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) only purchases VA (Veterans Affairs), FHA (Federal Housing Administration), and USDA Rural Development insured loans. These are loans that are insured by another part of the federal government and are only available to specific types of homeowners (e.g. veterans and 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 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 to 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 will 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.

US Government auction & quotes

After US Government debt is sold at Treasury auctions, those securities trade exclusively in the over-the-counter (OTC) markets. An OTC trade is one that does not 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 has more price changes. When a bond can be quoted in 32nds, there are more possible prices the bond can trade at.

US Government debt quotes will look different, but the process of converting them to a price is the same 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. Although you don’t see a fraction above, the quote translates to a bond price of 95 and $\frac{\text{8}}{\text{32}}$ 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, there is no reduction of the fraction.

If you utilize the same “fraction-boot-scoot” method we used with corporate bonds, you can convert the quote to a price. The only difference is how the fraction is presented. Let’s look at a few examples.

A US Government bond is quoted at 95-8. What is its price?

Step 1: calculate the fraction

• $\frac{\text{8}}{\text{32}}$ = 0.25

Step 2: boot the decimal back to the big number

• 95 + 0.25 = 95.25

Step 3: scoot the decimal once over to the right

• $952.50

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?

As you can see, the process is very similar to the way we approach corporate bond quotes. Yes, the quotes look and feel 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 to this process. Due to their short-term zero coupon nature, they are quoted in “discount yield” form. Treasury bill quotes are provided in yield form, reflective of the rate of return the bill provides.

For example, a Treasury bill quote might look like 3.2%. Instead of providing an actual price, the investor knows that they will achieve an overall return (yield) of 3.2% based on the discount of the bond. Remember, Treasury bills are bought at discounts, mature at par, and do not have a coupon.