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Federal Housing Finance Agency
Office of Federal Housing Enterprise Oversight: Working Papers
This paper links the probabilities of default and prepayments to the distribution of losses associated with a synthetic portfolio of Fannie Mae and Freddie Mac mortgages randomly samples from 30 year fixed rate prime and subprime mortgages. The simulations exploit historical relationships found between mortgage characteristics and economic conditions in time and space as estimated in a competing risk conditional default and prepayment hazard model and a loss given default model. Estimations of loss distributions indicate that subprime loans exhibit greater dispersion and higher loss rates than prime loans. For instance, expected or mean simulated losses for subprime loans are found to be 5 to 6 times higher than for prime loans. However, the use of simple risk sharing arrangements can greatly mitigate expected losses and reduce the variation of losses.