What Is a Dwarf?

While it is a distasteful relic from another era, the term "dwarf" is sometimes used as a slang term to describe a pool of mortgage-backed securities (MBSs) issued by the Federal National Mortgage Association (FNMA), otherwise known as Fannie Mae, with a shorter maturity date of 15 years.

Key Takeaways

  • The term "dwarf" is distasteful slang used to describe a pool of mortgage-backed securities (MBSs) issued by Fannie Mae with a maturity of 15 years.
  • Fannie Mae's dwarf derives its name from its length relative to the company's standard 30-year fixed-rate mortgage security—the benchmark financial instrument in mortgage markets.
  • Dwarfs cater to investors who prefer to tie-up their capital in mortgages over a shorter time period.
  • The term is similar to the offensive moniker "midget," given to the 15-year MBS offered by federal agency Ginnie Mae.

Understanding a Dwarf

Fannie Mae is one of the governing bodies permitted to issue MBS that are guaranteed by an independent government organization in the secondary market.

Fannie Mae's dwarf derives its name from its length relative to the company's standard 30-year fixed-rate mortgage security, the benchmark financial instrument in mortgage markets against which swap spreads to other securities are calculated.

Fannie Mae purchases mortgages from banks, credit unions, and mortgage brokers, injecting them with money to make more loans, and then packages them together into an MBS to sell to investors, freeing up funds to buy additional mortgages.

Other than a smaller time span, dwarfs are pretty much the same as regular Fannie Mae MBSs. The reason for offering them is because some investors would rather tie-up their capital over shorter periods of time.

The Government National Mortgage Association (GNMA), or Ginnie Mae, a U.S. government corporation within the U.S. Department of Housing and Urban Development (HUD), provides a similar product. Instead of dwarfs, its 15-year MBS has taken on the highly offensive informal moniker "midget."

Dwarfs vs. Midgets

Both Fannie Mae's dwarfs and the GNMA's midgets come with guarantees of timely payment, regardless of whether the underlying mortgages generate enough cash flow. However, that does not mean that receipt of the principal, the repayment of the mortgage, and interest, the amount charged to borrow money to buy a home, are set in stone.

Fannie Mae's guarantee hinges on its corporate health, while the GNMA securities are backed by the full faith and credit of the U.S. government.

Fannie Mae, a publicly-traded company that operates under Congressional charter with a mandate to provide liquidity and increasing available credit in mortgage markets, typically distributes its dwarfs in $1,000 denominations. The GNMA's midgets, on the other hand, are issued in $25,000 minimum denominations.

Both are subject to federal and state taxes and when bought at a discount might be liable for capital gains taxes if sold or redeemed.

Disadvantages of Dwarfs

As previously mentioned, Fannie Mae's dwarfs are not guaranteed by the U.S. government. Government-sponsored enterprise (GSE) debt is solely the issuer's obligation and carries greater credit risk than U.S. Treasury securities.

Dwarfs carry the risk of the issuer not making timely payments of principal and interest or defaulting on the loan. In addition, certain economic, political, legal, or regulatory changes, or natural disasters can impact Fannie Mae's financial well-being. As a result, paying dwarf holders may be difficult, and they may lose money.

Dwarfs might have call provisions allowing issuer redemption of the bonds before the maturity date. However, selling them before maturity may realize substantial gain or loss, and the secondary market might be limited. Liquidity risk can be an issue, depending on the dwarf's features, lot size, and other market conditions.

Interest Rate Risk

The prices of dwarfs, just like regular and midget MBSs, fluctuate with interest rates. When the cost of borrowing falls, the valuations of these asset-backed securities (ABS) usually decline as well.

Low interest rates increase the likelihood of homeowners refinancing their mortgages. Higher prepayments are a negative for the MBS holder because it results in them getting their money back faster than planned without collecting interest.  Suddenly, a chunk of income disappears and the investor is saddled with money to reinvest in a low interest rate environment.