Mortgage-Backed Security

Also known as: MBS, Agency MBS, Pass-through

Thousands of home loans bundled into a bond — with the homeowners' right to refinance baked into your risk.

3 min read · 591 words · Updated

1 · SnapshotThe one idea to remember
Key intuition: an agency MBS is a government-quality bond where you have sold the homeowner an option to repay whenever it suits them. The extra yield is that option's premium.
2 · BeginnerWhat is it, really?

A mortgage-backed security turns a pool of thousands of individual home loans into a tradable bond. Homeowners' monthly payments — interest and principal — flow through to investors pro rata.

In the US, most MBS are "agency" paper: Fannie Mae, Freddie Mac or Ginnie Mae guarantee the credit, so investors don't worry about homeowners defaulting. What they do worry about is homeowners doing something perfectly legal and unpredictable: paying early.

When rates fall, homeowners refinance — returning your principal exactly when reinvesting it is least attractive. When rates rise, they cling to their cheap mortgages, stretching your bond out just when you'd love the money back. This "prepayment risk" makes MBS behave unlike any ordinary bond.

The homeowner's option, and who is short it
The poolor agencyInvestorsHomeownersthe borrowersThe guarantoron agency paper2Passed through1Interest and principal3The mortgage, repaid early4Paid on time, agency paper

a paymentonly if a condition is met

The same securitisation plumbing as any other pool, plus one thing no other borrower has: the right to repay early, for free.

Every month

  1. Homeowners → The pool Ordinary mortgage instalments, collected by a servicer that keeps a fee.
  2. The pool → Investors Investors receive both interest and a return of principal every month, which is why the maturity of an MBS is an estimate rather than a date.

When rates fall

  1. Homeowners → The pool Homeowners refinance. Investors get their money back precisely when there is nothing as good to reinvest it in — the negative convexity that defines the asset class.

When a borrower defaults

  1. The guarantor → Investors An agency guarantee covers credit loss but never prepayment. On non-agency paper this arrow does not exist, and the loss runs up the tranches instead.
Asset class
Securitised fixed income
Instrument type
Pass-through / structured pool
Traded
OTC; TBA market for agencies
Typical users
Banks, money managers, the Fed

Which risks decide the outcome

Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.

  • Marketdecides it
  • Creditdecides it
  • Liquiditymatters
  • Fundingmatters
  • Operationalbarely applies

What decides it here. Homeowners hold a free option to repay early, so your money comes back exactly when there is nothing as good to reinvest it in. That is market risk with the sign reversed.

What the five mean, and which one decides where →

3 · IntermediateHow it works in practice

Prepayment behaviour

  • Refinancing incentive: prepayments surge when current mortgage rates fall ~50bp+ below the pool's rate.
  • Turnover: people move, divorce, die — a baseline prepay speed independent of rates.
  • Burnout: pools that have already been refinanced heavily respond less to new incentives — the fast repayers already left.
  • Speeds are quoted in CPR (annualised % of pool prepaying).

Negative convexity

The prepayment option caps upside: when rates fall, prices rise less than a normal bond (your bond shortens as refinancing looms); when rates rise, prices fall more (the bond extends). MBS holders are paid, via higher yield, for accepting this always-unfavourable shape.

The TBA market

Most agency MBS trade "To-Be-Announced": buyers agree coupon, issuer, month and price without knowing which specific pools will deliver — a brilliant liquidity convention that makes MBS the second-most liquid bond market on earth. Pools with desirable traits trade above TBA ("specified pools", pay-ups).

Structuring: CMOs

Dealers re-slice pass-through cash flows into tranches — sequentials, PACs (prepayment-protected), IO/PO strips (interest-only/principal-only) — reallocating prepayment risk to those who want it, in either direction.

Worked example: you buy a 5% pool at 102. Rates drop 1%; refinancing waves return principal at 100 — your 102 purchase price took an instant haircut on every dollar returned. The same drop would have sent a Treasury up 7 points.
4 · AdvancedPricing & valuation

Valuation: OAS with a prepayment model

MBS cash flows depend on the whole rate path, so pricing is Monte Carlo over a term-structure model with an empirical prepayment function \(\text{CPR}(\text{incentive}, \text{age}, \text{burnout}, \dots)\):

$$ P = \frac{1}{N}\sum_{\text{paths } j} \sum_t \frac{CF_t^{(j)}}{\prod_{s\le t}\big(1 + r_s^{(j)} + \text{OAS}\big)} $$
What the symbols mean
  • Pa price, or a present value
  • Nthe normal distribution, or a count
  • ta point in time
  • Cthe price of a call option
  • Fthe forward or futures price
  • rthe interest rate, per year

The option-adjusted spread is the constant spread making model price equal market price — the residual yield after paying for the embedded option. OAS across coupons reveals which parts of the stack are cheap given your prepay model; the model is the alpha and the risk.

Greeks of a mortgage

  • Effective duration/convexity: computed by bumping the curve through the model; convexity is negative around the refi threshold.
  • Vega: short volatility — MBS lose value when rate vol rises (the homeowner's option gains). MBS hedgers' vol demand moves the swaption market.
  • Current-coupon spread and primary–secondary spread link MBS pricing to actual mortgage lending rates.

Non-agency and credit MBS

Without the agency guarantee (jumbo, legacy subprime, European RMBS), credit modelling joins prepayment: default and severity curves stress-tested on home prices — the machinery whose failure defined 2008.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.

5 · Desk notesHow practitioners think about it
Practitioner note: an MBS position is short a swaption straddle on rates struck near the homeowner's refi point. Hedge duration and you've still got the vol short — 1994, 2003 and 2022 all reminded someone of this.

Now say it back

Close the page and give Mortgage-Backed Security in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.

  1. Who wants what — two parties wanted opposite things badly enough to write it down.
  2. What the contract obliges, and when — not the payoff; the obligation.
  3. Where the money comes from — name the source, or you have described a hope.
  4. What makes it lose — the ordinary way, not the dramatic one.

Do it with a clock → · why these four

Put Mortgage-Backed Security beside any other instrument →

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