Making a Case for Deep Cover Mortgage Insurance

Abstract

The U.S. housing finance system remains unchanged since 2008, when the Federal Housing Finance Authority placed Fannie Mae and Freddie Mac (the GSEs) into conservatorship. As a result, the GSEs continue to present a significant risk exposure to taxpayers. The authors demonstrate the role that deep cover mortgage insurance can play in bringing additional private capital to housing finance, thereby reducing the risk that the GSEs present to the taxpayers. Using methods published by Andrew Davidson and Alex Levin, the authors present results that compare the effectiveness and cost of deep cover mortgage insurance with the Freddie Mac STACR 2015-DNA2 transaction and find that the market-implied pricing is equivalent to insurance capitalized to a 97% expected shortfall earning a 16% return. Counterparty risk measured as excess expected shortfall, under simplifying assumptions, is found to be very low relative to the risk transferred away from the GSEs.