The availability of funds in the primary market depends a great deal on the existence of secondary markets. First, mortgage funds are loaned to a homebuyer by a lending institution in the primary market. The mortgage is then sold to a secondary market agency that may, in turn, sell it to other investors in the form of mortgage backed securities. Mortgage backed securities fall into two general types: Bond-type securities and pass through securities. Bond-type securities are long-term, pay interest semi-annually, and provide for repayment at a specified date. Pass through securities, which are more common, pay interest and principal payments on a monthly basis. Some types of pass through securities pay even if payments are not collected from the borrower.
Because a primary lender sold the mortgage, the lender can take the money it receives from the sale and make another mortgage loan, then sell that new loan to the secondary market, and continue the cycle. The secondary market agency can pool the mortgages it buys to create mortgage backed securities, which they then sell to investors. As the secondary market agency sells the mortgage backed securities to investors, it now has more funds to buy more mortgages. It can then create more mortgage backed security pools to sell to investors again, and the cycle continues.
The market is able to function as it does because standardized underwriting criteria are used to qualify borrowers and property. A mortgage will only be purchased by the secondary market if the primary market lender conformed to the secondary market’s underwriting standards. Since lenders want to sell their loans, they must follow the underwriting standards of those agencies. The three largest secondary market agencies are Fannie Mae, Freddie Mac, and Ginnie Mae. Therefore, a conforming loan is typically a loan that conforms to Fannie Mae’s underwriting guidelines. Private companies such as hedge funds and investment banks also participate in the flow of mortgage funds by buying mortgage backed securities. The recent credit meltdown and economic recession was partly due to the buying and selling of mortgage backed securities. Investors borrowed incredible amounts of money and leveraged themselves so dramatically that when the value of mortgage backed securities went down, it was enough to create enormous liquidity problems for the companies and many went out of business (Bear Stearns, Merrill Lynch, etc.). Unfortunately, many of the same dynamics that caused the financial collapse are still in operation today. The secondary market still exists with Fannie Mae (infused with taxpayer money) now buying up to 99% of all loans originated in the United States.