Accounting for Credit in the Federal Budget Revisiting the cost of risk Deborah Lucas Assistant Director, Financial Analysis Division, Congressional Budget Office

Overview Budgetary accounting for credit under FCRA Consequences of excluding a charge for risk Why market risk has a cost (for the government and for the private sector) Developing fair value cost estimates Examples of recent CBO fair value estimates Student loans GSEs

The Federal Credit Reform Act of 1990 (FCRA) Moved federal direct loan and loan guarantee programs from a cash to an accrual basis Subsidy cost of a direct loan or loan guarantee is the discounted value of expected net cash flows Cash flows are discounted to the disbursement date at Treasury rates of similar maturity Administrative costs are excluded from subsidy costs but recorded elsewhere in the budget FCRA takes into account the expected losses from default but not the cost of the associated market risk. Market risk arises because losses from defaults tend to be larger during economic downturns, when they are most costly Investors require compensation for market risk in the form of higher expected returns

Goals of FCRA SEC. 501. PURPOSES. The purposes of this title are to-- § 501(1) (1) measure more accurately the costs of Federal credit programs; § 501(2) (2) place the cost of credit programs on a budgetary basis equivalent to other Federal spending; § 501(3) (3) encourage the delivery of benefits in the form most appropriate to the needs of beneficiaries; and § 501(4) (4) improve the allocation of resources among credit programs and between credit and other spending programs.

Consequences of excluding the cost of market risk in budgeting for credit Favors providing credit over economically equivalent amounts of grant assistance Appears cheaper for the government to provide credit than for the private sector The government’s apparent advantage increases with the riskiness of the undertaking being financed Many credit programs have a negative or zero subsidy rate in the budget e.g., –17% for direct “unsubsidized” student loans Programs may show a zero cost by requiring participants to pay the FCRA subsidy cost (e.g., energy innovative technology program §1703 self-pay loans)

What is the cost of risk to the government? Two common arguments for why the government has a cost advantage in providing credit: Treasury can borrow at risk-free rates The government doesn’t need to earn a profit

Why the government’s cost of capital exceeds Treasury rates The government borrows $100 million to make a direct loan. Consider the government’s notional balance sheet right after it makes the loan, which is due in one year. Loan interest rate = Treasury rate = 3% Assets Liabilities Risky loan $100m Treasury Debt $100m

Why the government’s cost of capital exceeds Treasury rates Notional balance sheet at end of the year if the loan pays off in full: Assets Liabilities Cash $103m Treasury Debt $103m

Why the government’s cost of capital exceeds Treasury rates Notional balance sheet at end of the year if the loan defaults and recovery is only $73: Assets Liabilities Cash $73m Treasury Debt $103m Taxpayers -$30m Treasury borrowing costs are low because of taxpayer backing. Taxpayers are equity partners in federal credit obligations. The government’s cost of capital is a weighted average of the cost of debt and equity (as for a private sector firm).

Does the government need to earn less profit than private entities? Accountants and economists define profit differently: The accounting definition includes all earnings that accrue to equity holders (whereas interest on debt is treated as a cost) Economists think that the return to equity is also a cost: A fair return to equity holders (and debt holders) compensates them for the time value of money and for risk-bearing. In competitive markets, firms earn “zero economic profits” (prices are driven down to just cover the cost of inputs, including capital). Abnormal profits only arise when competition is limited. Taxpayers – as equity holders in federal credit commitments – would expect to receive a normal economic rate of return on those investments.

What risks do investors require compensation for? Market (or systematic) risk is costly to investors It gives rise to a “market risk premium” The risk premium is an expected rate of return in excess of the Treasury rate. (A higher risk premium on a loan means it is worth less in present value terms.) Investors in risky debt require a risk premium because defaults are more likely and more severe during economic downturns, when resources are scarcer and hence more valuable. Idiosyncratic risk is not priced because it can be diversified away Investors in loans and loan guarantees also need compensation for expected default losses.

Decomposing yield spreads A “yield spread” is the difference between the yield- to-maturity on a debt instrument and on a Treasury security of equal maturity E.g., YTM on Treasury bond is 5%, YTM on Ford bond is 8% Components of spread include: expected losses from default; market risk premium; liquidity; tax. FCRA estimates account for default losses but not other components.

Developing fair value cost estimates CBO’s budget estimates for TARP, and for Fannie Mae and Freddie Mac, are on a fair value basis CBO has provided fair value estimates for other programs for informational purposes e.g., student and small business loans Fair values reflect what market prices would be in an orderly market with willing buyers and sellers They are not liquidation or distress prices Private sector accounting standards and practice provide guidance on application of fair value principles to federal credit

Developing fair value cost estimates Often implemented using risk-adjusted discount rates Accommodates other methods such as options pricing models and comparable market prices Challenges include Increased complexity Developing capacity to make, evaluate, and clearly explain more complicated estimates Maintaining consistency of estimates across programs Potentially greater volatility in estimates Making it all add up (e.g., adjustments to financing accounts)

CBO examples: Fannie Mae and Freddie Mac CBO (after consulting with the budget committees) put them on budget at fair value Risk premium for loan guarantees is imputed from (adjusted) spreads between jumbo and conforming mortgages Fair value of portfolio holdings taken from Fannie and Freddie financial disclosures

CBO examples: Fannie Mae and Freddie Mac In a recent letter to Congressman Barney Frank, CBO estimated the cost of new business in future years under alternative budgetary treatments:

CBO examples: Federal Student Loans CBO estimated the fair value cost of federal direct and guaranteed loan programs for informational purposes Student loans (and other consumer credit) have market risk because defaults rise in recessions Fair values inferred from interest rates charged on private student loans prior to the financial crisis Adjustments made to account for administrative costs in direct and guaranteed programs more symmetrically than under FCRA rules

CBO examples: Federal Student Loans In a letter to Senator Judd Gregg, CBO compared the FCRA and fair value costs of the existing programs and the program proposed by the President:

Selected CBO publications The Budgetary Impact of Fannie Mae and Freddie Mac, September 16, 2010 The Budgetary Impact and Subsidy Costs of the Federal Reserve's Actions During the Financial Crisis, May 2010 Costs and Policy Options for Federal Student Loan Programs, March 2010 Budgetary Impact of the President's Proposal to Alter Federal Student Loan Programs, March 2010 CBO's Budgetary Treatment of Fannie Mae and Freddie Mac, January 2010 Federal Financial Guarantees Under the Small Business Administration's 7(a) Program, October 2007 The Risk Exposure of the Pension Benefit Guaranty Corporation, September 2005 Estimating the Value of Subsidies for Federal Loans and Loan Guarantees, August 2004 Evaluating and Accounting for Federal Investment in Corporate Stocks and Other Private Securities, January 2003