The secondary market is where investors trade previously owned mortgages and mortgage-backed securities.
Whether you’re a real estate novice, a real estate pro, or want to learn more about secondary markets, you’re in the right place. I’ve been teaching real estate for years. One thing I see people always struggle with is understanding real estate markets.
In this post, I’ll define the secondary market, review its history, and provide a few examples that will clarify the concept. Let’s get started!
What Is a Secondary Market?
The secondary market is the resale marketplace of loans. Specifically, in real estate, it’s where investors buy and sell mortgages and mortgage-backed securities. These markets are different from the primary markets where the mortgages originate. In the secondary market, no origination of mortgages or securities takes place; instead, the investors trade with each other with the mortgages and securities they already own. These mortgages are the ones that banks have already issued, and credit unions and corporations have been bought by investors. The prices of these mortgages and securities are set according to their demand and supply in the secondary market.
For example, a real estate builder manufactures housing units and sells them to investors in the primary market. An investor purchases a housing unit, the first sale of a particular housing unit. An end user purchases this house from the investor. Since this is the second time the housing unit has been traded, it is considered a secondary market. The investor already owned these housing units, and when end users purchase them, it will be called a secondary-market transaction.
How Does a Secondary Market Work?
The secondary market in real estate consists of previously owned mortgages. This marketplace facilitates the buying and purchasing of mortgages or loans. The transactions in the secondary market provide funds for further mortgage lending and real estate purchases. While the origination of a loan is a primary market transaction, the purchase of this loan by the investors is a secondary transaction.
Sometimes these loans are packaged into mortgage-backed securities, and investors buy them through mutual funds, insurance, and pension funds. Similarly, bonds in the secondary market are sold to banks, corporations, investment banks, and individual investors. Fannie Mae is also an example of a secondary market participant as it doesn’t originate loans but purchases and guarantees them.
A Brief History of the Secondary Market and the FHA
The best way to understand the secondary market is to understand its history. Let’s go back to 1934. After the stock market crashed, the government needed to stabilize the economy and fix the market. In 1934 the government introduced The Federal Housing Administration, also known as FHA; the FHA’s Primary purpose is to ensure lenders from loss and insure loans.
They did this because before the crash, for people to take out loans, they would need massive down deposits, sometimes as high as 40%. These loans also had small margins for borrowers to pay back the loans, sometimes as low as 5-10 years with large monthly payments. Many people could not afford housing, making many American renters or homeless, which, if you didn’t know, usually isn’t good for the economy.
The FHA made it significantly more accessible for people to purchase a home. They fixed both issues by requiring a smaller down payment and a lower monthly payment that would extend the loan over 30 years. This made owning property for middle and lower-class people more realistic and is almost identical to how we do it today.
For banks to accept the loans, they worked with the government to establish some loan guidelines to make the bank’s investment safer. They set three rules; some were added as the years went on, an employment check, a credit check, and a property appraisal.
This was fantastic for people who wanted to become homeowners, and in 1938 the number of homeowners began to rise, but this created a separate issue. Banks realized they needed more money to give out more loans. Because instead of getting large chunks in the beginning or having the loans paid off faster, they now had to wait 15-30 years for a return on their investment.
So in 1938, the government created the Federal National Mortgage Association or Fannie Mae. This was built to buy FHA-insured mortgages from lenders, creating a secondary market. It gives the first lenders or the banks enough capital to provide more loans for borrowers, while the secondary market makes money off interest. Afterward, everyone was happy. The middle class could finally own homes, the banks had enough capital to give out as many loans as needed, and a secondary market was born where people could invest.
In 1968 Fannie Mae was split, and the Government National Mortgage Association, or Ginnie Mae, was created. The main focus of Ginnie Mae is to ensure liquidity for US government-insured mortgages.
Today Fannie Mae is no longer a government agency and is privately owned. Fannie Mae buys mortgages on the secondary market, puts them together, and then sells them back as mortgage securities bonds to investors on the open market.
Types of Secondary Markets
Secondary markets are broadly classified into two categories, but there are other types too. The following are the two main types of secondary markets:
Stock Exchange Market
A stock exchange market is a centralized platform where investors trade securities through the exchange. There is no direct contact between the investors, and the buying and selling take place through an exchange. The exchange acts as a guarantor, and there is no counterparty risk in these transactions. For example, if a person wants to purchase Apple stock. In this case, that person will have to buy it from someone who already knows Apple stock. Plus, since it’s a secondary market, Apple won’t take part in this transaction. Other examples of stock exchanges include New York Stock Exchange (NYSE), Amsterdam Stock Exchange, BSE, LSE, etc.
The over-the-counter market is a secondary market where investors buy and sell loans and securities directly with each other without the involvement of a third party. It is a decentralized market where there is no regulatory oversight. The price of the loans and securities varies from seller to seller, and it isn’t necessary for a lender to offer the best price. Since the investors deal directly with each other, there is a higher counterparty risk involved in the transactions.
Primary vs. Secondary Markets
Two types of markets deal with assets and securities, and these are primary and secondary markets. The primary market is where the securities or loans in commercial real estate originate. Companies create loans and sell them to investors who purchase them for the first time. The purchase of loans in the primary market occurs through Initial Public Offering (IPO). An IPO offers a company’s shares, securities, or assets on a public stock exchange to the public for the first time. Most of the time, the companies sell these shares to large investors, and small investors cannot purchase them. Thus, the primary market is the one that offers financing only for the issuing companies. In real estate, the primary markets are also known as gateway markets.
Once the investors purchase those securities from the issuers in the primary market, they sell them in the secondary market. The trade that occurs in the secondary market is without the involvement of the issuers. The investors buy and sell these securities to each other, and the amount received from the secondary market goes to the investors. The primary market is the market where the company (issuer) interacts with the investors, and the secondary market is where the investors interact with each other. The following is the summary of the key differences between the primary and secondary markets:
|Primary Market||Secondary Market|
|Mechanism||Issuers originate loans||Lenders sell these mortgages or bundle them into mortgage-backed securities.|
|Benefits||Banks and credit unions sell mortgages to the secondary market||Investors buy secured loans and get income from the interest|
|Examples||Banks, mortgage brokers, credit unions||GSEs, government agencies, private agencies|
Secondary Market Example
FHA loans are examples of how secondary markets work. FHA (Federal Housing Administration) insures loans so that homebuyers can purchase homes at lower down payments. These loans are available through FHA-approved lenders only. These lenders purchase FHA loans in the secondary market and then sell them to the end users. The lenders must meet certain eligibility requirements for purchasing these loans.
Frequently Asked Questions
What is the Importance of a Secondary Market?
Secondary markets provide an opportunity for investors to generate income. Without a secondary market, it would be impossible for the real estate business to flourish. The majority of the sales in real estate are resales that occur in the secondary market. Secondary markets provide affordability, potentially higher profit, and many growth opportunities. These markets benefit all economic players, including investors, borrowers, lenders, banks, and aggregators.
Who Buys the Loans in the Secondary Marketplace?
There are three main types of secondary market buyers: GSEs (Government-Sponsored Enterprises), government agencies, and private entities. A few examples of the GSEs include Fannie Mae and Freddie Mac. The government agencies include FHA, VA, and USDA, which ensure government-backed loans. The private entities include insurance companies and pension funds.
What are Mortgage-Backed Securities?
Mortgage-backed securities that are secured by other loans. Banks and credit unions bundle mortgages into mortgage-backed securities. Financial institutions sell these mortgage-backed securities in the secondary market to government-sponsored entities. These GSEs use mortgage-backed securities as collateral and create new securities. Investors can purchase these investments and generate income from them.
What to Know for the Real Estate Exam
Understanding the secondary market is complex, and usually, this is where things start to get confusing for most people. Understanding the secondary market is sometimes what separates great real estate agents from the best, as the best can sometimes predict where the market is going. Remember, Fannie Mae was established to create a secondary market that funds the banks to give out more loans while they collect interest. Investors buy and sell mortgages and mortgage-backed securities in this market. Mortgage-backed securities help investors earn income, and thus everyone wins. . If you have understood how secondary markets work, learn about other Real Estate Terms that are important for your real estate exam.