Agency securities are obligations issued by the government throughvarious political subdivisions. Most federal agency securities are notobligations of the US Treasury.

• Government sponsored enterprise (GSE) are privately owned, publicly chartered entities.
• They were created by Congress tohelp students, farmers and homeowners.
• The five GSEs that issuedebentures are the Federal Farm Credit System, Federal Home Loan BankSystem, Federal National Mortgage Association, Federal Home Loan BankCorporation, and Student Loan Marketing Association.
• With the exception of thesecurities issued by the Federal Farm Credit Financial AssistanceCorporation, GSE securities are not backed by the full faith and thecredit of the US government and thus investors are exposed to (but verylittle) credit risk.
• In addition to debentures (debtsecurities that are not backed by a collateral), Fannie Mae and FreddieMax issue mortgage-backed securities, securities backed by a pool ofresidential mortgage loans.

• Federal related institutions are arms of the federal government.
• They generally do not issuesecurities directly in the marketplace.
• They are exempt from SECregulation.
• The institutions obtain financingfrom the Federal Financing Bank.
• The securities are forimport-export, rural telephone, small business, etc.
• Generally these securities arebacked by the full faith and credit of the USgovernment, and therefore most FRI securities essentially have no creditrisk.
• The major issuers have been theTennessee Valley Authority (TVA) and the Ginnie Mae.

Agency mortgage-backedsecurities are issued by Fannie Mae, Freddie Macand Ginnie Mae, with pools of mortgage loans as collaterals. Each month thetotal of all interest and principal payments made by the mortgage loans in thepool, less a servicing spread, goes to the security holders. Therefore the cashflows from a mortgage-backed security are determined by cash flows from theunderlying mortgage loans.

Note that the cash flows of a mortgage-backed security is differentfrom the monthly mortgage payments of the underlying mortgage loans. There aretwo factors that cause the discrepancy:

• Servicing fees: these are administrative costs of servicing (collecting monthly payments, maintaining records, etc) the mortgage loans. If the mortgage rate is 8.125% and the service fee is 50 basis points, then the investor receives interest of 7.625%. The interest rate that the investor receives is called net interest.

• Prepayments: a payment made in excess of the monthly mortgage payment is called a prepayment. When a prepayment is not for the entire amount it is called a curtailment. Typically there is no penalty for prepaying a mortgage loan. Prepayment is caused when :
• a homeowner sell his/her home.
• the market rate falls.
• a homeowner becomes default andthe property is sold.
• the property is destroyed by fireand the insurer pays off the mortgage.

Therefore the monthly cash flows of a mortgage-backed security havethree components: net interest, scheduled principal repayment and prepayment.

There are three types of mortgage-backed securities:

• Collateralized mortgage obligations (CMOs) are bond classes (called tranches) created by redirecting the cash flows of mortgage-related products (pass-throughs and whole loans) so as to mitigate prepayment risk. Principal component (both scheduled principal repayments and prepayments) of the monthly cash flows from the underlying mortgage loans are distributed to each tranch on a prioritized basis. In another word, it can transfer (not eliminate) the various forms of this risk among different classes of bondholders so that a CMO class has a different coupon rate from that for the underlying collateral. Investors can select the tranches of a CMO based on their cash flow and risk-return preferences. However, the CMO, the passthrough securities, and the pool of underlying mortgage loans have the same amount of total prepayment risk.

A mortgage passthroughsecurity is a security created when one or more holders of mortgages form acollection of mortgages and sell shares or participationcertificates in the pool. The mortgage is said to be securitized if it is included in such a pool. Loans that meet therequirements of Fannie Mae, Freddie Mac and Ginnie Mae's are called conforming loans. The cash flow of apassthrough depends on the cash flow of the underlying pool of mortgages. Themonthly payments are passed through to the certificate holders on a pro ratabasis. An investor of a passthrough gains the diversification benefits -- theprepayment risk now is spread over a pool of mortgages.

A mortgage loan issecured by the collateral of some real estate property. The interest rate onthe mortgage loan is called the mortgagerate or contract rate. If theborrower defaults, the lender has the right to foreclose on the loan and seizethe property to ensure the timely payment of the debt. There are many types ofmortgage designs available in the US. Themost common type has the following characteristics: fixed interest rate,level-payment, fully amortized (no mortgage balance outstanding at the end ofthe loan term).

The monthly payment of a mortgage loan has two components:

• Interest = (1/12) x Fixed annual interest rate x outstanding mortgage balance at the beginning of the month.
• Scheduled principal repayment (also called amortization) = Fixed mortgage payment - interest.

Early mortgage payments mostly go toward interest. As the mortgagebalance is paid down, more and more mortgage payments are used to repayprincipal.