Agency mbs

What Is Agency MBS?

An Agency MBS, or Agency Mortgage-Backed Security, is a type of fixed-income security that represents an ownership interest in a pool of mortgage loans. These securities are issued or guaranteed by a U.S. government agency or government-sponsored enterprise (GSE). The primary guarantors of Agency MBS include Ginnie Mae (Government National Mortgage Association), Fannie Mae (Federal National Mortgage Association), and Freddie Mac (Federal Home Loan Mortgage Corporation). Investors in Agency MBS receive payments derived from the principal and interest payments made by homeowners on the underlying mortgages. This structure allows for the creation of liquid investment instruments from illiquid mortgage loans, a process known as securitization.

History and Origin

The concept of pooling mortgages and selling them to investors to provide liquidity to the housing market emerged in the mid-20th century. The Federal National Mortgage Association, or Fannie Mae, was established in 1938 as part of the New Deal, initially as a federal government agency designed to act as a secondary mortgage market facility by purchasing Federal Housing Administration (FHA)-insured loans from private lenders⁴⁰, ⁴¹. This created liquidity, allowing lenders to fund more home loans³⁹.

In 1968, Fannie Mae was privatized, and the Government National Mortgage Association, or Ginnie Mae, was created as a government-owned corporation within the Department of Housing and Urban Development (HUD)³⁸. Ginnie Mae's role was to guarantee timely payment of principal and interest on privately issued mortgage-backed securities collateralized by government-insured or guaranteed mortgages, such as FHA, VA (Veterans Affairs), or USDA (U.S. Department of Agriculture) loans³⁷. Unlike Fannie Mae and Freddie Mac, Ginnie Mae's guarantees are explicitly backed by the full faith and credit of the U.S. government³⁶.

Two years later, in 1970, the Federal Home Loan Mortgage Corporation, or Freddie Mac, was established by Congress to further expand the secondary mortgage market, particularly to help thrift institutions manage interest rate risk³⁵. Both Fannie Mae and Freddie Mac typically purchase conventional conforming mortgage loans, pool them, and then issue and guarantee mortgage-backed securities collateralized by these loans³³, ³⁴. These entities have been pivotal in facilitating homeownership by providing a robust and liquid secondary market for mortgages.

Key Takeaways

• Agency MBS are debt securities backed by pools of mortgage loans and guaranteed by U.S. government agencies or government-sponsored enterprises like Ginnie Mae, Fannie Mae, and Freddie Mac.
• They provide investors with regular cash flows derived from the principal and interest payments of the underlying mortgages.
• The government backing or sponsorship generally makes Agency MBS a lower-risk investment compared to private-label mortgage-backed securities, but they still carry prepayment risk.
• Agency MBS play a crucial role in housing finance by providing liquidity to mortgage originators, enabling them to make more loans.
• The yield of an Agency MBS is influenced by prevailing interest rates, the coupon rate, and the expected life of the security, which can be affected by prepayments³².

Interpreting Agency MBS

Interpreting an Agency MBS involves understanding its sensitivity to various market factors, particularly interest rate risk and prepayment risk. Unlike a traditional bond where the investor receives a fixed stream of payments and the return of principal at maturity, an Agency MBS repays principal throughout its life³¹.

When interest rates fall, homeowners are more likely to refinance their mortgages at lower rates, leading to faster prepayments of the underlying loans in the Agency MBS pool²⁹, ³⁰. This accelerated return of principal forces investors to reinvest their funds at lower prevailing interest rates, which can reduce the overall yield of the security. Conversely, when interest rates rise, homeowners are less likely to refinance, causing prepayments to slow down. This extends the average life of the Agency MBS, meaning investors are locked into lower-than-market coupon rates for a longer period²⁸. This phenomenon, where the duration of the MBS changes in an undesirable direction in response to interest rate movements, is known as negative convexity.

Hypothetical Example

Consider an investor purchasing an Agency MBS with an initial face value of $100,000, representing a share in a pool of 30-year mortgages with a weighted average coupon rate of 4.5%. For simplicity, assume monthly payments are directly passed through to the investor.

Initially, the investor expects a certain stream of monthly principal and interest payments based on models assuming a standard prepayment speed. In this scenario, if general mortgage rates drop significantly to 3.5%, many homeowners in the underlying pool might choose to refinancing their mortgages. As a result, the investor would receive a larger portion of their principal back earlier than anticipated.

For example, instead of receiving a steady, amortizing principal payment over 30 years, they might receive an additional lump sum of principal as mortgages are paid off early. This means the investor now has cash that needs to be reinvested. If new bonds or other fixed-income securities are offering lower yields (e.g., 3.5%), the investor faces the challenge of finding comparable returns, impacting the overall realized yield of their initial Agency MBS investment.

Practical Applications

Agency MBS are widely used in financial markets for various purposes. They are a core component of many institutional investment portfolios, including those of pension funds, insurance companies, and mutual funds, due to their relatively high credit quality and liquidity.

One significant application is in the implementation of monetary policy by central banks. The Federal Reserve, for instance, has historically acquired large quantities of Agency MBS as part of its large-scale asset purchase programs (Quantitative Easing) during and after economic crises, such as the Global Financial Crisis of 2008 and the COVID-19 pandemic²⁷. These purchases were aimed at supporting U.S. housing markets and improving overall financial market conditions²⁶. As of June 2024, the Fed held approximately $2.3 trillion of Agency MBS²⁵. The Fed also engages in the reduction of its Agency MBS holdings through balance sheet runoff, allowing securities to mature without reinvestment²⁴. This activity directly impacts the supply and demand dynamics in the Agency MBS market and, by extension, mortgage rates and housing affordability.

Furthermore, Agency MBS are used by banks to manage their balance sheets and comply with capital requirements. Federal regulators' guidelines can make Agency MBS an attractive asset class for banks due to their comparatively favorable capital treatment relative to other asset types²³. Their role also extends to enabling greater diversification for lenders by allowing them to sell off loans and free up capital for new lending.

Limitations and Criticisms

While Agency MBS offer significant benefits, they are not without limitations and criticisms. The primary risk for investors is prepayment risk. This risk means that the actual maturity and cash flows of an Agency MBS are uncertain because homeowners can prepay their mortgages at any time without penalty²². When interest rates decline, prepayments tend to increase, forcing investors to reinvest their returned principal at lower rates, potentially reducing their overall yield²¹. Conversely, when rates rise, prepayments slow, extending the duration of the security and locking investors into lower-than-market rates for longer²⁰.

Another consideration is that while Agency MBS are considered to have minimal default risk due to the explicit or implicit government guarantee, they are still subject to market price fluctuations based on interest rate movements and investor demand¹⁹. Though Agency MBS themselves are typically perceived as safe, the broader market for mortgage-backed securities, including non-agency varieties, faced significant scrutiny during the 2008 financial crisis. Some narratives suggested that securitization of "bad loans" and faulty risk ratings for residential mortgage-backed securities (RMBS) were key culprits, though some research challenges the extent to which AAA-rated subprime securities contributed to losses in the non-agency market¹⁵, ¹⁶, ¹⁷, ¹⁸. While Agency MBS are distinct due to their government backing, the complexity and interconnectedness of the overall mortgage market can sometimes lead to broader market sentiment affecting their pricing.

Agency MBS vs. Non-Agency MBS

The key distinction between Agency MBS and non-Agency MBS lies in their guarantee.

Investors often confuse the two because both are types of mortgage-backed securities. However, the presence or absence of a government guarantee fundamentally alters the credit risk profile of the security. Non-Agency MBS played a more direct and significant role in the initial stages of the 2008 financial crisis due to their exposure to subprime mortgages and associated high default risk, unlike their agency counterparts¹¹, ¹².

FAQs

How do Agency MBS provide liquidity to the housing market?

Agency MBS provide liquidity by allowing mortgage originators (like banks) to sell the mortgages they create into the secondary market. This frees up capital for these lenders, enabling them to make new mortgage loans to more homebuyers, thereby facilitating the flow of money into the housing sector⁹, ¹⁰.

Are Agency MBS considered safe investments?

Agency MBS are generally considered very safe investments, especially those guaranteed by Ginnie Mae, which have the full faith and credit of the U.S. government backing their principal and interest payments⁸. Fannie Mae and Freddie Mac also guarantee their securities, though their implicit government backing became explicit only after the 2008 financial crisis. While credit risk is minimal, investors still face prepayment risk and interest rate risk.

What is the "pass-through" nature of Agency MBS?

The "pass-through" nature refers to how the payments from the underlying mortgages are distributed to investors. As homeowners make their monthly mortgage payments (including principal and interest), these payments are collected by a servicer and then "passed through" to the Agency MBS investors, typically on a pro-rata basis, after deducting servicing and guarantee fees⁷.

How does the Federal Reserve's balance sheet relate to Agency MBS?

The Federal Reserve holds a significant amount of Agency MBS on its balance sheet as part of its monetary policy operations⁵, ⁶. By buying or selling these securities, the Fed can influence long-term interest rates and the overall supply of money in the economy, impacting the cost of borrowing for mortgages and other loans³, ⁴.

Do Agency MBS have a fixed maturity date?

Unlike traditional bonds, Agency MBS do not have a precisely fixed maturity date due to the possibility of mortgage prepayments². While the underlying mortgages might have a stated term (e.g., 30 years), borrowers can pay off their loans early through refinancing or selling their homes. This causes the effective maturity, often measured by weighted average life, to fluctuate, creating prepayment risk for the investor¹.