Abstract :
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.
r 2005 Elsevier B.V. All rights reserved.
