The new issue of National Affairs features my article with Jason Delisle, “The Case for Fair-Value Accounting.” We go into a lot of detail about what fair-value accounting (FVA) is, why it’s needed, and how both parties have hypocritically flip-flopped on it.
I’m not someone who is easily shocked by government misconduct, but when we assembled all the examples of accounting malfeasance for this article, even I was surprised at how widespread and deceptive it all is.
Some quick background: The “fair value” of an investment is its current market price. Built into the market price of any asset are the expectations of its future value and the risk that those expectations may not be met. Both components of the price are critical. All else equal, investors obviously prefer assets with higher expected returns, but that preference is mediated by the risk involved. Investors may prefer low-returning assets with low risk (such as bonds) over high-return and high-risk assets (such as stocks). FVA cost estimates naturally include both expected returns and the cost of risk.
But most federal credit programs are scored based on expectations only, disregarding the cost of market risk. When the federal government offers student loans, for example, it estimates how much students will pay back and then assumes that its estimate carries no uncertainty. But no private investor would purchase the right to collect student loan repayments for just the expected value. The investor would demand a lower price for such a risky asset.
By placing a greater value on its assets than the market does, the government generates a number of bogus “free lunch” scenarios, and politicians try to exploit them:
For example, in the depths of the recession, Ohio senator Sherrod Brown proposed that the federal government buy up private student loans, convert them to federal loans, and then reduce the interest rates that borrowers pay. Lenders holding the loans would be paid face value for them — that is, the government would pay the lenders the full outstanding balance on the loans. Borrowers would receive new, better terms and repay the remainder of their loans to the Department of Education. The CBO was required under [current law] to show that this transaction would result in an immediate $9.2 billion profit to the government.
Bear in mind that this was a debt swap in which borrowers would pay less interest to the government than they would pay to private lenders. But, miraculously, $9.2 billion in new cash for the government would appear out of thin air as soon as the transaction was made. This money could then promptly be spent on more government programs.
Under FVA, Senator Brown’s scheme would not have generated a profit at all, but rather a cost of $700 million.
Now consider the Federal Housing Administration’s single-family mortgage-insurance program, which provides default guarantees to home-mortgage lenders:
Home buyers secure subsidized mortgages, which are loans with terms better than any private lender would offer without the government guarantee. Because [government accounting] rules exclude a market-risk premium, the program appears to both subsidize homeowners and generate profits for the government, “earning” a $60 billion free lunch for the government over ten years. But once a market-risk premium is added to these tallies, the loan guarantees show a $3 billion annual cost.
The same problem of disregarding market risk affects public pensions:
As discussed earlier, [government] accounting enables the federal government to claim a “profit” simply by purchasing a private-sector loan. In the pension world, the analogous transaction is the “pension-obligation bond,” which allows states to conjure money through an interest-rate arbitrage scheme. In essence, a state sells a government bond that pays, say, a guaranteed 5% interest rate and then places the proceeds from the bond sale into the pension fund. The trick is that the pension fund is assumed to return 8%, so the state nets 3% per year in “free” money. The fallacy, of course, is that the pension fund’s 8% expected return carries risk — which is why investors are willing to buy the (safer) pension-obligation bonds in the first place.
The examples go on and on, and the only way to end this mischief is to apply FVA to all government credit and investment programs.