How does an MBS security work?

There was a question suggesting if interest rates rise and insurance firm holds MBS, then prepayments will fall resulting in a reduction of an insurance firms surplus:

As an MBS holder do we make our yield on homeowners paying back their loans? So if rates are low and people will repay faster which is a good thing for MBS holders?

The large holding in mortgage securities adds uncertainty to cash flows. When interest rates rise, slower prepayment rates reduce cash inflows and associated interest on interest yield. These cash flows are an integral part of the reserve funding formula and a source of surplus growth.

When interest rate falls, prepayments reduces as homeowners won’t want to re-finance their mortgages at a higher rate. Falling prepayments will reduce the amount of cash coming in as you’ll only get the monthly instalments rather than the lump-sum that they would pay to settle their mortgage. This reduces the surplus. I’m assuming this is what the answer is getting at.

Another way I can think that surplus will fall is due to the fall in the value of the MBS due to an increase in interest rates.

when rates fall, homeowners would want to refinance their mortgages and thus, prepayments increase. this causes a sudden influx of cash to MBS holders. whether this is a good or a bad thing depends on circumstances, but generally this is unfavorable (for the investors or MBS holders) because while investors now have excess cash to invest, the interest rate environment is low and so your re-investments yields would drop. the sudden increase of prepayments increase the surplus (assets - liabilities) of an insurance company’s portfolio.

when rates rise, homeowners will not refinance their mortgages and thus, prepayments fall. this reduces cashflow to MBS holders. however, there is also a possibility of homeowners to retire their mortgages in face of the higher mortgage rates if they have floating rate mortgages. since cfai does not discuss this scenario (when dealing with MBS), we assume that most mortgages are fixed rates and homeowners do not have the capacity to retire their mortgages early (they can only refinance, not retire).

before issuing the MBS, the bank holding the mortgages would already have a projection/budget of inflows due to mortgage payments or prepayments with underlying assumptions of future interest rates. if rates move beyond these assumptions, then the prepayments will shift significantly and breaks the projection.

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Thanks both for detailed answers.

So are you able to answer these two short questions

If I am a portfolio manager

  1. Why do I want to hold MBS in my portfolio

  2. How do I profit from MBS securities?

  1. MBS, being a callable bond, has negative convexity if you’re the investor. so if you think interest rate volatility would be low, you can buy MBS (short convexity)

  2. MBS has tranches if you recall from Level 1, a senior and a mezzanine. since mezzanine has higher yield compared to senior, you can exploit the tranches regarding your views on “default correlations” between the two tranches. if you think the default correlation is a strong positive (meaning if the senior tranche default, mezzanine will also default and vice versa), you short the senior and long the mezzanine. so if your mezzanine tranche defaults, there’s high chance the senior defaults too, so why stick with the senior tranche with lower yields?

MBS also has very close correlation with real estate markets, so if you think real estate is going to perform well compared to corporate bonds, you can short corporate bonds and long MBS.

MBS is just a fancy form of callable bond, so any strategy you can think of about a callable bond applies to MBS in general.

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