In financial terms, a primary market is where products are sold to the public. For a real estate lender, this refers to “loan origination”. Once a loan is originated on the primary market, it may be sold on the secondary market. The secondary market is where lenders and investors buy and sell existing mortgages or mortgage-backed securities. This frees up money for additional mortgage lending. So, you can think of the secondary market as the “resale marketplace” of loans.
But let’s take a step back. Because if you understand the history, it will help you understand what the secondary market is and why it exists.
Prior to the stock market crash of 1929, most lenders required a down payment of 20 to 40 percent before they would issue a loan to the borrower. If that was still the case today, not many people would ever qualify for a home loan. Basically, you’d need to have a lot of money to access more money. Talk about the rich getting richer!
Not only did lenders require a large down payment, but the loan was a straight note mortgage, which meant they would only pay the interest. The term was typically 1 to 7 years, and at the end of the 7 years, if the borrower could not pay the entire balance, a new loan would be negotiated.
After the stock market crash of 1929, the government needed to stabilize the economy and stimulate the stock market. In 1934, the government introduced FHA-insured loans. The primary purpose of the FHA is to ensure lenders from loss so that the lenders aren’t scared of lending to people with a wider variety of economic backgrounds.
The FHA made it possible for more people to purchase a home. They did this by requiring a smaller down payment and a smaller monthly payment that would be paid back over the course of 30 years. A portion of the payment would be applied to the principal, and the remaining would pay down the interest. This is more like what we’re used to seeing today.
A 30-year fixed-rate mortgage with monthly payments was a new concept in 1934. There was much more risk involved with this new type of lending than only lending to wealthy people with many assets. To reduce the lender’s risk, the FHA required lenders to verify the borrower's employment, have the property appraised by a neutral third party, and have a title search performed. If the government guidelines were met, then the lender would negotiate the loan.
Both the lenders and the government knew that a 30-year loan would present a greater chance of default, so the government insured the loan. They charged the borrower a one-time up-front insurance premium based on the loan amount, and one-half percent annually on the loan balance. If the borrower defaulted on the loan and the loan amount exceeded the price of the property, the FHA would pay the difference.
Great, right? Well…. not so fast.
By 1938, lenders who were offering the FHA-insured loans had a problem. These banks were used to doing loans and getting money back very quickly. Once a loan was repaid, the lender would have money to lend out to a new borrower. But now, with smaller down payments and banks having to wait 30 years to recover the debt, there was not as much money on hand to lend out to new people seeking home loans.
So in 1938, the government created the Federal National Mortgage Association, or Fannie Mae. The purpose of Fannie Mae was to buy FHA-insured mortgages from lenders. This created a secondary marketplace where loans could be re-sold to investors, which provided lenders with fresh money to lend out to new borrowers.
Of course, a loan had to conform to Fannie Mae guidelines before the agency would purchase a loan from a lender. Today, Fannie Mae is a quasi-government agency that is privately owned, and Fannie Mae stock may be purchased on the New York Stock Exchange. Fannie Mae buys mortgages on the secondary market, pools them together, and sells them back as mortgage securities to investors on the open market. Monthly principal and interest payments are guaranteed by Fannie Mae, but not by the US government.
In 1968, Fannie Mae was split, and the Government National Mortgage Association, or Ginnie Mae, was created. Ginnie Mae is a federally-owned corporation of the Department of Housing and Urban Development. Ginnie Mae administers special assistance programs, and its main focus is to ensure liquidity for US government-insured mortgages, including those insured by the FHA and VA.
Agencies like these keep the secondary market going, and the secondary market keeps the housing market going. Knowing a little about how the secondary market works will help when it’s time for your exam!
And if you do not remember anything else, just remember the secondary market is the resale marketplace.