Government Agencies and Sponsored Entities

5.2 Government Agencies and Sponsored Entities

Government agencies and sponsored entities play a crucial role in the U.S. financial markets by issuing securities that help finance various public policy objectives. Understanding these entities and the securities they issue is essential for anyone preparing for the Series 7 Exam. This section will delve into the nature of agency securities, the differences between government-owned and government-sponsored entities, and the types of securities issued by these agencies.

Introduction to Agency Securities

Agency Securities are debt instruments issued by government agencies or government-sponsored enterprises (GSEs) to support specific financial functions. These securities are typically considered low-risk investments due to their association with the government, though they are not directly backed by the U.S. Treasury unless explicitly stated.

Purpose of Agency Securities

Agency securities are designed to provide funding for specific sectors such as housing, agriculture, and education. They help facilitate liquidity in these sectors by providing a reliable source of capital. For investors, agency securities offer a relatively safe investment with yields higher than U.S. Treasury securities.

Government-Owned vs. Government-Sponsored Entities

Understanding the distinction between government-owned and government-sponsored entities is fundamental to grasping the landscape of agency securities.

Government-Owned Entities

Government-owned entities are fully owned and operated by the federal government. Securities issued by these entities are backed by the full faith and credit of the U.S. government, making them virtually risk-free. An example of such an entity is the Government National Mortgage Association (GNMA or Ginnie Mae).

• Government National Mortgage Association (GNMA): GNMA guarantees mortgage-backed securities (MBS) issued by approved lenders, providing liquidity in the housing market. These securities are backed by the full faith and credit of the U.S. government, ensuring timely payment of principal and interest.

Government-Sponsored Entities (GSEs)

GSEs are privately held corporations created by Congress to enhance the flow of credit to targeted sectors of the economy. Unlike government-owned entities, GSEs do not have the full backing of the U.S. government, though they are perceived to have an implicit guarantee due to their federal charter.

• Federal National Mortgage Association (FNMA or Fannie Mae): Fannie Mae provides liquidity to the mortgage market by purchasing mortgages from lenders, thus allowing them to issue more loans. It issues debt securities to fund its operations, which are not backed by the U.S. government but are considered low-risk.

• Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac): Similar to Fannie Mae, Freddie Mac buys mortgages from lenders and packages them into mortgage-backed securities. These securities help provide liquidity and stability to the housing market.

Types of Securities Issued by Agencies

Agency securities come in various forms, each serving different purposes and offering distinct characteristics.

Mortgage-Backed Securities (MBS)

MBS are pools of mortgages that are packaged together and sold as a single security. These securities provide investors with periodic payments derived from the underlying mortgage payments.

• Pass-Through Securities: These are the simplest form of MBS, where mortgage payments are passed directly to investors after deducting servicing fees. GNMA, FNMA, and FHLMC are major issuers of pass-through securities.

• Collateralized Mortgage Obligations (CMOs): CMOs are more complex MBS that divide the pool of mortgages into tranches, each with different maturities and risk levels. This structure allows investors to choose a tranche that matches their risk tolerance and investment horizon.

Debt Securities

GSEs issue debt securities to raise capital for their operations. These securities include bonds and notes with varying maturities and interest rates.

• Agency Bonds: These are long-term debt securities with maturities typically ranging from 1 to 30 years. They offer higher yields than U.S. Treasury bonds due to the lack of explicit government backing.

• Agency Notes: Shorter-term debt instruments with maturities ranging from a few months to a few years. They are used to meet the short-term funding needs of the agency.

Overview of Major Agencies

Understanding the roles and functions of major government agencies and GSEs is crucial for the Series 7 Exam.

Government National Mortgage Association (GNMA or Ginnie Mae)

• Purpose: GNMA guarantees the timely payment of principal and interest on MBS issued by approved lenders. It supports the housing market by providing liquidity and stability.
• Securities: GNMA issues pass-through MBS, which are backed by the full faith and credit of the U.S. government.

Federal National Mortgage Association (FNMA or Fannie Mae)

• Purpose: Fannie Mae enhances liquidity in the mortgage market by purchasing and securitizing mortgages. It aims to make housing more affordable by providing a steady flow of funds to mortgage lenders.
• Securities: FNMA issues MBS and debt securities, including bonds and notes, to finance its operations.

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

• Purpose: Similar to Fannie Mae, Freddie Mac provides liquidity, stability, and affordability to the U.S. housing market by purchasing mortgages and issuing MBS.
• Securities: FHLMC issues MBS and debt securities, with a focus on providing a diverse range of investment options.

Student Loan Marketing Association (SLMA or Sallie Mae)

• Purpose: Originally created to support the student loan market, Sallie Mae has transitioned to a private company. It still plays a role in providing student loans, though its securities are no longer considered agency securities.
• Securities: Historically, SLMA issued debt securities to fund student loans, but it now operates as a private entity.

Federal Farm Credit Banks (FFCB)

• Purpose: FFCB provides credit and financial services to agricultural and rural communities. It supports farmers, ranchers, and rural infrastructure projects.
• Securities: FFCB issues bonds and notes to raise capital for lending to the agricultural sector.

Practical Examples and Case Studies

To better understand the role of agency securities, consider the following scenarios:

Scenario 1: Investing in GNMA Securities

An investor seeking a low-risk investment with a steady income stream might consider GNMA securities. These pass-through securities offer the safety of government backing and regular interest payments, making them an attractive option for risk-averse investors.

Scenario 2: Diversifying with FNMA and FHLMC Securities

A portfolio manager looking to diversify fixed-income holdings might include FNMA and FHLMC securities. These MBS provide higher yields than U.S. Treasuries, with the added benefit of supporting the housing market. The manager can choose from various tranches in CMOs to match the portfolio’s risk profile.

Scenario 3: Supporting Agriculture with FFCB Bonds

An investor interested in supporting rural communities might invest in FFCB bonds. These securities finance agricultural projects and rural infrastructure, offering a way to contribute to community development while earning a return.

Key Considerations and Exam Tips

• Implicit vs. Explicit Guarantee: Understand the difference between securities with explicit government backing (e.g., GNMA) and those with an implicit guarantee (e.g., FNMA, FHLMC).
• Types of MBS: Familiarize yourself with pass-through securities and CMOs, including their structure and risk characteristics.
• Role of GSEs: Recognize the role GSEs play in providing liquidity and stability to specific sectors, such as housing and agriculture.
• Exam Focus: Pay attention to the distinctions between government-owned and government-sponsored entities, as well as the types of securities they issue.

Summary

Government agencies and sponsored entities are vital components of the U.S. financial system, providing essential funding for housing, agriculture, and other sectors. Understanding the securities issued by these entities, along with their risk and return profiles, is crucial for the Series 7 Exam. By mastering the concepts outlined in this section, you’ll be well-prepared to tackle questions related to agency securities and their role in the financial markets.

Series 7 Exam Practice Questions: Government Agencies and Sponsored Entities

By understanding these concepts, you will be well-prepared to answer questions on government agencies and sponsored entities in the Series 7 Exam.

In this section

• Government National Mortgage Association (GNMA): Understanding Ginnie Mae and Its Role in Mortgage-Backed Securities
  Explore the Government National Mortgage Association (GNMA), also known as Ginnie Mae, and its critical role in guaranteeing mortgage-backed securities (MBS). Learn about the full faith and credit backing by the U.S. government, and delve into practical examples of GNMA securities.
• Federal National Mortgage Association (FNMA) in U.S. Securities
  Explore the role of the Federal National Mortgage Association (FNMA) in the U.S. secondary mortgage market, its operations, implicit government backing, associated risks, and analysis of FNMA securities.
• Federal Home Loan Mortgage Corporation (FHLMC)
  Explore the role of the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, in the U.S. mortgage market. Understand the types of securities it issues, investment strategies, and regulatory considerations.