Federal agencies

Mortgage agency securities

Three federal agencies exist to incentivize homeownership for Americans. We’ll discuss each of them in this section.

Ginnie Mae, officially known as the Government National Mortgage Association (GNMA) guarantees VA (Veterans Affairs), FHA (Federal Housing Administration), and USDA Rural Development insured loans. These are loans that are only available to specific types of homeowners (e.g. veterans, low-income householders).

Due to the minimal risk involved, the US Government directly backs Ginnie Mae securities, making them virtually default-risk-free like Treasury securities… As we’ll discuss below, this is unlike all other agencies that only have indirect backing.

Fannie Mae, officially known as the Federal National Mortgage Association (FNMA), purchases insured (VA and FHA) and conventional (non-insured) mortgages. Freddie Mac, officially known as the Federal Home Loan Mortgage Corporation (FHLMC), only purchases conventional mortgages.

With a significant amount of non-insured mortgages handled by these two agencies, Fannie Mae and Freddie Mac both are considered riskier than Ginnie Mae and only have an indirect backing from the US Government. Additionally, both are publicly traded companies. Although they were started by the US Government, they are technically owned by their stockholders.

These agencies typically purchase mortgages from lenders with capital raised by investors. By doing so, lenders are flooded with cash they can then lend out for new home purchasers. The agencies then begin to collect mortgage payments from the purchased mortgages and subsequently pass through the income to investors. Similar to how mortgages are paid off, mortgage agency securities typically make monthly payments to investors representing principal and interest.

The securities purchased by investors are known as mortgage-backed securities (MBS). Retail investors tend to gain access to these securities through mutual funds, which we’ll learn about in a future section.

MBSs are subject to two unique risks, which are prepayment and extension risk. When an investor purchases a normal, non-mortgage related bond, they know how long their bond will last. If the bond has a 20-year maturity, they know the bond cannot last more than 20 years.

When an investor purchases an MBS, they will not know the exact maturity. While the majority of mortgages are 30-year mortgages, most mortgages do not last 30 years. Many homeowners pay off their mortgages early, refinance their mortgages, or sell their homes and pay off their mortgages. In each of these circumstances, the mortgage comes to an end when the homeowner pays back the principal of the loan.

If you were to invest in an MBS, you won’t know how long your investment would last. If interest rates fall, you can expect many homeowners to refinance and get rid of their old mortgages. In this type of environment, your investment will likely end sooner than expected. You wouldn’t be too happy about it, either. Your MBS had a higher yield than what the current market offers (lower interest rates), but your investment is ending earlier than expected. This is prepayment risk.

It can also go the other way if interest rates rise. When this occurs, homeowners generally keep their mortgages longer and avoid refinancing. Therefore, your mortgage-backed security has a lower yield than what the current market offers (higher interest rates), and your investment will last longer with fewer people paying off their mortgages. This is extension risk.