We just discussed Treasury products, all of which have the direct backing of the U.S. government. In practical terms, these securities would “go down with the ship” only if the U.S. Treasury couldn’t 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 different from direct backing. It’s like telling a friend before they go swimming, “If you get in trouble, I’ll save you only if I’m able to.” Indirect backing still matters to investors, but it isn’t as strong as the backing Treasuries receive. With directly backed U.S. government securities, investors expect the government to do everything it can to prevent a default.
We’ll learn about specific types of agency securities in this section, including:
The U.S. government often subsidizes areas it considers essential to American life, and food production is one of them. To support agriculture, the government created the Federal Farm Credit System, which offers easier-to-obtain loans to farmers across the United States.
Farmers can use this system for:
The Federal Farm Credit System issues bonds to the investing public to finance its activities. The money raised is then loaned to farmers at favorable interest rates. This structure helps keep borrowing relatively cheap and accessible for many farmers.
Homeownership is another area the U.S. government incentivizes. Real estate plays a major role in the economy, and the government generally prefers a market environment where Americans can buy and sell homes more easily and where home values can reasonably be expected to rise over time.
The government supports homeownership 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. An example makes the benefit clearer.
Assume you decide to buy a house. Unless you can pay cash, you’ll need a mortgage loan. Many homebuyers work with local banks and lending institutions to borrow the necessary funds. After the application process, your local bank lends you money to buy the property. Once you move in, you begin making mortgage payments to your local bank.
Later, you receive a letter from Fannie Mae stating that it bought your mortgage and that you’ll now make your mortgage payments to Fannie Mae. The loan terms don’t change - only the institution receiving your payments changes.
When agencies buy mortgages from banks, the banks receive large sums of money they can lend out again as new mortgages. In other words, the local bank that originally lent you money can now lend that same amount to another customer. This system helps make borrowing for home purchases more accessible and can put downward pressure on interest rates.
To finance these activities, the agencies sell securities - specifically, mortgage-backed securities (MBS). A commonly issued type of MBS is a Pass-Through Certificate (PTC). PTCs do what the name suggests: they pass through mortgage payments to investors.
To see how this works, consider a second example. Freddie Mac wants to raise money to buy mortgages from banks across the nation. To do so, it issues PTCs, which typically have a denomination of $25,000 (but can be sold in denominations as small as $1,000). Freddie Mac uses the capital raised to purchase mortgages from several different banks and then places those mortgages into a portfolio.
Each homeowner whose mortgage was purchased by Freddie Mac makes monthly payments to Freddie Mac. Over the life of each mortgage, Freddie Mac receives monthly payments that include both interest and principal:
Freddie Mac collects these mortgage payments, keeps a small amount to cover operating expenses, and then passes the rest through to the MBS holders. As a result, investors receive monthly payments of varying interest and principal. In effect, investors are in a position similar to the bank that originally lent the money and collected the mortgage payments.
MBSs are subject to two unique risks: prepayment risk and extension risk. With standard, non-mortgage-related bonds, investors know the maturity. For example, a bond with a 20 year maturity can’t last more or less than 20 years (unless it’s callable). With an MBS, investors won’t know the exact maturity. Even though many mortgages are written as 30-year mortgages, many don’t last 30 years. Homeowners may pay off early, refinance, or sell the home and pay off the mortgage. In each case, the mortgage ends when the outstanding principal is repaid.
If interest rates fall, many homeowners refinance and pay off their old mortgages early. In that environment, MBS investments will likely end sooner than expected. Investors typically dislike this outcome because the MBS may have offered a higher yield than the current market (lower interest rates), but it ends earlier than expected. This is prepayment risk.
If interest rates rise, the opposite can happen. Homeowners tend to keep their mortgages longer and avoid refinancing. Investors are then stuck holding lower-yielding MBSs for longer because fewer homeowners pay off early. This is extension risk.
Like all interest-paying securities, MBSs are also subject to reinvestment risk. Because MBS payments are made frequently (monthly), reinvestment risk can be significant.
Ginnie Mae, officially known as the Government National Mortgage Association (GNMA), guarantees V.A. (Veterans Affairs) or FHA (Federal Housing Administration) insured loans. These loans are available only to certain homeowners (for example, low-income purchasers and veterans). Due in part to the minimal risk involved, the U.S. Government directly backs Ginnie Mae securities. Remember, other agencies generally have indirect backing. Ginnie Mae securities are considered virtually default-risk free, similar to 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), 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. They also have only indirect backing from the U.S. Government. Fannie and Freddie are publicly traded companies. Although the U.S. Government founded these organizations, they’re 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 main reason for this difference is that mortgage interest is tax-deductible to the homeowners making the monthly payments. The IRS won’t allow tax benefits for both the people making the mortgage payments and the people receiving those payments.
The Student Loan Marketing Association (SLMA), also known as Sallie Mae, specializes in offering student loans to its customers. SLMA started as a government-sponsored enterprise and originally worked similarly to the agencies discussed above. It was spun off as a private business in 2004 and now operates as a standalone company with no government backing. The company also has publicly traded stock outstanding (ticker: SLM).
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