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Researchers suggest that changing the way the government assesses risk for its loan programs could ease the financial fallout from economic shocks and recessions. Image: Nick Youngson/Alpha Stock Images

Changing how government assesses risk may ease fallout from extreme financial events

Posted on January 30, 2019

UNIVERSITY PARK, Pa. — Government loan programs keep money in reserve to cover recessions and other unexpected financial events, but two Penn State researchers suggest that changing the way those programs assess risk may ease taxpayer burden and better prepare the country for extreme economic events.

“There’s a debate among policy makers and academics over what is the best method for the government to report and account for the credit risks that the government takes on with insurance programs — like FHA insurance programs, Fannie Mae and Freddie Mac, Social Security Insurance — all of these are insurance programs that are effectively being borne by the taxpayers,” said Brent Ambrose, Smeal Professor of Real Estate and an associate of Penn State’s Institute for CyberScience. “When the government accounts for risk it is supposed to reflect the liabilities that the government is incurring — and the question is, are they accurately accounting for these risks?”

In a study, the researchers said that federal loan programs, such as the ones that provide loan guarantees and direct loans to make home ownership more affordable to low- and moderate-income borrowers, currently account for risk independently, but they may be vulnerable to correlated losses during an extreme economic event, such as a deep recession, which is a sharp decline in economic activity. According to the researchers, instead of assessing the risk to the programs separately, the government should treat the government-backed loans as a portfolio and adjust the premiums that borrowers pay to better reflect that model.

“Let’s say there’s a recession and all of the sudden, you have lots of claims on unemployment at the same time that mortgages are defaulting and hitting the government on that side of the equation, too, so you have correlated defaults,” said Ambrose, who worked with Zhongyi Yuan, assistant professor of risk management. “Everything is going bad at the same time and you’re getting exposed to all these losses at the same time. In our example, there are three government programs in the mortgage space that are doing essentially the same thing, all accounting for the risk independently, but we’re not recognizing that if the housing market collapses, they’re all going to get hit with defaults at the same rate, essentially.”

The amount of risk connected to government loan programs is significant, according to the researchers, who added that the federal government administers more than a hundred direct loan and guarantee programs, not including programs such as Social Security or federal civilian and military pension benefits. The researchers report that the combined value of federal credit programs was estimated to be about $18 trillion in 2013. Two of these programs, Fannie Mae and Freddie Mac, account for about half of the $10 trillion U.S. mortgage market.

While the new estimation method would not necessarily help the country avoid a financial shock, more accurately pricing the premiums could ease the recovery process, especially for taxpayers.

“This might help it so the government wouldn’t have to come to the taxpayers and increase the budget deficit to pay the claims,” said Ambrose. “As taxpayers, we’re on the hook for the losses, regardless of what happens, but this is just a way to better price the premiums that the homeowner would have to pay to reflect the risk.”

The researchers presented their findings at a recent meeting of the Federal Reserve Bank of New York. The findings were also published in the December issue of the Federal Reserve Bank of New York Economic Policy Review. Whether this recommendation is implemented is now in the hands of policymakers.

“The hope is that this will stimulate debate in Washington among the policymakers who might decide that maybe we do need to change the way we account for these programs on the books of the government,” said Ambrose.

The researchers analyzed data on 30-year fixed-rate mortgages that were purchased, or those that were guaranteed by government-sponsored entities, or GSEs. Both Freddie Mac and Fannie Mae are examples of GSEs. The data, which are made publicly available by the Federal Housing Finance Agency, covered GSE loans from 2000 to 2016.

Computations for this research were performed on the Penn State’s Institute for CyberScience Advanced CyberInfrastructure (ICS-ACI).

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