What is a Dwarf
Dwarf is a slang term used to describe a pool of mortgage-backed securities (MBSs) that have been issued by the Federal National Mortgage Association (FNMA), or Fannie Mae, with a maturity of 15 years. Fannie Mae is one of the governing bodies able to issue MBSs that are guaranteed by an independent government organization in the secondary market.
BREAKING DOWN Dwarf
Fannie Mae's dwarf security derives its name from its length relative to Fannie Mae's standard 30-year fixed-rate mortgage security, the benchmark security in mortgage markets against which swap spreads to other securities are calculated. Fannie Mae is a government-sponsored enterprise (GSE), which is an independent organization sponsored by the federal government and created by Congress for a public purpose, such as creating affordable housing. The term is similar to the informal moniker midget, given to the 15-year mortgage-backed securities with principals and interest guaranteed by 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).
Characteristics of Dwarfs
Dwarfs are subject to federal and state taxes. When bought at a discount, they may be subject to capital gains taxes if sold or redeemed. A dwarf is bought and sold in the secondary market. Liquidity depends on a dwarf’s features, lot size and other market conditions. An investor pays a commission for a secondary-market transaction.
As a GSE, Fannie Mae is a privately owned corporation created by the federal government for providing liquidity and increasing available credit in mortgage markets. Fannie Mae typically issues dwarfs in $1,000 denominations that are not guaranteed by the U.S. government. GSE debt is solely the issuer’s obligation and carries greater credit risk than U.S. Treasury securities.
Because Fannie Mae is a publicly traded company registered with the Securities and Exchange Committee (SEC), the corporation’s quarterly and annual reports, including reports of current events impacting the organization and other disclosures, are publicly available. The documents provide insight into the economic health of the organization, including short- and long-term corporate goals and the opportunities and challenges the company faces. Studying these documents helps investors determine the strength of any guarantee Fannie Mae provides for dwarf holders.
Risks of Dwarfs
Dwarf prices fluctuate with interest rates. When interest rates increase, dwarf prices decrease; when interest rates decrease, dwarf prices increase. As a result, dwarf holders lose profit when investing at lower interest rates. Interest rate fluctuations typically have a greater effect on long-term dwarf prices.
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 situation. As a result, paying dwarf holders may be difficult, and they may lose money.
Dwarfs may have call provisions allowing issuer redemption of the bonds before the maturity date. Issuers often call bonds when interest rates decline. Dwarf holders face reinvesting their returned principal at lower interest rates, reducing their potential earnings. Also, dwarfs sold before maturity may realize substantial gain or loss, and the secondary market may be limited.