Government securities FINRA test prep

In this article we’re going to review US Treasury securities,  agency securities and collateralized mortgage obligations or CMOs.  The United States government is one of the largest issuers of debt in the world. Treasury securities are issued in a variety of forms, and  with a variety of maturities. We will start our review with the US government treasury bill.l. The T-bill is the US government’s short term debt security, and it’s issued with maturities in four weeks, 13 weeks, 26, and 52 weeks. You can also see it on your exam as one month, three months, six months, or 12 months. There are no nine month T-bills.

T-bills are issued at a discount from their face value. They pay no semiannual interest, and they appreciate up to their face value at maturity. That appreciation represents the investor’s interest. Treasury notes serve as the vehicle to fund the intermediate term financing requirements of the government. A Treasury note, or a T-note  is issued in $1,000 par value increments. The notes pay semiannual interest, and have a maturity range of 1 to 10 years.

The long term financing is done by issuing the T-bond, or the long bond, as it is sometimes referred to. It’s also issued in $1,000 par increments. It pays semiannual interest, and it has a maturity range of 10 to 30 years. The US Treasury, through policy decisions, ultimately decides what maturity ranges to issue on the T-bills, T-notes, and T-bonds.

Treasury bill pricing

The T-bill, again, remember is a discounted security that’s priced at a discount of par. On your exam, if you see a quote for a treasury security where the bid for the security looks higher than the ask, the security in question is most likely a T-bill. 

Bid  Ask

2.61 2.59

In the quote above, 2.61 appears to be greater than 2.59, but these are quoted as a discount from par, and a 2.61% discount is a larger discount and therefore a lower dollar price than a discount of 2.59%.

to clarify this concept let’s look at a real world example that you’re almost likely familiar with. Let’s say you walk into Nordstrom’s, and you want to buy a shirt. The shirt is on two different racks. The shirt is on the rack with the sale price of 10% off, and it’s also on another rack with a sale price of 20% off. The question is, which shirt do you purchase?

Well, certainly you purchase that shirt from the 20% off rack, and the reason Is simple.  20% off represents a lower price than 10% off. This is exactly how the pricing of the T-bill  works. The higher discount on the bid represents a lower dollar price in terms of dollars and cents.

Treasury note and Treasury bond pricing

Treasury notes and treasury bonds are priced in the same way, and they’re priced as a percentage of par down to 1/32s of 1%. A quote of 92.02 or it could be presented as 92-02  Represents a quote of 92 2/32 % of $1,000. Now, we’re going to ask you to go back to your grammar school days and to get reacquainted with some fractions here. So 92.02 translates to,  a dollar price of $920.625. A quote of 98.04, 98-04, is 98 and 4/32s percent of 1,000, and that would translate into a dollar price of $981.25.

So you may have to work a couple of fractions there, but not to worry. Remember, the numbers  to the right of the decimal or the dash represents 1/32s of 1 percent. You may be asking yourself, why do they price these issues in such small increments? Because when large, large governments or large, large pension funds buy treasury bonds, they don’t buy $10,000, or $100,000 or $1 million. These big governments and institutions purchase and sell bonds in increments of hundreds of millions of dollars. And when you’re talking about that amount of money, 1/32 of a percent represents significant dollars

Treasury STRIPS

Treasury STRIPS and treasury receipts are zero coupon bonds. A zero coupon bond is one that is issued at a discount and pays no semiannual interest. STIRP stands for separate trading of registered interest and principal securities. STRIPS are issued directly by the US government. The US government issues these discounted securities, or zero coupon bonds, where an investor may purchase $1,000 principal payment perhaps 30 years from now at a discount from its $1,000 par value, and maybe the investor pays $420 for that $1,000 payment. Over the years the STIRP appreciates up to par, and each year it becomes more and more valuable. That appreciation represents the investor’s interest for the time that they own it.

A treasury receipt is similar to a treasury STRIP with one important difference. A treasury receipt is created by a bank or a broker dealer. A treasury STRIP is issued directly by the US government. So with a treasury receipt perhaps Goldman Sachs goes into the marketplace, and they buy $1 billion worth of 30 year treasury bonds. Those 30 year treasury bonds actually contain 61 payments. The 30 year treasury bond has two semiannual interest payments every year for a total of 60 during the term of the bond and one principal payment at maturity. So Goldman Sachs will take these securities, put them into a trust or an account, and sell the principal payment at a discount to investors who would like to have the confidence of knowing that they will get $1,000 at a certain point in time. And then they sell off the semiannual interest payments to other investors who would like that semiannual cash flow.

The test would focus on whether or not you know that the receipt is issued by a bank or a broker dealer versus the STRIP, which would be issued directly by the US government. An important consideration for investors when putting money aside for the long term is the impact of inflation. Inflation is a persistent increase in prices, and it erodes the value of the dollar. $1 10 years from now isn’t going to be worth what $1 is today. Saying that another way, $1 10 years from now will not buy the same amount of goods and services as it will today. income-oriented investors who are seeking protection from inflation May want to consider treasury inflation-protected securities also known as titsTIPS. With a TIP, the treasury adjusts the par value of the security based on the rate of inflation. Because of this adjustment the investor can be assured that they are indeed keeping up with inflation. It’s important to know that the principal of the security is adjusted every six months and the rate stays the same.

for example if  if a tip had a coupon rate of 4%, that 4% TIP would pay 4% times $1,000, or $40 per year. If inflation was 2% over the course of the year,  that 2% would be added to the principal amount. At the end of the year the TIP would have a principal value of $1,020. the TIP would now pay 4% of $1,020, and the interest payment therefore would be for $40.80.  the income generated by the security is going up as the principal is adjusted for inflation.

Government agency securities

Agency issues are debt securities issued by government sponsored entities or government sponsored enterprises. Many of these entities are designed to provide liquidity to the secondary mortgage market, Which in turn provides access to home financing for residential mortgages.

The Government National Mortgage Association or “Ginnie Mae” buys up pools of mortgages that have been insured by the FHA and VA, and Ginnie Mae then sells off the interest in these pools in what are known as pass through certificates. These pass through certificates have a minimum denomination of $1,000. Ginnie Mae has always, always been guaranteed by the US government, meaning that if Ginnie Mae is unable to make timely payments, the US government would pick up the check. Some time back, we went through a fairly significant financial crisis, and the government ultimately put the government sponsored entities into conservatorship, or backstopped them, and the US government stands behind all of these  entities to ensure timely payment. 

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Fannie Mae– Federal National Mortgage Association– Sallie Mae, and Freddie Mac. Fannie Mae and Freddie Mac are providers of mortgage financing. They initially started out as private for-profit corporations. Their stocks are publicly traded, but they are ultimately guaranteed by the federal government. The federal government found during the financial crisis that, if either of these entities went bankrupt, it would have a catastrophic effect on the financial system throughout the world

Fannie Mae and Freddie Mac issue CMOs and other pass through certificates to investors to obtain the financing to purchase these pools of mortgages.

Sallie Mae provides financing for student loans. What happens is, when students attend college or higher education institutions, many times they will be taking out loans to pay for those tuition bills. Sallie Mae will stand by those loan obligations, and they will go out, and they will purchase portfolios of these loans, and then sell off interest in those loans to investors. These are some of the government sponsored entities that you need to be aware of for your exam.

The Federal Farm Credit system

The Federal Farm Credit System is an umbrella for the federal government to provide financing to farmers, and there are three different entities that provide capital to farmers for a variety of different things. 

The Federal Land Bank provides money for mortgages so that farmers can go out and buy that 1,000 acres, and grow the wheat, or the corn, or whatever the case may be. 

The bank of the cooperatives provides capital so that farmers can out and buy the seed, and the grain, and the things that they need to plant their crop.

Federal Intermediate Credit Bank provides capital to farmers to buy those big John Deere tractors and other large equipment purchases.

And what the Federal Farm Credit System will do is they, too, will pool these mortgages these loans for equipment and seed into a big pool. The FFCS will then sell off interest in those pools to investors who wish to earn some interest income on the payments that are made into those pools.

Collateralized Mortgage Obligations /CMOs

Many of you have heard the term Collateralized mortgage obligation or CMO but perhaps are not sure about what CMOs are or how or why CMOs are created. During the financial crisis CMOs had a kind of a negative connotation, but in reality, CMOs serve a very, very significant purpose in our economy. Now, to explain this concept, let’s imagine that we are all residents of one town, and  we all have gone to the only bank in town to obtain our mortgages for our homes.The role of a bank is that of a financial intermediary. It stands in between transactions. The bank takes on deposits, and pays an interest at a low rate, and then takes those deposits and lends them out to people who need to borrow money at a higher rate.The bank wants to make the spread between those two rates, but at some point, a bank is going to run out of money to lend.If we all had our mortgages at the only bank in town and a new person moves into town, wanting to obtain mortgage financing to purchase a house, the bank may say, “you’re very well qualified. We just don’t have the money available to lend.”

So In order to obtain more funds to lend, this bank will take all of its mortgages– and perhaps they’ve written $500 million worth of mortgage loans to everybody in the town. And the bank will sell this portfolio of mortgages into the secondary mortgage market. Now the $500 million comes back into the bank, and that next person who comes into town needing a mortgage, the bank now has the money to lend to that individual.

This is how the pools of mortgages are sold into the secondary mortgage market.Once this pool has been sold, it’s going to be packaged into a CMO, a collateralized mortgage obligation. And it is going to be split up into different maturity ranges. Not every mortgage in this pool is going to be a 30 year mortgage. Perhaps some are 10 year loans. Some are 15 year loans and. Some 20 and some are 30 year loans. All of the loans have different repayment terms, and investors who would like to purchase these  CMOs would purchase them in what is known as a tranche, and that is the French word for slice. So they will pick a maturity range where they would like to be paid out for. As people make the monthly payments on their mortgage, that monthly payment comes into the CMO and is then sent out to the investor. Investors who purchase CMOs will receive monthly interest and principal payments based on the monthly mortgage payments made by the homeowners on the underlying property. 

Let’s continue our review of CMOs, or collateralized mortgage obligations, and take a look at several different features that can be associated with the investment in a CMO. Two different types of CMOs– A planned amortization class, and you a targeted amortization class. These features are designed to provide protection to investors in CMOs based on how the payments are received into the pool of mortgages.

You can imagine, when interest rates fall, homeowners have a tendency to refinance more quickly. When homeowners refinance more quickly, it causes the principal repayment on the CMO to accelerate, and the investors in the CMO will be paid off sooner than he or she had hoped or anticipated. Alternatively, when interest rates rise, homeowners will tend to refinance less. When interest rates increase and homeowners refinance at a slower rate, it causes the principal repayment into the portfolio of mortgages to slow down, and the investor in the CMO will then be subject to extension risk, meaning it will take the investor a longer period of time to receive their principal back because interest rates have increased, and refinancing, and therefore principal repayment, has slowed.

With a planned amortization class– sometimes referred to as a programmed amortization class– the investor is protected from both prepayment and extension risk. So if the principal payments accelerate into the CMO, those payments will be sent off to a support class so that the CMOs are not paid off too quickly. Should the refinancing activity slow down, the CMO will pull principal payments from a support class to make sure that the investor is not subject to extension risk.A planned or programmed amortization class CMO is designed to provide protection from both extension risk and prepayment risk. A targeted amortization class only provides protection to the investor in the event of prepayment risk. If the money comes in too quickly, the CMO will send it somewhere else, but if it comes in too slowly, they will not pull it from somewhere else.

CMOs that have been issued by Ginnie Mae, Fannie Mae, Freddie Mac, they are all insured by those entities and subsequently by the US government. A private labeled CMO is one that has been created by a banker or a broker-dealer. Perhaps Goldman Sachs goes into the marketplace and buys $1 billion worth of mortgage loans. They will then take this pool of mortgages and slice it up into CMOs, and sell them off to investors who wish to receive monthly interest and principal income.The private labeled CMO carries the credit risk of the issuing bank or broker-dealer. That’s an important test point. The private labeled CMO has been issued or created by a bank or broker-dealer, and it carries the credit risk associated with the bank or broker-dealer that created that CMO. Even if every single mortgage in that CMO has been insured by Fannie Mae, Freddie Mac, or Ginnie Mae, the entities that guarantee the mortgages in the CMO cannot guarantee that Goldman Sachs, or the private entity that created this CMO, will then distribute the money where it needs to go. Only the mortgages in that pool would be insured, not the distribution of that income. This is an important test point.

We hope that this article has helped you prepare for your upcoming finra exam.

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The Securities Institute of America

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