The availability of funds in the primary market depends largely on the existence of secondary markets. First, mortgage funds are loaned to a homebuyer by a lending institution in the primary market. The mortgage is then sold to a secondary market agency who, in turn, may 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 provide for repayment on a specific date. Transferred securities, which are more common, pay interest and principal payments monthly. 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 bundle the mortgages it buys into mortgage-backed securities, which they then sell to investors. As the secondary market agency sells the mortgage-backed securities to investors, it now has more funds to purchase more mortgages. You can then create more pools of mortgage-backed securities to sell back to investors, and the cycle continues.

The market is able to function as it does because standardized underwriting criteria are used to qualify borrowers and property. The secondary market will only buy a mortgage if the primary market lender meets secondary market 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 conforms to 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 due in part to the buying and selling of mortgage-backed securities. Investors borrowed incredible amounts of money and became so dramatically leveraged that when the value of mortgage-backed securities went down, it was enough to create huge cash flow 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 continue to operate today. The secondary market still exists with Fannie Mae (infused with taxpayer money) now buying up to 99% of all loans originated in the US.