This paper presents a risk-neutral approach used by the Congressional Budget Office to inform its estimates of the fair-value cost of mortgage obligations. The fair-value cost is the amount that a private entity would charge in a competitive market for taking the risks associated with a government activity. CBO’s approach adjusts the probability distribution of macroeconomic variables to obtain a risk-neutral distribution of default, recovery, and prepayment rates. The macroeconomic variables are calibrated by determining the adjustment that leads the estimates of the fair-value of credit-risk–transfer securities to match their observed prices and fit the pricing of private mortgage insurance. CBO then uses that risk-neutral distribution to develop projections of cash flows that incorporate market risk and can be discounted to the present with Treasury rates to obtain estimates of the fair-value cost of government mortgage obligations. To demonstrate the approach, this paper applies it to estimate the cost of backstopping pools of mortgages against catastrophic losses.
