This paper describes the methods and data that CBO uses to estimate the cost of market risk for three categories of federal credit programs: housing and real estate loans, student loans and other consumer loans, and commercial loans.
Summary
By Michael Falkenheim and Wendy Kiska
Market risk is the component of financial risk that remains even after investors have diversified their portfolios as much as possible. Investors demand additional compensation to take on market risk. In that way, they can earn more than the return on Treasury securities, which are regarded as risk free, after netting out the average cost of default. The Congressional Budget Office supplements its formal cost estimates, which do not include the cost of market risk, with fair-value estimates, which include that cost. Because the fair-value cost of credit programs includes market risk, it can differ substantially from the official budgetary cost of such programs, which is determined in accordance with the Federal Credit Reform Act of 1990.
In this report, CBO describes how it estimates the cost of market risk in its fair-value estimates of credit programs. CBO uses different data sources and methods for different types of loans:
- Housing and real estate loans. CBO estimates a risk premium using market prices for private mortgage insurance and credit-risk-transfer securities, interest rate spreads, and other market information.
- Student loans and other consumer loans. CBO estimates market risk as a multiple of the loans’ expected default losses, using the pricing of securities backed by private consumer and student loans and making a separate adjustment for income-driven repayment plans; and
- Commercial loans. CBO estimates their market risk as a multiple of their expected default losses, which are based on the pricing of corporate bonds.
CBO’s current method for estimating the fair value of student, consumer, and commercial loans adjusts projected cash flows for market risk and then discounts them to the present using the yields on Treasury securities. That method represents a refinement of CBO’s previous method, in which the agency relied more heavily on adjusting discount rates instead of cash flows to incorporate market risk. In the past, CBO discounted the future cash flows of most credit programs using a rate that was equal to the Treasury interest rate plus a risk premium. Now, CBO only applies the adjusted-discount-rate method to housing and real estate loans.