Foverall budgeting for loan programs is a mess. Uncle Sam often claims to make a profit by guaranteeing mortgages, lending to students, and making other loans. But these claims are based on questionable accounting. So questionable, in fact, that the non-partisan Congressional Budget Office believes it should be done away with. The CBO proposed an alternative accounting approach inspired by private sector standards, which shows that the federal government suffers a loss on loans. Mortgage guarantees, student loans, and business loans are not profit centers. They impose real costs on government.
The federal bean count may seem obscure, but it is important. The CBO predicts that the federal government will lend or guarantee more than $ 1.5 trillion in 2021. According to official rules, this loan appears to generate a profit of $ 42 billion. Under the CBO’s preferred approach, however, it generates a loss of $ 47 billion, or nearly a difference of $ 90 billion, in a single year.
Budget figures influence political choices. Decision makers have a range of tools to pursue their goals. To make the university more affordable, lawmakers can give scholarships to students, create targeted tax breaks, or offer subsidized loans. The same goes for home ownership support, green energy acceleration and a myriad of other policies. Lawmakers should choose among these tools based on their ability to achieve desired goals.
Understanding the budgetary implications is one aspect of this analysis. The challenge is to present them on an equal footing. The current fiscal rules underestimate the cost of lending because they do not properly account for its risks. Current fiscal rules thus encourage legislators to favor credit as a policy tool. As a result, recipients too often have to go into debt to qualify for federal assistance.
To avoid this distortion, the CBO recommends budgeting loans by valuing loans, loan guarantees and other financial instruments based on their fair market value. These values reflect market assessments of the cost of potential risks.
The professional debate on budget accounting often involves technical concepts. But you don’t need them to figure out the issues here. All you need to understand is family.
Suppose your aunt wants to start a business making designer face masks. She needs $ 10,000 to get started. She talks to dozens of banks and lenders online. The best deal is a one year loan at 10% interest on a peer-to-peer lending site. Over the next year, she will have to pay $ 1,000 in interest. Your aunt knows you have extra money in a savings account with zero interest. So she makes you an offer. Why don’t you lend him the $ 10,000 at 6%? You would earn $ 600 more than what the bank pays you. And she would save $ 400.
Your aunt is candid about the possibility of default. It sends you a link to the underwriting algorithm used by the online lending site. Most people who take out loans like hers pay in full, but some don’t. Looking at thousands of similar loans, the algorithm expects default losses to average $ 400. Your aunt has no intention of defaulting. But she suggests that you focus on the average in evaluating her proposal. After subtracting the expected defaults, you would still earn $ 200 more, on average, by lending it than by leaving money in the bank.
This offer provokes a lively family debate. Your dad thinks the loan is a win-win for the family. You earn extra money and your aunt saves money.
Your partner does not agree. Yes, you would earn $ 200 on average. But you would also take a big risk. The defaults are an average of $ 400, but you could lose the $ 10,000. Plus, defaults are more likely to happen during tough economic times, exactly when you would run out of money the most. The loan therefore involves real costs of risk beyond the average loss of $ 400.
One way to account for these costs is to compare your aunt’s proposal with a situation in which you face the same risks. The peer-to-peer lending site offers many comparable loans. Instead of loaning to your aunt, you could loan to a stranger. You would earn $ 1,000 in interest and face $ 400 in expected default losses. On average, you would earn $ 600. This is what the market believes is necessary to offset loan risks. Maybe you think it’s attractive. Maybe not. Either way, the open market offers $ 400 more compensation than your aunt.
Lending to your aunt might just be the right thing to do. The family is the family. But you should go in with your eyes open. The loan is not a win-win, concludes your spouse. Your aunt would earn $ 400. However, by taking unmatched risk, you could lose $ 400.
This family drama sums up the budgeting debate in a nutshell. The official budget rules take your father’s point of view. The loan pays off whenever the interest payments are greater than the defaults plus the interest you would have earned from the bank (zero, in this case). (For Uncle Sam, the math is the same, except the government is replacing bank savings rates with Treasury borrowing rates.)
The CBO takes your spouse’s point of view. Lending to your aunt comes with risks. To break even on a loan, you need to be fully compensated for taking that risk. If you lend at below market rates, you are not fully compensated. This is an actual cost, which is reflected in fair value, but not official budgeting.
This debate leaves budget experts in a dilemma. Should they side with the father or the spouse? Fortunately, there is a way out. The correct answer is to agree with both. Both approaches provide useful information. Congress should therefore adopt budgetary rules that integrate both.
This is easy to do. Suppose Congress is considering a loan to your aunt. He could follow the budgetary effects with three digits. The government would make an average of $ 600 lending at market rates to small businesses like your aunt’s. He would forgo an average of $ 400 by offering to lend at below-market rates. And that would bring in $ 200, on average, when this subsidized loan was granted.
Congress is expected to use the incoming $ 200 when forecasting its future budget position. On average, the subsidized loan will leave its coffers a little bigger. But Congress should use the cost of $ 400 to compare the loan with other policy options. The soft loan gives your aunt $ 400; the same would apply to a subsidy of $ 400 or a tax credit of $ 400. The budget should show that these options cost the same. Congress would then have to choose between them on the basis of their merits.
You might object that the loan, unlike the grant or the tax credit, actually makes money. Uncle Sam ends up $ 200 early rather than $ 400 late. This $ 600 difference is real, but it has nothing to do with choosing how best to help your aunt. If Uncle Sam wants an extra $ 600, the government can just give a loan at market rates. This decision to take a risk and be compensated as a lender is separate from the decision to subsidize your aunt and how.
It is the same with your family. You can help your aunt without giving her a loan. Instead, you could just give her $ 400 to pay off part of the interest on a peer-to-peer loan. She would get the same financial support as if you gave her a below-market loan. And you would avoid the risks, both financial and family, if she is not able to pay it back.
Your family may or may not be able to handle this level of transparency. Taking out the loan may be a more life-saving way to help your aunt than writing her a check. It is a legitimate family concern. But it’s not for Uncle Sam.
Citizens and lawmakers deserve transparency when evaluating federal loan programs – they should know how much the government can make on its loans and how much it is giving up by subsidizing borrowers. Good budget accounting can get them there.
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