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The Takeaways: MIT Sloan Faculty Members Offer Their Perspectives (continued)

What is the true cost of government-backed credit?

Deborah Lucas
November 13, 2012
The U.S. government is arguably the largest financial institution in the world. If you add the outstanding stock of government loans, loan guarantees, pension insurance, deposit insurance, and the guarantees made by federal entities such as Fannie Mae and Freddie Mac, you get to about $18 trillion of government-backed credit. Through those activities, the government has a first-order effect on the allocation of capital and risk in the economy.

The question of what those commitments cost the public is important; accurate cost assessments are necessary for informed decisions by policymakers, effective program management, and meaningful public oversight. My research and that of others has shown that if one takes a financial economics approach to answering that question—one that is consistent with the methods used by private financial institutions to evaluate such costs—it leads to significantly higher estimates than the approach currently used by the federal government.

At the core of the problem are the rules for government accounting, which by law require that costs for most federal credit programs be estimated using a government borrowing rate for discounting expected cash flows, regardless of the riskiness of those cash flows. That practice systematically understates the cost to the government because it neglects the full cost of risk to taxpayers, who are effectively equity holders in the government’s risky loans and guarantees.

An alternative approach to cost estimation—a fair value approach based on market prices—would fully take into account the cost of risk. Fully accounting for the cost of risk makes a significant difference: An estimate of the official budgetary cost of credit programs in 2013 shows them as generating savings for the government of $45 billion, whereas a fair value estimate suggests the programs will cost the government about $12 billion.

Finance Matters: The MIT Sloan Finance Group Blog
Deborah Lucas is the Sloan Distinguished Professor of Finance

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