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Markets in which mortgages or mortgage-backed securities are bought and sold. 'Whole Loan' Markets Versus Securities Markets: Secondary mortgage markets are of two general types. 'Whole loan' markets involve the sale of mortgages themselves, sometimes on a loan-by-loan basis but more often in blocks. Such markets, which arose in the U.S. soon after World War II, primarily involve the one-time sale of newly originated mortgages to traditional mortgage lenders. In the 1970s, markets also developed in mortgage-backed securities issued against pools of mortgages. Instead of selling, e.g., $50 million of whole loans, the loans are segregated in a pool and $50 million of securities are issued against the pool. These securities are actively traded after the initial issuance, and they are attractive to investors that would not ordinarily hold mortgages, such as pension funds or mutual funds. Mortgage-backed securities always have some kind of 'credit enhancement,' or guarantees of payment beyond the promises of the individual mortgage borrowers. The most important of the guarantors are Ginny Mae, Fanny Mae, and Freddie Mac. Impact on Interest Rates: Secondary markets reduce mortgage interest rates in several ways. First, they increase competition by encouraging the development of a new industry of loan originators. Called different names in different countries (in the U.S. they are called 'mortgage companies' or 'mortgage banks'), they all have in common that they require little capital and tend to be aggressive competitors. Absent secondary markets, the only institutions originating mortgage loans are those with the capacity to hold them permanently, termed 'portfolio lenders.' In small communities especially, borrowers may be at the mercy of one or a few local banks or savings and loan associations. The entry of mortgage companies that can sell into the secondary market breaks up these local fiefdoms, much to the benefit of borrowers. The development of whole loan markets in the U.S. is largely responsible for the growth of this industry. Secondary markets also increase efficiency by encouraging a specialization of lending functions that reduces costs. Portfolio lenders typically do everything connected to originating and servicing loans, even though they may do some things quite inefficiently. Secondary markets, in contrast, create pressures to break functions apart and price them separately, and this imposes a discipline on mortgage companies to concentrate on what they do best. Many mortgage companies have ceased servicing loans, for example, because they can do better selling the servicing to companies that specialize in that function. In addition, conversion of mortgages into mortgage-backed securities permits a better distribution of the risk of holding fixed-rate mortgages (FRM's). As one example, depository institutions don't want to take the risk of funding long-term assets with short-term liabilities. But they can originate FRM's, convert them to securities, and sell the securities to pension funds, which have long-term liabilities. Mortgage-backed securities also are 'liquid' while mortgages themselves are not. This means that in most cases mortgage-backed securities can be sold for full value within the day whereas selling the same amount of mortgages could take weeks. Because most investors value liquidity and are willing to accept a lower yield to get it, converting liquid mortgages to liquid securities puts downward pressure on the rates charged to borrowers. Shopping Complexities: The downside of secondary markets from a borrower's perspective is that shopping for a mortgage becomes more complex. The secondary market is largely responsible for market nichification, which makes it difficult for a borrower to determine whether a price quote applies to his or her particular deal, and price volatility, which makes it risky to compare a price quote on Monday with one from another loan provider on Tuesday. Nichification and volatility underlie several common scams perpetrated on borrowers by loan providers. Ginny Mae: The mortgage-backed security market was begun in 1970 by Ginny Mae, a wholly-owned agency of the federal government. The agency guaranteed the payments on securities issued by lenders against pools of FHA and VA mortgages. Fannie Mae and Freddie Mac: These firms are 'government-sponsored enterprises' (GSE's), which means that they are privately owned, but receive support from the federal government and assume some public responsibilities. Operations: The GSEs purchase 'conforming' mortgages from the lenders that originate them. They hold some, which are funded by issuance of debt. The remainder are 'securitized' sold in the form of securities that the GSE's guarantee. Conforming mortgages are those that meet the underwriting requirements of the agencies and are no larger than the largest loan the GSE's are allowed by law to purchase. In 2003 the maximum was $322,700. It is raised every year in line with increases in home prices. Conforming mortgages account for roughly 80% of the conventional (non-FHA/VA) home loan market. Absence of Competitors: The GSE's have no competitors in the conforming loan market. Because of their government backing, the GSE's can sell notes and securities at a lower yield than any strictly private secondary market firm. This gives them a monopoly or rather a duopoly, since there are two of them in the market in which they operate. The GSE's do have emulators, however, in the non-conforming market. While the cast of players changes, at any one time there are usually 15 or more strictly private firms that purchase non-conforming loans and securitize them in much the same way as the GSE's. The Public Stakes: If you are a potential borrower eligible for a conforming loan, your interest rate will probably be about 3/8% lower than it would be absent the GSE's. This reflects their relatively low funding costs, part of which is passed through to borrowers. In addition, if you are a low or low-to-moderate-income borrower and/or reside in an under-served area, you might find a loan through a GSE. As part of their public responsibility, the GSE's commit to purchase specified numbers of such loans.