Fair Value Accounting Overestimates Lending Costs

I agree with Charles Lane that a great many federal loan guarantee programs are misguided and simply “benefit interest groups with no clear payoff for the overall economy.” But as he and I also agree, they don’t all fit that bill—the policy case for student loans is based on a real market failure. Where I don’t agree is with his passion for “fair value accounting,” a budget that would be enshrined into law by a bill that passed the House of Representatives in February and that mandates that the government pretend lending programs are more expensive than they are. What’s at issue here is not, I think, very well explained by saying that Fair Value Accounting “adjusts the discount rate to reflect the risk of widespread defaults during downswings in the business cycle, would be more accurate.” I’m going to put this below the fold because it’s really long and arguably disputes about accounting rules are boring.

Douglas Elliot’s brief Brookings discussion offers a clearer explanation as does the Congressional Budget Office’s brief on the matter. Both Elliot and CBO Director Doug Elmendorf come down on Lane’s side of the debate so I think I’m being generous in relying on them as sources.

The basic issue is that because a federal lending program involves different sums of money coming in at different times, if you want to calculate the net present value of a program you need to apply a discount rate to the future cash flows. The common sense rate to use is the one used by current law—the federal government’s cost of funds in credit markets. The alternative “fair value” proposal is to ignore the actual cost to the federal government and instead make it so that (quoting the CBO) “the discount rate applied to expected future cash flows would be the same as what private financial institutions would use.” Proponents of using this number describe it as “measur[ing] the costs of federal loans and loan guarantees at market prices” but that’s exactly what they’re not doing. The interest rate on federal debt is a market price. It just happens to be the case that the market interest rate on federal government debt is lower than the market interest rate charged to private financial institutions. Note that if you are running a private financial institution and are considering borrowing some money to finance an investment project and you have an above-average cost of funds, nobody is going to let you argue that it’s somehow “more accurate” to book the cost at generic rates. Conversely, if a given private actor has a below-average cost of funds that’s a real fact that’s relevant to what actions it does and doesn’t make sense for him to undertake. Appealing to a “generic market” rate over the actual rate actually being charged in actual markets is a confusing idea.

Proponents of fair value offer a theoretical argument and an empirical one.

The theoretical argument, to quote Elliot, is that “Credit losses are quite correlated with the economy as a whole, which means that these programs cost taxpayers most at the times when they are least able to deal with the added expense.”

In other words, if we conceive of the US government as like a giant credit union of which We The People are all members the problem with direct lending is that the loans are most likely to go bust in a recession, leaving us individually in the whole at the very same time that we’re personally strapped for cash due to layoffs and cutbacks. The problem is that if this were the correct way to think of the US government, then this would be priced into the market interest rate charged to the US government. And indeed I suspect that if the government of Iceland were to try to borrow dollars on international capital markets in order to finance a lending program to Iceland’s citizens that it would run into exactly this problem and it would be reflected in the borrowing costs. But the US government isn’t a giant credit union, it’s a sovereign state with a fiat currency. Look at US fiscal policy since the final year of the Bush administration and you’ll see that we respond to the fact that raising taxes in the middle of a recession would be unusually painful by not raising taxes in the middle of a recession, which is very sensible of us.

The empirical argument, returning to the CBO, is that under current practice “the costs reported in the budget are generally lower than the costs to even the most efficient private financial institutions” and “purchases of loans at market prices appear to make money for the government.” But, again, this is all just a way of saying that if the facts were different market conditions would be different and there’d be no need for this controversy. The costs reported in the budget are generally lower than the costs to the most efficient private financial institutions because the government’s costs of funds are in fact lower. And precisely because the government’s costs of funds are in fact lower, purchases of existing private loans at market rates can in fact make money for the government. If that sounds funny, the answer is to again remember that the United States of America is not a credit union and “making money for the taxpayers” is not a real public policy goal. The government could “make money” by establishing a government-owned monopoly on the sale of shoelaces, but it would still be a bad idea.

Long story short, one of the signal features of the US government is that it has an enormous risk-bearing capacity and we sell ourselves short as a nation if we choose to adopt accounting rules that ignore that risk-bearing capacity.