Understanding Mortgage Holdings: Securitization and Banks' Balance Sheets

The process of mortgage lending and the subsequent treatment of mortgage loans by banks is a fundamental aspect of the financial sector. This article explores whether banks hold mortgages on their balance sheets or if these loans are sold and securitized into mortgage-backed securities (MBS).

The Role of Banks in the Mortgage Market

When you take out a mortgage loan from a bank or a similar financial institution, the action goes beyond just securing a home. Most banks with a mortgage division do not keep the loan on their balance sheet for very long. Instead, they quickly sell the loan to investors or into a larger financial product. The buyer may keep the loan in their portfolio for steady long-term income or package it with other mortgages and sell it as a collateralized debt obligation (CDO).

Classification of Mortgages

First-lien, single-family mortgages are often packaged into securities. These securities are then insured by government-sponsored entities such as Freddie Mac, Fannie Mae, FHA, or Ginnie Mae. Approximately 70% of first-lien single-family mortgages fall into this category. What makes this process fascinating is that while the securities are securitized, they are often held on the balance sheet of the originating bank. This practice reduces the amount of capital the bank needs to hold against the loan and exempts the loan interest from state income tax.

Independent Mortgage Banks

It's worth noting that not all mortgages are issued by traditional banks with branches. Many independent mortgage banks (IMBs) such as Quicken Loans, do not hold the loan for very long. These IMBs are more like sales and marketing operations. They work with borrowers to document and originate the loan but quickly sell the loan into the capital markets.

The Secondary Market for Mortgages

The secondary market for mortgages is enormous, with a value of around $5 trillion. This market is incredibly sophisticated and complex because most US borrowers prefer a 30-year fixed rate mortgage that is freely pre-payable and has limited recourse. Managing these loans is challenging due to the wide range of potential outcomes, from pre-payment in just a few months to defaulting and needing to sell the property for recovery. To handle these risks, a complex ecosystem has developed, including service providers, bankers, and arbitrageurs.

The Secondary Market Ecosystem

The secondary market for mortgages operates like a nested system, with each level representing a different stage in the process:

Assets: House, Mortgage, Mortgage-Backed Security, Collateralized Mortgage-Backed Security Cash Flow: Borrower, Servicer, Trustee, Securities Investors

This framework ensures that the flow of funds and the management of risks are well-coordinated across various stakeholders, from the borrower to the investors who ultimately take ownership of the mortgage-backed securities.

Conclusion

The treatment of mortgage loans by banks is a critical area that involves complex financial transactions and market dynamics. Understanding whether a mortgage is held on a bank's balance sheet or securitized into mortgage-backed securities provides insights into the financial mechanisms that support the housing market. This understanding is particularly important for both investors and borrowers who need to navigate the complexities of the mortgage market.

References

For more detailed information on the mortgage market and securitization, consult the following resources:

Freddie Mac Fannie Mae FHA (Federal Housing Administration) Ginnie Mae (Government National Mortgage Association)