Tag: Accounting

Budgeting for Federal Lending Programs Is Still a Mess

On Monday, the Government Accountability Office (GAO) defended the current method for budgeting for federal lending programs, known as “credit reform.” By endorsing the status quo, GAO puts itself at odds with the Congressional Budget Office (CBO), which has championed a “fair value” alternative. The details are wonky but the stakes are big. Over a decade, federal lending support for mortgages, student loans, and the Export-Import Bank could appear $300 billion more costly under fair-value budgeting than under credit reform.

CBO is right to question the way we budget for these programs. But GAO is right that CBO’s version of fair value is the wrong solution. Instead, we need a new approach that captures the strengths of both ideas, while avoiding their flaws. I laid out that alternative in a recent report.

One reason we need a new approach is that credit reform violates fundamental principles of good budgeting, for reasons that have nothing to do with the fair value debate.

The problem

Credit reform uses present values to measure the budget impact of federal loans, recording any expected gains or losses the moment a loan is made. But the rest of the budget operates on a cash basis, recording the budget effects of tax and spending policies as they happen over time. These two approaches do not mix well together. By using present values, credit reform can make federal lending appear to mint money out of thin air. It also credits the budget today for earnings it won’t see until well beyond the official budget window.

Consider a simple example: the government lends $1,000 to a business for four years expecting a 4 percent annual return, or $40-a-year for a total of $160. To finance the loan, the government issues $1,000 in Treasury bonds that pay 1.5 percent interest. At $15 per year, interest costs total $60. Thus, the government would net $100.

 

New New Table

How should we budget for those expected gains? One possibility would be to track cash flows, as we do for other government activities. The government lends $1,000 in year one, nets $25 in each of the four following years, and gets repaid $1,000 in year five. Its overall gain would be $100, just as it should be.

That gets the cash flows right, but the timing is ill-suited to budgeting. The upfront cost can make the loan look costly even though it actually brings in money. If Congress focused on a three-year budget window, for example, the loan would look like it costs $950 even though it actually earns $100 over its full life.

A poor solution

We can avoid that problem by eliminating the confusing lumpiness of the cash flows. Credit reform does so by calculating the net present value of the return on the loan, discounted using the government’s borrowing rate. That calculation (the second row in the table) shows an instant gain of $96 when the loan is made. (The $96 is slightly less than the $100 because of pesky technical details.)

Credit reform thus eliminates the lumpiness but at a big cost: it misleadingly claims the returns to lending happen instantly. In reality, those returns accumulate gradually over the life of the loan. In its zeal to get rid of the lumpiness bathwater, credit reform mistakenly throws out the timing baby. As a result, lending programs can look like a magic money machine.

Unlike tax increases or spending cuts, lending programs get instant credit for returns they won’t see for years, sometimes far beyond the official budget window. To take an extreme case, a 100-year loan on the above terms would score as almost $1,300 in immediate budget gains under credit reform, all before the government collects a dime in interest.

To the best of my knowledge, no other person, business, or organization budgets or accounts for loans this way (please share any counterexamples; Enron doesn’t count). Instead, they either accept the lumpiness of the cash flows or use an approach that avoids the lumpiness while reflecting the real timing of returns.

A better answer

It isn’t hard: Instead of tracking all the cash flows, we can report just the net returns on the loan. When the loan is first made, there aren’t any. In our example, the $1,000 loan exactly offsets $1,000 in borrowing to finance it. The reverse happens in year five when the loan gets paid off. In between, the government nets $25 each year: $40 in interest payments less $15 in annual financing costs.

Tracking net returns is a highly intuitive way to report the budget effects of making the loan. It would match the way we budget for tax and spending programs, and would respect the budget window.

The government can and sometimes does make money from its lending programs, but not instantly. The budget community should disavow the credit reform approach and recognize that earnings accumulate gradually over time. CBO, GAO, and budget wonks should join hands to fix this problem regardless of where they sit in the fair value debate.

Note: For more on the technical details, including how to deal with loan guarantees, how the fair value debate reappears in deciding how to measure net returns, and a second challenge in budgeting for lending programs, see my report and policy brief.

 

 

The $300 Billion Question: How Should Congress Budget for Federal Lending Programs?

Lending programs create special challenges for federal budgeting. So special, in fact, that the Congressional Budget Office estimates their budget effects two different ways. According to official budget rules, taxpayers will earn more than $200 billion over the next decade from new student loans, mortgage guarantees, and the Export-Import Bank. According to an alternative that CBO favors, taxpayers will lose more than $100 billion.

Those competing estimates pose a $300 billion question: Which budgeting approach is best?

As I document in a new report and policy brief, the answer is neither one. Each approach tells only part of the story. Congress would be better served by a new approach that fairly reflects all the fiscal effects of lending.

Compared with what?

If lending programs perform as CBO expects, they will bring in new money that the government can use to reduce the deficit, increase spending, or cut taxes. In that sense, taxpayers may come out more than $200 billion ahead.

But these programs do not fully compensate taxpayers for their financial risk. If the government took the same risk by making loans and guarantees at fair market rates—perhaps by investing in publicly traded bonds—taxpayers would make much more. Taxpayers are subsidizing the students, homeowners, and companies that borrow through these programs. In that sense, taxpayers come out more than $100 billion behind.

The same issue can arise in personal life. Suppose your aunt asks for a $10,000 loan to start a business. You’ve got exactly that much in a government bond fund earning 2.5 percent, and she offers to pay 5 percent. She’s got a good head for business, so the risk of default is very low; realistically you expect a 4 percent annual return.

The loan sounds like a winner, right? Her 4 percent beats the bond fund’s 2.5 percent, if you can handle the risk. But there’s one other thing: your brother-in-law, equally good at business, would like a similar loan, and he’s willing to pay 6 percent, with an expected net of 5 percent.

Now the loan to your aunt sounds like a loser. Your brother-in-law’s 5 percent beats her 4 percent. You might still prefer to lend to her, but you would come out behind in financial terms.

The competing CBO estimates reflect this dichotomy. One approach compares the financial returns of lending with doing nothing (the $200 billion gain in CBO’s case, 4 percent versus 2.5 percent in yours). The other compares the returns with taking similar risks and being fully compensated (the $100 billion loss in CBO’s case, 4 percent versus 5 percent in yours).

Both comparisons provide useful information. If you want to predict the government’s future fiscal condition, you should compare the financial returns of lending with doing nothing. If you want to measure the subsidies given to borrowers, you should compare returns with the fair market alternative.

When you discuss your aunt’s proposal with your spouse, you would be wise to mention not only the potential financial gain (“4 percent is better than 2.5 percent”) but the subsidy to your aunt (“4 percent is less than the 5 percent your brother would pay”). Only then can you have an open discussion of your family’s financial priorities.

Today’s approaches

The same information is necessary for an open discussion of federal budgeting. But official budget rules, created by the Federal Credit Reform Act of 1990 (FCRA), require CBO to use just the first approach in its budget analyses. Official estimates thus measure the fiscal effects of lending, not the subsidies provided to borrowers. CBO rightly believes, however, that policy deliberations are incomplete without measuring the subsidies, which CBO calculates separately using an approach known as fair value.

Policy analysts have vigorously debated the pros and cons of FCRA and fair value for years. Neither side has scored a decisive win for a simple reason: both approaches are incomplete. Fair value measures subsidies well, but tells us nothing about fiscal effects; this is its missing-money problem. FCRA measures lifetime fiscal effects well, but tells us nothing about subsidies.

By recording expected fiscal gains the moment a loan is made, moreover, FCRA makes lending appear to be a magic money machine. Lending may pay off over time, but the gains do not happen the moment the loan’s ink is dry. Like any lender, the government must be patient to earn those returns. It must hold the loan, perhaps for many years, and bear the associated financial risk.

A better approach

For those reasons, I believe we should replace both approaches with a more accurate budgeting method, which I call expected returns. As the report and brief describe, the expected-returns approach forecasts the fiscal effects of a loan by projecting the government’s expected returns year by year, rather than collapsing them into a single value at the time the loan is made, as both FCRA and fair value do.

Expected returns accurately tracks the fiscal effects of lending over time, thus avoiding both fair value’s missing-money problem and FCRA’s magic-money-machine problem. It also provides a natural framework for reporting the fiscal effects of lending and the subsidies to borrowers. Expected returns would give policymakers and the public a more accurate assessment of federal lending than either of the approaches we use now.

How Much Does the United States Really Owe?

My latest column at the Christian Science Monitor takes a crack at this perennial question. Short version: You ought to add about $4.6 trillion to whatever debt figure you are using. Why? Because the United States has about $7.3 trillion in non-debt liabilities (mostly pension and health benefits), offset by about 2.7 trillion in assets. These numbers aren’t perfect–for example, they dramatically understate the value of the gold the U.S. owns and put no value on the government’s ability to tax–but they illustrate that what the U.S. owes is more than its Treasury debt.

America is deep in debt. But how deep?

That question seems simple, yet analysts and pundits give answers that differ by trillions of dollars. Sometimes tens of trillions. That confusion arises because there are various ways to tote up America’s debts.

Many observers often focus on the publicly held debt – the bonds that the Treasury has sold into financial markets. By that measure, the federal government owed a bit more than $10 trillion at the end of last fiscal year.

That figure is important because it measures how much the federal government has had to rely on outside investors. For that reason, it does not include the special Treasury bonds in the Social Security Trust Fund and similar accounts owned by the federal government itself. From an accounting perspective, those bonds net to zero – a part of the government owes money to another part. But they are important to Social Security legally and politically. Some analysts use a measure that includes the trust funds, bringing the federal debt to more than $14 trillion.

That’s not the only measurement disagreement. Social Security and Medicare reflect a major commitment to seniors in the years ahead, but the government hasn’t identified enough dedicated financing to pay for them. Some analysts believe these unfunded amounts should be viewed as debts as well. Their size depends on technical factors like the future growth rate of health spending and how far you look into the future. Depending on their choices, analysts can get huge measures of indebtedness: $50 trillion or more.

This range of figures – $10 trillion, $14 trillion, $50 trillion – sows confusion about how indebted the United States is. Yet none of them captures all of America’s debts. The government has a host of other obligations that often get overlooked.

These other liabilities appear in the government’s little-known financial statements. Those statements use concepts familiar to anyone who has worked with a corporate balance sheet listing assets and liabilities. The government’s liabilities include more than $7 trillion in obligations that don’t appear in standard budget measures.

That’s real money, even in Washington.

The largest are commitments to federal employees, retirees, and veterans, including pensions and postretirement health benefits. Those commitments, which get surprisingly little attention, now stand at almost $6 trillion.

Another $1 trillion in liabilities includes obligations for environmental cleanup, government insurance payouts, and ongoing commitments to Fannie Mae and Freddie Mac. Add in publicly held debt, and the government owes more than $17 trillion, before accounting for future commitments to Social Security or Medicare.

Of course, the government has assets: buildings, aircraft carriers, and a sizable portfolio of financial assets. Federal accountants tally those as worth a bit less than $3 trillion. The government’s net liabilities round out to nearly $15 trillion, 50 percent larger than the public debt alone and comparable to the value of all goods and services produced by the US economy each year.

The US is thus in debt to the tune of roughly 100 percent of gross domestic product. That’s daunting, but it need not be fatal. As the economy recovers, our obligations – both past and future – should be manageable if policymakers overcome our greatest liability: a political system that addresses short-term crises rather than long-term challenges.

Full disclosure: In an earlier life, I served on the board that establishes accounting standards for the federal government. Yes, I am that much of a budget wonk. 

Groupon’s Revenue Measure Shrinks More Than 50%

About a month ago, I remarked on Groupon’s explosive revenue growth (and its equally impressive cost growth).

The company revised its financial results yesterday, and the revenue picture looks less explosive. In the latest update of its S-1 registration statement, Groupon reported $393 million in Q2 revenues. That’s a remarkable figure for such a young company but a far cry from the $878 million it previously reported.

And what happened to the almost $400 million in missing revenue? That money–payments to the merchants who provide goods and services for Groupons–is now subtracted before reporting revenue rather than deducted after as an expense. In short, Groupon went from a gross measure of revenue to a net one.

The bad news for Groupon is that the new presentation makes the company appear less than half as big as it did previously. The good news, I suppose, is that its expenses went down by the same amount.

Groupon’s effort to go public has been one of the bumpier ones in recent memory. Its first filing emphasized a profit measure, essentially profits before less marketing expenses, that was widely ridiculed. That got dropped in the second draft. And now a gigantic restatement of revenue in the third draft. Not to mention, the company’s recent difficulties with the SEC’s quiet period requirements.

Tax Loopholes, Wealth Destruction, and Health Reform

AT&T, Caterpillar, Deere, and Verizon garnered headlines last week (and an unwelcome summons to Capitol Hill) for announcing that a provision in the recent health care legislation would result in substantial accounting write downs. AT&T, for example, told the SEC that it expects to take a $1 billion charge in the first quarter because the law eliminates a tax subsidy for providing prescription drug coverage to retirees. According to the Wall Street Journal, Credit Suisse estimates that the total accounting hit for corporate America will total $4.5 billion.

Citing these impacts, a Wall Street Journal editorial denounced the provision as “a wholesale destruction of wealth and capital.” White House Press Secretary Robert Gibbs, in contrast, praised it as “closing a loophole.”

Who’s right?

To figure that out, I spent a lovely Saturday afternoon tracking through the intersection of health policy, tax policy, and financial accounting and emerged with a clear verdict: Gibbs is right. The provision does indeed close a tax loophole.

But the WSJ isn’t completely wrong. The first law of loopholes is that every loophole benefits someone. If you close a loophole, someone will be hurt. That’s what’s happening here. The extra subsidy for retiree prescription drug coverage provided an extra financial boost for AT&T, Caterpillar, et al. Eliminating the loophole will thus reduce the value of the companies and the wealth of their shareholders, just as the WSJ alleges. But it’s hard to get too teary-eyed since that value and wealth were created by the loophole in the first place.

And now to the details:

Continue reading “Tax Loopholes, Wealth Destruction, and Health Reform”

The Spectre of Creative Bookkeeping

A spectre is haunting Europe — the spectre of creative bookkeeping.

In an article in this morning’s Wall Street Journal (“Debt Deals Haunt Europe“), Charles Forelle and Susanne Craig provide more examples of the “aggressive” bookkeeping that European nations have deployed to satisfy the deficit and debt targets of the Growth and Stability Pact.

Greece, of course, takes honors in the field, not just for its recent use of derivatives to hide liabilities (see my earlier post), but also for other creative moves in the past. For example, the authors report that Greece:

insisted to the Eurostat statistics authority that large portions of its military spending were “confidential” and thus excluded from deficit calculations. In 2000, Greece reported that it spent €828 million ($1.13 billion) on the military—about a fourth of the €3.17 billion it later said it spent. Greece admitted to underreporting military spending by €8.7 billion between 1997 and 2003.

Such shenanigans are hardly unique to the Greeks. Other players include:

  • Portugal, which “classified subsidies to the Lisbon subway and other state enterprises as equity purchases” in 2001, and
  • France, which “arranged a deal with the soon-to-be privatized France Telecom in 1997 under which the company paid the government a lump sum of more than €5 billion. In return, France agreed to assume pension liabilities for France Telecom workers. The billions from France Telecom helped narrow France’s budget gap.”

Although dated, these examples illustrate some basic strategies that governments use to conceal the size of their deficits and debts: pretend the spending does not exist (Greece), pretend that spending is really an investment (Portugal), or pretend the future pension liabilities aren’t real (France).

A topic for another day is how these strategies may have been used in the United States. Suffice it to say that strategy three–ignoring future pension costs–is widespread both in governments and the private sector.

How Governments Hide Their Liabilities

In my testimony to the Senate Budget Committee the other day, I recommended that Congress set specific fiscal targets for bringing our out-of-control deficits and debt under control. My particular suggestion? Get the publicly-held debt down to 60% of GDP in 2020.

By budgeting  standards, that makes for a great bumper sticker: “60 in 20“.

But as the New York Times points out in two articles today, a measurable target isn’t enough. You also need to make sure that the government doesn’t game the accounting to hide its liabilities.

Exhibit A is Greece. The story was originally broken by Der Spiegel earlier in the week, and is described in the NYT by Louise Story, Landon Thomas Jr., and Nelson D. Schwartz in “Wall St. Helped Greece to Mask Debt Fueling Europe’s Crisis“:

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels. …

Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.

In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.

Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.

The winning quote:

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

Exhibit B are all the contingent liabilities of the United States government, of which Fannie Mae and Freddie Mac have been the most prominent (and expensive). In “Future Bailouts of America,” Gretchen Morgenson interviews budget expert Marvin Phaup (now at George Washington University and previously a colleague of mine at the Congressional Budget Office). She writes:

“If we are extending the safety net, extending the implied guarantee to the debts of a lot of other financial institutions, and we know those guarantees are valuable and costly, then we ought to start budgeting for it,” Mr. Phaup sad in an interview. “We can’t reduce the costs of these subsidies if we can’t recognize them.” …

As the number of firms with implicit government backing has risen because of the crisis, so too have the expected costs of those commitments, Mr. Phaup said. And yet, under current budget policy, those costs will be ignored until the recipient of the guarantee collapses — the precise moment when the guarantee is likely to cost taxpayers the most.

If we are going to set an explicit target for the publicly-held debt–60 in 20!–, we need to think carefully about what politicians may strategically omit from the calculation of the 60.


Counterintuitive Accounting: Ambac Edition

Earlier today, Ambac Financial Group (a big bond insurer) reported that it earned more than $2 billion in the third quarter, or $7.58 per share. As reported over at Marketwatch, these must be among the lowest quality earnings in accounting history:

Ambac Financial Group reported a $2.19 billion quarterly profit Wednesday as the company got a big accounting boost from deterioration in the perceived creditworthiness of its main bond insurance unit. …

Most the gain came as credit spreads widened on Ambac Assurance Corporation, the company’s main bond insurance subsidiary. When credit spreads widen, that implies investors are more concerned about a company not being able to meet its obligations. However, when this happens, it reduces some of the insurer’s liabilities. For example, if the insurer is deemed to be less capable of standing by its derivatives-based guarantees, the value of those liabilities falls. That results in a derivatives gain.

In short, earnings skyrocketed because investors became even more doubtful about Ambac’s ability to pay its future liabilities. I see many benefits in mark-to-market accounting generally, but this treatment of liabilities is counterintuitive to say the least. There must be a better way.

Ambac shares closed at a lofty $1.50 per share, up 35% on the day. It’s not often that you encounter a stock that trades for less than one-fifth of its quarterly earnings …

Disclosure: I have no investments in Ambac or any bond insurer.