Mortgage Loans: A Look Behind the Scenes - The Mortgage Originator, Aggregator, Securities Dealer & the Investor

(April 14th, 2008)

To investors, a mortgage loan is a source of future cash flows or incoming payments from borrowers. These cash flows are freely traded on the secondary mortgage market where they are bought, sold, stripped and securitized. A secondary mortgage market is where mortgage originators such as banks and lenders trade with mortgage securitizers (like Fannie Mae and Freddie Mac) and other investors. In this article, we will explain how a borrower's monthly payment ends up with many different investors holding mortgage-backed-securities (MBS), collaterized debt obligations (CDO) or collaterized mortgage obligations (CMO).

There are 4 main participants in a mortgage transaction; the mortgage originator, the aggregator, the securities dealer and the investor.

1) The Mortgage Originator

The mortgage originator is the first company with which a borrower does business. Examples of mortgage originators include banks, mortgage brokers and bankers. The difference between banks & mortgage brokers is that banks use their own money to close the mortgages, while mortgage brokers act as a source of connection between the borrowers & the banks. The difference between banks & mortgage bankers is that mortgage bankers use a 'warehouse line of credit' to fund loans and then sell these newly originated loans to investors in the secondary market.

Many banks prefer to aggregate or accumulate mortgages for a period of time before selling them on the secondary market as a whole. Other banks prefer to sell each mortgage individually as soon as they are originated. This is done so as to eliminate risk; because as soon as a bank locks in a specific interest rate for a borrower, it is taking on a great risk. While interest rates on the market may have moved higher, the bank is locked in at a lower interest rate thus not allowing it to make more money. In order to avoid this, some banks hedge the interest rate on their mortgages sold so as to avoid interest rate fluctuations. Mortgage originators make money via the closing costs that are charged to originate a loan + the interest rate differentials between what the borrower locks in and the premium that secondary market investors will pay.

2) The Aggregator

The Aggregator is the second participant in the secondary markets. Examples of an aggregator include large mortgage originators affiliated with the Federal government and Wall Street. They are Fannie Mae and Freddie Mac. Aggregators purchase newly originated mortgages from smaller originators (such as mortgage bankers & the banks) and together with their own originations securitize their investments into private mortgage-backed securities.

Just like originators, aggregators must hedge their mortgages from the time they purchase a mortgage, through the securitization process until it is sold to a securities dealer. They make money by adding a markup in the price they pay for mortgages and the price at which they can sell the mortgages to securities dealers'

3) Securities Dealers

After a mortgage-backed-security (MBS) has been created, it is sold to a securities dealer who then sells to investors. Many Wall Street brokerage firms have special trading desks with securities dealers who create all sorts of deals with their MBS including collaterized debt obligations (CDO) or collaterized mortgage obligations (CMO). Some of these CDOs or CMOs have AAA credit ratings compared to the underlying MBS loans. Dealers make a profit by adding a markup on their mortgage backed securities before selling to investors.

4) Investors

Investors are the final buyers of mortgage-backed-securities. They are insurance companies, pension funds, hedge funds such as Bear Stearns, foreign governments and some mutual funds. Collaterized mortgage & debt obligations sold to investors offer a higher yield potential based on the quality of credit and risks of interest rates.

From the time a bank originates a mortgage loan, it is cut, sliced & traded and can become part of a Collaterized Mortgage Obligation (CMO) or a Collaterized Debt Obligation (CDO). The end user of the mortgage can be a hedge fund that will take advantage of interest rate fluctuations to leverage their investments, or it might be a a foreign country bank that likes the AAA credit rating. Because the secondary mortgage market is huge with many Wall Street firms, government agencies & banks, the mortgage loan you borrow is cut and traded amongst tons of different parties.

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