Mortgage-Backed Securities

§ 01How MBS work and the risk of prepayment

§ 02Why 2008 was about loan quality, not securitization

MBS are safe when backed by quality mortgages and honestly rated. The 2008 crisis was not about securitization itself but about the quality of the underlying loans and the failure of rating agencies.

§ 03Why MBS yields lag a falling rate

§ 04Negative convexity: the prepayment price ceiling

Negative convexity -- the price ceiling prepayment creates: When rates fall, an ordinary bond just keeps climbing in price. An MBS cannot climb the same way. Falling rates set off exactly the refinancing wave described above, so principal comes back at par (100 cents on the dollar) precisely when the bond would otherwise trade at a premium. Prepayment therefore caps how high the price can rise. That capped upside -- paired with close-to-full downside when rates rise -- is what 'negative convexity' means: the MBS gains less than a plain bond when rates drop, yet can lose about as much when they climb. It is the same asymmetry a callable bond has, and it is why MBS trade at higher yields than comparable Treasuries even before any default risk.

§ 05Extension risk: repaid too late when rates rise

Extension risk -- the rising-rate mirror: Prepayment's opposite is just as costly. When rates rise, no one refinances a 4% mortgage into a 7% one, so prepayments slow to a trickle. The principal you expected back early now dribbles in, and the bond's effective life stretches out -- right when you would most like your cash back to reinvest at the new, higher rates. So the pain cuts both ways: rates fall and you are repaid too soon (prepayment risk); rates rise and you are repaid too late (extension risk). Either way the timing moves against the investor, which is the deeper reason MBS demand extra yield.

§ 06Tranches: slicing one pool into ordered bonds

Tranches -- slicing one pool into different bonds: A pool of mortgage payments rarely ships as one undifferentiated bond. Issuers carve it into tranches (French for 'slices') that receive cash in a set order. Senior tranches are paid first and absorb losses last, so they earn the highest ratings and the lowest yields; subordinate tranches are paid last and absorb the first losses, so they pay more. Collateralized mortgage obligations (CMOs) also slice by prepayment timing -- steering early principal to some tranches and later principal to others -- which lets a buyer choose how much prepayment and extension risk to take. This is how a single pool can serve both a conservative insurer and a yield-hungry hedge fund at once, and, in 2008, how losses that looked modest at the pool level wiped out the junior slices entirely.