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Risk v. Profit

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from the magazine

Risk v. Profit

Uncle Sam needs a better way to budget for federal lending. Autumn 2020
Economy, finance, and budgets
Politics and law

Federal budgeting for lending programs is a mess. Uncle Sam often claims to make a profit guaranteeing mortgages, lending to college students, and making other loans. But those claims rest on questionable accounting. So questionable, in fact, that the nonpartisan Congressional Budget Office believes that it should be scrapped. The CBO has proposed an alternative accounting approach inspired by private-sector standards—one that shows the feds taking a loss on lending. Mortgage guarantees, student loans, and commercial lending are not profit centers. They impose real costs on the government.

Federal bean counting may seem arcane, but it’s important. The CBO forecasts that the federal government will lend or guarantee more than $1.5 trillion in 2021. Under official rules, that lending appears to generate a $42 billion profit. Under the CBO’s preferred approach, however, it generates a $47 billion loss—almost a $90 billion difference, in a single year.

Budget numbers influence policy choices. Policymakers have a range of tools for pursuing their goals. To make college more affordable, lawmakers can give grants to students, create targeted tax breaks, or offer subsidized loans. The same is true for supporting home ownership, accelerating green energy, and myriad other policies. Lawmakers should select among these tools based on how well they achieve desired ends.

Understanding budget consequences is one aspect of this analysis. The challenge is presenting them on an equal footing. Current budget rules understate the cost of lending because they don’t account properly for its risks. Current budget rules thus inspire lawmakers to favor lending as a tool of policy. As a result, beneficiaries too often have to go into debt to qualify for federal help.

To avoid this distortion, the CBO recommends that we budget for lending by valuing loans, loan guarantees, and other financial instruments based on their fair market value. Those values reflect market assessments of the cost of potential risks.

Professional debate over budget accounting often involves technical concepts. But you don’t need them to understand 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 speaks to dozens of banks and online lenders. The best offer is a one-year loan at 10 percent interest from a peer-to-peer lending site. Over the next year, she would have to pay $1,000 in interest. Your aunt knows that you have some extra money in a savings account, earning zero interest. So she makes you an offer. Why don’t you lend her the $10,000 at 6 percent? You would earn $600 more than the bank is paying you. And she would save $400.

Your aunt is up-front about the possibility of default. She 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 across 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 expected defaults, you would still make $200 more, on average, by lending to her than by leaving money in the bank.

This offer sparks a lively family debate. Your father thinks that the loan is a win-win for the family. You make some extra money, and your aunt saves some money.

Your spouse disagrees. Yes, you would make $200, on average. But you would also be taking a big risk. Defaults are $400, on average, but you might lose all $10,000. Moreover, defaults are most likely to happen during bad economic times, exactly when you’d miss that money most. The loan thus involves real costs from risk beyond the average $400 loss.

One way to account for those 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 lending to your aunt, you could lend to a stranger. You’d get $1,000 in interest and face $400 in expected default losses. On average, you would net $600. That’s what the marketplace believes is necessary to compensate for the risks of lending. Maybe you think that’s attractive. Maybe you don’t. Either way, the open marketplace is offering $400 more compensation than your aunt is.

Lending to your aunt may well be the right thing to do. Family is family. But you should go into it with your eyes open. The loan isn’t a win-win, your spouse concludes. Your aunt would win $400. By taking on uncompensated risk, though, you could lose $400.

This family drama captures the budgeting debate in a nutshell. Official budget rules adopt your father’s perspective. Lending is profitable whenever interest payments are more than defaults plus the interest you would have earned from the bank (zero, in this case). (For Uncle Sam, the calculation is the same, except the government replaces bank savings rates with Treasury borrowing rates.)

The CBO takes your spouse’s view. Lending to your aunt involves risk. To break even on a loan, you need to be fully compensated for taking that risk. If you lend at below-market rates, you aren’t being fully compensated. That’s a real cost—one that fair value considers but that official budgeting does not.

This debate leaves budget experts in a quandary. Should they side with the dad or with the spouse? Happily, there’s a way out. The right answer is to agree with both. Both approaches provide useful information. So Congress should adopt budget rules that incorporate both.

This is easy to do. Suppose Congress were considering a loan to your aunt. It could track the budget effects with three numbers. The government would earn $600, on average, by lending at market rates to small businesses like your aunt’s. It would give up $400, on average, by offering to lend at below-market rates. And it would net $200, on average, from making that subsidized loan.

Congress should use the $200 inflow when forecasting its future budget position. On average, the subsidized loan will leave its coffers a bit fatter. But Congress should use the $400 cost when comparing the loan with other policy options. The subsidized loan gives $400 to your aunt; so would a $400 grant or a $400 tax credit. The budget should show these options costing the same. Congress should then choose between them on their merits.

You might object that the loan, unlike the grant or tax credit, actually brings in money. Uncle Sam ends up $200 ahead rather than $400 behind. That $600 difference is real—but it has nothing to do with the choice of how best to help your aunt. If Uncle Sam wants an extra $600, the government can simply make a loan at market rates. That decision to take a risk and be compensated as a lender is separate from the decision of whether and how to subsidize your aunt.

The same is true in your family. You can help your aunt without giving her the loan. Instead, you could just give her $400 to pay part of the interest on a peer-to-peer loan. She’d get the same financial help as if you gave her a below-market loan. And you’d avoid the risks—both financial and familial—if she isn’t able to pay it back.

Your family may or may not be able to handle that degree of transparency. Making the loan may be a more face-saving way of helping your aunt than writing her a check. That’s a legitimate family concern. But it’s not for Uncle Sam.

Citizens and lawmakers deserve transparency when evaluating federal lending programs—they should know how much the government may make on its lending and how much it gives up by subsidizing borrowers. Good budget accounting can get them there.

Photo: Niall_Majury/iStock

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