Agency Securities

Now that you understand Treasury securities (the safest bonds), you can see how agency securities occupy the next rung on the safety ladder; still very safe, but with a key distinction in government backing.

What Are Agency Securities?

• Issued by government-sponsored enterprises (GSEs) or federal agencies
• Most are NOT directly backed by the U.S. government
• Considered very safe but carry slightly more credit risk than Treasuries
• Primarily focused on the housing market (mortgages)

Key Agencies and Government Backing

This is one of the most tested distinctions on the SIE exam:

Key distinction:

• Ginnie Mae is a wholly owned government corporation; its securities carry the same explicit guarantee as Treasuries
• Fannie Mae and Freddie Mac are government-sponsored enterprises that were placed under federal conservatorship in 2008, but their backing remains implied, not legally guaranteed

Exam Tip: Gotchas

• Only GNMA has the full faith and credit backing of the U.S. government. Fannie Mae and Freddie Mac have implied backing only. This is a frequently tested distinction; if the exam asks which agency security is "backed by the full faith and credit of the U.S. government," the answer is always Ginnie Mae.

Mortgage-Backed Securities (MBS)

Pass-through certificates are the most common type of MBS:

• A bank pools together many individual mortgages
• The pool is sold to investors as a single security
• Monthly mortgage payments (principal + interest) pass through to investors
• Investors receive monthly payments (unlike semiannual payments for most bonds)

Key Risks of MBS

• Prepayment risk is the primary concern; when rates drop, homeowners refinance, and investors get their principal back earlier than expected and must reinvest at lower rates
• Extension risk is the opposite; when rates rise, nobody refinances, so the security lasts longer than expected while yielding below-market rates

Think of it this way: Imagine you lent money to a friend expecting repayment in 5 years. If rates drop, your friend refinances and pays you back in 2 years; now you have to re-lend at lower rates (prepayment risk). If rates rise, your friend holds on as long as possible, and you are stuck earning below-market interest for longer than expected (extension risk).

Exam Tip: Gotchas

• Prepayment risk occurs when rates FALL (homeowners refinance), not when rates rise.
• Extension risk occurs when rates RISE (nobody refinances), not when rates fall.
• MBS pay monthly (not semiannually like most bonds).

Asset-Backed Securities (ABS)

• Similar structure to MBS, but backed by pools of non-mortgage assets
• Common underlying collateral: auto loans, credit card receivables, student loans
• Same pass-through structure, same prepayment and extension risks

Collateralized Mortgage Obligations (CMOs)

CMOs add complexity on top of basic MBS:

• Divide MBS cash flows into tranches (slices) with different maturities and risk profiles
• Each tranche receives principal payments in a specific order
• Designed to give investors more control over maturity and risk exposure

Key tranche types:

• Companion tranches absorb most of the prepayment and extension risk, shielding PAC tranches
• CMOs are complex securities and are generally NOT suitable for most retail investors

Exam Tip: Gotchas

• Companion tranches absorb the most risk; Planned Amortization Class (PAC) tranches are more stable and predictable.
• CMOs do NOT eliminate prepayment risk; they redistribute it among tranches.