Definition
MBS are created by pooling mortgages and selling claims on their cash flows. Agency MBS (Ginnie Mae, Fannie Mae, Freddie Mac) carry implicit or explicit government guarantees. The primary risk is prepayment: when rates fall, homeowners refinance, returning principal early and forcing investors to reinvest at lower rates. MBS have negative convexity due to this prepayment behavior.
lightbulb Example
An investor buys a Fannie Mae MBS yielding 5.2% backed by 30-year mortgages. When rates drop to 3.5%, homeowners refinance en masse, returning principal early at par and ending the investor's 5.2% income stream.
verified_user Key Points
- Backed by pools of residential or commercial mortgages
- Agency MBS have government backing
- Prepayment risk is the primary concern
- Negative convexity from prepayment optionality