[seanhunter]

The stuff I read is that it was the hedge implementation that lost them all the money. It's very hard to know for sure how that happened without being inside the situation.

Long answer: Hedging rate risk in general is a very deep topic. Investment banks have massive swaps desks that are built on the back of this and there are numerous examples of people losing a ton on hedges and in certain cases the dealer banks have been fined for miss-selling etc. Not saying that's the case here but it is at least possible. For example in the UK there was this[1] and in the US from memory there were numerous munis who settled and received payouts after losing a ton on rates hedges.

On top of that, hedging rate risk on an MBS is slightly more complex than for a regular bond because it amortizes and as the underlying loans prepay or default this affects future cashflows from the bond. So you can only hedge the forward rate risk given certain assumptions about prepayment/default and if those assumptions turn out to be off you will be imperfectly hedged. Normally that isn't that big of a deal if you have a big portfolio as you can roll swaps on or off to fix the problem [2] but the cost of that adjustment is going to be a factor of how "wrong" you are about the default profile of the collateral and how much rates have moved.

[1] https://www.theguardian.com/business/2013/oct/23/interest-ra... [2] There is also the problem of default correlation skew here meaning you have so called "wrong way risk" where if your assumptions are wrong on one bond they're highly likely to be wrong across your portfolio. This is as opposed to normal portfolio thinking where a diversified portfolio helps.