Mortgage-Backed Securities

What Are Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are bonds created by pooling thousands of individual home mortgages into a single tradeable security. Homeowners' monthly mortgage payments, interest and principal, flow through to bondholders as cash flows. The US agency MBS market is approximately $9 trillion outstanding, making it the second-largest fixed-income market in the world after US Treasuries.

MBS are the backbone of the American housing finance system: over 70% of US mortgages are securitized into MBS, which are then sold to investors (pension funds, insurance companies, banks, the Fed, and foreign governments). Without the MBS market, mortgage rates would be significantly higher and home ownership rates significantly lower.

MBS are also one of the most complex instruments in fixed income because of their unique risk characteristics, particularly negative convexity and prepayment risk, which create hedging dynamics that amplify interest rate moves and directly influence the Treasury market, mortgage rates, and financial conditions.

How MBS Are Created: The Securitization Chain

Step 1: Mortgage Origination

A homebuyer takes out a 30-year fixed-rate mortgage from a bank (Wells Fargo, JPMorgan, etc.) or a non-bank lender (Rocket Mortgage, United Wholesale Mortgage).

Step 2: Sale to GSE

The lender sells the mortgage to a government-sponsored enterprise (Fannie Mae or Freddie Mac) or to Ginnie Mae (for FHA/VA loans). The GSE pays the lender par value, freeing up the lender's capital to make more loans.

Step 3: Pooling

The GSE pools thousands of similar mortgages (same approximate rate, region, loan type) into a single security, an MBS "pass-through" bond.

Step 4: Guarantee

The GSE guarantees timely payment of interest and principal to MBS holders, regardless of whether individual homeowners default. This guarantee converts credit risk into prepayment risk.

Step 5: Sale to Investors

The MBS is sold to institutional investors. Monthly payments from homeowners flow through the GSE to bondholders.

Agency vs. Non-Agency MBS

Negative Convexity: The Defining MBS Risk

Negative convexity is what makes MBS fundamentally different from every other bond type. It means that MBS holders are systematically disadvantaged in both rising and falling rate environments:

When Rates Fall (Prepayment Risk)

Homeowners refinance their mortgages at lower rates, returning principal to MBS holders at par. The MBS investor receives money back when they don't want it, in a low-rate environment where reinvestment options are poor. The bond's duration shortens (less sensitivity to further rallies) just when you'd want longer duration to capture gains.

When Rates Rise (Extension Risk)

Nobody refinances. The MBS investor is stuck holding below-market-rate bonds for much longer than expected. Duration extends (more sensitivity to further selloffs) just when you'd want shorter duration to limit losses.

The Hedging Feedback Loop

This negative convexity forces MBS holders to hedge dynamically:

• Rates fall → MBS duration shortens → hedge by buying Treasuries (to add duration back)
• Rates rise → MBS duration extends → hedge by selling Treasuries (to reduce duration)

These hedging flows are pro-cyclical: they amplify rate moves in both directions. When the $9 trillion MBS market collectively adjusts hedges, the forced Treasury buying/selling creates significant price pressure. This is why large rate moves tend to accelerate rather than mean-revert, MBS hedging creates momentum.

Prepayment Speeds: The Key Variable

The 2020-2021 Refi Boom

When 30-year mortgage rates fell to 2.65% (January 2021), prepayment speeds surged to 40%+ CPR for some pools. MBS investors faced massive reinvestment risk: they received billions in prepaid principal that they could only reinvest at near-zero yields.

The 2022-2024 Lock-In Effect

The mirror image: with mortgage rates above 6.5% and most outstanding mortgages originated at 2.5-4.0%, prepayment speeds collapsed to historic lows (CPR ~4-6%). Homeowners with 3% mortgages will not refinance to 7%. This created:

• Extended MBS durations, making MBS more rate-sensitive
• Slower Fed QT MBS runoff, only $15-20B/month vs. the $35B cap
• Housing market freeze, homeowners won't sell (lose their low rate), reducing housing inventory

The Fed and MBS: $2.7 Trillion of Influence

How the Fed Accumulated Its MBS Portfolio

The QT MBS Runoff Challenge

The Fed's QT plan allows up to $35 billion/month in MBS to mature or prepay without reinvestment. However, actual runoff has been much slower (~$15-20 billion/month) because:

1. Prepayment speeds are at historic lows (lock-in effect)
2. The Fed does not actively sell MBS (only passive runoff)
3. The remaining portfolio is dominated by low-coupon bonds that nobody is refinancing

This slow MBS runoff is a key reason the Fed's balance sheet is declining more slowly than planned, and why some FOMC members have discussed actively selling MBS to accelerate the process.

MBS Spread Impact

The Fed's MBS purchases compressed the "primary mortgage spread", the gap between the 30-year mortgage rate and the 10-year Treasury yield, from a normal 170-180 bps to as low as 100 bps during peak QE. As the Fed withdraws, this spread has widened back to 250-300+ bps, adding approximately 70-130 bps to mortgage rates beyond what Treasury yields alone would dictate.

MBS and the 2008 Financial Crisis

The subprime MBS crisis was the proximate cause of the worst financial disaster since the Great Depression:

The Chain of Failure

Why Rating Agencies Failed

Rating agencies (S&P, Moody's, Fitch) assigned AAA ratings to senior tranches of subprime MBS pools based on models that assumed: (1) housing prices could not decline nationally, (2) mortgage defaults in different regions were uncorrelated, and (3) historical default rates (from a period of rising home prices) were representative. All three assumptions were catastrophically wrong. The result: institutional investors who thought they held AAA bonds (equivalent to Treasuries in safety) actually held instruments that would lose 30-90% of their value.

MBS Trading and Investment

Key Instruments

The TBA market is the primary mechanism for MBS trading, it allows forward delivery of generic MBS pools without specifying the exact bonds. This forward mechanism is what makes the MBS market so liquid despite the heterogeneity of the underlying mortgages.

MBS as a Spread Product

MBS investors earn a spread over Treasuries that compensates for:

1. Prepayment risk (~30-50 bps in normal environments)
2. Negative convexity (~20-40 bps)
3. Liquidity premium (~10-20 bps for less liquid pools)

Total MBS spread over Treasuries: typically 60-120 bps in normal markets, 150-300+ bps during stress. For income-focused investors, MBS offers a yield pickup over Treasuries with agency-guaranteed credit quality, the trade-off is the complexity of prepayment and convexity risk.

Why MBS Matter for Every Investor

Even if you never buy an MBS, the market affects you through:

1. Mortgage rates: MBS yields directly determine the 30-year fixed mortgage rate that most Americans pay
2. Housing affordability: MBS spread widening raises mortgage rates independent of Fed policy
3. Treasury market dynamics: MBS hedging flows amplify Treasury rate moves
4. Fed policy: The pace of MBS QT affects financial conditions and the liquidity cycle
5. Systemic risk: The MBS market's size ($9T) and complexity make it a perpetual source of systemic risk during stress