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Congress established the Joint Select Committee on Budget and Appropriations Process Reform in the Bipartisan Budget Act of 2018 to address the many flaws in current tax and spending procedures. Among the things that need fixing is the Federal Credit Reform Act (FCRA) of 1990, which artificially and systematically lowers the costs of the government’s credit assistance programs.
The federal government makes direct loans and issues loan guarantees to assist students, farmers, small businesses, and others. It also guarantees the mortgages of millions of homeowners directly through certain federal programs and indirectly through the backing of securities sold by Fannie Mae and Freddie Mac, which are now under full federal control. In providing this assistance, the government subsidizes loans through various mechanisms and takes on potential liabilities associated with loan defaults and other risks, while also receiving fees paid by banks and, in the case of direct loans, repayments from borrowers.
FCRA was enacted as part of the 1990 bipartisan budget agreement to improve the budgetary assessment of the government’s diverse and complex credit-related programs. Prior to 1990, Congress and the executive branch assigned costs and benefits to these programs using cash accounting, which provided a distorted view of their budgetary effects.
For instance, when the government issued guarantees for loans made by private sector banks, the federal budget would often show substantial initial savings from the issuance of the guarantees because the banks were required to pay up-front fees when loans were originated. The cost to the government of guaranteeing the loans was only recorded when payments were made to banks to cover losses associated with defaults. But these federal payments for loan defaults often took place many years after the loans originated and sometimes well beyond the five- or 10-year timeframe of the federal budget. Using cash accounting very often gave the misleading impression that issuing loan guarantees, even with lenient terms for the borrowers and the potential for large financial losses for the government, actually benefitted the federal budget.
By contrast, when the government lent money directly to borrowers, cash accounting made the transaction look artificially expensive. The government recorded the loan disbursement as an outlay and the repayments from borrowers as receipts, or negative outlays. For the many different types of loans with repayment periods beyond the timeframe of the budget, the initial outlay would far exceed the expected repayments occurring within the budget window, thus making the issuance of the direct loans look more expensive for the government than they really were.
FCRA was a major advance because it instituted accrual accounting for most credit programs. Under accrual accounting, the federal budget records the net subsidy cost of a direct loan or loan guarantee at the time the loan is originated based on the present value of all future financial flows from the transaction. Present value calculations use discount rates to assign a value in today’s terms to a receipt or a payment that is scheduled to occur in a future year. The purpose of accrual accounting is to capture the government’s all-in net exposure (or profit) after taking into account all of the disbursements and receipts. With accrual accounting, direct loan and loan guarantees get assessed using an identical methodology, which allows for a fairer comparison of the competing approaches. Further, using accrual accounting for credit programs allows for more useful comparisons with the budgetary costs of the government’s traditional spending programs.
The problem with FCRA is the requirement, written into the law, that the government use Treasury interest rates when discounting the value of future financial flows. The U.S. government pays very low interest rates on the money it borrows because investors view these debt instruments as essentially “risk free.” There is little prospect of default on U.S. government debt (despite the brinksmanship around debt ceilings) because the U.S. is the world’s richest country and the federal government has essentially unlimited capacity to tax U.S. citizens to pay back borrowed funds.
As the Congressional Budget Office (CBO) has explained on numerous occasions in recent years, a risk-free interest rate is the wrong one to use when discounting the financial flows of federal credit programs. When the federal government makes loans or issues loan guarantees, such as to students, it is taking on the risk associated with broad macroeconomic shifts that might affect the ability of borrowers to meet their payment obligations. Among other things, a prolonged recession and high unemployment would raise the number of loans in default. This risk — called market risk — is not included in the rates the government pays on the money it borrows in public markets. Rather, market rates are what private sector creditors demand when putting capital into investments that carry this risk.
Using Treasury rates instead of market rates to discount the payment flows of credit programs artificially lowers the costs of federal credit programs, which creates perverse results. Because students pay interest rates on direct loans that exceed the rates the Treasury pays on its bonds, the issuance of new direct loans and loan guarantees by the government appears to create profits rather than losses. Using the FCRA required methodology, CBO estimates that the student loan subsidy rate is -4.1 percent, which means the government records a $41 million negative outlay (or profit) when issuing $1 billion in new direct and guaranteed loans. If market rates were used instead of Treasury rates to discount the payment flows, the budget would record a cost of $161 million for every $1 billion in new direct and guaranteed loans.
Moving from Treasury to market rates to assess the government’s credit programs would substantially raise the government’s projected deficits over the coming decade. Using Treasury rates, CBO estimates that, in 2019, the government’s credit programs will make commitments that, in present value terms, will generate a profit of $37.4 billion. With market rates, the agency estimates that these same programs will generate a net loss for the government of $37.9 billion — a difference of $75.3 billion. Over the next decade, using market rates would likely add close to $1 trillion to the government’s projected budget deficit, which is already expected to exceed $12 trillion.
CBO is non-partisan and does not take positions on policy matters, but it does from time to time comment on technical questions related to the budget process. For several years, the agency has said FCRA should be amended to use market instead of Treasury rates as the basis for discounting the financial flows associated with credit programs. Academic experts in the field agree with CBO on this point.
Membership on the joint committee is split evenly between Republicans and Democrats, and the law stipulates that the committee can only advance recommendations that have majority support from both parties. Fixing this flaw in credit reform should be something both parties support. It is needed to ensure Congress is getting accurate information on the costs of programs that have the potential to create significant liabilities for future taxpayers.
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