Midgets

Midgets is a slang term referring to Government National Mortgage Association (GNMA) bonds, which are secured by mortgages backed by federal agencies. The GNMA was started in an attempt to make affordable housing available to lower-income families. The term midget is used by dealers to refer to these bonds, and it is not used by GNMA to formally describe any of its securities.

Midgets guarantee principal and interest on mortgage-backed securities (MBS) backed by loans insured by the Federal Housing Administration and the Department of Veterans Affairs. New midgets are issued in $25,000 minimum denominations.

Mortgage-backed securities (MBS) are an investment in a pool of mortgage loans. These loans comprise the underlying asset and provide cash flow for the securities. Because the principal and interest of the underlying loans pass through to the investor, MBS are pass-through investments. Bondholders receive a monthly pro-rata principal and interest distribution over the life of the investment. MBS have maturities up to 30 years.

Each MBS has an average life, or estimated time until the last principal payment. Average life depends on changes in principal payments that are affected by interest rates and the rate at which mortgage holders prepay loans.

Because they are backed by the U.S. government, midgets are considered to be of the highest quality. When an investor buys or sells a midget, he pays a commission. The midget’s interest income is subject to federal and state taxes — and potentially to capital gains taxes when sold or redeemed. A midget’s liquidity depends on its features, lot size and other market conditions: Midgets experiencing significant principal pay-down are harder to sell.

Midget prices fluctuate with interest rates: When interest rates rise, the market price of outstanding midgets declines; when interest rates decline, the midgets’ market prices rise. Also, interest rate changes affect mortgage prepayment rates: Prepayments typically increase as interest rates decrease because mortgage holders refinance at lower rates. In contrast, rising interest rates typically slow loan prepayments. The prepayment rate for a mortgage pool affects a midget’s average life and yield.

Midget holders may receive their principal sooner than expected when mortgage holders prepay their loans. Midget holders may reinvest the principal at a lower interest rate and lower their profits. However, midget holders may receive their principal later than expected if mortgage holders delay prepaying their loans. Midget holders may miss reinvesting their principal at a higher interest rate.

Although midgets carry minimal credit risk because they are backed by the U.S. government, all bonds carry the risk of the issuer not making timely payments or defaulting on the loan. In addition, midgets sold before maturity may realize substantial gains or losses. Because the secondary market may be limited, midget holders face liquidity risk.