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Fair Value Accounting: The obscure rule change that could make student loans more expensive

Mark Wilson/Getty Images

There are over $3 trillion in loans outstanding that the federal government has either made directly or guaranteed in partnership with private lenders. And there's a big fight afoot as to how to account for those loans in the federal budget. Critics — like Michael Grunwald in a recent Politico feature on credit programs — allege that "government accounting quirks still make credit programs look much cheaper than they really are," and they have an issue brief from the Congressional Budget Office on their side.

But there's really nothing especially quirky about the accounting method the government uses. What it does is count up how much money is being loaned out, tries to estimate how much of that money is going to get paid back, and then estimates the cost of the program as the difference between the two. For most of these programs, the government estimates that a large enough share of loans will be repaid that the government — like a bank — will end up with more money than it started out with. In other words, it's a pretty banal system.

But skeptics — including the House Republican caucus — want to move to something called Fair Value Accounting. FVA does a much better job of calculating the economic value of federal credit programs to its recipients, but at the cost of muddying the waters about the actual dollars and cents involved. It's an incredibly obscure-sounding issue, but it has massive implications for basic stuff like the interest rate on your student loan or how many people will be able to get an affordable mortgage.

1) Why is there a fuss about accounting for federal credit programs?

The federal government's credit programs are enormous in scale, with over $3 trillion in loans outstanding. That's spread across approximately 120 separate programs, but two thirds of it is concentrated in student loans and mortgage guarantees. And here's the striking thing about it — those loan programs are profitable, which makes them very appealing to members of Congress.

Because the US government prints dollars, there is essentially no chance that it will default on its debts. Buyers of American government debt are subject to inflation risk, but that exact same risk exists for anyone who sells dollar-denominated debt. Consequently, the American government can borrow money more cheaply than any private company. Here's a chart illustrating the "spread" between the interest rate on very safe corporate debt and the interest rate on federal debt.

Because the federal government can get cash more cheaply than a private bank, it can offer loans to individuals or corporations at interest rates that are cheaper than what the market provides and yet are still profitable for the government. If Congress doesn't want the government to get involved with lending money directly, it can also "guarantee" private loans and create the equivalent effect.

2) What's wrong with the current accounting method?

Elizabeth Warren in her TARP oversight days (Brendan Smialowski/Getty)

One unfortunate consequence of accounting for government credit subsidy programs as profitable is that it carries the implication that the government is not subsidizing the borrowers. Senator Elizabeth Warren of Massachusetts appeared to be making a form of this argument during a 2013 controversy over student loan interest rates, in which she cited the profitability of federal student loans as an argument that current rates were too high. After all, the point of federal student loans is to encourage people to get an education.

Conversely, back when Warren was the lead congressional oversight staffer for the TARP bailout program she insisted on the use of Fair Value Accounting. And while it's true that TARP was profitable, it's also true that the banks that got TARP funds were the recipients of a massive government subsidy. The same is true for the recipients of federal housing loans, student loans, and other credit programs. When the government loans you money at a cheaper rate than any private bank would offer — or when government loan guarantees induce banks to lend to you at a discount rate — you are getting a subsidy.

3) How would Fair Value Accounting solve the problem?

FVA corrects the misleading impression that federal credit programs aren't subsidies by changing the accounting methods. In particular, instead of using the federal government's actual cost of funds, FVA would have the government book the loans using private-sector interest rates. Proponents of FVA, like Jason Delisle of the New America Foundation and Jason Richwine of the Heritage Foundation, characterize this as a way to "incorporate the cost of the market risk associated with expecting future loan repayments."

In business, a guarantee of $100 is generally considered more valuable than a 50:50 shot at $200, which is one of the reasons borrowing money can be expensive. FVA, by using the private sector's cost of funds, incorporates the private sector's risk aversion.

4) What's wrong with FVA?

FVA's proponents are very sophisticated, but there is one giant obvious problem with their preferred method — accounting as if the federal government had the private sector's cost of funds doesn't make it true. Canceling all federal loan programs would make the deficit go up, not down. Expanding them would make it go down, not up. It is true that canceling all loan programs would make the government's balance sheet less risky, but the whole reason the government can borrow so cheaply in the first place is that it can't go bankrupt.

On the other hand, FVA does an excellent job of illustrating the benefits of federal credit programs to their clients. Just because most recipients of Export-Import Bank loans end up repaying the loans with interest doesn't mean they aren't beneficiaries of a sweetheart deal. The government is assuming risk on their behalf that a private bank would have charged for. Avoiding that payment is valuable, and FVA correctly captures that.

5) Can we take a break for a song?

Sure. But if there's one thing you take away from this, it should be that you can't reduce all the tradeoffs in a policy debate to a question of accounting. Thus, the Beatles' classic "Can't Buy Me Love."

6) If credit programs benefit recipients at no cost, why not do more?

There's the rub. The accounting fight can get technical, and it does contain some technical aspects. But the real issue is political. Paying for a new program with deficit spending is unpopular and paying for one with new taxes is even less popular.

By contrast, accomplishing a worthy social purpose — or doling out a subsidy to a favored special interest — in a way that doesn't cost anything looks much more appealing. Viewed in this light, the big problem Fair Value Accounting would solve isn't about risk. It's about politics. Denying Congress an off-budget vehicle for subsidizing favored activities would change those incentives. Giveaways to sugar farmers, rural electrical cooperatives, and nuclear power plant builders would be harder to keep in place if they registered as increasing the deficit rather than decreasing it. By the same token, switching to FVA would greatly encourage cuts to student loan programs.

7) But seriously — if it's free why not offer discount loans to everyone?

Janet Yellen sets the overall demand level (Alex Wong/Getty)

This is actually more or less what the Federal Reserve does when it wants to boost the economy. Short-term interest rate cuts and "quantitative easing" and most every other tool in the Fed's stimulative arsenal is about, in some sense, increasing the affordability of credit across the economy.

In normal times, the Fed's ability and willingness to do this is limited by its fear of inflation. Too much cheap credit for too long, and all you'll get is higher prices.

Since the Fed is the ultimate arbiter of economy-wide monetary policy, this means federal credit programs don't increase the total amount of credit in the economy. Instead, they redistribute capital away from sectors that don't get subsidies to sectors that are subsidized. More economic resources flow toward higher education, building owner-occupied houses, and exporting manufactured goods than would flow in a world without student loans, the FHA, and the Export-Import Bank.

8) How big a deal is this really?

The vast majority of these programs are small in size and, while important to the specific companies and people who benefit from them, not that big a deal in the scheme of things. But as this graphic from the Committee for a Responsible Federal Budget shows, the FVA dispute does have important implications for housing and higher education policy:

Switching either of these programs to FVA in a deficit-neutral way would end up requiring tens of billions of dollars in offsetting cuts. If you think homeownership and higher education are things the government should be encouraging, that's a disturbing idea.

Switching either of these programs to FVA in a deficit-neutral way would end up requiring tens of billions of dollars in offsetting cuts. If you think homeownership and higher education are things the government should be encouraging, that's a disturbing idea.

On the other hand, using federal credit programs as a revenue-generator creates some perverse incentives. The Education Department's Parent PLUS loan program often looks a bit like predatory lending, but its profits help pay for other programs which strengthens its support on Capitol Hill and in the agency.

9) The bottom line — who's right about this?

Proponents of Fair Value Accounting raise a lot of valid concerns about the way the United States Congress handles federal loan programs. To me, trying to resolve those problems with FVA is a cure worse than the disease. It is simply the case that many policy initiatives have costs that are not budgetary in nature. Imprisoning non-violent drug offenders, for example, costs money. But it also inflicts hardship on the incarcerated and their families. In addition to raising revenue, a higher gasoline tax would have benefits in the form of reduced air pollution.

It's good for politicians to consider these things, and it's even good for the federal government to try to formalize its estimates of these costs. But what is fundamentally called for here is political judgment not an accounting rule. It is also true that many — and perhaps most — federal credit programs are somewhat ill-conceived as policy and that it would be easier to get rid of them if we implemented FVA. But the federal government's ability to make affordable loans available in situations that would be too risky for a private bank is a real consequence of its nature as a sovereign state, not some kind of accounting error.

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