Three federal agencies exist to encourage homeownership in the United States. This section introduces each one and explains how their mortgage-backed securities work.
Ginnie Mae, officially the Government National Mortgage Association (GNMA), guarantees mortgage-backed securities backed by loans insured by:
These programs are designed for specific groups of borrowers (for example, veterans and some low-income households).
Because the underlying loans are government-insured, Ginnie Mae securities are directly backed by the U.S. government. That makes them very similar to Treasury securities in terms of default risk.
Fannie Mae, officially the Federal National Mortgage Association (FNMA), purchases both:
Freddie Mac, officially the Federal Home Loan Mortgage Corporation (FHLMC), purchases only conventional mortgages.
Because Fannie Mae and Freddie Mac handle a significant amount of non-insured mortgages, they’re generally considered riskier than Ginnie Mae. They have indirect backing from the U.S. government rather than a direct guarantee. Both are also publicly traded companies. Although they were created by the U.S. government, they’re technically owned by their stockholders.
These agencies typically buy mortgages from lenders using capital raised from investors. When a lender sells mortgages to an agency, the lender receives cash and can make new loans to homebuyers. The agency then collects the mortgage payments on the loans it purchased and passes that income through to investors.
Similar to how mortgages are paid off, mortgage agency securities typically make monthly payments to investors that include both principal and interest.
The securities investors buy are called mortgage-backed securities (MBS). Retail investors often access MBS through mutual funds, which you’ll learn about in a future section.
MBS are subject to two unique risks: prepayment risk and extension risk.
With a typical (non-mortgage) bond, you know the latest possible date you’ll get your principal back. For example, a bond with a 20-year maturity can’t last longer than 20 years.
With an MBS, you don’t know the exact maturity. Even though many mortgages are written as 30-year loans, most don’t actually last 30 years. Homeowners may:
In each case, the mortgage ends when the homeowner repays the remaining principal.
That uncertainty affects you as an investor. If interest rates fall, many homeowners refinance to get a lower rate. That means principal is returned to you sooner than expected, and you may have to reinvest at the new (lower) market rates. This is prepayment risk.
The opposite can happen when interest rates rise. Homeowners are less likely to refinance, so mortgages tend to stay outstanding longer. Your MBS may keep paying for longer than expected, even though its yield is now lower than what new investments offer in the higher-rate market. This is extension risk.
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