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Trading and Capital-Markets Activities Manual

Instrument Profiles: U.S. Government Agency Securities
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Agency securities are debt obligations issued by federal agencies or federally sponsored agencies. Federal agencies are direct arms of the U.S. government; federally sponsored agencies are privately owned and publicly chartered organizations which were created by acts of Congress to support a specific public purpose (also referred to as government-sponsored entities or GSEs). 

Federal agencies are arms of the federal government and generally do not issue securities directly in the marketplace. These agencies include the Government National Mortgage Association (GNMA or Ginnie Mae), Export-Import Bank, Farmers Home Administration (FmHA), General Services Administration (GSA), Maritime Administration, Small Business Administration (SBA), Tennessee Valley Authority, Commodity Credit Corporation, Rural Electrification Administration, Rural Telephone Bank, and Washington Metropolitan Area Transit Authority. All federally related institutions are exempt from registration with the Securities and Exchange Commission (SEC). Except for securities of the Private Export Funding Corporation and the Tennessee Valley Authority, the securities are backed by the full faith and credit of the U.S. government. 

Government-sponsored entities include agencies in the following areas: 

  housing (such as the Federal Home Loan Mortgage Corporation and Federal National Mortgage Association) 
  farm credit (such as the Federal Farm Credit Bank System and Farm Credit System Financial Assistance Corporation) 
  student loans (such as the Student Loan Marketing Association) 
  small business (the Small Business Administration) 
  export funding (the Export-Import Bank) 

GSEs issue both discount and coupon notes and bonds. Discount notes are short-term obligations, with maturities ranging from overnight to 360 days. Coupon notes and bonds are sold with maturities greater than two years. The securities are not backed by the full faith and credit of the U.S. government. Consequently, investors purchasing GSEs are exposed to some potential credit risk. The yield spread between these securities and Treasury securities of comparable maturity reflects differences in perceived credit risk and liquidity. 

GSEs issue direct debt obligations and guarantee various types of asset-backed securities. This section discusses only securities that represent direct obligations of federal and federally sponsored agencies. For a discussion of securities issued or guaranteed by some of these agencies, see ''Residential-Mortgage-Backed Securities,'' section 4110.1. Also, many GSEs are active in issuing structured notes. The role of the agency and particular risks involved in these securities are discussed in section 4040.1, ''Structured Notes.'' 

CHARACTERISTICS AND FEATURES 

Federal-agency securities such as those issued by the Government National Mortgage Association are backed by the full faith and credit of the U.S. government. However, government-sponsored agency securities are not guaranteed by the U.S. government, although market participants widely believe that the government would provide financial support to an agency if the need arose. This view has gained some credence as a result of the federal government's operations to bolster the Farm Credit System in the mid-1980s. U.S. agency securities are also exempt from SEC registration. 

USES 

Agency securities are deemed suitable investments for banks. They are frequently purchased by banks and held in their investment portfolios. 

DESCRIPTION OF MARKETPLACE 

In the primary market, government agencies and GSEs sell their securities to a select group of commercial banks, section 20 subsidiaries of commercial banks, and investment banks known as ''selling groups.'' Members of a selling group advise the agencies on issuing debt, placing the debt with end-users, and making markets in these securities.

Prices for the securities traded in the secondary market can be obtained from the ''Money and Investing'' section of The Wall Street Journal or the financial section of local newspapers. Other media, such as Internet financial sites and Bloomberg, provide over-the-counter quotes as well. 

Federal Agencies 

Federal agencies do not issue securities directly in the marketplace. Since 1973, most have raised funds through the Federal Financing Bank, although many of these institutions have outstanding obligations from previous debt issues. Federal agencies include the following: the Export-Import Bank of the United States, Commodity Credit Corporation, Farmers Home Administration, General Services Administration, Government National Mortgage Association, Maritime Administration, Private Export Funding Corporation, Rural Electrification Administration, Rural Telephone Bank, Small Business Administration, Tennessee Valley Authority, and Washington Metropolitan Area Transit Authority (neither the Tennessee Valley Authority nor the Private Export Funding Corporation is backed by the full faith and credit of the U.S. government). 

Federally Sponsored Agencies 

Following is a summary of the main federally sponsored agencies and the types of obligations that they typically issue to the public. The Federal Farm Credit Bank System issues discount notes; short-term bonds with maturities of three, six, and nine months; and long-term bonds with maturities of between one and 10 years. The Federal Farm Credit Bank also issues medium-term notes which have maturities of between one and 30 years. The Federal Farm Credit System Financial Assistance Corporation issues 15-year notes, guaranteed by the federal government, which were issued to support the Farm Credit System in the mid-1980s. 

The Federal Home Loan Bank System issues discount notes that mature in one year or less and non-callable bonds with maturities ranging from one to 10 years. These debts are consolidated obligations of the 12 regional Federal Home Loan Banks whose mandate is to provide funds to savings and other home-financing member organizations. 

The Federal National Mortgage Association (Fannie Mae) issues short-term discount notes and long-term bonds with maturities of up to 30 years. Fannie Mae has also issued indexed sinking-fund debentures which are callable and contain features of both mortgage-backed securities and callable corporate bonds. The Federal Home Loan Mortgage Corporation (Freddie Mac) issues discount notes and a limited number of bonds. The Student Loan Marketing Association (Sallie Mae) issues unsecured debt obligations in the form of discount notes to provide funds to support higher education. 

PRICING 

Agency notes and bonds are quoted in terms of 32nds (a percentage of par plus 32nds of a point). Thus, an investor will be willing to pay 101.5 percent of par for an agency security that is quoted at 101:16. Short-term discount notes are issued on a discount basis similar to the way that U.S. Treasury bills are priced. 

Agency securities trade at yields offering a positive spread over Treasury security yields because of slightly greater credit risk (due to the lack of an explicit government guarantee for most obligations) and somewhat lower liquidity. 

HEDGING 

The price risk of most agency securities is hedged in the cash market for Treasury securities or by using Treasury futures or options. As with all hedges, yield curve and basis risk must be monitored closely. In addition, dealers who are actively conducting arbitrage trades and other strategies should have the capability to monitor their positions effectively. 

RISKS 

As with any security, much of the risk is a function of the type of trading strategy conducted by an institution. 

Interest-Rate Risk 

Agency securities are subject to price fluctuations due to changes in interest rates. As with other types of securities, the longer the term of the security, the greater the fluctuation and level of interest-rate risk. Moreover, some agency securities are subject to greater interest-rate risk than others. Agencies that issue structured notes that are direct obligations, such as step-up notes from a Federal Home Loan Bank, may have greater risk than other agency securities. 

Credit Risk 

The credit risk of agency securities is slightly higher than that of Treasury securities because they are not explicitly guaranteed by the U.S. government. However, their credit risk is still low due to the implied government guarantee. 

Liquidity Risk 

Agency securities as a whole are not as liquid as U.S. Treasury securities, but liquidity varies widely within the agency market, depending on the issuer and the specific debt obligation. In general, agency securities have large trading volumes on the secondary market that help to keep the liquidity risk low. However, various debt provisions and structured notes of different agency securities contribute to differing levels of liquidity risk within the agency market. 

ACCOUNTING TREATMENT 

The Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125,''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' determines the accounting treatment for investments in government agency securities. SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

Federal-agency securities have a 0 percent risk asset capital weight, as they are direct and unconditionally guaranteed obligations of federal agencies. 

Obligations of federally sponsored agencies (not explicitly guaranteed) have a 20 percent risk asset capital weight. 

For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.'' 

LEGAL LIMITATIONS FOR BANK INVESTMENT 

General obligations of U.S. government agencies are type I securities, and are exempt from the limitations of 12 USC 24 (section 5136 of the U.S. Revised Statutes). Banks may purchase these securities for their own accounts without limitation, other than the exercise of prudent banking judgment. (One exception is an obligation of the Tennessee Valley Authority (TVA), which is a type II security. Investments in the TVA are limited to 10 percent of a bank's capital stock and unimpaired surplus.) 

REFERENCES 

Commercial Bank Examination Manual. Washington, D.C.: Federal Reserve System. 
Fabozzi, Frank J., ed. The Handbook of Fixed Income Securities. 4th ed. Burr Ridge, Ill.: Irwin, 1991. 
The First Boston Corporation. Handbook of U.S. Government and Federal Agency Securities. 34th ed. Chicago: Probus Publishing Company, 1990. Stigum, Marcia L. The Money Market. 3d ed. Homewood, Ill.: Dow Jones-Irwin, 1990. 

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