The mortgage industry in the United States is broken into two parts. There is the Primary Market and the Secondary Market.
Why are there two markets?
What purpose is served by having two markets?
Who is served by
Let's start with what is a mortgage.
A mortgage is a loan which is secured by some specified real estate as a collateral. In this, the borrower receives upfront payment and agrees to make a predetermined series of payments to the lender over the term of the loan.
There are 3 types of cash flows involved here:
1) Interest on the outstanding principle
2) Payment of principal as per the mortgage schedule
3) Prepayment of principal - This is repaying the principal over
and above the scheduled amount
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Types of Mortgage Markets:
Primary Mortgage market:
This is where a loan (mortgage) is originated. In this market a borrower is obtaining some form of mortgage from a primary lender.
Primary lenders are -
Who is served by Primary market:
Primary market is for average consumers. This is the place a consumer will go to when he/she wants to borrow money for the purchase of a house/real estate. Primary lenders in this market will help these borrowers with information regarding various options available and viability.
Some of the benefits are:
-> Low cost associated with loan
-> Flexibility and convenience
-> Smaller down payment required
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Secondary Mortgage Market:
Mortgages which are originated by primary lenders are aggregated and then sold in this market.
When a person takes a loan, it is processed, funded as well as serviced by a bank. In this bank is using it's own funds which means it's capital is tied up and hence ability to make more loans is reduced for the duration of the mortgage. That's why they will sell these loans in the secondary markets. This way they get back the funds which can be utilised again to make more loans. Benefit to primary lender: Capital freed to issue more loans
Most of the times, this portfolio of loans is sold to an aggregator. An aggregator will purchase the individual mortgages and then pool the similar securities to create MBS. Aggregator makes money by way of purchasing at a lower price and selling at premium. Benefit to Aggregator: Profit by buying low and selling at a premium
Investors in the market- Investors are Insurance companies, Pension funds, etc. They can invest for a longer term. An MBS securities has an underlying of mortgages which are grouped together. An individual loan may have issues reg nonpayment causing risks but when there is a portfolio, this risk gets diversified.
These MBS securities are provided ratings, and based on the risk and rating, various competitive rates are offered. Investors can chose to invest as per their risk /return objective.
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