Secondary Mortgage Market in Detail It Puts Essay

Excerpt from Essay :

secondary mortgage market in detail. It puts light on the functioning of secondary mortgage market. It also discusses different tools that are used in this market and the benefits and drawbacks of this market. This paper also highlights some of the secondary mortgage market organizations and agencies. The evolution and growth of secondary mortgage market has also been discussed in this paper.

The secondary mortgage market is a place where the investors buy mortgage loans from the originators. An originator itself can be an investor also, by buying the loans provided by other originators. An originator can also sell these loans to an intermediary, who then converts these loans into securities and sell them to other people. It is a place where the mortgages originated in the primary mortgage market are resold. The already issued notes are also sold in the secondary mortgage market. These notes are purchased by the investors whose investment mix leads them to invest in such securities. These investors may invest in single securities or they diversify their funds by investing in pools of such securities. The securities issued in secondary mortgage markets are backed up by assets and they are also supported by the reputation and capital of the mortgage firm which is issuing the respective security. (Cummings and DiPasquale, 1997).

The secondary mortgage market decreases the interest rate risk by dividing it into different categories. The different categories in which the interest rate risk is divided are as follows; pipeline risk, portfolio risk and packaging risk. This market also facilitates the procedure of provision of loans as many temporary lenders are available in secondary mortgage market that are willing to provide any kind of loan that is required by the borrowers and in comparison to them portfolio lenders in other markets only provide loans that fit in their investment mix. This market also fulfills the varying needs of borrowers. It decreases the liquidity risk of private lenders by enabling them to invest in a large pool of assets and by expanding the opportunities that are available to them. This market enables the lenders and the borrowers to invest in a secure manner by reducing default risk to a great extent and providing profitable proposals for both the lending parties and the borrowing parties. (Hunter, 2001)

Parties Involved in Secondary Mortgage Market:

Investor:

These are the huge organizations that always seek to have reliable and valuable assets in their portfolio. The mortgage backed securities available in secondary mortgage markets are purchased by such investors either individually or in the form of diversified portfolios.

Borrowers:

These are the households that are looking for funds in order to finance their housing. They seek loans in order to purchase houses but they don't have a direct link with the secondary mortgage market.

Financial institutions:

They are the intermediaries that borrow funds from investors by selling them mortgage backed securities. They then lend these funds to investors and in return they keep an asset of borrower as a guarantee until the total amount of loan is refunded by the borrower.

Functions of Secondary Mortgage Market:

The secondary mortgage market involves the sale of mortgage backed securities. By doing so the risk contained in a mortgage loan is transferred to a third party. The sale of securities backed by mortgage reduces the probability of default risk- the risk that a borrower might not return the borrowed amount as the mortgage backed securities are backed up by the worth of an asset and by the reputation and capital of an intermediary as well. Following major functions are performed by secondary mortgage markets:

Interest Risk Management:

The interest risk in secondary mortgage markets is divided in to the following; pipeline risk- the risk that the interest rate will increase between the time the lender has made a commitment to the borrower and the time by which the loan is finally being sold. This risk is handled by temporary lenders. These are the institutions that originate loans and sell them in secondary mortgage market in a short period of time without holding them in their investment mix for long period of time. The temporary lenders originate loans with the sole purpose of reselling and therefore they sell these loans as soon as possible. The temporary lenders reduce the pipeline risk because they originate and sell loans immediately so the changes in prices are negligible. Another category is packaging risk- the risk that the interest rate may increase between the times the loans are purchased and prepared for resale. This risk is transferred to intermediaries. The last category of risk is portfolio risk- the risk that the value of combination (portfolio) of assets and liabilities will decrease due to the increase in interest rate, it is tackled by organizations that have diversified portfolios and they purchase mortgage backed securities provided by intermediaries.

It is impossible to create a system that can manage risk in a better way as compared to secondary mortgage markets as the temporary lenders are specialized in handling pipe line risks, the conduits or intermediaries are very efficient in selecting loans which they can keep in their portfolio without increasing their liabilities excessively and the remaining diversified pool of securities is handled effectively by the investment community.

Servicing loans:

In secondary mortgage markets the loans are provided more efficiently due to the better management of pipeline risk. The temporary lenders either give all the powers to the intermediary regarding the refunding of loan and interest or they might retain the servicing with themselves. The difference in price which occurs due to these procedures is the estimated market value of the servicing. This price difference is usually 0.5% to 1.5%.

Fulfilling varying needs of borrowers:

In secondary markets the temporary lenders provide almost any kind of loan that is being demanded by the borrower. The probability of sale of loan depends on whether the loan fits in the investment mix of investor or not. The secondary market also provides the temporary lenders with the influential information on the basis of which they can determine the amount they want to charge for their loan.

However, in the case of portfolio lenders the loans are originated and sold only if they fit in the investment mix of lenders. In addition to that lenders also face difficulties regarding their pricing decision and they also face difficulties concerning the underwriting of loans. The probability of default risk in the absence of secondary mortgage market is relatively high.

Basis of secondary mortgage markets:

The underlying reason for the requirement of secondary mortgage markets is the inefficiency of primary mortgage markets in providing sufficient funds. The reason why mortgages might not appeal the lenders is that the evaluation of credit risk is very expensive and time consuming process and it might not be calculated properly and this can lead towards the default of loan.

Secondly, even if the credit risk is managed efficiently, if the lenders invest in mortgages then this might threaten their liquidity. The purchase of mortgages increase the liquidity risk of lenders to a high extent as these are long-term assets with a life time of fifteen to thirty years.

Thirdly, if the lender has limited amount of capital and he considers mortgages far more risky than other investments, he will surely do for other investments as he will use his constrained capital efficiently.

The last factor affecting mortgages are government subsidized lenders as these lenders have an access to low priced funds and they exclude the private lenders from market by providing funds at a low cost. Due to a lower rate as compared to the market rates people prefer such lenders.

A secondary mortgage market is required if the lenders cannot tackle interest rates and liquidity risks. This institution provides a basis for secure lending of both long-term and short-term loans and it manages the risks far more efficiently as compared to private lenders.

Advantages of secondary mortgage markets:

Following are the advantages of secondary mortgage markets:

Increase in availability of funds:

The secondary mortgage markets increase the availability of funds. Moreover, they also fill the geographical gap between the lenders and the borrowers. In addition to that, secondary mortgage markets also handle the institutional gaps between different institutions in which the potential to retain and create the long-term assets differ.

Decrease in cost of mortgages:

The secondary mortgage markets lower down the cost of mortgage by allocating risk appropriately. They associate long-term mortgages with long-term funds. Credit risk is avoided through diversification. Private lenders are able to avoid liquidity risk as they are provided with various funding opportunities.

Reduction in transaction cost:

"A SMF can reduce transaction cost of mortgage lending and investment through standardization of mortgage loan documentation, underwriting and servicing and creation of standardized securities." (Lea 23). By doing this the secondary mortgage markets recuce the transaction costs for both the borrowers and the lenders.

Availability of housing finance:

A secondary mortgage market enables the borrowers to afford…

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