When the borrower gets his mortgage from a bank or other lending institution in order to finance his or her house purchase, this transaction is considered to belong to the Primary Market. At this point, the lender has a choice of either servicing the loan for the time equivalent to that loan duration (5, 10, 15, 20, 30 years or any other such term) or sell it to someone else.

Some lenders decide that they want a steady and secured income coming from systematic, monthly payments from the borrower. They collect their income in the form of interest earned on the loan. The higher the loan and the longer the term of the loan, the higher the interest going to the pockets of lenders is.
If the lender decides to sell the loan immediately after underwriting it, it then operates in the Secondary Market. These lenders make their money by bundling these loan notes together into a package and then selling them to a different lender in the secondary market.

If the volume of the loans they sell on the secondary market is significant, they make quite a bit of money on a monthly basis without worrying about the future of the loan, reducing interest rates, or potential problems with the borrower. They forfeit their potential future earnings in exchange for cash on hand today.

The secondary market copes with mortgages that were originated in the primary market and consists of investors who buy the mortgage notes. It allows mortgage lenders to refill their cash reserves, which, in turn, permits them originate even more new mortgages. The investors profit from the attention that the mortgages charge.

There are both private and public investors. The first group consists of banks, thrift institutions and other private individuals, while the secondary market consists of public investors. The major public investors are: Federal National Mortgage Association (FNMA) also known as Fannie Mae, Government National Mortgage Association (GNMA), known as Ginnie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac.

Fannie Mae was founded in 1938 for the purpose of providing a secondary market for mortgages insured by Federal Housing Administration (FHA). It is a government sponsored corporation that buys mortgages on the secondary market, pools them, and then sells them as mortgage-backed securities on the open market. As explained earlier, it helps to replenish the supply of lendable money in the primary market.

Ginnie Mae is a wholly owned corporation within the Department of Housing and Urban Development (HUD). It came into existence in 1968. Ginnie Mae’s provides financial assistance to low and moderate-income homebuyers by means of promoting mortgage credit. It also guarantees payment of principal and interest on mortgage-backed securities.

Secondary market is a very important player in the mortgage business. It provides liquidity in the market. Let us assume that a bank wants to sell one or more mortgages but no one else wants to purchase them. That is where any of the three above-mentioned public investors step in who entered the loans. They will buy these loans and thus enable the bank to make more home loans.

In order for these loans to be purchased by one of the public investors, the loan has to adhere to sets of pre-determined criteria established by Fannie Mae, Freddie Mac or Ginnie Mae. In a case borrower defaults on the mortgages after it has been sold at the secondary market, and it is later found out that these guidelines were not met, the bank that originally approved the loan might be forced to buy the loan back.

There are more than 100 major rating agencies around the world, and three of the largest and most important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.

Credit ratings are widely used by investors because they provide a convenient tool for comparing the credit risk among various investment alternatives. The analysis of risk is crucial in determining the interest rate a syndicator will need to offer to attract sufficient investment capital. From the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this critical, third-party analysis both sides of the transaction can rely upon for unbiased, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.

Unfortunately for many investors in collateralized debt obligations during the Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were subsequently downgraded. In defense of the agencies, they were providing an analysis of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any analysis and widely ignored by investors who are counting on the rating to be a market forecasting tool rather than the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.

There is a deeper problem with the ratings agencies that began to surface in the Great Housing Bubble. Ratings agencies used to charge investors for their risk analysis, but there was a transition to charging the issuers instead. As one might imagine, there are reports that ratings agencies were concerned if they gave CDOs poor ratings, their primary source of income would go elsewhere. This put pressure on the agencies to overlook certain problems or merely list them as footnotes to their reports rather than lower a rating due to a foreseeable contingency such as a decline in house prices.