Thursday, April 26, 2007

Essentially, but not Really

Standard & Poor's Equity Research is one of the more professional of the securities research outfits. In their Outlook for April 25, 2007, they state:

The [mortgage-backed securities] themselves are typically issued by quasi-governmental entities like Ginnie Mae, or federally chartered enterprises like the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). These mortgage securities are high quality and carry essentially no credit risk. Investors are guaranteed interest and principal payments, but are subject to prepayment risk.

Let's take last things first: "These mortgage securities...carry essentially no credit risk." "Essentially" is the giveaway. These 'agency CMOs' do in fact carry credit risk. The AAA credit rating which most of them hold means only that their credit risk is minimal, relative to other securities. Certainly noone would claim that Fannie Mae or Freddie Mac securities are better than Ginnie Mae securities, which are "guaranteed by the full faith and credit of the U.S. Government," but even US Government agencies could, in principle, default, and in fact have refused in the past to pay according to the original terms of their bonds.

Like other complex securities, the agency CMOs should ideally be bought by people who have studied them and understand them. Ginnie Mae securities are indeed backed up by "the full faith and credit of the U.S. Government," but Fannie Maes and Freddie Macs come in various flavors, some of which are collateralized by Ginnie Maes but most of which are backed by packages of loans owned by the agencies themselves. When analyzing what this means, one should consider that Fannie Mae has been under criminal and civil investigation by Congress and various government agencies since 2004 for accounting shenanigans - with Freddie also sometimes investigated, and both Fannie and Freddie live in a multi-trillion dollar never-never land of credit derivatives which have the experts very worried.

Standard & Poor's juxtaposition of "federally chartered enterprises" and "Investors are guaranteed interest and principal payments" makes it sound like these securities have something like a government guarantee. As a matter of fact, Fannie Mae herself emphasizes that they do not, and no serious source ever said outright that they do.

Even to the extent that governmental (GNMA) or private, internal (FNM, FRE) guarantees do exist, to whom is the guarantee made? Not to the individual investor. Typically, the private investor's beneficial interest in these securities is held in an account which the investor's introducing broker opened for him with a broker-dealer. The broker-dealer is the owner of record, and the broker-dealer's terms of service say that they are not required to have any dealings with the investor: their client is the introducing broker. In other words, any guarantee which does or does not exist is made only to the broker-dealer, who is not required even to talk to you.

I have nothing against agency CMOs. In fact, I own several, and am perfectly happy with them. And I'm not expecting their issuers to default in the near future. But there's a difference between good securities and heavenly ones.


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