When you take a loan, the bank can “sell” your loan to an investor. What does that process look like, and why would an investor want to buy loans?
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I don’t think that personal loans are really common enough for this to be a thing.
But when it comes to mortgages and business loans, there is a thing called CDO or collateralized debt obligation, which in turn is a type of ABS, asset backed securities.
Basically, a large bundle of loans is “securitized”. Which mostly means that a shell company is formed to own a large bundle of loans and then investors can buy a share of a CDO, which is like one small piece of a bundle of tons of loans.
The CDO will be separated into traunches based on risk requirements. But basically, because there are so many loans bundled together it’s stasticaly very unlikely for a CDO to fail. So they make for interesting investments. And banks sell them because… They can I guess? If they can collect the loans, bundle them and securitize them they will get their cut on the way.
My understanding is that a type of CDO called a mortgage backed security, was largely responsible for the 2008 recession. People say that this sort of thing won’t happen again because today’s CDO of favor- the CLO isn’t tied to consumer mortgage rates and exposed to a single market.
Imagine a world where there’s a super popular toy that costs a quarter.
Let’s say that you get two quarters from your parents. Instead of just spending that money your friend comes up to you and says they don’t have a quarter to buy the super popular toy. They want the toy really badly. They’ll give you 2 cents a week for a year if you give them a quarter today. This is a pretty good deal for you because you’ll end up with a little over a dollar in a year for your quarter today. You can buy four of the toys your friend buys today in a year. But this is pretty risky because maybe your friend doesn’t pay you back. So you agree that if your friend doesn’t give you two cents every week you get to take the toy they bought and you know that your friend gets a nickel every week for their allowance so they’ll have the money to give you every week. You also know you can sell the toy to another kid for a quarter if your friend welches.
This is a pretty good deal for everyone. It’s such a good deal that another friend at school comes up to you and asks to borrow a quarter to buy the same toy. You give this friend the same deal and now you don’t have any quarters left. Then the next day a third friend asks to borrow a quarter and you’d like to do this deal because you’re now getting 4 cents a week and would like to get 6 cents a week but you’re out of quarters and won’t have another quarter to lend out until seven weeks later.
So you go to your older brother who mows lawns during the summer so your brother has a lot of quarters. You tell him about the terms you’ve got with your friends and your brother says he’ll buy the rights to the 2 cents per week for fifty cents. So instead of getting a little over a dollar in a year you get half of that now. He also says that he’ll take over collecting the 2 cents from your friends so long as you make sure the kid you loan the quarter to has a weekly allowance of at least a nickel.
You sell the two loans to your brother for a dollar. You go back to the third kid and loan him a quarter. Word gets out and half the kids at school borrow a quarter from you. You sell the loans to your brother for fifty cents. Your brother realizes this is a good deal for everyone but doesn’t want to spend all day at the elementary school collecting pennies so he tells your best friend who knows all these kids that if your best friend collects the 2 cents every week from all the kids then he’ll get 1 cent per month for every loan that he collects from. So your best friend collects all the money, keeps his 1 cent a month and gives your brother all the money.
You’re able to keep loaning quarters out by selling the loans to your brother. Your brother is able to see his lawn mowing money that was just sitting in his piggy bank grow because you’re out there hustling to lend quarters. Your brother gets his money every month because he’s paying your best friend to collect the weekly payments and take back toys when necessary.
If you wouldn’t have sold these loans to your brother then none of this happens. You would lend out your two quarters and you would have been done. The kids at your school wouldn’t have been able to buy the hot new toy. Your brother’s lawn money would have just gathered dust in his piggybank and your best friend wouldn’t be making any money.
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So the reason a “bank” sells a home loan right after making it is two-fold. First, it’s a matter of specialization. Businesses that are good at giving out loans, i.e. doing the work of looking at income, appraising the value of the house, interfacing with the customer, are efficient at doing that. In the example above, you are in a position to know the allowances of kids, how trustworthy they are, etc. because you go to school with them. But businesses in that position may not have a lot of capital to lend out because managing capital is a different skill set than marketing to home buyers and processing their loan applications. Second, even if a business was good at managing capital they probably don’t have capital. They might have a little capital to lend out to get the ball rolling like the kid in the example above but they need more capital to make more loans.
As to why an investor would want to buy a home loan? Generally, investors don’t like buying home loans. Home loans are relatively safe compared to other investments but they don’t pay much interest, have a long payoff period, and can be paid off in full with no penalty by the customer. Specifically, a fixed rate is pretty terrible for an investor because the investor is locked into getting 3% interest for thirty years even when the market is paying 8% interest. These are all good things for home buyers but bad things for investors.
So the majority of home loans are purchased by Freddie and Fannie Mae which are two corporations that are the brother in this situation. They have a lot of money and they use it to buy loans so that lenders can make more loans. They are publicly chartered corporations which basically means they were started by the government to buy these loans in order to increase the availability of home loans and increase home ownership in America. They aren’t government agencies but for-profit corporations created by the government for this specific purpose. They make money (hopefully) but aren’t going to ever get out of the loan-making business or expand into investment banking.
They don’t just buy any home loan though. They have standards that must be met for the loan to be bought. The home buyer must have a certain amount of income, the income must be documented in certain ways, the property must be of a certain type, they will only lend 80% of the value of the property, etc. If a loan is made by a lender (the kid/you in the example above) that doesn’t meet the criteria (the kid doesn’t get an allowance) then these loan buyers will refuse to purchase it. The kid wouldn’t be able to sell it to their brother and would have to just collect the money themselves. But so long as a lender makes a loan to a purchaser that meets those criteria then the loan will be purchased by these entities on what is known as the secondary mortgage market.
Loans that do not meet those criteria will not be bought and these are what are known as portfolio loans because lenders that make them must keep the loans in their own “portfolio” of investments.
The secondary mortgage market in America allows for the fixed 30-year mortgage to exsist. If the government hadn’t created these brother entities to purchase home loans you wouldn’t just see interest rates on home loans go up you’d see market movements where suddenly you just couldn’t get a fixed-rate mortgage in America.
Also, these entities generally aren’t interested in running around and collecting money from people so they pay loan servicers to collect the money. So one entity will make the loan to you, then immediately transfer the servicing of the loan to an entity that specializes in servicing the loan, and then will sell the loan on the secondary market. So you may get the loan from Loan Depot (RIP), you might send your first check to Chase all the while the monthly payments are going to a third party that bought the loan.
Most comments talk about why but not how.
The actual process usually goes like this.
When you open a savings account at a local bank, they loan that money out to someone else and collect interest on it. The local bank is only allowed to use a certain percentage of their savings deposits for loans.
In order to create more loans, and generate more fees they sell their existing loans to a institutional bank (IB) like Chase with the agreement they will still do all the customer service for a small fee but IB collects the vast majority of the interest and now owns all the risk associated with that loan. The local bank then uses the proceeds from the sale to generate more loans.
IB doesn’t want to lock up all their money in loans either, so they collect all the loans from all over the country and create a single security (think one loan made up of all the other loans) with a very specific risk metric based on loan types house types and credit worthiness of the recipients. They are able to sell shares of this security to the broader financial market and free up their money.
The investors who bought the security hold it to collect the stable interest rate. These are often insurance companies, private wealth funds, and pension funds.
So your loan now has three institutions benefiting
Local bank: percentage fee for creating and servicing the loan.
Institutional bank: percentage fee for packaging and servicing the security.
Investors: the majority of the interest.
The entire Collateralised Mortgage Obligation (CMO) market was built on this system. Imagine that you are a bank, and you have 100 homes worth $1 million each that you have lent them the money for. All you are going to do is collect interest on them for 20 years.
Some smart guys figured out that you could bundle all those mortgages together, pooling the equity, the mortgage payments and the debt payments, and then “slice” them up into different financial instruments. Each “tranche” (the French word for ‘slice’, BTW) offered up a different risk profile.
The most senior tranche would pay the lowest interest rate, but would have first dibs on the money in the payment pool. If there was a problem and some of the 100 people didn’t pay their mortgages on time, presumably these senior tranche holders wouldn’t be affected. That’s why they are paid the lowest interest rate.
The next level up only gets paid if all the senior tranches get paid first. Normally, this isn’t a problem, as most people strive to make their mortgage payments. But because there is *some* extra risk, they get a higher interest paid to them than the senior tranche.
Finally, there is a speculative tranche that only gets paid if everyone below is paid. It gets the highest interest rate, and carries the most risk. If a bunch of people can’t pay their mortgage because of recession, then the holders of this tranche might get nothing.
So, why would the banks do this? To make more money, which happens two ways: first off, banks can only lend so much money at one time. By selling off these mortgages, the banks can then create new mortgages and generate new fees. Second, the banks take their cut in terms of commissions and fees to bundle all these mortgages together.
Why would investors want it? If you were running a small pension fund for the municipal employees of Podunk, for example, the Fed’s push to near-zero interest rates means you can’t generate enough returns on the AAA-rated investments you are required by law to place the pension funds in to actually meet the outflow you need to pay off the pensions, and that problem was getting worse as more people retired. These CMOs, especially the higher rated tranches, offered higher rates that the pension fund managers were salivating for. And, wouldn’t you know, Standard & Poor’s and Moody’s bond rating services *never* found a reason not to give a AAA rating to these, even the highest and most speculative tranches.
And so we got the 2008 financial crisis.
When you get a mortgage loan there are actually two things that can be sold. One is the rights to the interest. The other is the servicing rights.
What most people don’t know is that servicing rights are separate and often sold to a totally different company. This is what most people think of when thier loan is sold. but in reality just the rights to service the loan and collect that fee is sold. Your actual loan balance is likely held by a totally different company and when that sells you are not even notified.
Oh wow, I’m uniquely qualified to answer this!
So the interest on a 30 yr loan is a lot of money. Often between 1.5-3x the loan value.
If your mortgage rate is 6%, 4.5 or whatever % is to the federal reserve to “make” that money. Banks and other hands touch it in there, not important now. The final broker gets that 1.5% and it’s based on your credit worthiness. Their goal is to usually profit about 80 basis points or about 0.8%. .2 goes to the loan officer. Usually. I forget the exact margins but that’s close enough for here.
So on a 500k loan, the brokerage is scooping up 5k plus origination fees and some other flat fees.
There’s costs to collecting the loan payment every month. The broker probably doesn’t want to do that. It can be a lot of work and only pays a tiny fee. Enough to survive in volume though, especially if you can manage costs and specialize.
The profit is in collecting that loan long term though. 500k is about 1M in interest. A piece of that goes to the services who is processing collection. The owner of the loan gets the rest of that 1M.
So the brokerage has a list of investors, who buy loans from them. They buy the bulk portion or the servicing rights or both. If you buy the loan, you get a fat accounts receivable line. 1.5M over the next 30 years.
The services gets a flat monthly fee too, for a few hundred dollars. Add this up over time, this is a big deal for both parties.
And you are buying them for a flat fee from the brokerage. A few thousand to buy the loan and servicing and everyone wins.
Most of this is done by email, phone call and spreadsheet. This is why loans get lost all the time. The industry is very resistant to software because this can all be automated. It would lead to massive massive reductions in headcount and ancillary staff.
Most loans are “sold” before the paperwork is even signed.
And none of this money here really matters because it’s all made up anyway.
Fanny and Freddy are the biggest buyers of these mortgages.
Real estate attorney here. I’ve litigated against dozens of banks over hundreds if not thousands of securitized mortgages.
In most instances, loans are bought and sold through a system called MERS, which is short for Mortgage Electronic Registration Systems Incorporated. MERS essentially acts as a trading platform for loans which are packaged into pools. The pools of loans are rated by risk and then sold for a premium or discount to various investor entities. These trades are virtually never recorded in any public place and getting information about the true owner of a loan is damn-near impossible unless you have a lawyer on your side.
Investors buy mortgages (or on the west coast, deeds of trust) because they are a relatively safe investment that are guaranteed by the value of the home. Although there are exceptions for purposes of this ELI5, when a home is foreclosed, it is put up for auction. If the highest bidder bids more than the balance due on the loan, the loan is paid off. Whatever money is left over after paying the loan is used to pay any other liens on the property, including taxes and 2nd mortgages. If there is still money left over from the bid after all those liens etc are paid, what’s left goes to the previous owner.
If no one bids as much as the mortgage, the investor in the loan (or their assignee) gets the property and all the other liens get wiped out without being paid.
So buying mortgage loans, so long as they aren’t upside down, is a very safe investment that generates great revenue not only through interest, but also through fees, penalties, and other charges. Happy to answer any questions people have.
I work for a company that buys used car loans; it’s a safe investment as well as most need the car and pay it first even at 25 percent interest
Could you create your own investment company, buy your own home loan, and just never pay yourself and technically own your house?
Follow up question: how do I buy my own mortgage debt, for a fraction of the price, so I can forgive it? Serious question. What’s keeping me from doing this?
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