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.
- Asset class
- Securitised fixed income
- Instrument type
- Pass-through / structured pool
- Traded
- OTC; TBA market for agencies
- Typical users
- Banks, money managers, the Fed
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.
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.
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 \(\text{CPR}(\text{incentive}, \text{age}, \text{burnout}, \dots)\):
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.