We just discussed Treasury products, all of which maintain the direct backing of the U.S. government. Essentially, these securities “go down with the ship” only if the U.S. Treasury cannot make required interest or principal payments to bondholders (highly unlikely). Federal agencies can also borrow money by issuing bonds, but their debt is generally indirectly backed by the U.S. government.
Indirect backing is unique. It’s like telling your friend right before they go swimming, “if you get in trouble and start drowning, I’ll only save you if I’m able to.” Indirect backing is valuable to investors, but it’s not as strong as the backing afforded to Treasuries. Investors with directly-backed U.S. government securities know the government will do everything it can to prevent a default.
We’ll learn about specific types of agency securities in this section, including:
Generally speaking, the U.S. government prefers subsidizing essential aspects of American life. Providing ourselves with the food we eat is one of them. To do so, the U.S. government created the Federal Farm Credit System, which offers easy-to-obtain loans to farmers across the United States. A farmer seeking short-term financing at harvest or long-term funding to pay for farming equipment can utilize this system.
The Federal Farm Credit System issues bonds to the investing public to finance their activities. The money raised is loaned out to farmers at favorable interest rates. Because of this system, it’s cheap and easy for many farmers to obtain loans from the government.
Homeownership is an American staple the U.S. government incentivizes. Real estate plays a significant economic role, and the government prefers to create a friendly market environment. That way, Americans can freely buy and sell their homes and reasonably expect home values to increase over time.
The government incentivizes home ownership through three federal agencies: Ginnie Mae, Fannie Mae, and Freddie Mac. These organizations work with banks and lending institutions across the United States and purchase their mortgages. Let’s work through an example to understand how this benefits the real estate market.
Assume you decide to buy a house. You’ll need a mortgage loan unless you can pay for the home in cash. Many real estate purchasers work with local banks and lending institutions to borrow the necessary funds. After a lengthy application process, your local bank lends you money to buy the property. Soon after moving in, you begin making mortgage payments to your local bank to repay the borrowed funds. Then, you receive a letter from Fannie Mae stating they bought your mortgage, and you will now make your mortgage payments to them. The loan remains the same, except for the institution receiving your payments.
When agencies buy mortgages from banks, the banks receive significant sums of money they can now lend out as new mortgages. The local bank that initially lent you money can now lend the same amount to another customer. This system makes borrowing money for home purchases more accessible, lowering interest rates for everyone. To finance their activities, the agencies sell securities. Specifically, they sell mortgage-backed securities (MBS). A commonly issued type of MBS is a Pass-Through Certificate (PTC). PTCs work exactly how they sound - they pass through mortgage payments to their investors.
To better understand this concept, let’s work through another example. Freddie Mac wants to raise money to buy mortgages from banks across the nation. To do so, they issue PTCs, which typically maintain a denomination of $25,000 (but can be sold in denominations as small as $1,000). Freddie Mac uses the raised capital to purchase mortgages from several different banks, then places them in a portfolio.
Each homeowner with a mortgage purchased by Freddie Mac starts making monthly payments to Freddie Mac. The agency receives monthly allotments of interest and principal over the life of each mortgage. Mortgage payments consist of part interest and part principal. At the beginning of a mortgage, a homeowner’s payment is mostly interest. Towards the end of a mortgage, the principal represents the most significant portion of the payment.
Freddie Mac now receives mortgage payments from the homeowners. The agency charges a small amount to pay for operational expenses, then passes through the rest to the owners of the MBSs. The holders of these securities receive monthly payments of varying interest and principal. Essentially, investors act like the bank that lent the homeowners their money and now collects their mortgage payments.
MBSs are subject to two unique risks: prepayment and extension risk. Investors who purchase standard, non-mortgage-related bonds know how long they last. For example, a bond with a 20 year maturity cannot last more or less than 20 years (unless it’s callable). Investors who purchase an MBS will not know the exact maturity. While most mortgages are 30-year mortgages, most do not last 30 years. Many homeowners pay off their mortgages early, refinance, or sell their homes and pay off their mortgage. The mortgage ends when the homeowner pays back the outstanding principal in these circumstances.
If interest rates fall, many homeowners refinance and pay off their old mortgages early. In this environment, these investments will likely end sooner than expected. Investors aren’t too happy about it, either. Their MBS had a higher yield than what the current market offers (lower interest rates) but ended 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. Investors are stuck with lower-yielding MBSs that last longer due to fewer homeowners paying off their mortgages. This is extension risk.
Like all interest-paying securities, MBSs are subject to reinvestment risk. Since payments are made frequently (monthly), this risk is significant.
Ginnie Mae, officially known as the Government National Mortgage Association (GNMA), guarantees V.A. (Veterans Affairs) or FHA (Federal Housing Administration) insured loans. They are only available to specific homeowners (e.g., low-income purchasers and veterans). Due in part to the minimal risk involved, the U.S. Government directly backs Ginnie Mae securities. Remember, all other agencies have indirect backing. Ginnie Mae securities are virtually default-risk free, like Treasury securities.
Fannie Mae, officially known as the Federal National Mortgage Association (FNMA), purchases insured (V.A. 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 are considered riskier than Ginnie Mae. Plus, they only maintain indirect backing from the U.S. Government. Interestingly, Fannie and Freddie are publicly traded companies. Although the U.S. Government founded these organizations, they are owned by stockholders.
Interest from U.S. government securities is typically subject to federal taxation but exempt from state and local taxes. Interest from agency-created MBSs is fully taxable (subject to federal, state, and local taxation). The primary reason for the difference is that mortgage interest is tax-deductible to the homeowners who make their monthly payments. The IRS won’t allow tax benefits for those who make the mortgage payments and those who receive those payments!
The Student Loan Marketing Association (SLMA), also known as Sallie Mae, specializes in offering student loans to its customers. SLMA initially started as a government-sponsored enterprise and worked similarly to the agencies discussed above. It was “spun off” as a private business in 2004 and now operates as a standalone business with no government backing. Additionally, the company has publicly traded stock outstanding (ticker: SLM).
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