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The availability of funds in the primary market depends to a large extent on the existence of secondary markets. First, the mortgage funds are lent to a homebuyer by a lender in the primary market. The mortgage is then sold to a secondary market agency, which in turn can sell it to other investors in the form of mortgage-backed securities. Mortgage-backed securities fall into two general types: bond-type securities and transfer securities. Bond-type securities are long-term, pay interest semi-annually, and are repaid on a specific date. Transferred securities, which are more common, pay interest and principal payments on a monthly basis. Some types of value transfers pay even if the payments are not collected from the borrower.

Because a primary lender sold the mortgage, the lender can take the money it receives from the sale and make another mortgage loan, then sell that new loan to the secondary market and continue the cycle. The secondary market agency can pool the mortgages it buys to create mortgage-backed securities, which it then sells to investors. As the secondary market agency sells the mortgage-backed securities to investors, you now have more funds to buy more mortgages. You can then create more pools of mortgage-backed securities to sell back to investors, and the cycle continues.

The market can work the way it does because standardized underwriting criteria are used to qualify borrowers and property. The secondary market will only purchase a mortgage if the primary market lender meets the secondary market’s underwriting standards. Since lenders want to sell their loans, they must follow the underwriting standards of those agencies. The three largest aftermarket agencies are Fannie Mae, Freddie Mac, and Ginnie Mae. Therefore, a conforming loan is typically a loan that meets Fannie Mae’s underwriting guidelines. Private companies, such as hedge funds and investment banks, also participate in the flow of mortgage funds by purchasing mortgage-backed securities. The recent credit crunch and economic downturn were caused in part by the buying and selling of mortgage-backed securities. Investors borrowed incredible amounts of money and leveraged themselves so dramatically that when the value of mortgage-backed securities fell, it was enough to create huge liquidity problems for companies and many went out of business (Bear Stearns, Merrill Lynch, etc.). Unfortunately, many of the same dynamics that caused the financial collapse are still at work today. The secondary market still exists with Fannie Mae (infused with taxpayer money) now buying up to 99% of all US originated loans.

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