Difference Between Agency and Non-Agency Mortgage-Backed Securities
Mortgage-backed securities (MBS), which are groups of home mortgages that are sold by the issuing banks and then packaged together into “pools” and sold as a single security, can be classified in two ways: “Agency” or “non-Agency” securities.
Definitions of Agency and Non-Agency MBS
Agency MBS are created by one of three quasi-government agencies: Government National Mortgage Association (known as GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corp. (Freddie Mac). GNMA bonds are backed by the full faith and credit of the U.S. government and thus are free from default risk. While FNMA and Freddie Mac securities lack this same backing, the risk of default is negligible. Securities issued by any of these entities are referred to as “Agency MBS.”
Private entities, such as financial institutions, can also issue mortgage-backed securities. In this case, the MBS are referred to as “non-agency” MBS or “private label” securities. These bonds are not guaranteed by the U.S. government or any government-sponsored enterprise since they often consisted of pools of borrowers who couldn’t meet Agency standards. Many of these were the “Alt-A” and “sub-prime” loans that gained notoriety during the 2008 financial crisis. It, in conjunction with the lack of government backing, means that non-Agency MBS contain an element of credit risk (i.e., a possibility of default) not present in Agency MBS.
A brief history of non-agency MBS
The heaviest issuance of non-Agency MBS occurred from 2001 through 2007 and then ended in 2008 following the housing/financial crisis. According to JP Morgan’s 2010 piece “Non-Agency Mortgage-Backed Securities, Managing Opportunities, and Risks," “The outstanding balance of non-agency mortgages grew from roughly $600 billion at the end of 2003 to $2.2 trillion at its peak in 2007.”
The rapid growth in the non-agency MBS market is widely cited as being a key catalyst for the crisis since these securities provided a way for less creditworthy homebuyers to gain financing. It eventually led to an increased in delinquencies, causing non-Agency MBS to collapse in value in 2008.The “contagion” subsequently spread to higher-quality securities, accelerating the crisis and causing new issuance to come to a halt.
The asset class has performed very well in the subsequent recovery, however, rewarding contrarian money managers who took the risk of buying into a very depressed market in 2009. Money managers can still invest in non-Agency MBS today despite the lack of new issuance, as the securities issued prior to the financial crisis continue to trade in the open market.
Leave the analysis to the pros
Except in the rarest of cases, non-Agency MBS aren’t for individual investors. In its piece “Finding Opportunities in Today’s Non-Agency Mortgage Market,” the asset management firm PIMCO outlines the various considerations involved in selecting individual securities within this market segment:
- Housing market analysis, on both the national and local levels
- Public policy analysis
- Analysis of the various individual segments, or tranches, within each MBS deal to determine those issues with the optimal risk/return profile
- Market liquidity
- Interest-rate and yield curve analysis
- Analyzing the various servicing entities
Although it isn’t advisable for investors to purchase non-Agency MBS on their own, many actively-managed bond funds own these securities. In many cases, the funds have owned these bonds since the post-crisis period, in which case they would have made a large contribution to returns. While there isn’t nearly as much upside in non-Agency MBS now as there was five years ago, consider their presence in a bond fund as an indication the manager is willing to seek opportunities in unpopular market segments.