An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the $8 trillion U.S. residential mortgage market. Their hybrid government–private status, and the perception that they are too big to fail, make them a potentially larg...

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Bibliographic Details
Published in:Journal of monetary economics 2006, Vol.53 (1), p.155-176
Main Authors: Lucas, Deborah, McDonald, Robert L.
Format: Article
Language:English
Subjects:
Credit market
Credit risk
Empirical tests
Financial economics
Financial institutions
Financial regulation
Hedging
Interest rates
Liabilities
Monetary economics
Mortgage companies
Mortgages
Options pricing
Public enterprise
Real options analysis
Risk management
Securities prices
Studies
U.S.A
Value at risk
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Summary:Fannie Mae and Freddie Mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the $8 trillion U.S. residential mortgage market. Their hybrid government–private status, and the perception that they are too big to fail, make them a potentially large, but largely unaccounted for, risk to the federal government. Measuring the size and risk of this liability is technically difficult, but important for the debate over the appropriate regulation of these institutions. Here we take an options pricing approach to evaluating these costs and risks. Under the base case assumptions, the estimated value of the guarantees is $7.9 billion over 10 years, with a combined .5 percent value at risk of $122 billion. We evaluate the sensitivity of these estimates to various modeling assumptions, and also to the regulatory regime, including forbearance policies and capital requirements. The analysis highlights the benefits, but also the challenges, of taking an options-based approach to evaluating the value of federal credit guarantees.
ISSN:0304-3932
1873-1295
DOI:10.1016/j.jmoneco.2005.10.001