Why are Loans Sold?

What happens to a loan that is sold to a different institution? Why are loans sold?

1 Answer

When a loan is sold from one bank to another nothing changes about the loan other than who the owner is, and where you will make your payment. The terms of the loan remain that same, so things like payment amount, payment date, interest rate, remaining term, etc all stay the same. The new lender is purchasing a fixed asset that already has specified terms so they have no right to change the terms of your loan.

As for why loans get sold there are a number of reasons. Sometimes they are sold right after origination, sometimes they are sold after they are already an established, seasoned loan.

Loans Sold Directly After Origination

Sometimes loans are sold shortly after they are closed. When this is the case it is normally because the originating lender does not service their loans. Sometimes loans are sold twice within a short period after origination; this is normally the case when a mortgage banker sells to a pass-through. I get into that in a minute.

When a loan is sold after closing, it is done because the lender who loaned you money at closing is not intending to service the loan. Often this is the case with a mortgage banker. A mortgage banker by definition is a mortgage lender who loans money but does not have the capacity to accept deposits. Most true banks that lend fund their loans via the deposits they take in. A "mortgage banker" has the ability to lend, but not to take in deposits. Because of this, they normally fund from 1 or 2 sources. They can either fund from "warehouse lines" or self fund. A warehouse line is a line of credit the banker has, specifically in place to fund loans. A self funding banker would fund from an account where they have their own funds. Either of these solutions however are short term funding for a long term asset.

Think of it this way, a banker may have a line of credit for typically somewhere between 3 million and 250 million dollars or so, depending on their size. If they are closing $5 million a month in loans, and they have $5 million available on a line of credit, what happens at the end of the month? They have to sell the loans on their line of credit, or else they can't fund any more loans because they don't have any available credit. Because of this bankers sell loans as quickly as possible after closing. A good banker, in normal times can turn their warehouse line 3 times a month. This means that with $5 million in credit, they can fund $15 million in loans. Currently, with the more difficult credit markets, bankers are turning their lines much slowly, possibly as slow as once a month.

In the above case, a banker would write your loan and fund it (lend you the money), then sell the loan to a company that services loans, typically a depository bank. You then make payments to this lender.

A second option is that the originating banker sells the loan to a pass-through mortgage lender. This is a very similar process, on a larger scale. The pass-through lender exists to buy completed loans (rather than writing them themselves), but does not have the monetary capacity to take in an unlimited amount of loans, so when they get them they then sell to a servicing lender. In this example your loan would be sold twice, normally within the first few months of closing. The reason this may happen is that the pass-through lender is offering lower rates to the originating banker, so the banker chooses the pass-through to send the loan to, in order to get a better deal for the client.

Loans Sold Well After Being Originated

Loans may also be sold well after origination. The reason for this is normally altogether different. Let’s say that a bank has a portfolio of loans, worth a face value of $300 million. Each month the bank makes a little money when all the borrowers make their payments. The payments provide a steady source of cash flow to the bank, as well as earning the bank more interest than what they are paying out on deposits. This is the basic function of a bank, maintain a spread between loans and deposits, and operate profitably within that spread. Let’s say that this bank however wants to expand, maybe to buy a smaller bank, or to open new branches, etc. They may not have the money to do that. You can't use someone’s deposits to buy a new bank, you may use retained profits, but you can't just use the funds from Mr. Smith's checking account to fund your growth, because what happens if Mr. Smith wants to close his account?

The way the bank grows is by selling assets, in this case mortgage loans. They can sacrifice the future interest and steady cash flow of those loans for immediate money by selling the loans to another bank. In this way, let’s say they sell the $300 million in loans, they now have the cash needed to expand, and you the borrower have to make your payment to the new bank. Similarly, on the other side of the coin, a bank may choose to purchase loans exchanging immediate cash for future steady income and profits.

Lastly, loans may be sold after origination because a bank has defaulted. In the case of an FDIC default, if the FDIC cannot find another bank to buy the failed institution, they will go in and begin selling off assets from the defaulted bank. Just like a bankruptcy, assets are sold to repay creditors. The assets of a bank are its loans, so the defaulted bank, via the FDIC will sell their loans to another bank.

There are certainly other reasons that a loan may be sold, but the vast majority of loans being sold fall into one of the above categories.