Where Does Mortgage Money Come From?

Have you ever asked yourself where does Mortgage Money come from? How come that there seems to be un unlimited amount of funds for Mortgages?

If most mortgages take 30 years to get repaid, who sits around and waits to get paid off?

How does this impact you and your ability to obtain an affordable mortgage to either buy a home or business property? 

Before 1930, the process of buying homes in the United States was quite different from today.

Homebuyers typically relied on short-term loans, often lasting 3 to 7 years. These loans required large down payments, often around 50% of the property's value, with a big payment due at the end of the term. 

Then, when it became due, you either saved enough during the 7 years to pay off the balance at the end, called a "balloon" payment or you had to take another 5 to 7 years loan.

Balloon payments are called such because they involve a large, "inflated" final payment at the end of a loan term, similar to how a balloon expands.

Because Balloon Payments are difficult to pay off and there is no guarantee you would qualify for another loan at the time of their repayment, today Federal Law forbids them when lending on a primary residence. 

When the Great Depression hit, most people did not have any savings and the real estate market imploded. People could not afford to pay their 7 years mortgage and the Banks did not know what to do.

In an effort to solve this national problem, Marriner S. Eccles, Chairman of the Federal Reserve from 1934 to 1948, developed the foundational concepts that led to the creation of a secondary mortgage market in the 1930s. 

Secondary Market means that instead of the Bank having to wait 3 to 7 years to get repaid, they could now sell the mortgage to someone else, make a profit AND recoup the funds to lend on a new mortgage!  

This means the financial institution did not need to wait anymore! they could sell their mortgages as fast as they could create them.

This lead to the creation of the the Federal National Mortgage Association (FNMA), a.k.a. Fannie Mae in 1938 and later in 1970 to the creation of the Federal Home Loan Mortgage Corporation (FHLMC) a.k.a Freddie Mac.

But who has such deep pockets to be able to buy mortgages as fast as they are originated and wait for 30 years?

The Bond Market!

What is that? 

The word Bond means:

"An Agreement with Legal Force," "a certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time."

When you buy a bond, you are essentially lending money to the issuer (creator of the bond) in exchange for periodic interest payments and the return of the bond's face value (the value that is written on the bond) at maturity. 

The bond market is crucial for providing long-term funding and is considered more stable compared to the stock market.

But who buys these bonds?

Pension Funds, Life Insurance Companies, Foreign Central Banks, other Banks, Mega Private Investors and more...

Here is an example of the typical Investments of a Life Insurance Company in the USA:

Notice that Long Term Bonds and Mortgages (which are also Bonds) account for 80% of their investments. Also notice that Stocks are a mere 2.2%.

Big Banks, Institutional Money, Foreign Governments, Insurance Companies, etc... invest the majority of their holdings into Bonds! 

There is an Ocean of Money going into Bonds.

Traditionally, the size of the Bond Market has been many times that of the Stock Market. 

Even though Mortgages are written for 30 years, they have become tradeable financial instruments that are bought and sold on a daily basis by Big Mega Money.

The United States in my opinion leads the world in this area of finance.

This is why in the US you are able to obtain a mortgage relatively in the cheap, and you have so many options to choose from. 

In my native country of Chile it not like that at all, nor is it like this in Europe.  

It may not seem this way to many people at the moment, but when it comes to buying a home, the USA is still the land of opportunity compared to the rest of the world! 

As of this writing, there is an incredible opportunity to still get a mortgage at a low rate.

Have a look at this Bond Chart for the 30-year Mortgage Backed Security (MBS), offering to pay 4.5% per year (to the investor who buys it):

Mortgage Backed Securities are traded and quoted in terms of a percentage.

This means that an MBS trading at 100%, investors are willing to pay its full face value. If the MBS has a value of $10 million, the investor is willing to pay $10 million. 

If it trades, as in the above chart at 97.91%, this means investors are willing to buy the MBS for slightly less than its face value, in this case at 2.09 percentage points less.

In the case of a MBS with a face value of $10 million this means the investor would be willing to pay $9,791,000. 

This is because this particular MBS pays 4.5% per year in interest, and the market wants a higher rate of return than just 4.5%.

If they pay less than 100%, when the bond matures, they will get 2.09% more ($209,000) and that, according to market forces, makes up for the difference between what the Bond is offering to pay and what the market desires to get.

But, how does the Bond Market relate to the Mortgage Market?

In this way:

The Servicer, which is the company that is going to manage your mortgage and collect payments, roughly gets paid 0.5% of the interest rate per year. Additionally, Fannie Mae or Freddy Mac, who create the MBS by a process called Securitization (this means collecting many mortgages and packaging them into one MBS) get another 0.5% per year.

Roughly, if a Mega Money Investor buys the MBS offering to pay 4.5% per year, by the time the Bank gives a mortgage to you as the “consumer,” you would be paying a rate of 5.5%.

In essence, by adding 1% to the MBS, you can estimate where Mortgage Rates sit at on any given day.

One more thing: if you look at the Bond Chart, you will notice that the price of this Bond is going UP.

This means Mega Money Investors are hungry and want to buy MORE of these MBSes.

Because they want to buy MORE, then the issuers of these MBSes need to create more mortgages to sell.

In order to create more MBSes, or to have more "product" to sell to the Mega Investors, the issuers need to entice the public to get a mortgage.

Without the public getting a mortgage, the issuers (Fannie Mae, Freddie Mac) don't have a product to sell.

So...if Mega Investors are hungry and want to buy more and you can see their willingness to buy more because they are starting to pay more for the MBS, in order to increase supply, Fannie Mae and Freddy Mac will DECREASE mortgage rates to entice more people to get a mortgage!

And this is how we get to the rule that "if mortgage bonds go up, rates come down."

In other words, the Investors are the DEMAND side when it comes to Mortgages, and the Issuers are the SUPPLY side.

But wait a minute! What about the Federal Reserve? Aren't they the ones who fix mortgage rates? Nope. 

But, isn't that what the press relentlessly announces day in and day out? Yes.

The influence of the Federal Reserve is indirect. By increasing their rates they may make Government Bonds more attractive than MBSes and decrease their demand. This may in turn force the Issuers of MBSes to increase mortgage rates to now entice Investors to buy their MBS.

On the flip side, if the Federal Reserve decreases their rate, this may now make the MBS more attractive, therefore increasing demand for MBSes, and therefore the Issuers would lower mortgage rates to entice the public to get a mortgage so they would have more "product" to sell the MBS investors.  

So that is an indirect influence. Ultimately, many economists believe that the Federal Reserve cannot completely control the market. External factors, such as large war expenditures and government waste could through a wrench in the works in the long term.

Many economists believe that we are in a long-term uptrend in interest rates, and right now we are experiencing a temporary low.

If you are interested in finding out more or would like to take advantage of the low in interest rates we are experiencing right now, don't hesitate to call or write.

You can also self-schedule a Free Brainstorming Consultation here.