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 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. We evaluate the sensitivity of our 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 on options-based approach to evaluating the value of federal credit guarantees.