How the American Mortgage Machine Works

Originators are probably the players most familiar to investors. They are in charge of the process and, in many cases, deal directly with borrowers. But for a mortgage with typical terms and size, they are generally not the player who ultimately owns the loan.

One of the main reasons is the unique taxpayer support system in the US housing market, through government-sponsored companies. Fannie Mae FNMA 1.27%

and Freddie Mac FMCC 0.87%

buy loans from originators, secure them and resell them to investors as agency mortgage bonds. Therefore, the economy of many originators is ultimately driven by the volume of loans they produce and sell through Fannie or Freddie. This business model also avoids credit risk and requires less capital, making it attractive to investors.

But selling loans is quite complicated. For anyone else to be interested in buying or negotiating loans negotiated by third parties, many things need to happen to commoditize a 30-year mortgage. The originators sell mainly in standardized sets of mortgages that are organized in groups of half-point interest rates, such as 2.5% or 3%. Investors buy slices of these pools in the form of a securitization.

This fee is not the same as the debtor is paying. A 3% mortgage can end up in a 2% pool. This is because, to further standardize the loan, parts of the interest go to pay for other transformation services. One part is for Fannie or Freddie, to cover their basic cost to secure the mortgage, in addition to various adjustments based on the individual mortgage. Another part is for a servicer, who handles the borrower’s collection and then pays it to investors, tax authorities and so on.

In exchange for this long-lasting flow of fees, employees are at risk. On the one hand, when interest rates fall, more mortgages are refinanced and paid in advance, causing servicers to miss out on these payment flows. Agents also cover some missed payments before a mortgage actually defaults. In an economy where many people are missing payments, this can be detrimental. The increase in payment delays during the pandemic, for example, has severely affected servers.

Originators may also have to use private mortgage insurance if the loan-to-value ratio is too low for a guarantor, perhaps because the borrower is putting less than 20% in value. Borrowers can pay this fee directly or indirectly through a higher mortgage rate.

Even after paying for the service and credit risk, an originator cannot always count on a predictable selling price for each mortgage. Mortgage rates or the relative price between deposits may change during the long closing period, but borrowers like to “block” the rates offered. There is a huge market for future mortgage delivery, known as the TBA market, or “To Be Advertised”, which is used to effectively protect this rate risk for creditors. But it has a cost that can vary according to the duration of protection.

An emerging technology component of the business is using data and analysis to synchronize the rate offered on a mortgage with how it can be covered and sold, explains Vishal Garg, chief executive of Better, a company that owns digital homes. “You can be a much better market participant by combining the demand of the end investor with that of the consumer,” he says. “A traditional loan officer cannot contemplate all scenarios.”

The originators have some natural counterparties that assume the interest rate risk. The demand from investors like mortgage property funds, informed about how cheap they can finance themselves, helps to drive prices up.

A great way to manifest fee risk is the speed with which people pay in advance. This, in turn, can affect what investors are willing to pay because the securities derived from these mortgages have a shorter useful life. So even though originators enjoy the benefits of volume when many people are refinancing, they can earn less by selling mortgages. Of course, when the Federal Reserve is buying mortgage bonds and when the rates on other fixed income assets are so low, the originators’ profits from selling mortgages can remain very high.

Smart investors will understand how changes in the market would affect their portfolios.

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