I just purchased a house. While my wife and I had been planning for this purchase, we also knew that mortgage rates are historically low, so we were eager to lock in these borrowing costs. But a few days ago, I received a letter in the mail stating that Fannie Mae purchased my loan. Our mortgage loan was relatively new, around 45 days. Why was my lender so keen to sell my loan? I had only made one payment to them!

If you’ve had a mortgage, chances are you’ve received the same letter from Fannie Mae (or Fannie’s brother, Freddie Mac). Have you ever wondered why mortgage lenders sell your mortgage? Just who are Fannie and Freddie, anyway? This behind-the-scenes buying of mortgages is key to understanding how mortgage rates are calculated.

Who are Fannie and Freddie?

The Federal National Mortgage Association (FNMA, otherwise known as “Fannie Mae”) was created in 1938 as part of the New Deal. Thirty-two years later, the Federal Home Loan Mortgage Corporation (FHLMC, aka “Freddie Mac”) was born. These companies are government-sponsored enterprises to help the secondary market for mortgages.

When you get a mortgage, you get your loan through the primary market. Lenders in the primary market include banks, credit unions, and wholesale lenders (available through mortgage brokers like Stewardship).

Once your lender loans you the money, they will often turn around and sell that loan in the secondary market—often to Fannie or Freddie. Why? It’s simple. To lend out money for a house, you need A LOT of capital. Being able to originate my loan, collect some fees, and then get fresh capital once they sell my loan ensures the lender maintains liquidity to keep this process going.

My loan was over $300,000. Although I’m paying them back monthly, it will take a lot of time for my lender to recoup enough from me to be able to lend to someone else. Multiply this over hundreds and thousands of customers, and you can see why having a secondary market is vital to a robust mortgage market with lenders who are willing and able to lend.

Mortgage Backed Securities

Here’s where it gets interesting. After Fannie Mae buys my loan, they package it with other similar loans and create a mortgage backed security (MBS). This MBS is sold on the bond market where it can continue to be traded by investors. Payments of principal and interest by the homeowners (like me) are paid to the owners of the MBS. These payments are what determine the coupon rate, or payment, to the investors.

The secondary market and mortgage rates

Let’s say an investor paid $1,000 for an MBS with a coupon rate of 5% ($50 coupon per year). The coupon rate stays the same, but the price can change, which will also change the yield (rate).  

$1,000 with $50 coupon = 5% yield

But sentiment has changed. Investors don’t want a 5% yield anymore and sell mortgage backed securities. Now, the price drops to $800.

$800 with $50 coupon = 6.25% yield

Alas, investors are fickle. They decide they like mortgage backed securities after all and start buying more shares. Now, the price rises to $1,200.

$1,200 with $50 coupon = 4.16% yield

As you can see, as the price of MBS falls, the yield increases. Conversely, as prices rise, rates decrease.

Thus, the secondary mortgage market is the largest driver of mortgage rates on new home loans. Every day, lenders look at the secondary mortgage market to determine where to set rates for new mortgages. For example, if the market shows that MBS are being sold off and rates are rising, lenders will increase their rates for new mortgages.  Suppose “market rates” are 5%, lenders wouldn’t lend at 4%–they would lose money on this deal. 

Lenders react quickly to price changes in the MBS market. Rates can change daily, even multiple times a day, if the MBS market is volatile.

What factors affect the secondary MBS market?

Expected inflation: An investor in a security with a fixed coupon payment (like mortgage backed securities) is especially susceptible to inflation. Coupon payments don’t adjust upward with inflation. If inflation is expected to spike in the future, investors will sell MBS, causing yields on those mortgage backed securities to rise. Thus, mortgage rates on new mortgages will also increase.

Risk aversity: Investors naturally have to find a mix of higher risk assets (like stocks) and lower risk assets (like Treasury bonds and MBS). When investors increase their risk appetite, they sell bonds to buy stocks. This causes yields to rise. When the stock market is falling, investors sell stocks and buy bonds, which causes yields and rates to fall.

The Federal Reserve: No, the Fed lowering short-term rates to near zero doesn’t mean you’ll get a 0% mortgage. However, other Fed actions have a direct effect on mortgage rates. In times of economic shock, the Federal Reserve has enacted quantitative easing—the buying of securities.  Recently, the Fed announced $700 billion would be spent to purchase Treasury bonds and mortgage backed securities. They do this to keep rates low and ensure there is liquidity in the credit markets.

Lock in your mortgage rate

The secondary mortgage market, with help from Fannie Mae and Freddie Mac, are critical to promoting a well-oiled, functioning home loan market. Mortgage backed securities aren’t simply another Wall Street financial product—they are instrumental to providing liquidity to financial institutions so more people can benefit from home ownership.

If you are in the process of obtaining a mortgage—new or refinance—I hope this helps explain how lenders use the secondary market to set their rates.

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