Fair Value in Play for 2016 U.S. Budget Process

A recent topic of debate in the U.S. budget community centers on how the federal government should estimate the cost of providing loans to various borrowers such as students and homebuyers. Currently costs are assessed assuming that the government’s cost of capital is equal to the Treasury rate. Proponents of switching to a “fair-value” approach would include an additional charge for the cost of the risk transferred to taxpayers. Congress recently weighed in on the matter by including provisions in its budget resolution for fiscal year 2016 requiring the Congressional Budget Office (CBO) to provide supplementary fair-value information on credit programs costs. That change will yield significantly higher price tags for many programs.

The government budgets for credit by estimating the timing and amount of associated future cash flows to and from the U.S. Treasury and discounting them to the present. Once a present value is determined, the Congress can compare it to the amount to be loaned – with the difference being the expected subsidy – and determine funding levels and lending ceilings.

Sounds straightforward enough but, as in other areas, a debate has opened regarding the appropriate discount rate to be used in calculating present values. For more than 20 years, federal agencies have calculated present values for credit programs using the risk-free rates on Treasury securities as the discount factors. In contrast, private financial institutions and even investors use risk-adjusted discount rates to calculate present values and expected returns on investment that are commonly referred to as fair-value estimates.

Proponents for a move to fair-value accounting (including the CFP’s Deborah Lucas) have argued that the use of risk-free discount rates neglect the costs of market risk and results in a systematic understatement of costs. (See http://bit.ly/1IB6o92, http://bit.ly/1Pm3KYX, and http://bit.ly/1EI21Td.) Neglecting that cost leads to the unintuitive conclusion that the government earns a sizable profit from its largest credit programs, even though the terms offered to borrowers are, ostensibly, much better than could be offered through the private markets. For similar reasons, CBO has supported a move to fair-value estimates. (See http://1.usa.gov/1H5Iv3O and http://1.usa.gov/1EIwSy0.) Moreover, CFP-affiliated researchers are continuing to do work to improve the government’s capacity to make accurate fair-value estimates of program costs.

Other observers, including staff at the Center for Budget and Policy Priorities, have raised questions on the efficacy of using fair-value concepts in credit budgeting. (See http://bit.ly/1A3Sqti.) Their basic contention is that use of fair-value concepts requires the government to add an extra amount to the cost of loan programs based on a risk premium that the government doesn’t really pay as a cash cost. They assert that adding that extra cost overstates deficits and forces needless spending offsets.

Will new information on fair-value costs of credit programs have real consequences? Potential outcomes fall into three categories: 1) little impact if policymakers continue to focus on the official cost estimates; 2) procedural implications if the House Budget Committee Chairman chooses to use the new estimates to raise budgetary points of order; and 3) significant programmatic ramifications if Congress chooses to have such estimates determine funding and program levels.

Although the resolution was not signed by the President and therefore does not carry the force of law, it does specify the rules the Congress intends to follow throughout the 2016 budget process. At the request of the Budget Committee Chairman in the House or Senate, CBO will prepare a fair-value estimate of legislation funding or modifying loan and loan guarantee programs. CBO will be required to provide such estimates for the government’s largest loan programs, including those designed to provide credit to homeowners and students.

The House Budget Committee Chairman is authorized to use these supplemental estimates for the purposes of determining budget-related points of order – a procedural maneuver that complicates consideration and passage of legislation. If the Chairman exercises this power and starts raising such points of order on credit program funding levels, the House will either need to accommodate his points or waive them altogether by adopting special (i.e., alternative) rules.

Studies performed by CBO in recent years indicate the application of fair-value concepts to federal lending would result in significantly higher costs relative to the estimation methodology currently mandated under the Federal Credit Reform Act (FCRA). For example, CBO published a report in May 2014 showing that from 2015 to 2024:

• Department of Education loan programs would yield budgetary savings of about $135 billion under FCRA accounting but cost $88 billion on a fair-value basis;
• Ex-Im Bank programs would generate savings of $14 billion under FCRA but cost $2 billion on a fair-value basis; and
• Federal Housing Administration’s single-family mortgage guarantee program would provide savings of $63 billion under FCRA but cost $30 billion on a fair-value basis.

Given the magnitude of these higher costs and strict spending caps imposed under the Budget Control Act of 2011, the binding use of fair-value estimates for budget adoption would likely require Congress to shift funds from non-credit programs to lending activities, reduce or eliminate funding for loan programs, and/or reform loan programs to reduce expected costs.

Notwithstanding the budget resolution, FCRA mandates how loan programs are administered by the Executive Branch and the (not fair-value) estimates prepared by the Office of Management and Budget (OMB) govern budget execution. Accordingly, one could contend the CBO estimates are of small consequence. However, FCRA requires the Congress to provide an appropriation and a loan limitation or other authority to make loans. As a result, the lending limit set by the Congress (presumably prepared using CBO scoring) would be legally binding for budget execution regardless of OMB scoring. Importantly, it should be noted adoption of FCRA was accompanied by spending cap relief to offset costs associated with shifting from cash to accrual budgeting. No such relief was included as part of the 2016 budget resolution.

Federal credit program participants, both in government and the private sector, are very concerned by the potential impact of all this for their lending activities in the year ahead. We will continue to monitor and provide updates here as this new wrinkle in the U.S. federal budget process unfolds.