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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Mortgage and Agency FAQ Date: 11/25/2006 7:09 PM
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Since Jack never go around to doing this, I just went ahead and gave it the old college try. Since this has not previously been reviewed, please look at it and make any additions and corrections. I'll probably put it in right after TIPS and before Corporates, though it may fit better after corporates (which I haven't looked at yet).


Mortgage Securities and Agency Bonds

(Look under US Government Agency Bonds in bondonline link): http://www.bondsonline.com/Educated_Investor_Center/Types_of_Bonds.php


When consumers take out government backed mortgages from banks and other lenders, the loans are pooled, repackaged and made available to the public (and funds, etc.) in the form of mortgage securities (“pass-through certificates”) offered by the Government National Mortgage Association (GNMA or “Ginnie Mae”), “supported by the full faith and credit of the U.S. government, ” or by former government agencies, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), nicknamed Fannie Mae and Freddy Mac, which are now publicly traded companies. Fannie and Freddie are rated AAA, but it is worth reading news stories about accounting practices and questionable loan portfolios, since these companies do not have the same government guarantees as the HUD based GNMA.

GNMA bonds can be bought periodically as new issues for a minimum of $25,000. Fannie and Freddie bonds can be bought in $1000 increments and new issues are available (with no commission at some brokerages), as being bought and sold on the open market.

Although mortgage securities are issued with a maturity date and coupon payment, like other bonds, they are different in having continuous call provisions and paying off the principal in bits and pieces. When a home owner sells a house, pays off a mortgage early, or refinances, that mortgage ends, and a portion of a mortgage security that owns that mortgage gets called. The bond holder then receives back part of the principal, and the interest payments are based on the remaining principal. By time a 30-year mortgage security matures, there may be little left of the principal to be returned.

Historically, mortgage securities have been popular with investors, because they have paid higher interest (around 100 basis points on the average) than Treasuries, with almost as little risk of default. Even the periodic prepayment of principal was manageable, since it can in gradually over a long time. However, historically most people had 30-year mortgages and moved infrequently. Now, adjustable rate and “creative” mortgages are a widely used, home owners refinance frequently to take advantage of lower interest rates or the cash out the equity in their homes, and moving is commonplace. The result is that mortgage securities are much more subject to being called in bits and pieces than in the pass, especially when interest rates are low (and “reinvestment risk” for the bond holder is high).

There are also bonds issued by other government agencies, such as the Tennessee Valley Authority (TVA). These are AAA bonds, usually with call provisions, but without the bits and pieces calls of mortgage securities.
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