October 7, 1999,
revised April 2, 2003
"In a recent column
you said that there was no serious downside to borrowers from having their
loans sold, but you didn't point to any upside to the practice,
either�Don't loan sales raise costs, and don't borrowers end up paying
all the costs?"
True, loan
sales involve transaction costs, which ultimately must be borne by
borrowers. But these transactions costs are more than offset by the
greater competition and reductions in other mortgage costs that result
from secondary markets.
Largely because of secondary
markets, a knowledgeable and creditworthy home-buyer in the US pays a rate
only modestly higher than that charged to the US Government. The rate
spread between home mortgages and Government bonds is lower in the US than
anywhere else in the world, with the possible exception of the UK and
Denmark, which also have secondary mortgage markets.
Secondary mortgage markets are of
two general types. "Whole-loan" markets involve the sale of
mortgages themselves, sometimes on a loan-by-loan basis but more often in
blocks. Such markets, which arose in the US soon after World War II,
primarily involve the one-time sale of newly originated mortgages to
traditional mortgage lenders.
In the 1970s, markets also
developed in mortgage-backed securities issued against pools of mortgages.
Instead of selling, e.g., $50 million of whole loans, the loans are
segregated in a pool and $50 million of securities are issued against the
pool. These securities are actively traded after the initial issuance, and
they are attractive to investors that would not ordinarily hold mortgages,
such as pension funds or mutual funds.
Secondary markets reduce mortgage
interest rates in several ways. First, they increase competition by
encouraging the development of a new industry of loan originators. Called
different names in different countries (in the US they are called
"mortgage companies" or "mortgage banks"), they all
have in common that they require little capital and tend to be aggressive
competitors
Absent secondary markets, the only
institutions originating mortgage loans are those with the capacity to
hold them permanently, termed "portfolio lenders". In small
communities especially, borrowers may be at the mercy of one or a few
local banks or savings and loan associations. The entry of mortgage
companies who can sell into the secondary market breaks up these local
fiefdoms, much to the benefit of borrowers. The development of whole loan
markets in the US is largely responsible for the growth of this industry.
Secondary markets also increase
efficiency by encouraging a specialization of lending functions that
reduces costs. Portfolio lenders typically do everything connected to
originating and servicing loans, even though they may do some things quite
inefficiently. Secondary markets, in contrast, create pressures to break
functions apart and price them separately, and this imposes a discipline
on mortgage companies to concentrate on what they do best. Many mortgage
companies have ceased servicing loans, for example, because they can do
better selling the servicing to companies who specialize in that function.
In addition, conversion of
mortgages into mortgage-backed securities permits a better distribution of
the risk of holding fixed-rate mortgages. Historically, depository
institutions were well positioned to originate mortgage loans but if the
loans were long-term and had fixed-rates, they were not well positioned to
hold them because their deposits were short-term. Many pension funds, in
contrast, were well positioned to hold long-term investments but were not
equipped to originate and service mortgages. The development of markets in
mortgage-backed securities eliminated this impasse.
Mortgage-backed securities also
are "liquid" while mortgages themselves are not. This means that
in most cases mortgage-backed securities can be sold for full value within
the day whereas selling the same amount of mortgages would take 4 to 8
weeks. Because most investors value liquidity and are willing to accept a
lower yield to get it, converting illiquid mortgages to liquid securities
puts downward pressure on the rates charged to borrowers.
In addition to generating downward
pressures on mortgage interest costs, secondary markets also tend to
eliminate regional rate differences. At the turn of the century, the
Census of Housing showed mortgage rates to be about 2% higher in the
western states than in the east. By the 1950s, however, the differential
was down to 1/4%, largely because of the development of secondary markets.
Today, regional differentials are negligible.
Secondary markets have also vastly
expanded the size of the borrower pool. Portfolio lenders generally
restrict their loans to "A-quality" borrowers, in large part
because of regulatory concerns about their safety and soundness. Secondary
markets, in contrast, can access investors who are prepared to hold risky
loans if the price is right. The result has been the emergence of the
so-called "subprime market" and a new category of borrowers from
institutions -- borrowers who previously had recourse only to family,
friends, home sellers and loan sharks.
