Wall Street Trading

With the mortgage bailout bill playing center stage on all of the national news stations, I thought it was the perfect time to release the second post in my basic mortgage education series.  The first post of this series covered the history of mortgages and mentioned that the second post would explain what the secondary market is, and who the major players in the secondary market happen to be.

To start with, we will cover some definitions. Since I always like to have examples to help me wrap my head around concepts, I decided to provide an example for each lender class.   

·         Commercial bank - Nongovernmental financial institutions. Sometimes called full-service banks because they provide a wide range of services including checking and savings accounts, credit and loan arrangements, consumer and business loans (generally short-term with full recourse to the Borrower), and safety deposit box rentals. Commercial banks also sell and redeem US savings bonds.  A good example of a commercial bank is Bank of America.

·         Savings and loan – A federally or state chartered financial institution that takes deposits from individuals, funds mortgages, and pays dividends.  These institutions are required by law to provide home mortgages as a certain percentage of their loans.  An example of a savings and loan would be the previous World Savings that was swallowed by Wachovia.  Not many of these banking entities exist as most of them failed during the early 90’s in what has been called the savings and loan crisis.

·         Thrifts - A depository financial institution intended to encourage personal savings and home buying.  Washington Mutual is a good example of a thrift.

·         Mortgage Brokerage – An organization that is hired by large institutional lenders, such as pension funds of large unions or commercial banks. Most mortgage brokerages are small independent organizations such as Lone Star Funding.

If, after reading these definitions, it is not clear to you what the difference is between these institutions, it is not an absolute must in order to understand the secondary market, and you are not alone.  In the end the differences are really in the legal regulations that govern them. 

Whether someone applies for a mortgage through a commercial bank, a savings and loan, a thrift or a mortgage brokerage, the institution is known as the primary originator of the mortgage. Companies that later purchase loans from primary originators are referred to as secondary originators, because they sell the loans in the secondary market.  Primary originators package a large number of loans together and then sell them off to one of the three main purchasers of mortgage loans:  Ginnie Mae (GNMA), Freddie Mac (FHLMC) or Fannie Mae (FNMA). Once one of these groups purchases the loans, they are split up into smaller pools, and the principal and interest payments made by individual home buyers are then combined to create mortgage-backed securities.  These securities are subsequently sold on Wall Street to individual or institutional investors as bond class investments. By selling off these bonds FNMA, GNMA and FHLMC refill their coffers, which allows them to purchase more loans from primary originators, thereby allowing the primary lenders to make more loans to consumers. 

The breaking of this chain is what has caused the subprime crisis, sending a shivering shock through the entire credit market. In my next post in this series, we will cover the rolls of secondary originators such as Fannie Mae and Freddie Mac.

Houston Luxury Home

I decided to take an academic approach to organizing by mortgage education series. I felt it would be fitting for the blog category title of Basic Houston Mortgage Education. I will begin this series by covering a brief history of the United States mortgage market evolution.

Prior to 1934, when someone wanted to purchase a home and did not have all of the funds necessary for the transaction, the individual would head to the town center to meet with someone at the neighborhood bank. If one of the bank representatives knew the customer and considered them a good credit risk, the customer would get the loan. For the most part, mortgage loan terms were rather customer-unfriendly prior to 1934. Loan terms were limited to 50% of the property’s value, the repayment schedule was almost always 5 years or less, and ended with what is known as a balloon payment. A balloon payment is a term used in the mortgage market that means when one reaches the end of the allotted loan period there is still a balance, and at that time, the borrower is expected to pay in full the remaining loan amount. Unsurprisingly, at that time America consisted mostly of renters with only two out of five households owning their own homes.

In 1934, the Federal Housing Administration (FHA) legislation played a major role in helping the country out of the great depression. FHA allowed for a new type of mortgage aimed at assisting those folks who did not qualify under the previous existing loan programs. FHA lengthened the excessively narrow loan terms from the traditional 5 year loan to 15 year loans. FHA later extended the loan period to 30 years which is the time line that is still most common today.

The FHA started loan programs that lowered the down payment requirements to 20%, 10%, and in some cases lower than 10%, rather than the 50% down that was required by traditional lending standards. This move by legislators revolutionized the lending industry by forcing banks and lenders to modify their loan terms and created more opportunities for the average American to own their own home. Along with lengthening loan terms and reducing the required down payment, FHA also started the trend of qualifying people based on their ability to pay back the loan (something I think we forgot about that has caused the current subprime lending crisis). This opened massive opportunities for the less well connected Americans of the day.

Another stabilizing trend the FHA implemented was to ensure the quality of the home’s construction. FHA set standards that homes had to meet in order to qualify for the loan. These standards are still enforced today.

Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were very common in those days. FHA established the amortization of loans that we use today. Amortization means that each payment made includes all of the interest plus a certain amount of the principal amount that leaves a zero balance at the end of the loan term.

The revolutionary concepts introduced by FHA have grown to include a wide variety of loan products today. These different loan products are made available by something commonly referred to as the Secondary Market. Problems in the Secondary Market are to blame for the housing crisis we are experiencing today. We will cover what the Secondary Market is composed of, who the major players in the Secondary Market are, and how events in the Secondary Market affect the average Houston home buyer.