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

Deborah Lucas*, Robert L. McDonald

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

24 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)155-176
Number of pages22
JournalJournal of Monetary Economics
Volume53
Issue number1
DOIs
StatePublished - Jan 1 2006

Keywords

  • Financial institutions
  • Options pricing
  • Value at risk

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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