Loans and Loan Guarantees
To achieve some of its policy goals, the federal government reduces the price and increases the availability of credit for particular uses by guaranteeing private loans or making loans directly.
Those credit activities convey subsidies to borrowers—in the form of more-attractive loan terms than borrowers might otherwise obtain—at a cost to the government. The way that cost is treated in the federal budget has changed over time, most significantly in 1990 with the enactment of the Federal Credit Reform Act (FCRA). That legislation redefined the budgetary cost of federal credit activity: instead of the annual cash flow on all outstanding federal loans and loan guarantees, the budget now records the present value of future cash flows on credit extended in the current budget year. In making that change, the FCRA effectively put the accounting of federal credit on an accrual basis (as is the case for interest on federal debt held by the public and some pension costs for federal employees)
Although the government and private lenders estimate the value of loans and loan guarantees in essentially the same way, two exceptions make government credit programs seem less costly than comparable credit extended by private financial institutions. First, federal agencies’ administrative expenses are not included in estimates of subsidy costs (though they appear elsewhere in the federal budget). Second, those estimates exclude the cost of market risk—the compensation that investors require for the uncertainty of expected but risky cash flows. The reason is that the FCRA requires analysts to calculate present values by discounting expected cash flows at the interest rate on risk-free Treasury securities (the rate at which the government borrows money).
Calculations of present value (a single number that expresses a flow of current and future payments in terms of an equivalent lump sum paid today) depend on the particular interest rate used. For example, if $100 is invested on January 1 at an annual interest rate of 5 percent, it will grow to $105 by January 1 of the next year. Hence, under the assumption of a 5 percent annual interest rate (or discount rate), the present value of $105 payable a year from today would be $100.
In contrast, private financial institutions use risk-adjusted discount rates to calculate present values.
The FCRA adopted the private market’s definition of value (the present value of expected cash flows, with the two exceptions noted above) in an attempt to “place the cost of credit programs on a budgetary basis equivalent to other federal spending . . . and improve the allocation of resources among credit programs and between credit and other spending programs.”5 The costs of other programs in the federal budget are based on market prices—such as the estimated price of buying a weapon, repairing a road, or furnishing a service. In the case of credit programs, however, omitting some of the costs of providing credit results in an overstatement of the value of the government’s loans and guarantees. One indication of that overstatement is that proposed sales of federal loans to private investors usually appear to result in losses to the government because the market value of a loan is almost always less than the credit-reform value. The primary reason is the difference in discount rates used by the market and under credit reform.