Federal agencies

Mortgage agency securities

Three federal agencies exist to encourage homeownership in the United States. We’ll look at each one here.

Ginnie Mae, officially the Government National Mortgage Association (GNMA), guarantees loans insured by the VA (Veterans Affairs), FHA (Federal Housing Administration), and USDA Rural Development. 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 you’ll see below, this is different from the other agencies, which have only indirect backing.

Fannie Mae, officially the Federal National Mortgage Association (FNMA), purchases both insured (VA and FHA) mortgages and conventional (non-insured) mortgages. 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 considered riskier than Ginnie Mae and have only indirect backing from the US Government. In addition, both are publicly traded companies. Although they were started 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 loans to homebuyers. After purchasing the mortgages, the agencies collect the mortgage payments and pass the 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 purchased by investors are known as mortgage-backed securities (MBS). Retail investors often access these securities through mutual funds, which you’ll learn about in a future section.

MBSs are subject to two unique risks: prepayment risk and extension risk. With a typical non-mortgage bond, you know how long the bond can last. For example, if a bond has a 20-year maturity, it can’t remain outstanding beyond 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 their mortgages early, refinance, or sell their homes and pay off the loan. In each case, the mortgage ends when the homeowner repays the principal.

That means if you invest in an MBS, you won’t know exactly how long your investment will last.

• If interest rates fall, many homeowners refinance and pay off their existing mortgages. Your MBS is likely to end sooner than expected. This is prepayment risk.
• If interest rates rise, homeowners tend to keep their mortgages longer and avoid refinancing. Your MBS lasts longer than expected, and you’re stuck earning a lower yield than the current market offers. 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 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 has more frequent price changes. Quoting in 32nds allows more possible trading prices.

US Government debt quotes may look different, but converting them to a dollar price works the same way as with corporate bonds.

An investor finds three separate quotes for the same bond:

• 95-8
• 95:8
• 95.8

US Government quotes can use a dash, colon, or period. Even though you don’t see a written fraction, each quote translates to 95 and $\frac{\text{8}}{\text{32}}$ percent of par. The number to the right of the dash, colon, or period is always assumed to be in 32nds. Unlike corporate bonds, you don’t reduce the fraction.

If you use the same “fraction-boot-scoot” method used for corporate bonds, you can convert the quote to a price. The only difference is that the fraction is in 32nds. Here are 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. 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. Due to their short-term, zero-coupon nature, 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 providing an actual price, the quote tells the investor they’ll earn an overall return (yield) of 3.2% based on the bill’s discount. Remember, Treasury bills are bought at discounts, mature at par, and do not have a coupon.