To the finance & trading nerds out there: here's why callable debt is such a big deal. Like everything else in the mortgage bond world, it all comes down to prepayments.

Borrowers have the option to prepay their mortgage by refinancing or simply by paying more than the minimum requirement. Because of the prepayment option, mortgages have a duration (defined as the average maturity of the cash flows, weighted by the present value of the cash flows) much less than their 30-year term. For example, the 10yr treasury note has a duration of just over 8 years, but FNCL 5.5 TBA mortgage futures (the most liquid type of mortgage-backed security) have a market-implied duration of around 5 years.

Duration also measures the sensitivity of a bond's price to interest rates: for longer duration bonds, you are discounting the cash flows further back in time, so the rate at which you value future cash will have a greater effect on the present value. Think about it: if you are to receive $1000 in six months, it won't much matter to you if interest rates are at 1% or 10%. If the financial situation is relatively normal, $1000 in six months isn't worth much less than $1000 now. But a 30-year bond yielding only 1% is almost worthless (why would you lock up your money for 30 years at such a low rate), while one yielding 10% is extremely valuable.

If prepayment speeds were static (i.e. if people always paid off their mortgages at the same rate), Fannie Mae could issue debt with 5-year duration (probably ~7yr maturity) at, say, 5%, and buy 30-year mortgages (also with 5-year duration) yielding 6%. They would thus make 1% per year, and on average they would pay off their own debt right when the borrower pays off his mortgage. Fannie and Freddie do issue debt in this form, referred to as bullets.

The problem is that agency bullets have a very different convexity profile than mortgages. (If duration is the sensitivity of prices to interest rates, convexity is the sensitivity of duration to interest rates). Bullets have positive convexity: as interest rates go down, the bond has a longer duration. With low interest rates, future money isn't worth much less than money now. So when you are computing duration, the large cash flows towards the end of the bullet's life are dominant. Mortgages are exactly the opposite: they have negative convexity. As interest rates go down, a mortgage's duration gets shorter because borrowers refinance out of their old mortgage into a new one at a lower rate. If rates go up, the opposite happens.

So suppose rates go up. The debt that Fannie issued trades to a shorter duration, but the mortgages they own trade longer. This means that on average, Fannie would have to pay off its debt faster than the borrowers pay off their mortgages. When Fannie's debt comes due before the mortgages, Fannie will have to refinance. And since rates went up in this scenario, it will have to refinance into more expensive debt than before.

Now imagine rates go down. Fannie Mae's debt trades longer, and mortgages trade shorter. So Fannie Mae is still paying debt even after it received the cash flows from the mortgages. Even worse, it's paying debt at above market rates now that rates went down since issuance.

Callable agency debentures fix this problem by giving Fannie Mae the same option that borrowers have. As borrowers call their mortgages in (i.e. as they prepay them), Fannie can call its own debt by paying it off early. Fannie can now make sure the duration of its liabilities (its debentures) is matched by the duration of its assets (the mortgages it owns).

I'd be happy to explain any other aspect of the mortgage bond market, if there's anyone out there who's interested.