What is a Dwarf?
In the mortgage business, a dwarf is a group of mortgage-backed securities that mature in fewer than 15 years. The Federal National Mortgage Association (FNMA or Fannie Mae) issues dwarves.
How Does a Dwarf Work?
Mortgage-backed securities (MBS) are securities that represent an interest in a pool of mortgage loans. Let's assume you want to buy a house, so you get a mortgage from XYZ Bank. XYZ Bank transfers money into your account, and you agree to repay the money according to a set schedule. XYZ Bank (which could also be a thrift, credit union, or other originator) may then choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over the next several years) or sell it.
If XYZ Bank sells the mortgage, it gets cash to make other loans. So let's assume that XYZ Bank sells your mortgage to Fannie Mae. Fannie Mae groups your mortgage with similar mortgages it has already purchased (referred to as 'pooling' the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates, maturities). Pools that mature in fewer than 15 years make up dwarves.
Fannie Mae then sells securities that represent an interest in the dwarves, of which your mortgage is a small part (called securitizing the pool). It sells these MBS to investors in the open market. With the funds from the sale of the MBS, Fannie Mae can purchase more mortgages and create more MBS.
Why Does a Dwarf Matter?
For investors, an MBS is much like a bond, and dwarves are relatively short-term bonds in this sense However, it is important to note that payments that are part interest and part principal could be unfavorable to some dwarf investors, because with each decrease in outstanding principal there is a corresponding decrease in the amount of interest that accrues. The return of principal could also vary depending on how quickly the underlying mortgages are repaid.
Fannie Mae guarantees the timely payment of interest and principal on the MBS they issue -- that is, if the borrowers do not make their mortgage payments on time, Fannie Mae will still make timely interest and principal payments to their MBS investors. It is important to note that the U.S. government does not guarantee Fannie Mae. That is, if it cannot fulfill their obligations to its MBS investors, the government has no responsibility to rescue it.