A
plain vanilla mortgage
security is a
bond backed by a pool of home mortgages. The investor recieves his or her portion of the mortgage payments that the borrowers repay on a monthly basis. This means that the
cash flows that are provided by the bond are mostly
interest payments at first, and over time pay out more and more
principal.
Mortgage securities contain embedded options. When interest rates fall, homeowners refinance and prepay the mortgage. This leaves the bondholder in a lower interest rate environment with a fistfull of cash and no tasty (higher yielding) bond. Conversely, when the interest rates rise, people quit moving and refinancing, and the bond's duration just streches out. This leaves the bondholder with a sucky bond with a low coupon that is going to be around forever.
To compensate for all the junk mortgage investors have to deal with, the yields on mortages are higher than bonds without options.
Investment bankers can create all kinds of exotic options that slice and dice the cashflows into more predictable and more risky securities.