What Are Agency Mortgage-Backed Securities? The Expert’s Guide

Agency Mortgage-Backed Securities (MBS) are a type of investment security representing an ownership claim in a pool of residential mortgages issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, and the Government National Mortgage Association (GNMA), often called Ginnie Mae. These securities effectively transform individual home loans into standardized, tradable investments, backed by the implicit or explicit guarantee of these agencies.

Understanding the Core Mechanics

Agency MBS play a crucial role in the U.S. housing market by facilitating a continuous flow of capital from investors to lenders, thereby making mortgages more accessible and affordable for homebuyers. Let’s break down the key elements that define these securities:

The Mortgage Pool

At the heart of every Agency MBS is a pool of mortgages. These mortgages share common characteristics, such as similar interest rates, maturities, and loan types (e.g., 30-year fixed-rate). Lenders originate these mortgages following specific guidelines set by the GSEs or Ginnie Mae. Once a sufficient number of mortgages are accumulated, they are bundled together to form a mortgage pool.

The Securitization Process

This is where the magic happens. The GSEs (Fannie Mae and Freddie Mac) or Ginnie Mae purchase these mortgage pools from lenders. They then create mortgage-backed securities representing claims on the cash flows generated by the underlying mortgages in the pool. These securities are then sold to investors in the secondary market. This process of converting loans into tradable securities is known as securitization.

Pass-Through Securities

Most Agency MBS are structured as pass-through securities. This means that the principal and interest payments from the underlying mortgages are “passed through” to the investors holding the securities. The GSEs or Ginnie Mae act as guarantors, ensuring investors receive timely payments, even if some borrowers default. They charge a guarantee fee for this service, which is deducted from the mortgage payments before they are passed through to investors.

The Role of the Agencies

Fannie Mae and Freddie Mac primarily deal with conforming mortgages, meaning mortgages that meet specific size and underwriting requirements. These mortgages are generally considered lower risk than non-conforming mortgages. Ginnie Mae, on the other hand, guarantees MBS backed by mortgages insured by government agencies like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). These mortgages often serve borrowers with lower credit scores or down payments. The backing of Ginnie Mae carries the full faith and credit of the U.S. government, providing an added layer of security for investors.

Key Features of Agency MBS

• Liquidity: Agency MBS are highly liquid, meaning they can be easily bought and sold in the secondary market. This liquidity is due to the standardization of the securities and the widespread investor interest.
• Creditworthiness: The backing of Fannie Mae, Freddie Mac, or Ginnie Mae significantly reduces the credit risk associated with these securities.
• Predictable Cash Flows: Investors receive a stream of income from the underlying mortgages in the pool, providing a relatively predictable cash flow. However, this predictability is affected by prepayment risk, which we will discuss later.
• Minimum Denominations: Agency MBS are typically available in minimum denominations of $25,000, making them accessible to a wider range of investors.

Understanding Prepayment Risk

While Agency MBS offer relatively stable income streams, investors face prepayment risk. This refers to the possibility that homeowners will pay off their mortgages early, either through refinancing at lower interest rates or by selling their homes. When interest rates fall, homeowners are more likely to refinance, leading to a surge in prepayments. This reduces the principal outstanding on the MBS and can negatively impact the returns for investors, particularly if they purchased the MBS at a premium (above face value). Sophisticated investors employ various models to estimate prepayment speeds and manage this risk.

The Impact on the Housing Market

Agency MBS have a profound impact on the housing market. By providing a readily available source of funding for mortgages, they help to keep interest rates low and make homeownership more accessible. The securitization process allows lenders to originate mortgages without having to hold them on their balance sheets, freeing up capital for new lending. This increased liquidity and efficiency in the mortgage market ultimately benefits homebuyers.

Agency MBS: Frequently Asked Questions (FAQs)

Here are some frequently asked questions about Agency MBS to provide further clarification:

FAQ 1: What is the difference between a pass-through rate and a coupon rate on an Agency MBS?

The coupon rate is the stated interest rate on the mortgage-backed security. The pass-through rate is the rate investors actually receive after deducting servicing and guarantee fees. The pass-through rate is always lower than the coupon rate.

FAQ 2: What is the “WAC” and “WAM” of an Agency MBS pool?

WAC stands for Weighted Average Coupon, which is the average interest rate of the mortgages in the pool, weighted by the outstanding principal balance of each mortgage. WAM stands for Weighted Average Maturity, which is the average remaining term of the mortgages in the pool, weighted by the outstanding principal balance of each mortgage. These metrics provide insights into the overall characteristics of the mortgage pool.

FAQ 3: How are Agency MBS priced?

Agency MBS are priced based on factors such as prevailing interest rates, the expected prepayment speed of the underlying mortgages, and the creditworthiness of the agency guaranteeing the security. Market participants use complex models to assess these factors and determine a fair price. Prices are often quoted as a percentage of par (face value).

FAQ 4: What is a “To-Be-Announced” (TBA) market?

The TBA market is a forward market for Agency MBS. In this market, investors agree to buy or sell MBS for delivery at a future date. The specific mortgages that will be delivered are not known at the time of the trade, hence the name “To-Be-Announced.” The TBA market provides liquidity and price discovery for Agency MBS.

FAQ 5: What are the risks associated with investing in Agency MBS?

Besides prepayment risk, investors also face interest rate risk. If interest rates rise, the value of existing MBS may decline. Additionally, there’s extension risk, which is the risk that prepayments will slow down when interest rates rise, extending the life of the MBS and potentially reducing returns. Though agency-backed, there is always the risk that the implied or explicit guarantees of the GSEs or Ginnie Mae may be weakened or altered by future government actions, resulting in regulatory risk.

FAQ 6: How do I purchase Agency MBS?

You can purchase Agency MBS through a brokerage firm or a financial advisor. Many mutual funds and exchange-traded funds (ETFs) also invest in Agency MBS, providing a diversified and convenient way to gain exposure to this asset class.

FAQ 7: Are Agency MBS taxable?

Yes, the interest income from Agency MBS is generally taxable at the federal, state, and local levels. However, the tax treatment may vary depending on the investor’s individual circumstances and the type of account in which the MBS are held (e.g., taxable account, IRA, 401(k)).

FAQ 8: How do Agency MBS contribute to financial stability?

Agency MBS play a crucial role in providing liquidity and stability to the mortgage market. By standardizing mortgages and making them tradable, they allow lenders to access a broader pool of capital, reducing their reliance on traditional bank funding. This diversification of funding sources helps to mitigate systemic risk in the financial system.

FAQ 9: What happened to Agency MBS during the 2008 financial crisis?

During the 2008 financial crisis, the value of many MBS plummeted as defaults on subprime mortgages soared. This led to significant losses for investors and contributed to the broader financial meltdown. The crisis highlighted the importance of sound underwriting standards and risk management practices in the mortgage market.

FAQ 10: What is the difference between Agency MBS and Non-Agency MBS?

Agency MBS are backed by Fannie Mae, Freddie Mac, or Ginnie Mae, while Non-Agency MBS are not. Non-Agency MBS, also known as private-label securities, are typically backed by mortgages that do not meet the conforming loan criteria of the GSEs. As a result, they carry a higher degree of credit risk and typically offer higher yields to compensate investors.

FAQ 11: How can I use Agency MBS in my investment portfolio?

Agency MBS can be used to generate income, diversify a portfolio, and hedge against inflation. They are often included in fixed-income portfolios as a relatively safe and liquid investment.

FAQ 12: What are some resources for learning more about Agency MBS?

You can find information about Agency MBS from various sources, including the websites of Fannie Mae, Freddie Mac, and Ginnie Mae, as well as from financial news outlets, investment research firms, and brokerage firms.

Conclusion

Agency Mortgage-Backed Securities are a cornerstone of the U.S. financial system, facilitating homeownership and providing investors with access to a stable and liquid asset class. Understanding their characteristics, risks, and role in the market is essential for both investors and those involved in the housing industry. By carefully evaluating the factors that influence their performance, investors can make informed decisions and effectively incorporate Agency MBS into their investment strategies.