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GNMA, FNMA, FHLMC

Securities issued by these agencies contain additional guarantees that make them among the most creditworthy investments available. The secondary mortgage market plays a vital role in U.S. housing finance by providing support to the lending institutions. By selling their loans into the secondary market, lenders obtain additional funds that will enable them to make more loans to home buyers.

Traditional 15- and 30- Year Pass-Throughs—The Originals

The process starts when the homeowner obtains a mortgage. The mortgage lender or servicer then has a group of loans with similar characteristics securitized by GNMA, FNMA, or FHLMC. This group of mortgages is known as a "pool".

The security holder owns an undivided interest in the pool. The undivided interest entitles the owner to a pro-rata share of all interest payments and all scheduled or pre-paid principal payments. Thus, on each payment date, investors receive a payment that represents both principal repayment of the investment and interest on a declining investment amount. When the homeowner prepays principal in excess of monthly scheduled principal, the excess is passed through to investors. These accelerated principal receipts shorten the term of the securities and reduce total interest income as the outstanding principal amount of the investment declines.

Investors must understand that the expected term of mortgage-backed securities is essentially never the same as the stated term—and because mortgage or principal repayments can't be predicted exactly, the actual term is never known at the time an investment is made. In considering a particular pass-through, the investor must weigh the risk of an earlier- or later- than-expected retirement of principal and its impact on the timing of principal receipts and expected yield.

Although the standard pass-throughs have ultimate maturities of 15 to 30 years, the average weighted life of these securities is 7 to 10 years. Investors will receive the minimum scheduled principal payments each month as well as any prepayments of principal. Receiving monthly principal and interest gives investors flexibility and are a nice addition to many portfolios.

Why buy seasoned Ginnie Maes?

Short final maturities all money back within 6-13 years (finals of '04 to '10)

Invest small amounts many seasoned pools require as little as a $2500 investment

Less probability of refinancing risk than with new issues of same coupon.

These seasoned pools have been outstanding for from 15 to 25 years. The cost of refinancing lessens the financial advantage for the smaller, shorter mortgages remaining, as compared with recently issued 30-year mortgages of the same coupon.

Who Issues Pass-Throughs?

There are many types of mortgage-backed securities that give investors monthly payment of both principal and interest commonly referred to as "cash flow." This article provides background on the three housing agencies: Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), and Federal National Mortgage Association (Fannie Mae).

Government National Mortgage Association (GNMA)

The GNMA pass-through represents a pooling of Federal Housing Authority (FHA) and Veterans Administration (VA) mortgages on 1-to-4 family residences. Unlike conventional mortgages, FHA and VA mortgages are assumable in the event of sale of the underlying property. The full and timely payment of principal and interest is guaranteed by GNMA, which is backed by the full faith and credit of the U.S. Government. GNMAs are the only agency pass-through to provide this direct and explicit government guarantee.

Federal Home Loan Mortgage Corporation (FHLMC)

FHLMC participation certificates (PCs) represent an undivided interest in a pool of conventional, non-assumable 30 year fixed-rate mortgages. The participation certificate "passes through" to the holder a monthly cash flow which includes interest, scheduled principal repayments and any unscheduled return of principal (prepayments). FHLMC PCs are guaranteed only by the Federal Home Loan Mortgage Corporation, not directly by the U.S. government. Although not a direct government obligation, it is considered highly unlikely that the government would permit a default on a FHLMC-sponsored security.

Federal National Mortgage Association (FNMA)

FNMA mortgage-backed securities are formed by pooling fixed-rate conventional mortgages and, to a limited extent, FHA and VA mortgages. Interest and principal repayments are passed through to the holder on a monthly basis. Like FHLMC PCs, FNMA mortgage-backed securities are not directly backed by the U.S. government, but rather, are solely the obligations of the FNMA. It is also considered unlikely that the government would permit a default by FNMA.

All three agencies have a vital role in the availability of housing for Americans by linking investors with borrowers. They issue several different types of mortgage collateral reflecting today's diverse mortgage market. These include ARMs, 5-and 7-year balloons, and traditional 15-year and 30-year pass throughs. All of these securities work as pass-throughs because they represent the basic role reversal of a mortgage, where the investor receives a pro-rata share of the principal and interest paid on the "pooled" mortgages each month. While monthly cash flow involves some additional bookkeeping, it also has many benefits for investors. Receiving monthly principal and interest gives investors flexibility and may be a nice addition to many portfolios.