Which scenario represents the greatest risk related to mortgage-backed securities?

The scenario that represents the greatest risk related to mortgage-backed securities is when falling interest rates might accelerate early repayment of principal. This situation presents a critical concern for investors because when interest rates decline, homeowners are more likely to refinance their mortgages to take advantage of the lower rates. As a result, mortgage-backed securities can experience an influx of early principal repayments.

This prepayment risk is particularly significant for investors because the expected cash flows from the mortgage-backed securities are reduced. Investors advocating for higher yields may find themselves reinvesting the received principal at lower interest rates, potentially diminishing their future returns. Hence, while other risks, such as borrower defaults or illiquidity, can have serious implications, the impact of falling interest rates and subsequent early repayments directly affects the anticipated income from these securities, making it a primary concern for investors.