Thursday, January 28, 2021
Home Economy How American Mortgage Machine Works

How American Mortgage Machine Works

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Every family needs a home, and so do the many risks created by the 30-year mortgage that is standard in America.

Finding an investor to take each of those risks is a job of the Rube Goldberg contraption that is the U.S. housing-finance industry. Investors who don’t understand how it all fits together might one day find themselves scrambling for shelter.

This is part of the Heard Explainer series providing our columnists’ insight on economic and business topics in the news.

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

One major reason is the U.S. housing market’s unique system of taxpayer support, via the government-sponsored enterprises.
Fannie Mae
and
Freddie Mac
buy loans from originators, guarantee them and resell them to investors as agency mortgage securities. So in turn, many originators’ economics are ultimately driven by the volume of loans they produce and sell via Fannie or Freddie. This business model also avoids lending risk and requires less capital, making it appealing to investors.

But selling loans is rather complicated. To get anyone else interested in buying or trading loans negotiated by third parties, a lot of things need to happen to commoditize a 30-year mortgage. Originators primarily sell into standardized pools of mortgages that are organized into half-point buckets of interest rates, like 2.5% or 3%. Investors buy slices of these pools in the form of a securitization.

That rate isn’t the same as what the borrower is paying. A 3% mortgage might end up in a 2% pool. That’s because to further standardize the loan, parts of the interest go to pay for other transformation services. One portion is for Fannie or Freddie, to cover their base cost to guarantee the mortgage, plus various adjustments based on the individual mortgage. Another chunk is for a servicer, which handles collection from the borrower then pays out to investors, tax authorities and so on.

In exchange for this long-lasting stream of fees, servicers bear certain risks. For one, when interest rates drop, more mortgages are refinanced and prepaid early, causing servicers to lose those payment streams. Servicers also cover some missed payments before a mortgage actually defaults. In an economy where lots of people are missing payments, that can bite. The surge in payment deferrals during the pandemic, for example, fell hard on servicers.

Originators might 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% down. Borrowers can pay this fee directly, or indirectly through a higher mortgage rate.

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Even after paying for servicing and credit risk, an originator still can’t always count on a predictable sale price for each mortgage. Mortgage rates or the relative pricing between buckets might move during the long closing period, but borrowers like “locks” on offered rates. There is a huge market for future delivery of mortgages, known as the TBA market, or “To Be Announced,” which is used to effectively hedge that rate risk for lenders. But it carries a cost that can vary with how long the protection lasts.

An emerging technology component of the business is using data and analytics to sync up the rate offered on a mortgage with how it might be hedged and sold, explains

Vishal Garg,
chief executive of Better, a digital homeownership company. “You can be a much better market participant by matching end-investor demand to the consumer,” he says. “A traditional loan officer can’t contemplate all the scenarios.”

Originators have some natural counterparties that take on interest-rate risk. Demand from investors like mortgage real-estate investment trusts, informed by how cheaply they can fund themselves, helps drive pricing.

A big way rate risk manifests is that speed at which people prepay. This in turn can affect what investors are willing to pay, because securities derived from those mortgages essentially become shorter-lived. So even as originators enjoy the benefits of volume when lots of people are refinancing, they might earn less when selling mortgages. Of course, when the Federal Reserve is buying mortgage securities, and when rates on other fixed-income assets are so low, originators’ profits selling mortgages can remain quite large.

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

Write to Telis Demos at telis.demos@wsj.com