Agency Securities: Understanding GSEs and Federal Agency Bonds

4.2.2.2 Agency Securities

Agency securities play a critical role in the U.S. financial markets, providing liquidity and stability. These securities are issued by government-sponsored enterprises (GSEs) and federal agencies, and they serve various functions, including supporting the housing market and agricultural sectors. In this section, we will delve into the characteristics, types, and uses of agency securities, with a focus on prominent issuers such as Fannie Mae and Freddie Mac.

Understanding Government-Sponsored Enterprises (GSEs)

Government-Sponsored Enterprises (GSEs) are financial services corporations created by Congress to enhance the flow of credit to specific sectors of the economy, such as housing and agriculture. While GSEs are privately held, they have a public mission and benefit from certain government privileges. They do not carry the full faith and credit of the U.S. government, but they are perceived to have an implicit guarantee, which often results in lower borrowing costs.

Key Characteristics of GSEs

• Public Mission with Private Ownership: GSEs are designed to serve public purposes, such as promoting homeownership, but they are owned by private shareholders.
• Implicit Government Support: Although not explicitly guaranteed by the government, GSEs benefit from an implicit backing, which enhances their creditworthiness.
• Market Influence: GSEs are major players in the secondary mortgage market, purchasing mortgages from lenders to provide liquidity and facilitate home loans.

Prominent GSEs and Their Securities

Fannie Mae (Federal National Mortgage Association)

Fannie Mae was established in 1938 to expand the secondary mortgage market by securitizing mortgages, thus allowing lenders to reinvest their assets into more lending. Fannie Mae issues mortgage-backed securities (MBS) that are backed by pools of mortgages.

• Mortgage-Backed Securities (MBS): These securities are created by pooling mortgages and selling the cash flows to investors. They offer a way for investors to gain exposure to the mortgage market.
• Debt Securities: Fannie Mae also issues debt securities to finance its operations, which are considered to have low credit risk due to the perceived government support.

Freddie Mac (Federal Home Loan Mortgage Corporation)

Freddie Mac was created in 1970 to further support the secondary mortgage market. Like Fannie Mae, Freddie Mac buys mortgages and issues MBS.

• Participation Certificates (PCs): These are Freddie Mac’s version of MBS, representing interests in pools of mortgages.
• Debt Instruments: Freddie Mac issues a variety of debt securities, including reference notes and bills, to support its mortgage purchasing activities.

Federal Agency Securities

Federal agencies, unlike GSEs, are directly part of the federal government. Their securities are backed by the full faith and credit of the U.S. government, making them highly secure investments.

Types of Federal Agency Securities

• Government National Mortgage Association (GNMA or Ginnie Mae): Ginnie Mae guarantees MBS issued by approved lenders, ensuring timely payment of principal and interest. These securities are fully backed by the U.S. government.
• Federal Farm Credit Banks (FFCB): These banks provide credit to the agricultural sector and issue debt securities to fund their operations. Their securities are considered safe investments due to government backing.
• Federal Home Loan Banks (FHLB): These banks support mortgage lending and community investment by providing funds to member financial institutions. They issue consolidated obligations, which are highly rated due to government support.

Characteristics of Agency Securities

Agency securities, whether issued by GSEs or federal agencies, share several common characteristics:

• Liquidity: Agency securities are generally liquid, with active secondary markets that facilitate buying and selling.
• Credit Quality: While GSE securities have an implicit guarantee, federal agency securities are explicitly backed by the government, making them highly creditworthy.
• Yield: These securities typically offer higher yields than U.S. Treasury securities, reflecting their slightly higher risk profile.

Uses of Agency Securities

Agency securities are utilized by a wide range of investors, including:

• Institutional Investors: Banks, insurance companies, and pension funds invest in agency securities for their safety and yield.
• Individual Investors: These securities are also attractive to individual investors seeking income and diversification.
• Portfolio Diversification: Agency securities provide a way to diversify fixed-income portfolios while maintaining a relatively low risk profile.

Case Study: The Role of Fannie Mae and Freddie Mac in the 2008 Financial Crisis

During the 2008 financial crisis, Fannie Mae and Freddie Mac faced significant challenges due to their exposure to subprime mortgages. The U.S. government placed both entities into conservatorship to stabilize the housing market and prevent further economic turmoil. This move underscored the implicit government support for GSEs and highlighted their critical role in the financial system.

Practical Example: Investing in Agency Securities

Consider an investor looking to balance their portfolio with fixed-income securities. They might choose agency securities for their combination of safety and yield. By investing in a mix of Fannie Mae MBS and GNMA securities, the investor can achieve diversification while benefiting from the credit quality of these instruments.

Regulatory Environment

Agency securities are subject to various regulations to ensure transparency and protect investors. The Securities and Exchange Commission (SEC) oversees the registration and disclosure requirements for these securities. Additionally, the Federal Housing Finance Agency (FHFA) regulates Fannie Mae and Freddie Mac, ensuring they operate safely and soundly.

Conclusion

Agency securities are a vital component of the U.S. financial markets, offering investors a blend of safety, liquidity, and yield. Understanding the nuances of GSEs and federal agency securities is essential for any aspiring securities representative, as these instruments play a crucial role in supporting key sectors of the economy.

Series 7 Exam Practice Questions: Agency Securities