The initial instinct is to view the current-coupon MBS as a prepay-risk-free instrument, but this is assumption is amiss. If MBS were valued solely off their yield it would be the right move. However, valuation with OAS accounts for both the curve and optionality and results in a more complex risk picture. Decelerating the turnover, we push the MBS cash flow out causing a value-detrimental effect if the curve is steep, almost no effect if it is flat, and even some value gain if it is inverted.

On the other hand, surprisingly fast refinancing will increase the value of prepay option, which also damages the MBS investor position. However, the steep curve environment is now less risky than the flat or inverted one. With faster refinancing, potential losses are partially compensated for by shorter cash flows (discounted at lower rates) and out-of-the-money steep forward paths. In general, investors in current coupon MBS should certainly demand compensation for the combination of turnover risk and refinancing risk.

Liquidity and credit quality. TBA MBS are generally as or more liquid than debentures, supply of which may be limited from time to time. MBS and debentures are backed by the full faith of government agencies; in addition, MBS are collaterized by the property. While the credit of agency-backed instruments is typically never an issue, a common perception has been that agency MBS carry even higher credit quality than debentures.

Operational and model risk. Managing and hedging MBS portfolios requires more expertise and costs more to bankers and investors than similar operations with portfolios of bullets. The use of rigorous MBS models is necessary and can't be accomplished without comprehensive data collection and analytical processing. Even after the best models are built or licensed, an MBS investor is not immunized against model errors or a sudden change in market conditions or regulation (such as reducing cost of refinancing and boosting the prepay option value).

Supply and demand. Supply of MBS is driven by rates. When rates fall, supply grows and cheapens. As we will see in the next section, this effect explains the LOAS directionality, i.e. LOAS dependence on the level of rates. The directionality gets smaller if we measure OAS off the agency debenture curve. Indeed, agencies will issue more debts to accommodate for a larger MBS supply. This issuance will make debentures cheaper, too. >>>