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

3. 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

4. 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

5. 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.

6. 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)

7. 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

8. 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

9. 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

10. 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).

11. 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.

12. 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.

13. 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.

14. 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

15. 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)

16. 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

17. 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:

18. 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

19. 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:

20. 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