Credit Reform Act: Another Budget Loophole

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More news of a weak U.S. economy keeps rolling in. The Obama Administration and many in Congress are calling for a fresh round of stimulus spending. But Washington’s $1.3 trillion annual deficit coupled with a fiscally weary electorate means the stimulus advocates may finally be out of room to spend. Unless, of course, they take advantage of a major accounting loophole that can make the costs of federal programs virtually disappear.

This loophole may well have been unintentional when Congress passed the Federal Credit Reform Act in 1990. Nevertheless, it now threatens to undermine the benefits and intent behind this important law that changed how Congress and federal agencies must budget for government-backed loan programs. The Federal Credit Reform Act put government loan programs, such as the Federal Housing Administration’s mortgage insurance program, on an accrual accounting system rather than a cash one. Under accrual accounting, future costs are recorded up front when loans are made or guaranteed, rather than when interest subsidies or default claims are paid. This makes costs more transparent and forces Congress to budget for loan programs that commit taxpayers to future obligations. While accrual accounting is the most appropriate way for the government to budget for loan programs, the current accounting rules that bind federal agencies need to be improved. Specifically, a key provision in the law systematically undervalues the riskiness of the future obligations accrual accounting is meant to reveal. In the most perverse cases, many of the $2.8 trillion in outstanding loans made through government programs appear free or profitable.

This is true for such major programs as the FHA’s mortgage insurance program ($691 billion in outstanding loans), and government-backed student loans ($636 billion outstanding). In the same vein, lawmakers now shepherding the Obama Administration’s $30 billion program for banks to make loans to small businesses through Congress want the program treated like a loan program so that its costs almost magically disappear.

For each of these programs, accrual accounting analyses using market prices and risk assessments for similar types of loans and guarantees show higher costs than what Congress must budget for them. In effect, the loophole in the Credit Reform Act gives lawmakers a phony arbitrage opportunity that is ripe for abuse in today’s budget climate. Congress can take over any lending in the private sector, turn it into a direct loan program (or a loan guarantee) that offers borrowers lower interest rates, and lawmakers don’t have to come up with any money to fund it or offset its costs. Yet, these supposed cost advantages are really a mirage.

Imagine if the government was required to sell its direct loans or purchase full reinsurance for its guarantees in competitive, private market shortly after the loans were made. Purchasers would have to agree to honor all of the terms and benefits that the government granted to borrowers (i.e. low interest rates, flexible repayments plans, low collateral requirements, etc.). If this is what actually happened, investors in the private market would almost always value the loans at less than the value that the government records in its budget. That is, compared to what Congress may believe the loans cost, investors making these same loans with their own money would generally assign much higher costs because they would acknowledge more of the actual risks involved.

Here’s why the government’s cost advantages are a mirage: The government’s money and private investors’ money are the same. The federal government finances itself by taxing businesses and individuals, and these same businesses and individuals, acting in the private market, have signaled what they believe the costs and risks of the loans to be. If the government takes their money through taxes and then makes identical loans, is it fair to show a different set of prices and values for them? If the federal government used its power of eminent domain to buy you out of your house, you would certainly want the government to compensate you based on market prices not its own set of accounting rules that don’t even mention market prices.

Nearly all of the blame for the understated loan costs rests with a requirement in the Credit Reform Act . Budget analysts use the U.S. Treasury’s borrowing rate to measure the costs and riskiness of the loans (i.e. a discount rate applied to the risky cash flows from the loans). But U.S. Treasury interest rates don’t measure risk. There’s basically no risk of the U.S. Treasury defaulting on its debt because the government has the power to tax.   And dipping deeper into taxpayers’ pockets is exactly what the government would do if its loan programs suffered devastating losses. In other words, the low rates don’t have anything to do with the riskiness of the government’s loan programs. Taxpayers will always be on the hook one way or another – and acknowledging all the risk up front is fundamental to formulating an honest federal budget.

In the past few years there has been an explosion in federally-backed lending (see the chart below) – and flawed accounting rules will only encourage more growth. What’s more, there are a handful of enacted and proposed loan programs that show lawmakers how to take full advantage of the accounting rules.

Source: President’s FY2011 Budget Request, Analytical Perspectives

Take the Energy Policy Act of 2005. The law authorizes $47 billion in loan guarantees for projects using new technologies that reduce air pollution and greenhouse gases, with most of the funding targeted to nuclear power plant construction. The Department of Energy provides a 100% guarantee against default losses to private lenders who finance these projects. With the default risk on the government’s books, private lenders are willing to charge the energy projects a below-market interest rate. That lower rate is a government subsidy and a cost to taxpayers. But in this case, there appear to be no costs because the loan program’s sponsors included a key provision to exploit accounting rules for government loans.

Projects that receive a loan guarantee must pay the government for the subsidy they get on their loans, thus erasing the costs to the government, and theoretically erasing any benefit to the project sponsor. Intuitively, an energy project stands to gain nothing from this zero-sum transaction. Why would a business go through the Department of Energy’s paperwork exercises to get a government subsidy that it pays to itself? Consider how a similar program might work if it were designed as an income tax credit. Energy projects would be allowed to claim a $10,000 income tax credit if they agreed to simultaneously write a $10,000 check to the IRS.

The loophole in the accounting rules for loan programs ensures, however, that the fee that the Department of Energy charges an energy project for a loan guarantee is less than the fee a private entity would charge to take on the same risk. Thus a program that is “free” for taxpayers and requires energy projects to pay themselves a subsidy is currently oversubscribed with 170 applicants seeking $175 billion in loan guarantees – nearly four times the amount available.

While the Department of Energy’s “user pay” loan guarantees are a crafty way to hide the costs of government subsidies, another proposal introduced in the Senate last year takes the trick to its perverse extreme. The Private Student Loan Debt Swap Act, sponsored by Senator Sherrod Brown (D-OH), would allow borrowers with student loans not backed by the government to exchange their debt for new loans issued by the Department of Education. Lenders holding the private loans would be paid out in full by the government and borrowers would get new federal loans with lower interest rates and more generous repayment schedules. According to a preliminary (CBO) estimate, the bill would earn a profit of $9.6 billion for the government, if enacted. In other words, the Credit Reform Act makes it appear as if the federal government can buy up risky loans and replace them with loans that are more generous for borrowers and (still) make money for taxpayers. Meanwhile, an alternative, unofficial estimate (also by CBO) using private market values shows that the proposal costs$700 million.

Democratic leaders and a handful of Republicans in Congress were up to the same trick earlier this year when they instructed CBO to treat a proposed $30 billion capital injection fund for banks in the Small Business Lending Fund Act as a loan program. It was a brazen move given that the capital injection would be in the form of preferred stock, which the banks technically do not have to repay and therefore isn’t a loan. It also demonstrates the lengths to which some in Congress will go to wash any new program through the favorable accounting rules for loan programs. The CBO balked at the instruction and provided a cost estimate based on prices in the private market, which showed the program would cost $6.2 billion. But the Democratic majority is ignoring this estimate so that they can claim the legislation has no cost as debate on the bill continues in Congress.

There are signs that something of a backlash is occurring against these deceptive budgeting tactics. Congress included in the Troubled Asset Relief Program a mandate that federal budget agencies account for the program’s costs using market-based estimates, overriding the existing accounting rules for loan programs. Representatives Jeb Hensarling and Paul Ryan, two senior Republicans on the House Budget Committee, want to update the Credit Reform Act as part of a larger budget process bill so that loan programs would be priced like they are in the private market. CBO is also helping illuminate the perverse and illogical results of the current budget rules. The agency should be commended for voluntarily providing alternative (though still unofficial) “fair value” estimates when it reports the costs of new loan programs.

Lawmakers who want to use the Credit Reform Act loophole to advance their spending ambitions are unlikely to relinquish such a convenient and valuable budget gimmick without a fight. Nevertheless, there’s momentum behind a more honest set of rules for valuing government-backed loans. That’s good news for taxpayers and for the U.S. economy.

Jason Delisle is the Director of the Federal Education Budget Project at the New America Foundation.