Agency securities, obligations

What Is Agency Securities?

Agency securities are debt obligations issued by U.S. government-sponsored enterprises (GSEs) or by federal government agencies. These fixed income securities are not direct obligations of the U.S. Treasury, but they often carry an implied government backing, making them a relatively low-risk investment within the broader financial markets category of debt instruments. A key characteristic of agency securities is their role in supporting specific sectors of the U.S. economy, such as housing, agriculture, or education, by providing liquidity to those markets.

History and Origin

The concept of government-sponsored enterprises (GSEs) and the issuance of agency securities traces back to the early 20th century, with the first GSE, the Farm Credit System, established in 1916 to provide credit to the agricultural sector. However, the most widely recognized issuers of agency securities, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), emerged to address challenges in the housing finance system. Fannie Mae was created in 1938 during the Great Depression to provide liquidity to the mortgage market by purchasing FHA-insured loans from lenders.²²,²¹ This allowed banks to free up capital and continue lending to homebuyers.²⁰,¹⁹ In 1968, Fannie Mae was reorganized from a government agency into a publicly traded, shareholder-owned company.¹⁸,¹⁷ Two years later, in 1970, Freddie Mac was established by Congress under the Emergency Home Finance Act to provide competition to Fannie Mae and further expand the secondary market for mortgages.¹⁶,¹⁵ Both entities, along with the Federal Home Loan Banks, play a vital role in providing liquidity, stability, and affordability to the mortgage market.¹⁴

Key Takeaways

• Agency securities are debt instruments issued by U.S. government-sponsored enterprises (GSEs) and federal agencies.
• They are generally considered to have low credit risk due to an implicit government backing, though they are not direct obligations of the U.S. Treasury.
• The primary purpose of agency securities is to support specific sectors of the U.S. economy, such as housing and agriculture.
• Major issuers include Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
• These securities offer investors a balance between yield and relative safety.

Interpreting Agency Securities

Agency securities are interpreted primarily as instruments designed to facilitate the flow of credit to specific economic sectors. Their relatively low default risk, stemming from their government sponsorship, positions them between U.S. Treasury securities and corporate bonds in terms of risk-return profile. Investors typically evaluate agency securities based on their coupon rate, maturity, and prevailing interest rates. A higher yield compared to Treasury bonds of similar maturity often reflects a slightly higher perceived credit risk, even with the implicit government backing. However, this spread also offers investors an opportunity for enhanced income while still maintaining a high degree of safety for their investment portfolio.

Hypothetical Example

Consider an investor, Sarah, who is looking to invest $10,000 in fixed income securities. She wants something with a higher yield than a typical Treasury bond but still with very low risk. Sarah researches agency securities and finds a 10-year Fannie Mae bond offering a 3.5% annual coupon. A comparable 10-year U.S. Treasury bond might be offering a 3.0% yield.

Sarah decides to purchase the Fannie Mae agency security. Each year, she will receive $350 in interest payments. At the end of 10 years, she will also receive her original $10,000 principal back. This hypothetical investment allows Sarah to earn a slightly higher return than government bonds while relying on the perceived stability and implicit backing of the U.S. government-sponsored enterprise.

Practical Applications

Agency securities are widely utilized in various segments of the financial world. They are a common component of institutional investment portfolios, including those held by pension funds, insurance companies, and money market funds, due to their credit quality and stable income streams. The Federal Reserve also actively buys and sells agency debt securities and mortgage-backed securities (MBS) as part of its open market operations to influence monetary policy and support the U.S. housing market.¹³,¹²,¹¹ These purchases increase the quantity of reserve balances in the banking system, affecting liquidity.¹⁰ Furthermore, commercial banks hold agency securities to meet regulatory requirements and for their balance sheet management. The role of Fannie Mae and Freddie Mac in packaging mortgages into MBS and guaranteeing the timely payment of principal and interest on the underlying mortgages is crucial for attracting investors to the secondary market.⁹

Limitations and Criticisms

Despite their perceived safety, agency securities are not without limitations and criticisms. A primary concern revolves around the "implicit guarantee" from the U.S. government. While not explicitly stated, the market generally assumes that the government would intervene to prevent a major GSE from defaulting on its obligations, as evidenced by the 2008 financial crisis when Fannie Mae and Freddie Mac were placed into conservatorship.,⁸,⁷ This implicit guarantee has been criticized for creating a moral hazard, where GSEs might take on more risk than a purely private entity, knowing they have government backing.⁶,⁵ Critics argue that this arrangement allows GSEs to borrow at lower interest rates than private firms, creating an unfair advantage and potentially distorting capital markets.⁴,³ The conservatorship of Fannie Mae and Freddie Mac, which began in September 2008, highlighted the substantial taxpayer exposure linked to these entities and continues to be a subject of debate regarding the future of housing finance.,²,¹

Agency Securities vs. Treasury Securities

Agency securities and Treasury securities are both debt instruments associated with the U.S. government, yet they differ in their issuer and guarantee.

The key distinction lies in the guarantee. Treasury securities, like Treasury bonds, are direct obligations of the U.S. government and are backed by its "full faith and credit," making them essentially free of default risk. Agency securities, while often benefiting from an implicit government guarantee due to their critical public purpose, do not carry this explicit backing. This subtle but important difference can influence their yield and how they are viewed by investors.

FAQs

What is the primary difference between agency securities and U.S. Treasury bonds?

The primary difference is the issuer and the nature of the government backing. Agency securities are issued by government-sponsored enterprises (GSEs) or federal agencies and have an implicit, but not explicit, government guarantee. U.S. Treasury bonds are direct obligations of the U.S. Department of the Treasury and carry the explicit "full faith and credit" of the U.S. government.

Are agency securities safe investments?

Yes, agency securities are generally considered very safe investments. While they do not have the explicit backing of the U.S. government like Treasury securities, the implicit guarantee and the critical public purpose of the issuing entities mean they are widely perceived to have extremely low credit risk.

Do agency securities pay interest?

Yes, most agency securities pay interest to investors, typically on a semi-annual basis, similar to many other fixed income instruments. This interest payment is known as the coupon.

How do agency securities contribute to the economy?

Agency securities contribute to the economy by providing a reliable and affordable source of funding for specific sectors, most notably housing and agriculture. By purchasing loans from primary lenders, GSEs like Fannie Mae and Freddie Mac ensure these lenders have sufficient liquidity to continue issuing new loans, thereby facilitating homeownership and agricultural development.