4. Mortgage Securities: Mortgage securities are backed by an underlying bundle of mortgages. After a bank or mortgage company makes a home loan, it sells that loan to an investment bank or a quasi-governmental agency such as Fannie Mae or Freddie Mac. The bank or agency bundles these mortgages into securities that are sold to investors, who then receive payments based on the combined interest rate of the loans. While these securities can provide an income stream, they also carry a number of risks. For instance, if borrowers prepay their mortgages or refinance to take advantage of lower rates, mortgage-bond investors receive their initial investment back sooner than expected. Because homeowners generally refinance when interest rates are low, investors will have to reinvest at those lower rates. This is known as prepayment risk. Investors also face other risks, notably the risk that some homeowners may default on their mortgage payments. This can translate into a loss of money for mortgage-bond holders.
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