The availability of resources in the primary market is highly dependent on the existence of secondary markets. First, mortgage funds are loaned to a home buyer by a primary market lending institution. The mortgage is then sold to a secondary market agency that can in turn sell it to other investors in the form of mortgage-backed securities. Mortgage-backed securities fall into two general types: bond-type securities and revolving securities. Bond-type securities are long-term, pay interest semi-annually and provide repayment on a specified date. Pass-through securities, which are more common, pay interest and principal on a monthly basis. Some types of pass-through securities pay even if payments are not collected from the borrower.
Because a primary lender has sold the mortgage, the lender can take the money it receives from the sale and issue a new mortgage loan, then sell that new loan to the secondary market and continue the cycle. The secondary market agency can bundle the mortgages it buys to create mortgage-backed securities, which they then sell to investors. Since the agency sells the mortgage-backed securities to investors in the secondary market, it now has more money to buy more mortgages. It can then create more mortgage-backed safety pools to sell back to investors, and the cycle continues.
The market can function as it does because standardized underwriting criteria are used to qualify borrowers and real estate. A mortgage is purchased by the secondary market only if the primary market lender meets the secondary market's underwriting standards. Since lenders want to sell their loans, they must follow the underwriting standards of those agencies. The three largest secondary market agencies are Fannie Mae, Freddie Mac, and Ginnie Mae. Therefore, a conforming loan is typically one that meets Fannie Mae's underwriting guidelines. Private companies such as hedge funds and investment banks also participate in the flow of mortgage funds by purchasing mortgage-backed securities. The recent credit crisis and economic recession were partly due to the buying and selling of mortgage-backed securities. Investors borrowed incredible amounts of money and leveraged such leverage that when the value of mortgage-backed securities fell, it was enough to create massive liquidity problems for the companies and many went bankrupt (Bear Stearns, Merrill Lynch, etc.). Unfortunately, many of the same dynamics that caused the financial collapse are still at work. The secondary market still exists with Fannie Mae (infused with tax dollars) now buying up to 99% of all loans from the United States.
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