Reforming Credit Reform

The federal budget deficit will nearly triple to a historically unprecedented $1.2 trillion for the 2009 budget year, grim Congressional Budget Office figures reported in January. Thanks to all of the bailouts in the financial industry and the assumption of Fannie Mae and Freddie Mac, the deficit for the first four months of fiscal 2009 exceeded all of 2008. Now is not the time for miscalculating credit program costs, and yet research from Deborah Lucas (Finance) and her colleague Marvin Phaup (George Washington University) reveals this is precisely what is happening. The researchers conclude that under the federal government’s existing accounting rules set out in the Federal Credit Reform Act of 1990 (FCRA), the cost of credit programs is typically understated. Lucas calls the current system “light years behind accounting in the private sector,” saying that shortcomings make programs appear to cost taxpayers less than they really do. In order to more closely align budget costs with the full economic costs of programs, Lucas and Phaup say the FCRA needs to be amended.

The big stumbling block is that anything that makes a whole category of expenditures look more expensive is not going to be a big seller for Congress.In work published in Public Budgeting & Finance, Lucas and Phaup explain that although the FCRA improved the treatment of credit in the federal budget, the policies still fail to reflect true market values. Before Congress passed the FCRA, the federal budget used cash-basis accounting in most cases. Lucas explains that a cash-basis budget simply tracks cash flows and is “not very forward-looking.” This results in a misrepresentation of the costs involved in obligations that cover a large number of accounting periods. For example, accounting for the purchase of a million-dollar student loan on a cash-basis would involve recording the expenditure in the current year for the entire loan, even though the repayment of interest and principal that occurs over many years would largely offset the initial cost. Accrual basis accounting solves this problem, and FCRA moved credit from a cash basis to an accrual basis. In addition, the FCRA allowed accounting for the expected rate of loan defaults. However, several problems remain that prevent accurate accounting of the costs of credit, including failure to account for the cost of risk and omissions of certain administrative costs associated with extending credit.

The Perils of Ignoring Risk Premiums
In the open credit market, a risky loan would command a higher interest rate as a form of compensation for investors willing to tolerate the extra risk. This is known as a “risk premium,” Lucas says. “It’s in neglecting this market risk premium that the original Federal Credit Reform Act fell short.”

Tables 1 and 2 illustrate the costs of two federal credit programs, one with and the other without including the costs of risk. Table 1 shows the costs under the current system, and Table 2 shows the costs once the risk premium is included. The middle column in each table lists the cost of the loans the federal government made to America West Airlines (AWA) after September 11, 2001. The last column shows the cost of the loans it made to the Chrysler Corporation in 1979.

Table 1: Net Subsidies under Credit Reform (Millions of Dollars)

Table 2: Net Market Value Subsidies (Millions of Dollars)

Current accounting procedures (Table 1) suggest that the loan to America West resulted in a $37.4 million profit for the government. However, when the total cost of the loan is included (Table 2), the result is a $43.7 million loss. The 1979 loan to Chrysler went on the books as a $107.6 million loss to the federal coffers (Table 1). However, a more accurate assessment of the bill to the taxpayers is more than twice that much: $239 million (Table 2).

Lucas notes that the same accounting procedures used to calculate profits and losses in Table 1 are being applied to the $25 billion in aid to the U.S. auto industry that Congress approved in September 2008. “These loans to automobile makers are a prime example of a subsidy which will be under-recorded in the budget because of the current rules for accounting for risk,” she says.

Lucas reports that among economists there is significant support for federal accounting reform. “When I talk to my fellow economists, they think that the problem is so obvious and the solution is so obvious and trivial, it shouldn’t even be an issue.” She and Phaup mention in their paper that the President’s Budget Proposal for fiscal year 2009 includes plans to initiate discussions about credit reform with Congress and Congressional support agencies. According to this proposal, the executive branch will lead talks on topics such as the cost of market risk, more accurate valuation of variable-rate loans, and including administrative costs when estimating the cost of credit subsidies.

Stumbling Blocks to Credit Reform
The “big stumbling block,” Lucas says, “is that anything that makes a whole category of expenditures look more expensive is not going to be a big seller for Congress.” Even so, she emphasizes that it is vital for costs of credit to be accurately reflected in the federal budget and for policy makers to have accurate assessments of costs when choosing how to allocate public resources. Lucas and Phaup note that the importance of addressing this issue is highlighted by the federal government’s recent assumption of Fannie Mae and Freddie Mac, which together bear the credit risk for about $5 trillion of residential mortgages.

Lucas and Phaup conclude that it is feasible to change federal accounting procedures to more accurately align estimates of the cost of credit with the true economic cost of those activities. Doing so would improve accountability and transparency. They further propose that Congress consider extending the principles of credit reform accounting to other financial transactions of the federal government, such as investment in risky private securities. Lucas notes that in the case of investment in stocks, “when you do accounting that does not take risk into consideration, it looks like stocks are a free lunch. It’s that kind of free-lunch accounting that we want to avoid.”

“There is a consensus that market prices should reflect the resource cost of government obligations,” Lucas continues. “Furthermore, it’s not very difficult to make changes that would allow the people doing the budgeting to make a more accurate assessment of the costs of credit. A very small change could make many tens of billions of dollars of difference in the accuracy of the way we budget for credit.”