Where do Lenders Get The Money to Make Loans?

In the days before giant federal lenders, local savings and loans (S&Ls) used money from depositors to make loans. S&Ls charged interest on the principal (i.e., original loan amount) and fees to cover the expenses of managing the loans, activities like collecting payments and keeping detailed records. They paid their depositors a little interest, and the money left over was profit. S&Ls were in the loan business and often didn’t mind making long-term loans, unlike most banks. It was the S&Ls who provided the loans that facilitated home ownership until Government-Sponsored Entities (GSEs) came onto the scene in the early 1970s.

GSEs are institutions that buy loans from loan originators on the secondary market with the goal of providing lower housing costs and better access to financing. The big players are referred to as Fannie Mae, Freddie Mac and Ginnie Mae. They are actually the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Association (FHLMA), and the Government National Mortgage Association (GNMA)—which is part of the US Department of Housing and Urban Development.

Until GSEs came into existence, the person determining whether to lend you money represented the S&L; he sat across a desk from you and looked you in the eye to see if you were a worthy risk. In 1973, I had a summer job and I wanted to use my earnings to buy a house. I needed an 80-percent loan: I could come up with 10 percent for a down payment and the seller agreed to carry a 10-percent second loan. The house cost $18,000 and rent covered the mortgage payment on the first and second loans, plus the expenses of upkeep and ownership with a little cash left over. The lender at the S&L sized me up and pegged me for a guy who could and would pay his debts. Those were the days.

The world has changed since then. Most lenders do not keep home loans in their portfolios. The vast majority are sold to GSEs or to private groups such as pension funds or insurance companies.

Before the housing market correction in 2008, these private groups would often buy a block of mortgages and then borrow against them. This is called mortgage securitization (when investors pool large numbers of loans with an interest rate of, say, 6 percent and then go to the publicly traded bond market and borrow money at 4½ percent). Risk-averse lenders did not show much interest in mortgage-backed securities until AIG agreed to guarantee the loans (for a fee). To prove the investments were safe, bond rating companies like Moody’s or Standard & Poor’s would rate the mortgages (for a fee).

As the housing bubble grew and mortgages became easier and easier to secure, mortgage-backed securities became riskier and riskier. AIG and the bond rating companies continued to offer their services, and no one questioned whether AIG could afford to guarantee these enormous loans or whether the bond rating companies would go out of business if they did not supply the desired ratings.

Today, many more safeguards are in place to assure that lenders do not loan to people who cannot afford to pay, so mortgage-backed securities are much safer. They got a bad reputation when irresponsible lending practices allowed inappropriate loans to be made, driving housing prices much higher than they should have been. This is no longer the case.

These days, while I regret the loss of the personal relationship with the S&L lender, I appreciate the fact that the GSEs have made loans for single-family homes more affordable and available to the general public, putting the American dream within reach of a tremendous number of people who would never have qualified otherwise.

If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or visit www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.