Another Foray Into Mortgage-Backed Securities

Last week's column on Ginnie Mae pass-throughs drew a couple of astute reader emails.

Jack Riashi Jr. inquired whether it was true that mortgage-backed securities, or MBS, make payments monthly as opposed to quarterly or semiannually, making them ideal for someone looking to earn monthly income.

Sorry to say, I completely neglected to make that point in the column. Virtually all MBS make payments monthly, corresponding to the monthly schedule on which homeowners repay their mortgage loans. Most regular bonds pay semiannually.

Whether they're ideal for someone looking to earn monthly income depends on the investor. Someone who wants to know with absolute certainty how much he or she is going to receive each month might prefer to structure a bond portfolio from at least six different issues, each of which makes a fixed payment twice a year, with one payment each month. The prepayment risk associated with MBS (discussed last week) means the investor can't know for sure how much of his or her investment will be returned each month.

Thanks for pointing that out, Jack!

Meanwhile, Jim Salhany inquired about the other issuers of MBS -- Fannie Mae (FNM) and Freddie Mac (FRE).

Noting that these so-called government-sponsored enterprises, or GSEs, have been in the news recently because of a congressional initiative to take away their line of credit to the Treasury Department, he asked for information on the precise nature of the credit line.

Let's take a step back. Fannie and Freddie are the two biggest of a handful of debt-issuing entities that Wall Street calls agencies, but which are actually GSEs. Others include the Federal Home Loan Banks, FICO (Financing Corporation), REFCorp (Resolution Funding Corporation), Sallie Mae (SLM) and the Tennessee Valley Authority.

Each entity has a slightly different relationship with the federal government, but all were created by the government for a particular purpose. In the case of Fannie, Freddie and the Federal Home Loan Banks, each of which has a credit line with the Treasury Department, the purpose is to promote home ownership by making mortgage credit more accessible. Some of Fannie's and Freddie's board members are appointed by the President, and the firms are bound to meet affordable housing targets set by the Department of Housing and Urban Development.

Fannie and Freddie issue MBS, but they also issue regular bonds, which Wall Street calls agency securities. Virtually all agency securities are rated triple A, the highest possible rating, by credit rating agencies.

The initiative to take away the credit lines -- contained in a bill introduced by Rep. Richard Baker (R, La.) -- affects mainly these agency securities. While Fannie's and Freddie's MBS are guaranteed by the agencies, they are obligations of the underlying borrowers. But the agency securities are the sole obligations of Fannie and Freddie, and in a crisis, the agencies might need a credit line to meet those obligations. (Baker's bill would take away the credit lines of Fannie, Freddie and the Federal Home Loan Banks only.)

The key point about the credit lines is that they are purely symbolic: They have never been used, and if they ever had to be, they wouldn't provide much comfort to investors. Fannie's and Freddie's credit lines, established many years ago, authorize the Treasury Department to buy up to $2.25 billion of securities owned by each firm. But at the end of the first quarter, Fannie and Freddie had a combined $856 billion of direct obligations, and guaranteed a total of $1.6 trillion of MBS.

Any change in the law respecting GSEs would trigger a review of their credit ratings, the two major rating agencies, Moody's Investors Service and Standard & Poor's, have said. But it isn't certain that loss of the credit lines would lead to downgrades.

Moody's explanation of its triple A rating on Fannie Mae, for example, says it "reflects its status as a [GSE], its important role in U.S. housing finance policy and its healthy financial fundamentals."

In rating any GSE, Moody's says that after examining its financial and business fundamentals, it considers "the likelihood that the U.S. government will provide the support necessary for the timely payment of the GSE's debt, if required to prevent a default." A line of credit by the Treasury is seen as something that may strengthen the government's resolve to avert a GSE default. But loss of the lines of credit wouldn't necessarily force the conclusion that the government is unlikely to take action to avert a default, says Stanislas Rouyer, senior analyst at Moody's. "It's not clear it would have an impact on our rating," he says.

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