Depository vs. Secondary Market Mortgage Financing Systems

What is the difference between depository based and secondary market based mortgage financing system?

3 Answers

The main difference in this case is that a 'depository based' origination is what is commonly referred to as a 'portfolio loan', as compared to a secondary market based origination, which would be classified as a salable loan. Here's the details:

A secondary market based originationis a loan that is originated to a specific set of guidelines so that it may be sold at a later date on the secondary market. The secondary market, is simply a way that whole loans, or pools of loans, that have already been originated and closed can be sold between lenders or investors. It is 'secondary' because the loan is already originated. The market that exists between loan officers and borrowers is considered the 'primary market', in this market loans are originated.

As for the reason why a loan would be taken this direction, let's use an example. The numbers are much greater, but lets say that I am a bank than has $10 million available to lend. Let's say that the average loan amount in my area is $200,000. If I lend $200,000 to 50 people, I have lent all of my money. I then have to wait each month for payments to roll in, to begin to recoup my $10 million, plus the interest I lent at. I cannot loan to anyone new because I don't have the money to do so. Should someone default on their loan, I have then lost that entire $200,000 or whatever they owed at the time.

This is the way lending used to work, before the secondary market existed. The problem with this is that it is very limited.

  • I can only lend as much money as I've brought in, then I must wait for a long period of time to recover the money that I've lent.

  • My risk for lending tends to be greater because I eat the entire loss of a bad loan.

  • My credit qualifying guidelines must be incredibly high because I risk all of my own money in lending.

  • If my money was truly 'depository based', I must maintain my deposit levels at all times. If my customers want to withdraw funds from my bank, but I've lent almost all of it out, I could be in trouble. Think 'It's a wonderful life'. When everyone tries to withdraw money, but I've lent their money out long term, I either have to begin calling notes due, or I become insolvent and must close.

In a secondary market based origination (think Fannie Mae and Freddie Mac), if I am a bank with $10 million to lend, I can lend to many more people. As long as I follow Fannie and Freddie's rules I can sell the loan to them after closing. I will retain the customer, collect their payments, send them statements etc, but when the payment comes in I send it to Fannie Mae. Minus a small piece for my servicing that is. To go back to the previous example, let's assume all my loans are salable to Fannie Mae because they meet Fannie's requirements. I can lend $200,000 to 50 people, and then turn around and sell those loans to Fannie. I give them the loans, they give me my $10 million back and I can go find 50 more people to lend to.

At this point you should be asking yourself, how can Fannie Mae do this? Do they have an unlimited supply of money? The answer is this: They 'securitize' the loans. That means that they take hundreds of similar loans and put them into a package. This package is called a Mortgage Backed Security. It's an investment (a security) backed by mortgage loans. They can then sell this investment, let's say it's $100 million, to investors. Pension funds, private individuals, etc may invest money in this mortgage backed security, which frees Fannie Maes money up to go back to banks and buy more loans.

Once the process is complete it works this way: Joe Borrower goes into his bank and makes his house payment. The bank takes out their servicing premium, and passes the rest of the money to Fannie Mae. Fannie will take a small premium out and disburse the remaining money to the investors of it's mortgage backed security. This way of lending, allows 'liquidity' in the mortgage market as opposed to deposit based portfolio origination. As long as underwriting standards are held high enough, this system has proven over time to be a very efficient system to both borrow and lend.

The difference is that a depository system would use funds held at a bank.  Typically a bank would use its own funds to lend and then hold that loan instrument in its bank lending portfolio.  Banks are limited as to the amount of money they can lend.  This is based upon their capital and is governed under federal banking laws as well as being sometimes regulated by individual states. 

A secondary market system is truly a "pass through "systemthat allows lenders to write a mortgage and then sell the closed loan in a security.  This system creates liquidity and allows for an almost "endless supply of mortgage money as there is usually a buyer and seller available in the marketplace on any given day. 

In today's (Jan 2009) secondary market system,  you are experiencing a lack of buyers for some loans and thus, that is why guidelines have tightened and the liquidity for some loans has all but vanished.  Your local bank that does not sell its mortgage loans would be considered a "depository lender."  Your major bank and large and small mortgage lender would typically fall into the classification of a secondary market based lender.  I hope this answers your question.

Loans made under a depository system are made with rates based largely on a bank's cost of capital (deposit rates) and a banks assessment of the loan risk. In a secondary market system, rates are driven primarily by three factors, product liquidity, overall level of interest rates quality of the loan seller/lender.

Further, in a depository system, loans can be made in a much more personal e.g. heterogeneous manner. Under a secondary marketing system, loans are created to be sold against general loan sale/securitization loan standards. So, the depository system offers much more in the way of loan guidelines flexibility.