? A. It insures loans made by primary market lenders, allowing lenders to make riskier loans B. It makes more funds available for mortgage loans C. It stabilizes local markets by moderating the effects of real estate cycles D. Both B and C 10. A lender keeps a loan in portfolio if it: A. retains the loan and receives payments from the borrower B. sells the loan to a private investor C. sells the loan to a secondary market agency D. sells the loan but continues to service it on behalf of the buyer 11. One important result of the underwriting standards imposed in the secondary market is that: A. fewer loans are sold because of the strict uniform underwriting standards B. keeping loans in portfolio has become more prevalent C. lenders became more comfortable offering products like low-downpayment loans D. more lenders have begun operating nationwide, instead of just in local markets 2009 Rockwell Publishing 2

29 12. This secondary market agency was created in 1938 in order to create a secondary market for FHAinsured loans; it gradually expanded to include VA-guaranteed and conventional loans as well. A. Billie Gene B. Fannie Mae C. Freddie Mac D. Ginnie Mae 13. This secondary market agency is a part of the Department of Housing and Urban Development, rather than a government-sponsored enterprise. A. Federal Home Loan Mortgage Corporation B. Federal Housing Administration C. Federal National Mortgage Association D. Government National Mortgage Association 14. This secondary market agency was the last of the three agencies to be formed, in order to assist savings and loan associations by allowing them to participate in the secondary market. A. FHLMC B. FNMA C. GNMA D. OFHEO 15. The goals of Fannie Mae and Freddie Mac include providing programs to help with affordable: A. rental housing B. home purchases C. super jumbo loans D. Both A and B 16. A mortgage-backed security backed by pools of conventional loans would not be available from: A. a private investment bank B. Fannie Mae C. Freddie Mac D. Ginnie Mae 17. Which newly-created regulatory agency placed Fannie Mae and Freddie Mac into conservatorship in 2008? A. Federal Deposit Insurance Corporation B. Federal Housing Finance Agency C. Government National Mortgage Association D. Office of Thrift Supervision 2009 Rockwell Publishing 3

30 18. Which agency or agencies were, until recently, considered not to be backed by the "full faith and credit" of the federal government? A. Fannie Mae B. Freddie Mac C. Ginnie Mae D. Both A and B 19. During the height of the housing bubble, the government-sponsored enterprises started buying what type of loans? A. A-minus loans B. All subprime loans C. Automobile loans D. Home equity lines of credit 20. All of the following are considered to be beneficial effects of the secondary market agencies, except: A. increased home ownership rates B. lower mortgage interest rates C. more accurate prediction of borrowers' likelihood of default D. quicker and less expensive loan processing 2009 Rockwell Publishing 4