What is the Secondary Market?

We are all familiar with the idea of a “market,” which is a place where things are bought and sold, or in a more basic sense, where a transaction occurs. When we go to Wal-Mart, the car dealership, or even the supermarket, we are going to a “primary” market. In other words, we are the first owners of a product which has been manufactured for consumption.

A “secondary” market is where people go to purchase products that have been previously owned by someone else. Examples of this would be a flea market, garage sale, or even a used car dealership. Secondary markets exist for highly valued items too, such as homes or even stocks and bonds. Just because an item is sold on a secondary market doesn’t mean it is necessarily “secondhand” quality!

Often times in banking, we talk about secondary markets too. We can make loans, and then resell them to a different owner too. The best example of this is home mortgages. Investors like pension funds and insurance companies like to buy-up home mortgages, because they typically have a steady repayment stream and are well-collateralized. But, their primary function is not lending, of course, so it is easier to allow credit unions and banks to make the loans, and then later buy the loans from these financial institutions.

An interesting aspect of the secondary market for home mortgages, is that insurance companies and pension funds are looking for long-term investments. They will even buy loans that have rates fixed for as long as 30 years. This is further fascinating, because a bank would not ordinarily do a fixed rate loan for so long, but will make the loan only if it is certain it can later resell that loan to an investor! Thus we get the concept of “conforming” loan, which is a loan that conforms to the standards required to by a secondary market buyer.

Home mortgages are not the only type of loans bought and sold on a secondary market. Student loans are also sold into the secondary market, as well as farm mortgages, car loans, and even credit card receivables. Hypothetically, any loan could be sold on a secondary market, as long as there is a willing buyer.

Some of these secondary markets were originally established to help banks manage their liquidity. Being able to sell long-term fixed rate loans has been a great innovation for financial institutions, because it has become increasingly hard to attract long-term fixed rate deposits to match-fund those loans. The government even helped to initially establish these secondary markets by creating the companies that would purchase these loans. This was the reason behind creating Fannie Mae and Freddie Mac for home mortgages, Sallie Mae to buy student loans, and Farmer Mac to purchase farm mortgages.

Some of these secondary market actors received negative attention and blame for the last recession. Some have criticized the fact that secondary markets even exist, and questioned whether it was fair to buy and sell loans, with the borrower having no say in the matter. However, when a loan is sold into the secondary market, the terms of the contract do not and cannot change. And, many of the problems that resulted in the recession had to do with poor policy and auditing standards. We need to be careful not to throw out the baby with the bathwater, and acknowledge that the secondary market has been a wonderful innovation that benefits consumers and banks immensely.