Three federal agencies exist to encourage homeownership in the United States. Each one plays a slightly different role in the mortgage market.
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 loans are available only to certain groups of borrowers (for example, veterans and some low-income households).
Due to the minimal credit risk involved, the US Government directly backs Ginnie Mae securities. That makes them virtually free of default risk, similar to Treasury securities. As discussed below, this differs from the other agencies, which have only 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), purchases only conventional mortgages.
Because Fannie Mae and Freddie Mac handle a significant amount of non-insured mortgages, they’re considered riskier than Ginnie Mae and have only indirect backing from the US Government. In addition, both are publicly traded companies. Although they were created by the US Government, they’re technically owned by their stockholders.
These agencies typically purchase mortgages from lenders using capital raised from investors. This gives lenders cash they can use to make new mortgage loans. The agencies then collect mortgage payments on the mortgages they’ve purchased and pass 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 these securities through mutual funds, which are covered in a later section.
MBSs are subject to two unique risks: prepayment risk and extension risk. With a typical (non-mortgage) bond, you know the bond’s maturity. For example, if a bond has a 20-year maturity, it 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 mortgages, most don’t actually last 30 years. Homeowners may pay off the mortgage early, refinance, or sell the home and pay off the loan. In each case, the mortgage ends when the homeowner repays the principal.
That uncertainty creates two interest-rate-related risks:
If interest rates fall, many homeowners refinance to get a lower rate. Mortgages are paid off sooner than expected, so your MBS returns principal earlier than expected. This is prepayment risk. It’s especially frustrating because your MBS may have been paying a higher yield than what’s available after rates fall.
If interest rates rise, homeowners are less likely to refinance and more likely to keep their existing mortgages. Mortgages are paid off later than expected, so your MBS lasts longer than expected. This is extension risk. In this case, your MBS may be paying a lower yield than what’s available in the current higher-rate market.
After US Government debt is sold at Treasury auctions, those securities trade in the over-the-counter (OTC) markets. An OTC trade is one that doesn’t take place on a physical exchange like the New York Stock Exchange.
Similar to how corporate bonds are quoted, US Government debt is quoted in percentage of par format. However, instead of eighths, US Government securities are quoted in 32nds. Government bonds are quoted in 32nds because the market is larger and prices move in smaller increments. Quoting in 32nds creates more possible prices.
US Government debt quotes may look different, but converting them to a dollar price follows the same logic as with corporate bonds.
An investor finds three separate quotes for the same bond:
- 95-8
- 95:8
- 95.8
US Government quotes can be presented with a dash, colon, or period. Even though you don’t see a fraction written out, each quote translates to a bond price of 95 and percent of par. The number on the right side of the quote (after the dash, colon, or period) is always assumed to be in 32nds. Unlike corporate bonds, the fraction is not reduced.
If you use the same “fraction-boot-scoot” method used with corporate bonds, you can convert the quote to a price. The only difference is that the fraction is in 32nds.
A US Government bond is quoted at 95-8. What is its price?
Step 1: calculate the fraction
Step 2: boot the decimal back to the big number
Step 3: scoot the decimal once over to the right
Think you can do it on your own? Give it a try!
A US Government bond is quoted at 103:20. What is its price?
Step 1: calculate the fraction
Step 2: boot the decimal back to the big number
Step 3: scoot the decimal once over to the right
As you can see, the process is very similar to the way corporate bond quotes work. The quotes look different, but the method is the same. Both corporate and US Government securities are quoted in percentage of par format.
Treasury bill quotes are an exception. Because Treasury bills are short-term and zero-coupon, they’re quoted in “discount yield” form. Treasury bill quotes are provided in yield form, reflecting the rate of return the bill provides.
For example, a Treasury bill quote might look like 3.2%. Instead of giving a dollar price, the quote tells the investor the overall return (yield) based on the bill’s discount. Remember, Treasury bills are bought at discounts, mature at par, and do not have a coupon.
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