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Fair-Value Accounting Shows Switch to Guaranteed Student Loans Costs $102 Billion

Published:  March 23, 2012

This week the Republican majority on the House Budget Committee released a fiscal year 2013 budget resolution. For the second year in a row, the document includes a so-called “fair value” rule that applies to cost estimates for federal loan programs—including student loans. While the rule went largely unnoticed last year (except by us here at Ed Money Watch), this year it has attracted a bit more attention. And with any budget rule, added attention begets added confusion.

Many have mischaracterized fair-value accounting as a Republican gambit to reinstate some version of a guaranteed student loan program and replace the 100 percent direct lending model in place since 2010. If that is in fact the intent, Republican lawmakers are terribly confused because reinstating the guaranteed loan program in place of direct lending would cost $102 billion over a ten-year budget window according to fair-value estimates.

The math on this is simple. A 2010 Congressional Budget Office (CBO) study compared the two loan programs under fair-value accounting and found that the typical direct loan costs the government about $12 for every $100 lent, but the same loan made through the guaranteed program (under the Federal Family Education Loan [FFEL] program that existed in 2010) costs $20 for every $100 lent. Multiply the higher cost for guaranteed loans by the $128 billion in loans that will be issued annually over the next 10 years and you get an added cost of $102 billion. That means if Congress adopted fair-value accounting and then proposed a bill to reinstate guaranteed student loans, they would need to find $102 billion in spending cuts or tax hikes to make the switch budget neutral.

Student%20Loans%20Fair-Value.png

Guaranteed lending costs more than direct lending even under fair-value accounting because guaranteed lending subsidized both borrowers and private lenders. Direct lending subsidizes just the borrower because the government does not need to guarantee interest payments to private lenders or pay a complicated array of fees to guarantee agencies.

Is the fair-value movement really just about better, more honest accounting then? Mostly, yes. But it would also remove the budgetary incentive that Congress has under the current rules to expand subsidized loan programs. Under current rules, loans appear profitable even when they provide valuable subsidies to borrowers (and lenders). As a result, when lawmakers expand loan programs, it looks like they have simultaneously reduced spending. Generally, fair-value accounting reveals that government loan programs impose a cost on taxpayers when they subsidize borrowers (and lenders).

The difference arises because official rules value government loans as if the estimated performance of the loan (repayment rate, defaults, recovery rates, delinquencies, deferments, etc.) is certain to occur as projected. In contrast, fair-value accounting uses the exact same estimates of loan performance as the current rules (repayment rate, defaults, recovery rates, delinquencies, deferments, etc.), but it assumes that the estimated performance is not certain and that taxpayers bear a cost for assuming the risk that the loans will cost more than expected. The CBO explains that this is “market risk,” which is the risk that defaults will be higher and more costly in times of economic stress and that the federal government bears it when making loans just as any private lender would.

The Obama Administration’s proposal to revamp and expand the Perkins Loan program is a good example of the policymaking and political implications of fair-value accounting. The president’s proposal would turn the existing Perkins Loan program into one that allows some students to take out additional Unsubsidized Stafford loans—the most widely available federal student loans. Current accounting rules show that the proposal would generate a profit for the government—more lending at profitable terms means more profits. Fair-value accounting, on the other hand, shows the proposal would increase federal spending—more lending at subsidized terms means additional spending.

The table below, based on a 2011 CBO estimate of the Perkins Loan proposal included in the president’s fiscal year 2012 budget, compares the costs of the proposal under current rules and fair-value accounting.

FY12%20Perkins%20Proposal%20Fair-Value.p

Private companies that used to be the primary lenders under the old guaranteed loan program (Sallie Mae, et al) do not favor fair-value accounting because it gives them a shot at returning to the days of politically negotiated subsidies and rent seeking under the old guaranteed loan program. They support it because it shows that if Congress expands the federal student loan program or creates an entirely new one—such as the president’s Perkins Loan proposal—it imposes a cost on taxpayers. That makes such proposals unlikely to pass given today’s record budget deficits. Private student loan companies have a better chance, then, of preserving the small slice of the student loan market they currently occupy.

Lastly, there is the matter of loan sales. For years, student loan companies lobbied Congress to sell off the direct loan portfolio. Even last year, investment banks were pitching a similar (albeit nonsensical) idea to Congress as a phony way to reduce government debt. Current accounting rules show that selling the loans, even at market prices, would present a cost to the government, making a loan sale proposal a nonstarter. Fair-value accounting, on the other hand, would theoretically show that a loan sale is budget neutral. That is, the loans are worth what someone is willing to pay for them so selling them leaves the government in the exact same financial position had it kept them.

It’s possible that student loan companies see a move to fair-value accounting as a way to convince lawmakers to sell the government’s direct student loan portfolio. But it’s hard to imagine something like this coming to fruition. Even so, many ill-informed members of Congress think that selling the direct loan portfolio somehow reduces the government’s costs. Again, such a transaction, at fair-value prices, offers no financial gain to taxpayers.

There is no doubt that fair-value accounting would make it harder for Congress to expand student loan programs, be they guaranteed or direct lending programs. And that may well be the primary motive of some who support the accounting rule, just as those who oppose fair-value accounting tend to do so only because it ends the “free lunch” of providing subsidies while earning apparent profits. But setting political motivations aside, fair-value accounting is the most comprehensive and meaningful way to measure what taxpayers are being asked to give up when the government uses their money to make student loans. Whatever policy outcome it favors shouldn’t be a factor in whether to adopt it.

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