Pricing Government Credit: A New Method for Determining Government Credit Risk Exposure
22 Pages Posted: 10 Dec 2018
Date Written: December 2018
A growing debate centers on how best to recognize (and price) government interventions in the capital markets. This study applies a method for estimating and valuing the government’s exposure to credit risk through its loan and guarantee programs. The authors use the mortgage portfolios of Fannie Mae and Freddie Mac as examples of how policymakers could employ this method in pricing the government’s program credit risk. Building on the cost of capital approach, the method captures each program’s possible tail loss over and above its expected value. The authors then use a capital allocation approach to obtain each program’s marginal risk contribution. They show that the current practice of pricing the programs as stand-alone entities overestimates the value of the guarantee. By explicitly capturing the interaction of program losses, their method implies that the government’s overall capital reserve required to insulate taxpayers from losses can be lower than the reserve required when each program is evaluated in isolation. The authors also point out that the extent of this reduction hinges on the strength of (tail) dependence among the expected losses across the programs.
Keywords: capital allocation; government credit risk; marginal risk contribution; tail value-at-risk (TVaR)
JEL Classification: H6, H81, R28
Suggested Citation: Suggested Citation