Thursday, February 27, 2014

Why has my home loan been sold?

It's just human nature to simply want to understand things, especially important things (such as your home mortgage), so in this post we're going to explain what generally happens after you buy or refinance a home and why your loan may be "sold".

First of all, the vast majority of mortgage lenders will only fund loans that either "conform" to Fannie Mae or Freddie Mac underwriting guidelines (these are called conventional conforming loans), OR meet the minimum standards set forth by FHA, VA, or USDA (these loans are backed by the government with "insurance" or a limited "guarantee" against default). By only funding these types of loans, rest assured the mortgage lender can turn around and sell the loan to Fannie Mae, Freddie Mac, or Ginnie Mae (Ginnie Mae typically buys government loans). 

But what does it mean to "sell" a loan? First, we must must take a step back and think about what a mortgage loan actually is. A mortgage loan is nothing but a contractual right to receive payments based on the terms outlined in the mortgage note, along with the right to eventually take real property (foreclose) in the case of default. These "rights" are worth money, so this is where the Fannie, Freddie, and Ginnie come into play. These government sponsored enterprises (GSE's) are "on standby" ready to purchase only specific types of loans, and the process of selling mortgages to them is streamlined. Mortgage lenders establish relationships and get contractual "approvals" to sell their loans to these GSE's and typically sell loans to them within 60 days after the closing date. The GSE's pay the lender for these rights, along with a premium for all the work they did (found the customer, got the proper documentation, paid an underwriter to review all documents, etc.). 

What do you think the right to receive 360 monthly payments of $536.82 over a 30 year period would be worth to YOU (along with the right to foreclose in the case of default)? Your first calculation would probably be 536.82 X 360 = 193,255.78. Your next thought would probably be about other investment returns that would seem to be in the same "risk class" over the next 30 years. Right now, you could go out and buy a 30 year bond that would pay you almost 4% per year, and those are generally considered to be "risk free". Certainly, as interest rates rise in the future, you ought to average about a 7% annual return on your money if you were to buy these rights, considering the risk that you'd need to foreclose on the house and may not recoup your entire investment. So if YOU "require" a 7% return on your investment for this amount of risk, then plugging that into a financial calculator would say that the value (the "present value") of buying this bundle of rights is about $80K. Okay, well here is the surprise-- this was a $100,000 30 year fixed mortgage with a 5% interest rate. Why is the $100,000 "loan" only worth $80,000? This is because your required rate of return was 7%, which is reasonable. There is a lot of math is this paragraph, but this is EXACTLY why lenders want to be able to sell the loan to Fannie, Freddie, or Ginnie. These GSE's will pay the lender the full $100,000 PLUS a nice premium for their work! If the lender can't sell the loan, then they are going to be thinking just like YOU as far as other investment opportunities, so loans that are held "in house" (called "non-conforming" or "portfolio" loans) will generally require higher interest rates, and often have features that allow them to adjust with market rates. By quickly selling that $100,000 loan to a GSE, the mortgage lender gets the money right back (along with their premium for the work), and then they can make another $100,000 loan. They are now able to earn profits by using the same money over and over!

Okay, so now that we know what happens after most loans get funded and why they portfolio loans have higher interest rates, let's dig into why your loan may be "sold" to another lender. Fist off, when you get a notice that you will need to send your monthly mortgage payment to somebody else, your loan never got sold-- the "servicing rights" only got sold! "Servicing" a mortgage loan is just the act of collecting payments. The servicing lender is generally responsible for collecting payments, making sure escrow account balances are adequate, customer service (answering your questions), providing payoff statements, and foreclosure. So, if Fannie, Freddie, or Ginnie own the loan, then why are you sending your payments to Wells Fargo or Bank of America (etc.)? Well, the GSE's are NOT interested in servicing loans (otherwise you would just write checks to Fannie Mae, etc.). Obviously Wells Fargo, Bank of America, etc. are not going to do all of this paperwork for free, so the business of servicing a loan is a secondary way to earn revenue. The GSE's will pay servicing lenders an annual fee for taking care of this paperwork (and answering your calls, etc.). And guess what, just like a mortgage is nothing but a contractual bundle of rights that could be sold, so is a servicing agreement! 

But why would one lender want to purchase your servicing agreement? This is probably the question most people are curious about (as this explains why you would get a notice in the mail telling you to send your payments to a different lender). Think about interest rate trends and diversification. If a lender believes that interest rates are going up, then they may want to consider diversifying their revenue streams by purchasing some servicing rights from a different lender. As interest rates rise, refinances fall. As refinances fall, revenue from originating refinance loans falls. If you are a mortgage lender that has historically been originating mostly refinance loans, then you may want to consider "hedging" that revenue stream by purchasing the servicing rights to a bunch of loans. This is nothing more than a way for mortgage lenders to continue to earn profits, even as rising interest rates trigger a decline in refinance volume. 

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