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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2017

Revealing the Secondary Market

Loan origination is just the tip of the iceberg in the mortgage lending process

Revealing the Secondary Market

As a loan originator or branch manager, you deal with the primary market — selling and processing mortgages for borrowers — as a matter of course. On the other hand, the less familiar secondary market — the packaging and selling of those loans to agencies and investors — is a large operation that lurks beneath the surface of many mortgage companies and lenders, and is not as well understood.

Luckily, you don’t have to be an expert who is well-versed in all things secondary. What you do want, however, is to have confidence that your secondary market team — or the teams at the lenders you work with — have capable and knowledgeable individuals who can support your origination efforts and help you understand issues that can affect your borrowers’ loans.

It can be beneficial for originators to brush up on the interactions between the primary and secondary mortgage markets. Building a basic foundation of knowledge about how the secondary market works — and how it affects the loans they originate — can help originators better serve their borrowers and Realtor partners, and earn their trust as a valued mortgage expert.

Before addressing the basics of why and how pricing and lock policies are created — and why they may seem counterintuitive at times — let’s first take a look at some important definitions.

  • Primary Market. This is the origination market for mortgage loans. Originators, sales assistants and much of a mortgage company’s operations team’s efforts are focused on the primary market.
  • Secondary Market. This is the market for the sale of mortgage loans. The secondary market provides liquidity to the primary market. But, in doing so, it imposes its own operational considerations and requirements on the primary market. Many mortgage companies and lenders usually have a separate team dedicated to secondary market operations.
  • Liquidity. According to Investopedia, “Liquidity describes the degree to which an asset or security can be quickly bought or sold without affecting the asset’s price.” Guidelines standardize loan terms so that loans can be readily securitized and sold to investors, but the market for those securities can be subject to liquidity issues at times. Coordination between the primary and secondary market teams can play a big role in how liquidity impacts everyone’s bottom line.

What is a loan?

When you originate a mortgage loan, the price to the borrower can be described as the buy price. The sale of that loan to an investor is then the sell price. This gives an important insight into how mortgage lenders operate: They see each loan origination is not a single transaction, but two.

In other words, a mortgage loan is bought from a borrower and then sold in some manner to an investor. Successfully completing both transactions is paramount to a mortgage company’s ongoing success. It requires teamwork between primary and secondary areas to maintain loan sales to investors at the highest level of liquidity possible. Any interruptions will result in some sacrifice of revenue.

It’s common to think of a loan as a physical thing. Originators often say, “this is a good loan” and discuss their pipelines as if they are assembly lines as they strive for accuracy, efficiency and cost controls. Even liquidity issues consider loans to be like durable goods that can be bought and sold. This analogy is mostly appropriate, but not entirely.

Coordination between the primary and secondary market teams can play a big role in how liquidity impacts everyone’s bottom line. 

Loans are not things. They are financing terms and conditions that determine future cashflows from a borrower. Borrowers often understand this distinction better than originators. They focus on the monthly payments — the financing — and not the closing table. The collateral, the house, is obviously a physical object, but that is not what pricing is based on, and borrowers intuitively understand that.

At any given point in time, investors will determine the value of those cash flows — the price they will pay to buy a loan — from a present-value calculation. This is the important point of this distinction because, besides origination costs, many other factors influence pricing.

Pricing and lock policies

In addition to present-value calculations, there are two loan components that are priced separately in pricing models. The first is the service fee. This is usually the first 25 basis points (bps), or 0.25 percent if you prefer, of the note rate — of the interest cashflow. The rest of the note rate, and all of the principal cashflow, make up the other piece.

Investors may purchase the whole loan — both pieces combined — or just the second piece, which is still referred to as the loan but does not include the service fee. The agencies buy loans this way. When loans are sold using this latter method, a buyer for the service fee must be found in order to come up with a whole-loan price. The values for both of these components are determined by present-value calculations.

These present-value calculations present mortgage originators with a unique challenge: interest-rate risk. This risk comes about because the buy price is set when the borrower’s rate is locked, but the sell price isn’t final until the resulting funded loan is committed to be sold to an investor. These typically occur at different times.

Hedging is one of the main responsibilities of a mortgage company’s or lender’s secondary market team.

Another complication is that not all rate-locked loans will fund, and many that do fund have pricing characteristics that changed after they were locked. During the time between rate lock and committing loans for sale, pricing is constantly changing. All of these factors create a risk that the sell price will change relative to the buy price. This risk must be addressed for the mortgage lender to realize its expected revenues. This is done by hedging.

Hedging addresses the interest-rate risk. Hedge trades act as placeholders for the eventual sell prices that will capture the value of rate locks after loans fund and are committed for sale. Hedge trades may be used to sell the loans, or they may be paired off while simultaneously committing the loans to specific investors. In addition, on a daily basis, hedging must account for rate locks that will fall out (not fund), new daily lock volume and pricing characteristic changes on all pre-existing locks.

Hedging is one of the main responsibilities of a mortgage company or lender’s secondary market team. The team managing the overall hedge position must adjust outstanding hedges against changes in rate-lock loan-pricing characteristics quickly, so the hedge performance remains as effective as possible. This is important because the mortgage-backed securities market does not provide an effective hedge against those changes.

As a final tip, remember that even though many originators tend to call applications and rate locks “loans,” they technically aren’t loans — and they don’t begin realizing value — until they fund. That’s when interest accrual and principal repayment liability from the borrower begins. Lock polices focus on the uncertainty of this funding event in an ever-changing pricing environment.

Key takeaways

Now that you have a basic education, what does all this information mean to you, as a loan originator? There are several ways you can work with your secondary market professionals to ensure the best situation possible for your borrowers:

  1. Know your company’s lock policies. Ask for explanations for any of the rules that don’t make sense or that will impact the approach you take with borrowers in those circumstances.
  2. Anticipate borrower questions. Never make a promise to a borrower involving a loan’s characteristics or the anticipated funding date if you don’t fully understand the impact of those details and how your company’s lock policies might affect the loan pricing. 
  3. Communicate with your secondary marketing team. The secondary market team will want to know about any unusual circumstances that will alter or delay the funding of a loan. If your origination system has an alert function, address those alerts as soon as they come up. Do not wait until just prior to funding.

If you follow these tips, you’ll be well on your way to giving your borrowers a positive and smooth loan experience from application to closing and beyond, which will encourage them to return to you for their future home-purchase and refinance needs.


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