Chapter 12 Part 7 Flashcards
The Federal Home Loan Mortgage Corporation, nicknamed Freddie Mac, purchases residential
Federal Housing Administration, and Veterans Administration mortgages from savings institutions and resells them by means of mortgage-backed securities. Like Fannie Mae, Freddie Mac’s securities arc not guaranteed by the U.S. government
The most common type ofmmtgage-backed security that these government agencies issue is the
pass-through certificate
To create a pass-through certificate, the agency
“purchases a group of mortgages and pools them together. In the simplest scenario, the pool will only contain mortgages with similar interest rates and maturity dates. The agencies then sell interests in this pool to investors as pass-through certificates. Each certificate entitles its owner to a share in the cash generated by the pool of mortgages. Each month the homeowners make their mortgage payments into the pool. After certain administrative charges are deducted, the bulk of these payments is passed through to the investors every month.
The payment includes interest and principal”
Pass-through certificates are fully
negotiable. Investors can sell them to other investors after they are issued
The monthly interest payments that investors receive from agency mortgage-backed securities arc subject to
federal, stale, and local taxes
Mortgage-backed securities often pay
higher yields than treasuries. they can also provide investors with a source of monthly income and are considered relatively safe, conservative invcstn1cnts
As with most agency securities, FNMA and FHLMC certificates are backed by
the agency that issues them and not by the U.S. government. GNMA certificates, however, are directly guaranteed by the federal government.
In addition to the normal risks associated with all debt securities (interest-rate and credit risks), mortgage-backed securities have their own special risk, which is called
prepayment risk. Prepayment risk is similar to call risk in some ways. Many homeowners pay off their mortgages early. These prepayments are put into the mortgage pool and passed on to investors. Since any mortgage can be paid off at any time, the cash flow from a pass-through certificate may be unpredictable. The problem is exacerbated by the fact that many homeowners refinance when interest rates are low. Investors in pass-through certificates may find themselves worrying about how to reinvest large amounts of capital at a time when interest rates are low
Collateralizcd Mortgage Obligations are issued by Freddie Mac and also private companies. They are
bonds backed by pools of mortgages, mortgage pass-lhroughs, or other CMOs
CMOs differ from normal pass-through certificates in that they
divide the principal and interest payments from the underlying mortgages into various classes of bonds called tranches. Each tranche has a different payment schedule and a different rate of interest even though they are all backed by the same pool of mortgages. This gives investors a more predictable cash flow and helps to reduce (though not eliminate) prepayment risk
CMOs are considered to be
corporate securities. These securities are NOT exempt from the Securities Act of 1933. lnterest on CMOs is fully taxable
The local governments that issue municipal bonds include
cities, counties, school districts, and other public authorities, agencies, and commissions. United States territories and possessions also issue municipal bonds. Although the risk of default for a particular issue depends on the issuer, municipal investment-grade bonds are generally considered a rather safe, conservative investment
Since municipal bonds are exempt from
the registration provisions of the Securities Act, there is no prospectus issued. The issuer will provide investors with a similar document called an official statement and include a legal opinion that clarifies the tax status of the municipal bond’s interest
The main advantage of municipal bonds is that
their interest is exempt from federal income taxes. Most states also exempt the bonds issued within their state from state and local income taxes. Since municipal bonds allow investors to save money on taxes, they pay lower rates of interest than other bonds of similar credit risk
Bonds issued by a territory or possession of the United States, such as Puerto Rico, the U.S. Virgin Islands, Guam, and American Samoa are
not subject to federal, state, or local income taxes. They are triple-tax-exempt
