Why do mbs have negative convexity

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Last updated: April 8, 2026

Quick Answer: Mortgage-backed securities (MBS) exhibit negative convexity primarily due to prepayment risk, where homeowners refinance or sell when interest rates fall, shortening the security's duration and capping price appreciation. This occurs because MBS cash flows are tied to underlying mortgages, which borrowers can prepay without penalty in many cases. For example, during the 2003 refinancing boom, prepayment rates surged over 40% on some MBS pools when 30-year mortgage rates dropped below 6%. This asymmetric response to rate changes creates negative convexity, meaning MBS prices rise less when rates fall than they decline when rates rise.

Key Facts

Negative convexity in MBS primarily stems from mortgage prepayment options embedded in the underlying loans
During the 2003 refinancing wave, prepayment speeds on some MBS exceeded 40% when mortgage rates fell below 6%
The negative convexity effect became particularly pronounced during the 2008 financial crisis when MBS values declined sharply despite rate cuts
MBS duration can shorten by 2-4 years when rates fall 1-2% due to accelerated prepayments
Government-sponsored entities like Fannie Mae and Freddie Mac guarantee most agency MBS, which still exhibit negative convexity despite their implicit government backing

Overview

Mortgage-backed securities (MBS) are fixed-income investments created by pooling residential mortgages and selling shares to investors. The concept originated in the 1970s when the Government National Mortgage Association (Ginnie Mae) issued the first modern MBS in 1970. By 2023, the U.S. MBS market had grown to approximately $12 trillion, making it one of the world's largest fixed-income markets. These securities transformed housing finance by allowing lenders to sell mortgages to investors, replenishing capital for new loans. The market expanded significantly after the 1980s with private-label MBS, though agency MBS from Fannie Mae, Freddie Mac, and Ginnie Mae still dominate, comprising about 70% of outstanding MBS as of 2023. The 2008 financial crisis highlighted MBS risks when subprime mortgage defaults triggered massive losses, but agency MBS continued trading with government support.

How It Works

Negative convexity in MBS arises from the prepayment option embedded in most mortgages. When interest rates decline, homeowners can refinance at lower rates, prepaying their existing mortgages. This accelerates cash flows to MBS investors, who must reinvest at lower prevailing rates. Conversely, when rates rise, prepayments slow, extending the security's duration and exposing investors to longer-term rate risk. This asymmetric behavior creates negative convexity: MBS prices don't rise as much during rate declines (due to prepayment risk) but fall significantly during rate increases (due to duration extension). The effect is quantified using option-adjusted spread (OAS) models, which value the embedded prepayment option. For example, a 30-year agency MBS might have a positive convexity of +0.5 at issuance but develop negative convexity of -1.5 after rates drop 2%, reflecting changed prepayment expectations. Servicers' processing times and borrower behavior further influence prepayment speeds.

Why It Matters

Negative convexity significantly impacts investment portfolios and financial stability. For investors, it creates reinvestment risk during rate declines and extension risk during rate rises, complicating duration matching strategies. During the 2008 crisis, MBS negative convexity exacerbated losses as falling rates triggered prepayments while housing defaults reduced cash flows. The Federal Reserve's quantitative easing programs, which purchased over $2.5 trillion in MBS between 2008-2014, had to account for this convexity in monetary policy transmission. For homeowners, MBS markets influence mortgage rates and availability, though most are unaware of the securities' technical characteristics. Understanding negative convexity helps investors price MBS appropriately, manage interest rate risk, and assess systemic vulnerabilities in housing finance systems.