Section 3Function 3: Investment Products, Recommendations & Records
U.S. government agency securities (GNMA, FNMA, FHLMC)
41 min read
· Lesson 5 of 19
About This Lesson
One question runs this whole chapter: when an "agency" borrows, who actually stands behind the debt? Get the three-tier credit answer down (GNMA direct, the GSEs implied, legacy own-credit) and most questions fall. The other recurring fact is the tax twist: agency interest, GNMA included, is taxable at all three levels, with no Treasury-style state and local exemption.
What you'll cover
the credit-backing tiers: GNMA's full faith and credit, the GSEs' implied backing (FNMA, FHLMC, Farm Credit), and legacy own-authority issuers
pass-through certificates: monthly blended cash flows, PSA pricing, and prepayment versus extension risk
the smaller agencies (SLMA, TVA, FCS) and taxation: fully taxable at all three levels, even for GNMA
Government Agency Securities: Direct and GSE Issuers
Not all government-related securities carry the same guarantee. The exam tests
the critical distinction between securities backed by the full faith and credit
of the U.S. government and those issued by government-sponsored enterprises (GSEs)
that carry only an implied backing.
Full faith and credit agencies
Explicit U.S. government guarantee
GNMA (Ginnie Mae) — Government National Mortgage Association; a government agency within HUD
SBA loans, Farm Credit System, other direct federal agency obligations
Government-sponsored enterprises (GSEs)
Implied backing — no explicit government guarantee
FNMA (Fannie Mae) — Federal National Mortgage Association; publicly chartered but privately owned
FHLMC (Freddie Mac) — Federal Home Loan Mortgage Corporation; similar to FNMA
Important context: In 2008, the U.S. government
placed FNMA and FHLMC under federal conservatorship, providing an implicit guarantee that
has effectively functioned as explicit backing. However, for exam purposes, FNMA and FHLMC
are still categorized as GSEs without an explicit full faith and credit guarantee —
only GNMA carries that distinction.
Agency Credit Backing: Three Distinct Tiers
"Agency security" is one label stretched over three very different credit profiles, and the exam expects you to know which issuers carry the full faith and credit of the United States and which only borrow its glow. The tiering drives credit analysis, suitability, and the tax treatment covered later in the chapter:
Tier 1: Direct U.S. Government Backing
Securities issued or guaranteed by an agency that is part of the federal government. Default risk is the same as a direct Treasury obligation.
Issuer: Government National Mortgage Association (GNMA / Ginnie Mae) and the Tennessee Valley Authority (TVA).
Tier 2: Government-Sponsored Enterprises (GSEs)
Privately owned but federally chartered. Carry an implicit federal backing widely assumed by markets but not legally guaranteed. Higher yields than Treasuries reflect the modest credit-risk premium.
Issuers: Federal National Mortgage Association (FNMA / Fannie Mae), Federal Home Loan Mortgage Corporation (FHLMC / Freddie Mac), Federal Farm Credit Banks (Farm Credit System).
Tier 3: Own-Authority Backing
Issuer relies on its own revenue base or authority to repay. No explicit or implicit federal credit support.
Issuer (historical): Student Loan Marketing Association (Sallie Mae / SLMA) before privatization. Some legacy securities remain outstanding.
The most-tested credit fact in this chapter: GNMA is the only mortgage agency with direct U.S. government backing. FNMA and FHLMC are GSEs, and their securities carry no legal guarantee, whatever the market assumes. Expect the exam to probe this line from several angles.
The Three Mortgage Agencies: GNMA, FNMA, and FHLMC
GNMA (Ginnie Mae)
Full faith and credit
Type
Government agency (part of HUD)
Mortgages pooled
FHA-insured, VA-guaranteed, USDA rural only
Securities
Pass-through certificates
Min investment
$25,000 (originally)
Explicit guarantee
FNMA (Fannie Mae)
GSE — implied backing
Type
Publicly chartered, privately owned
Mortgages pooled
Conventional conforming; some FHA/VA
Securities
Pass-throughs + agency debt
Min investment
$1,000
Implied guarantee
FHLMC (Freddie Mac)
GSE — implied backing
Type
Publicly chartered, privately owned
Mortgages pooled
Conventional conforming primarily
Securities
Participation certificates (PCs) + debt
Min investment
$1,000
Implied guarantee
Tax trap: Unlike direct Treasury securities
(which are exempt from state and local tax), agency securities — GNMA, FNMA, and FHLMC —
are subject to federal, state, AND local income tax. This is frequently tested.
Agency securities are NOT the same as Treasuries for tax purposes.
GNMA vs. FNMA vs. FHLMC: The One Thing That Always Matters
When a question asks you to split the three mortgage agencies, one distinction decides most of them:
GNMA = full faith and credit. It sits inside HUD, an actual arm of the government, so its MBS match Treasuries for credit risk. Not, as you will see, for tax treatment.
FNMA and FHLMC = implied backing only. Privately owned, government-chartered GSEs, with no explicit U.S. guarantee of payment. The market treats them as nearly equivalent in practice; the exam tests the legal line, not the market's assumption.
The secondary distinction: GNMA pools only FHA/VA/USDA government-backed mortgages, while FNMA and FHLMC pool conventional (non-government-backed) conforming loans.
Concept Check
Which of the following agency securities carries the explicit backing of the full faith and credit of the U.S. government?
GNMA (Ginnie Mae) is the only mortgage agency whose securities carry the explicit full faith and credit guarantee of the U.S. government. GNMA is a government agency within HUD — not a GSE. FNMA and FHLMC are government-sponsored enterprises (GSEs), privately owned and chartered, whose securities carry only an implied backing. For exam purposes, only GNMA = explicit guarantee.
Concept Check
Which of the following agency securities is backed by the full faith and credit of the U.S. government?
GNMA (Government National Mortgage Association) is a government agency within HUD and its securities carry the full faith and credit guarantee of the U.S. government — the same guarantee as Treasury securities. FNMA and FHLMC are government-sponsored enterprises (GSEs), not government agencies. Their securities carry an implicit rather than explicit government guarantee (though the government placed them in conservatorship in 2008). FHLB bonds similarly carry only an implied guarantee.
Concept Check
Securities issued by private lenders and approved by which of the following agencies are directly backed by the full faith and credit of the U.S. government?
Only GNMA carries the direct full faith and credit backing of the U.S. government among the mortgage-related agencies. Ginnie Mae operates as a wholly owned government corporation within HUD, and securities approved and guaranteed under the GNMA program are direct obligations of the United States. FNMA and FHLMC are government-sponsored enterprises — privately owned but federally chartered — with only an implicit market expectation of federal support and no legal guarantee. FICB and similar farm credit issuers also operate as GSEs with cooperative-based credit support.
Section 2 of 4~10 min · 4 concept checks
Pass-Through Mechanics and Prepayment Risk
Pass-Through Certificates: How the Cash Flows Work
The flagship product of all three mortgage agencies is the mortgage pass-through certificate: a pool of individual mortgages, sold to investors in pro-rata slices, with thousands of homeowners' monthly payments flowing through as one blended check of principal and interest.
What investors receive each month:
Scheduled interest: The interest portion of each homeowner's
monthly payment, passed through pro-rata
Scheduled principal: The normal amortization portion of each
homeowner's monthly payment
Unscheduled principal (prepayments): Lump-sum paydowns when
homeowners refinance, sell their homes, or make extra principal payments
Because every monthly payment mixes principal with interest, the yield math gets harder than for a straight bond. Pass-throughs are priced against a prepayment speed assumption (PSA), a model of how fast the pool will pay down, and reality never matches the model exactly.
Prepayment Risk vs. Extension Risk
Two mirror-image risks come standard with every MBS, and they point in opposite directions:
Prepayment risk: When rates fall, homeowners refinance —
investors receive principal early and must reinvest at lower rates. The MBS shortens
in duration unexpectedly.
Extension risk: When rates rise, prepayments slow —
the MBS extends in duration unexpectedly, trapping investors in a below-market
security for longer than anticipated.
CMOs (Chapter 15) were created specifically to redistribute prepayment risk
among different investor classes (tranches).
Pass-Through Certificate Cash Flow Mechanics
The previous block gave you the shape of the cash flow; this one attaches the plumbing and the tax character. A pass-through certificate is a fractional interest in a mortgage pool held in trust: the trustee collects each month's principal and interest and passes each holder's share through, minus servicing fees.
Monthly Cash Flow Components
Interest Component
Taxable as ordinary income
The portion of each monthly mortgage payment representing interest charged on the outstanding principal. This declines over the life of the loan as principal is amortized down.
Principal Component
Return of capital, not income
The portion of each monthly mortgage payment representing scheduled principal amortization plus any prepayments from refinancing or home sales. Treated as return of cost basis, not as taxable income.
Contrast with Treasury bonds: a Treasury pays semiannual interest and returns principal once, at maturity. A pass-through pays monthly, principal and interest together, and the principal component speeds up whenever falling rates send homeowners to refinance.
Prepayment Risk and Reinvestment Risk
When mortgage rates fall, refinancing accelerates principal back to you ahead of schedule, and the only place to put it is the new, lower rate: the textbook definition of reinvestment risk. When rates rise, the mirror image: prepayments slow, the position stretches out, and you sit in a below-market security longer than planned. That is extension risk.
The combination makes MBS rate-sensitive in ways ordinary bonds are not, and the exam leans on one recognition above the rest here: MBS holders bear reinvestment risk, most acutely when rates fall.
Concept Check
An investor holds a GNMA pass-through certificate. Interest rates fall sharply and many homeowners refinance. What is the primary risk the investor faces?
When rates fall, homeowners refinance their mortgages, prepaying the underlying loans faster than expected. In a pass-through certificate, this accelerated principal is passed through to investors. While investors get their money back sooner, they must reinvest it at the now-lower prevailing rates — this is prepayment or reinvestment risk. GNMA has no default risk (government-backed). Extension risk is the opposite — prepayments slow when rates rise.
Concept Check
A CMO (collateralized mortgage obligation) is created from a pool of GNMA pass-through securities. Which of the following is true regarding the CMO's credit quality compared to the underlying GNMA collateral?
A CMO's credit quality derives directly from its collateral. When the collateral is GNMA pass-throughs (government-guaranteed), the resulting CMO carries the same AAA/government-equivalent credit quality. CMOs do not amplify or reduce credit risk — they redistribute prepayment risk among tranches. The tranching process changes the timing of cash flows, not the creditworthiness of the underlying mortgages. CMOs backed by non-agency mortgages would have lower credit quality.
Concept Check
A customer holds a Government National Mortgage Association pass-through certificate. The customer should expect each monthly distribution to consist of
Pass-through certificates distribute the cash flows from underlying mortgages on a monthly basis, with each payment combining interest charged on outstanding principal and scheduled principal amortization. Prepayments from refinancing or home sales accelerate the principal component during periods of falling rates. Treasury bonds pay semiannual interest only with principal returning at maturity, which contrasts with the pass-through structure. Principal-only distribution would not represent the economic substance of a mortgage-backed flow because each payment must cover both the cost of borrowing and amortization.
Concept Check
A registered representative is reviewing risks of mortgage-backed securities with a customer. Which risk increases significantly when prevailing mortgage interest rates fall?
When mortgage rates fall, homeowners refinance their loans at the new lower rates, accelerating principal repayment to MBS holders. The pass-through investor receives cash sooner than originally projected but must reinvest those proceeds at the now-lower prevailing market rate, the textbook definition of reinvestment risk. Default risk is reduced when rates fall because borrowers are refinancing into more affordable payments, not failing on existing ones. Currency risk does not apply because GNMA, FNMA, and FHLMC pass-throughs are denominated in U.S. dollars.
Section 3 of 4~6 min · 3 concept checks
Beyond the Big Three
Beyond the Big Three: SLMA, TVA, and Farm Credit
Three more agencies surface on the exam beyond the mortgage trio, each with one purpose and one credit profile to remember:
Agency
Purpose
Credit Backing
SLMA (Sallie Mae)
Originally chartered to fund federal student loans through purchases from lenders. Privatized in 2004; now operates as a private financial institution.
Legacy SLMA debt traded on its own credit. Current Sallie Mae corporate debt is fully private.
TVA (Tennessee Valley Authority)
Federal corporation providing electric power, flood control, and economic development across the Tennessee Valley region.
Direct U.S. government corporation. Bonds carry implicit-to-direct federal backing; revenues come from electricity sales.
FCS (Farm Credit System)
Federal Farm Credit Banks fund agricultural lending to farmers, ranchers, and rural cooperatives.
GSE structure similar to FNMA / FHLMC. Implicit federal backing through cooperative system; not a direct Treasury obligation.
Why the exam bothers: SLMA or TVA appears in an answer list mostly to see whether you recognize the name. SLMA means student loans, TVA means power, FCS means agriculture; that mapping answers nearly every question they show up in.
Concept Check
The Student Loan Marketing Association (Sallie Mae) was originally chartered to perform which of the following functions?
SLMA was created by Congress to support federal student loan programs by purchasing loans originated by private lenders. By creating a secondary market for student debt, the agency increased the willingness of banks and other lenders to extend education credit. SLMA was privatized in 2004 and now operates as a private financial-services company; legacy agency debt may still surface in exam questions referencing its pre-privatization role. Deposit insurance is the function of FDIC, not SLMA. Mortgage-backed securities for home purchases are issued by GNMA, FNMA, and FHLMC.
Concept Check
The Tennessee Valley Authority (TVA) is a federal corporation whose primary purpose is to
The Tennessee Valley Authority is a federally chartered corporation created during the Great Depression to provide electric power, flood control, navigation improvements, and economic development across the Tennessee Valley region. TVA bonds carry direct or near-direct U.S. government backing and generate revenue from electricity sales to utilities and end-users. Agricultural lending is the role of the Farm Credit System, not TVA. Mortgage guarantees are provided by GNMA, FNMA, and FHLMC. Broker-dealer regulation falls under SEC and FINRA, both unrelated to TVA.
Concept Check
A bond is issued by an entity within the Farm Credit System (FCS). The proceeds are used to support which of the following lending activities?
The Farm Credit System is a network of federally chartered cooperative lending institutions that fund agricultural credit needs across the United States. Borrowers include working farmers, ranchers, agricultural cooperatives, and rural infrastructure. FCS securities carry GSE-style implicit federal backing through the cooperative structure rather than direct Treasury obligation. Student loans were the historical province of SLMA before its privatization. Multifamily housing and industrial development financing fall under HUD-related programs and various redevelopment authorities, not FCS.
Section 4 of 4~7 min · 3 concept checks
Taxation
The One Tax Rule That Distinguishes Agencies from Treasuries
This distinction generates questions on every administration:
Treasury securities (T-bills, T-notes, T-bonds, TIPS, STRIPS): interest is federally taxable but exempt from state and local taxes.
Agency securities (GNMA, FNMA, FHLMC pass-throughs): interest is taxable at the federal, state, AND local levels, exactly like a corporate bond. No state or local exemption.
The memory hook: the exemption belongs to the direct issuer, the U.S. Treasury. GNMA may sit inside the government, but its MBS pass through private mortgage interest, and private mortgage interest carries no exemption anywhere.
Agency Securities Taxation: Fully Taxable at All Three Levels
Here is the most-tested tax fact about agencies, and the sharpest contrast with direct Treasury obligations:
Treasury Securities
Federal taxable, state/local exempt
Interest, OID accretion, and TIPS principal adjustments are all taxable at the federal level but exempt from state and local income tax. The exemption applies to direct obligations of the U.S. government.
Agency Securities (incl. GNMA)
Fully taxable at all three levels
Interest income from GNMA, FNMA, FHLMC, TVA, and similar agency issues is taxable at federal, state, and local levels. The credit backing of GNMA does not extend to tax-exempt status because the underlying obligations are private mortgages, not direct U.S. obligations.
The GNMA tax trap: the tempting logic runs "GNMA has direct government backing, so its income must be state-and-local exempt like a Treasury." Wrong. GNMA guarantees private mortgage cash flows; it does not issue direct Treasury obligations. The income keeps its character as mortgage interest from private homeowners, taxable at all three levels.
Capital Gains and Losses
Sell an agency security away from its adjusted basis and the difference is capital gain or loss under the standard more-than-one-year rule. Principal returned on a pass-through is never a taxable event; it reduces your cost basis instead.
Concept Check
An investor holds GNMA pass-through certificates. How is the interest income from these securities taxed?
Although GNMA carries the full faith and credit guarantee, its MBS interest is fully taxable at the federal, state, and local level — unlike direct Treasury securities, which are exempt from state and local tax. This is one of the most tested distinctions in this chapter. The tax exemption belongs to the Treasury as direct issuer; it does not extend to agency MBS even when the agency has an explicit government backing.
Concept Check
Which of the following correctly describes how interest from GNMA, FNMA, and FHLMC securities is taxed?
Interest from agency securities (GNMA, FNMA, FHLMC) is fully taxable at the federal, state, and local levels. This is a key distinction from direct Treasury obligations (T-bills, T-notes, T-bonds), which are exempt from state and local taxes. The exam frequently tests this distinction. Municipal bond interest is federally exempt (and often state-exempt for in-state holders). Agency MBS interest gets no special tax treatment.
Concept Check
Income from all of the following securities is fully taxable at the federal, state, and local levels EXCEPT
U.S. Treasury bonds, like all direct Treasury obligations, are exempt from state and local income taxation though fully taxable at the federal level. GNMA pass-throughs are the major trap: despite carrying direct U.S. government credit backing, the income they distribute represents interest from private mortgages held in the underlying pool. That income retains its private character for tax purposes and is therefore taxable at all three levels. Mutual fund dividends and corporate bond interest are likewise fully taxable at federal, state, and local levels.
SummaryExam-day review · 2 essentials blocks
Chapter Summary — Exam Essentials
Ch 12 Exam Essentials — U.S. Government Agency Securities
GNMA (Ginnie Mae): Only agency backed by the full faith and credit of the U.S. government. Issues mortgage-backed pass-through certificates. Pools consist of FHA/VA mortgages.
FNMA and FHLMC: Government-sponsored enterprises (GSEs), not full government agencies. Carry an implied (not explicit) government guarantee. Both were placed in government conservatorship in 2008.
Tax treatment: ALL agency securities (GNMA, FNMA, FHLMC) are fully taxable at federal, state, and local levels. This distinguishes them from Treasuries (state/local exempt) and munis (federally exempt).
Prepayment risk: All mortgage-backed pass-throughs are subject to prepayment risk. When rates fall, homeowners refinance → principal returned faster than expected → reinvestment at lower rates.
CMO credit quality: Equals the credit quality of the underlying collateral. GNMA-backed CMOs carry government-equivalent quality. The tranching structure redistributes prepayment risk — it does not change credit quality.
Agency Securities Exam Traps — Consolidated
Twelve agency traps with exam history. Read them through the night before; each one is the fact a real question turned on:
1. GNMA carries direct U.S. government backing. Of the
mortgage agencies, only GNMA has full faith and credit. FNMA and FHLMC are
GSEs with implicit (not explicit) backing.
2. GNMA income is fully taxable at all three levels.
Federal, state, and local. The Treasury state/local exemption does NOT extend
to GNMA despite the direct credit backing. Underlying mortgages are private
obligations.
3. FNMA = Fannie Mae, FHLMC = Freddie Mac, GNMA = Ginnie Mae.
Memorize the trade names. They appear in question stems both ways.
4. Pass-throughs pay monthly, not semiannually. Each payment
combines interest (taxable income) and principal (return of capital, reduces
basis). Treasury bonds pay only semiannual interest; principal returns at
maturity.
5. MBS bear reinvestment risk when rates fall. Homeowners
refinance, accelerating principal repayment. The investor must reinvest at
lower prevailing rates, the textbook reinvestment-risk scenario.
6. SLMA = Sallie Mae = student loans. Privatized in 2004;
current Sallie Mae corporate debt is fully private. Legacy SLMA agency debt
may still be referenced on questions.
7. TVA = Tennessee Valley Authority = regional power utility.
Federal corporation, direct U.S. government backing. Revenues come from
electricity sales in the Tennessee Valley region.
8. FCS = Farm Credit System = agricultural lending. GSE
structure. Implicit federal backing through cooperative system; not direct
Treasury credit.
9. GNMA minimum denomination is $1,000. Increments of $1
above the minimum. Larger pool participations available, but the retail
minimum is fixed at $1,000.
10. Agency yields exceed Treasury yields for the same maturity.
The spread reflects credit risk (modest for direct-backed agencies, larger
for GSEs), liquidity, and prepayment uncertainty on MBS structures.
11. Pass-through interest portion is taxable as ordinary income.
The principal portion is return of capital and reduces cost basis. Investors
must track both components for tax reporting.
12. Agency securities are NOT exempt securities under the 1933 Act
in the same way municipals are. They are exempt from registration,
but the tax treatment, suitability, and disclosure rules differ from those
applicable to munis or Treasuries.