when a mortgage is sold on the secondary market, how does the seller make money?

Question

The questions stems from the knowledge that mortgages are sold. So, I get a mortgage from finanicial institution XYZ. That institution turns around and sells the mortgage to Fannie Mae, Freddie Mac or some other larger financial institution. So, my question is: "where did XYZ's profits come from?" Does XYZ only make money on the fees they charge the original lender? Or does XYZ borrow the money at 1% (for example), sell it to a borrower at 6%, and they sell it on the secondary market at 4%. So their profit is that 2% difference between the 6 & 4? I just see these "mom & pop" mortgage lenders (not just brokers) poping up. What's their incentive and how do they make money?

Answer 1

It is perhaps best to look at the mortgage as consisting four separate businesses with different risk factors or other differentiating features.

The first is the origination of the loan, providing the funds initially and getting the documentation for the loan and terms all in order.

The second is the ongoing funding of the loan in return for interest and repayment.

The third is accepting the credit risk of the loans - the risk that the borrower may default.

The fourth is the servicing of the loan from an operational point of view, keeping the documentation, collecting the payments and handing them over to the party funding the loan, handling the termination of the loan etc.

These four businesses may all be carried out by the same party but it may be more efficient to have these carried out by different organisations. Lets take each business one at a time.

The largest competitive advantage in origination other than price is acccess to customers and within that I would include local connections as well as brand awareness. The only real risks here are mispricing the loan such that it can not be sold to another party at a profit.

The most important features of funding are having matching liability - and this is particularly true for fixed rate mortgage loans. Interest payments will be coming in at say 6% for 20 years and hence need funding at 4% for that time. Banks do not have a natural source of such liabilities. The S&L crisis was caused in part by the associations making such loans but funding them with short term floating rate deposits. The insurance industry does however have such liabilities in the form of annuities. So insurance companies have a need for such steady long term income sources.

Funding has one major risk - prepayment risk. This is the risk that interest rates fall and borrowers repay their existing loans and take out new cheaper loans. You haven't really asked about how the securitisation process works but in brief 1000 (say) mortgages are put together and the cash flows split into interest payments and capital repayments. These are further divided such that some of the securities are almost guaranteed to go to term while others are likely to mature earlier. The price of each security reflects the riskiness of the cashflows.

A holder of a principal only security actually benefits from falling rates and higher prepayment rates.

As part of this shuffling of risk the credit risk can be separated off (and this is at the heart of the sub-prime credit derivative/hedge fund crisis). These are high risk high reward securites where if things go wrong the holder receives nothing.

Lastly there is the processing - some service companies e.g. EDS specialise in running large data and operational centers. This business has economies of scale.

So the small local bank originates the loan, Fanny or Ginny buy it at a small premium to the face value. The originator receives a fee and the loan is transferred off its balance sheet which means that it does not have to hold capital (which is a scarce and expensive resource) against the loan. The loan is bundled into securities which are bought by investors having particular risk-reward requirements. Servicing is carried out by a specialist service provider. The borrower may be completely unaware that any of this has happened.

At the end of it all that has happened is a redistribution of risk and everyone gets paid for doing what they do best.

Answer 2

First -- XYZ sells in the primary market -- not in the secondary market. The secondary market is where investors who buy a mortgage-backed security (MBS) buy or sell from other investors.

Mortgage Lenders make money in many ways. The three biggest ways are originating mortgages, servicing mortgages and investing in mortgages.

Those who are particularly good at originating Mortgages like to sell them in order to raise more cash so that they can originate even more MBS. They make money by charging fees (points) at origination.

Those who are good at servicing mortgages will take over the billing and collection and charge a fee for doing this. It is usually a straight percentage (say 25 basis points) tha is stripped off the interest paid by home-owners. This means that those good at origination can get rid of the headaches involved with collection & concentrate on what they do well.

The third group -- those who want to invest hold onto mortgages. They actually benefit from the MBS market because they can sell their mortgages & use the proceeds to buy MBS. This is good for them because it allows them to diversify geographically and also cuts down on default risk -- since the agencies (GNMA, FNMA, FHLMC) guarantee principal.

Answer 3

Okay lets do the math here... You have 1,000,000 of cash to loan out. You could loan it out one time to 5 different home buyers and each would pay you say 7% interest.... that means in the first year you could expect to get 70,000 in interest payments and a small fraction of the original million dollars, it might take 15 year before you've got enough of the principal back to make another loan to someone... BUT suppose you took those loans you made and charged those 5 people 1.5% in closing costs... that's 15,000 buck up front.... Now flip those loan for face value and loan the million buck to 5 more borrowers... assume you can do the whole process of flipping the loan in 30 days... that means in a year you've made 180,000 and have zero risk since the risk of default is with Fannie Mae. So just because you think the fees are small you have to remember that the mortage company is making more than one fee of the capital they loan out they flip it over and over and over... and little amount that are risk free add up quick.

Answer 4

They make money on the application and other fees. If they have 100k, they can make a 100k loan. But if they sell the loan and charge a $300 application fee, they will do that as many times as they can. Mortgages are risky, so they want to sell it, but they want to make that $300 fee over and over.

Answer 5

They buy $1.00 USD in debt for $0.99 USD or less.