The Olden Days
In the “olden” days, when someone wanted a home loan they walked downtown to the neighborhood bank or savings & loan. If the bank had extra funds laying around and considered you a good credit risk, they would lend you the money from their own funds.
It doesn’t generally work like that anymore. Most of the money for home loans comes from three major institutions:
- Fannie Mae (FNMA – Federal National Mortgage Association)
- Freddie Mac (FHLMC – Federal Home Loan Mortgage Corporation)
- Ginnie Mae (GNMA – Government National Mortgage Association).
This is how it works now:
You talk to practically any lender and apply for a loan. They do all the processing and verifications and finally, you own the house and now you have a home loan and you make mortgage payments. You might be making payments to the company who originated your loan, or your loan might have been transferred to another institution.
The company you make your payments to very rarely owns your loan. They are the “servicer” of your mortgage. They are called the servicer because they are simply “servicing” your loan for the institution that does own it.
You see, what happens behind the scenes is that your loan got packaged into a “pool” with a lot of other loans and sold off to one of the three institutions listed above. The servicer of your loan gets a monthly fee from the investor for processing payments and taking care of your loan. This fee is usually only 3/8ths of a percent or so, but the amount adds up. There are companies that service over billions of dollars of home loans. Three-eighths of a percent on a billion dollars is a tidy income.
In fact, mortgage servicing is where lenders make the real money. The entire system of originating mortgages, including wholesale lenders, mortgage brokers and mortgage bankers is designed so that servicers get loans into their portfolio — hopefully at a “break even” level — but often at a loss. Mortgage servicing is where they make their profit.
Once your loan has been packaged into a pool and sold to Fannie Mae, Freddie Mac, or Ginnie Mae, the lender gets additional funds so they can make more loans (to service in their portfolio) and sell to those institutions, so they can get more money, and so on….
This is the cycle that allows institutions to lend you money.
Mortgage Backed Securities
Once Freddie Mac, Ginnie Mae, and Fannie purchase the pools, they break them down into smaller ownership parcels. These are called “mortgage backed securities.” Each security represents a small ownership interest, not in your specific loan, but in the pool of which your loan is only one part. The risk is therefore diversified and it is a very safe investment.
The mortgage backed securities are sold on Wall Street to institutions or individuals looking for a safe investment, but one that earns a higher interest rate than treasury bonds. You may even own some as part of your retirement fund or investment portfolio. Perhaps you have heard of Ginnie Mae bonds? Those are securities backed by the mortgages on FHA and VA loans.
By selling the bonds, Ginnie Mae, Freddie Mac, and Fannie Mae obtain new funds to buy new pools so lenders can get more money to lend to new borrowers.
And that is how the cycle works
So when you make your payment, the servicer gets to keep their tiny part, and the majority is passed on to the investor. Then the investor passes on the majority of it to the individual or institutional investor in the mortgage backed securities.
From time to time your loan may be transferred from the company where you have been making your payment to another company. They aren’t selling your loan again, just the right to service your loan.
There are exceptions
Loans above $625,500 do not conform to Fannie Mae and Freddie Mac guidelines, which is why they are called “non-conforming” loans, or “jumbo” loans. These loans are packaged into different pools and sold to different investors, not Freddie Mac or Fannie Mae. Then they are securitized and for the most part, sold as mortgage backed securities as well.
This buying and selling of mortgages and mortgage backed securities is called “mortgage banking,” and it is the backbone of the mortgage business.