What Is an Agency Debenture?
An agency debenture is debt (bonds) issued at a fixed, or variable, interest rate by a United States federal agency or a government-sponsored enterprise (GSE), for the purposes of procuring funds to finance their activities, which usually entails purchasing mortgages from various lenders.
- Agency debentures are debt, or bonds, issued at a fixed, or variable, interest rate by a United States federal agency or a government-sponsored enterprise (GSE), for the purposes of procuring funds to finance their activities.
- Rather than being backed by collateral, agency debentures rely on the creditworthiness and integrity of the debt’s issuer.
- Federal agency debentures are fully guaranteed and the interest payments are, usually, tax-exempt, while GSEs are implicitly guaranteed and their interest payments tend to be taxable.
- Agency debentures played a large role in the financial crisis of 2008, resulting in significant reforms to government-sponsored entities (GSEs).
- Common government-sponsored entities (GSEs) that issue agency debentures include Fannie Mae, Freddie Mac, Farmer Mac, and Ginnie Mae.
Understanding an Agency Debenture
Rather than being backed by collateral, agency debentures rely on the creditworthiness and integrity of the debt’s issuer. The minimum level of investment for agency debentures is generally $10,000, with the ability to increase that amount in increments of $5,000. Interest payments from federal agency debentures are usually tax-exempt while those from GSEs tend to be fully taxable.
Debentures issued by an actual federal agency, such as the Department of Agriculture, are backed by “the full faith and credit of the U.S. government.” This means that the U.S. government promises to honor the interest payments and the return of principal at maturity, even if the underlying agency is not able to honor their commitments.
Agency debentures issued by GSEs, on the other hand, are only implicitly guaranteed, which raises the risk of loss to the investor. That said, GSEs may borrow money directly from the U.S. Treasury if they are unable to repay their debts. The uncertainty, brought on by the fact that the U.S. Treasury is not obligated to lend them money, is the reason why agency debentures issued by GSEs are considered to have some credit risk.
It is also possible to purchase agency debentures as an investment strategy. This strategy can be a low-risk form of investing. Bonds issued directly through a government agency, not through a GSE, are guaranteed (backed by the U.S. government) to pay a fixed rate of interest and the bond’s full principal when the bond matures.
Agency Debentures During the 2008 Financial Crisis
Agency debentures drew widespread attention during the mortgage and credit crisis of 2008. The crisis brought into focus problems inherent in GSEs. The problem was that GSEs were using the implicit guarantee of a bailout by the U.S. Treasury while operating as private enterprises.
The two most commonly referenced examples were Fannie Mae, also known as Federal National Mortgage Association Corporation (FNMA), and Freddie Mac, also known as Federal Home Loan Mortgage Corporation (FHLMC).
Leading up to the financial crisis, these two entities made enormous profits by borrowing money at low rates, thanks to the implicit backing of the U.S. Treasury, and dealing in the secondary mortgage market. When the mortgage market collapsed, Fannie Mae and Freddie Mac both faced potential bankruptcy. Both entities held an enormous share of mortgages at the time.
The collapse of Freddie and Fannie would have led to the collapse of the housing market. The U.S. Treasury decided they were "too big to fail" and stepped in with a bailout worth $187 billion as a way to keep the entities from going bankrupt. The federal government has since taken over both of these entities to prevent a similar future occurrence.