While both banks and mortgage loan investors own loans and count on monthly loan income for profits, the mortgage loan investing business model differs from the bank’s in one key way: investors don’t need to originate mortgage loans. They don’t need to evaluate debt-to-income ratios, collect required disclosures, or deal with compliance.
Instead, investors purchase loans that banks have already underwritten and approved. They do this in what’s called the secondary market. And that’s critical to how mortgage loan investors make money.
Loan Origination and the Secondary Market
When a person first buys a home, refinances a home, or gets an equity loan from a lender, it’s a transaction within the primary mortgage market. Sometimes, lenders in the primary market want to sell off the loans they’ve originated or are servicing. One way to do this is by offering the loans for sale in the secondary mortgage market.
Think of it in the same way you would traditional public equity purchases. If an initial public offering (IPO) is a primary market offering, after that, stock purchases and sales take place in the secondary market.
Mortgage banks and nonbank lenders, which do not engage in the business of retail banking by accepting deposits from borrowers, originate mortgage loans from huge lines of credit, and immediately sell the loans on the secondary market, mainly to the government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac. These loans, which have strict and extensive underwriting guidelines, are frequently packaged into securities, sold as bonds, guaranteed by the GSEs, and backed by the US Treasury. While these bonds are very safe investments, their yields are usually quite low—barely above US treasuries—and may not even beat inflation.
Depository institutions, a.k.a. traditional banks, are not in the business of creating securities from their mortgage holdings. Instead, they sell their loans in pools on the secondary market to recapitalize.
Entire loans sold in the secondary market are referred to as whole loans, because the bank sells the rights to the entire loan, not just a securitized piece of a loan pool.
There are many risk-reducing benefits to investing in whole loans through the secondary market, but one of the most important is that you can select loans on which borrowers have been making consistent payments.
Banks take something of a leap of faith when they originate a mortgage, especially with low down-payment loan programs. Will the borrower pay? When you invest in mortgage loans through the secondary market, you are able to review extremely detailed information about the pay history, with a tracking of payment dates, amounts, and late fees, sometimes going back for years. From that information, investors can select loans that have an established, on-time pay history.
Investing in financial institution–generated secondary mortgage market loans means gaining an inherent stability and security because investors know that
● loan documents and procedures adhere to all applicable state and federal lending guidelines and servicing histories and data are accurate;
● there is usually no need to interior appraise or visit the property;
● loan servicers collect any payments and keep track of tax records;
● the payment terms cannot be changed unless the lender consents;
● borrowers are required to continue making payments and maintain insurance to retain their property. This is important because history shows that even in times of economic hardship, borrowers protect their homes. According to the Federal Reserve, foreclosure rates on residential mortgage loans during the financial crisis of 2008 to 2013 never exceeded 11.54 percent.[1] The truth is, Americans have, on average, more wealth in their homes than in their savings and retirement accounts combined.[2] Most Americans’ greatest source of wealth is the equity in their homes. According to Black Knight, the average homeowner with a mortgage has $113,900 of equity in their home.[3] That’s a powerful motivator, but besides the financial equity, they also have emotional equity. What’s the likelihood a homeowner will pack up and leave a home they have equity in and that they have invested their time and money into upgrading? In my experience, it virtually never happens. Borrowers fight to keep their homes, which is what mortgage loan investors want; and
● mortgage loan investors don’t own the property, just the lien on the property. I spent thirteen years as a real estate investor, an experience that taught me that owning and managing property as an investment is a high-risk, high-stress responsibility to be avoided. As a mortgage loan investor, the collateral pledged as security for the primary loan secures your investment. To the homeowner, the underlying collateral is more than just a means to mitigating investment risk; it’s the homeowner’s prized possession. It’s their biggest investment, and the place where they keep their families happy and safe. It’s also up to them to maintain and repair it. For an investor, this can be the best of both worlds. You don’t own the property, but you have the right to foreclose and sell the property at auction to recoup your investment if the borrower defaults.
Your Investment, Your Choice
When banks are in the business of lending, they have certain guidelines they need to follow to ensure they are meeting the investment needs of the communities they serve. The Community Reinvestment Act (CRA) requires banks to lend to a variety of different borrowers for a multitude of property types throughout their community.
Mortgage loan investors reviewing offerings on the secondary market for opportunities are not held to the same standards. We have the power to choose the types of properties and markets we invest in. This offers a level of diversification that can go far in further reducing risk and improving returns.
One of the most powerful advantages of mortgage loan investing is geographic diversification, or the ability to purchase loans in multiple markets in multiple states. Real estate investors tend to purchase properties only in one local market, which can expose an investor to tremendous risk during natural disasters or economic recessions. Since not all markets will be affected the same way during recessions, the ability to create geographic diversification further reduces portfolio risk.
In addition, thanks to this level of flexibility, investors can choose to only invest in loans secured by owner-occupied homes in the markets they choose. Investors can even choose collateral properties that show a clear pride of ownership and are located in low-crime neighborhoods.
Mortgage loan investing is a very passive, scalable, diversifiable, low-stress business. In mortgage investing, all the major responsibilities are outsourced to experts. My main responsibilities as an investor are
● finding new sellers of loans that meet my criteria; and
● reviewing loans for purchase.
I even outsource my bookkeeping and accounting responsibilities. But there’s more to the reasoning that the simplistic model makes mortgage loans the gold standard of alternative investments. There is the financial component. In other words, it comes down to yield.
[1]https://www.federalreserve.gov/releases/chargeoff/delallsa.htm [2]https://www.federalreserve.gov/publications/files/scf17.pdf [3]https://investor.blackknightinc.com/investors/press-releases/press-release-details/2018/Black-Knights-Mortgage-Monitor-Despite-Record-Setting-Tappable-Equity-Growth-Share-of-Total-Equity-Withdrawn-Hits-Four-Year-Low-in-Q1-2018/default.aspx