House Budget Would Raise Borrowing Costs for the Middle Class

College students walk across campus for class, February 2017.

The budget proposed by the U.S. House of Representatives last week would put fundamental aspects of the American dream—attending college and buying a home—further out of reach for many families. By using a budgeting gimmick called “fair-value accounting,” instead of the accounting methods prescribed by the Federal Credit Reform Act of 1990 (FCRA), House Republicans are intentionally making the costs of federal lending appear more expensive. The latest House budget plan, for example, would add $326 billion in fictional costs to the federal deficit due to fair-value accounting.

This column explains what fair-value accounting is, why it’s an inaccurate way to estimate costs, and what it could mean for Americans with student loans and home mortgages. Instead of undermining federal lending through budget trickery, Congress should focus its energy on solidifying the programs and lowering costs for working families.

How government accounting currently works

Applying fair-value accounting standards instead of current FCRA accounting methods has led to a debate over whether the federal government should factor the price of risk into budgeting costs related to government loans and loan guarantee programs in the same way that private market lenders do. The federal government, however, does not and should not operate like a private business that seeks to maximize profits.

The fundamental roles of federal credit programs are to ensure that Americans can obtain a loan whether market conditions are good or bad and to serve those who are underserved by the private market. When the federal government lends money in the form of student loans, or when it guarantees housing loans, the federal budget must account for how much money it lends out and how much it expects to get back in order to determine how much the program costs.

Its budget tracks revenues and expenditures and takes basic risks, such as the likelihood of borrower default, into account. Requiring the federal government to add costs to federal credit programs to make them look more like private businesses is both unnecessary and would likely increase costs for consumers.

When the federal government lends money out, it needs to have a sense of the extent to which loans are going to be repaid. That’s why the FCRA requires that the federal government take the lifetime costs of loan and loan guarantee programs into consideration upfront when accounting for credit programs in the budget. This requires building in estimates for the likelihood that loans will go into default or not otherwise be repaid. Since the value of money changes over time, the FCRA also requires the federal government to adjust the amount of revenue it expects to receive based on the length of time it will take to get repaid, as well as how much the value of the loan amount will change during that time. This change in value, as well as the risk of default, is accounted for by what is known as the discount rate.

Discounting future cash flows into present dollars matters because loan payments made in the future are not worth the same as a payment today: Think about the value of having $10 in 1940 versus $10 today to get a sense of this idea in practice. Future payments are also not guaranteed—some borrowers might default or refuse to repay.

For federal student loans and mortgages, this discount rate is equal to the government’s cost of borrowing, which is pegged to Treasury bonds, plus an amount that factors in the risk that some borrowers will not repay their loans.

What is fair-value accounting?

Fair-value accounting takes a different budgeting approach. Instead of using the government’s actual cost of borrowing, it adds an additional cost to the discount rate based on what the private sector would charge for a similar loan. This rate is higher than the government rate because a private investor will demand a higher return for a riskier investment.

Using the higher discount rate required under fair-value accounting makes the costs of federal lending look more expensive. It means that future cash flows are worth less money under fair-value accounting because they are discounted at a higher rate, so the government appears to receive less money back on a loan. Less money back makes federal loan programs look like they cost more. For example, if a student enters repayment with $10,000 in debt, they would pay back $13,810 after 10 years of repayment in nominal terms, according to CAP calculations, which assumed an interest rate of 6.8 percent. Using a 2 percent discount rate to reflect the present-day value of 10 years of payments, the government would receive $12,498. But using a higher discount rate of 5 percent, the government would receive payments valued in present-day terms of $10,842.

Greater government costs mean that programs seen today as self-sustaining would suddenly appear to cost the government billions of dollars. Congress would likely enact new policies to offset this apparent increased cost. For student loans, this could mean implementing worse borrower terms through higher interest rates, getting rid of flexible payment options, or eliminating some loan products entirely. Under Federal Housing Administration (FHA) mortgage loans, fair-value accounting could result in higher fees and underwriting standards, making loans more expensive and less accessible, especially for low- and moderate-income borrowers and first-time homebuyers.

Proponents of fair value base their argument on lending in private markets. They argue that high variability in cost estimates poses a market risk to taxpayers and that uncertainty can result in greater losses than estimated. To account for risk, private lenders add a cost premium above the present value of expected defaults. They believe that the government should do the same.

But this argument ignores several critical points. Unlike a private company, the federal government is not under pressure to maximize profits the way a private firm is. The core reason why the federal government lends money to begin with is that there are certain risks that private financial institutions are unwilling to take, but these risks bring significant benefits to the public. The federal government is in a unique position to assume risk and spread it across a wide portfolio to achieve public goals. For example, the federal government takes on substantial risk to extend loans with favorable terms to students with minimal to no credit history. Private lenders would not want to take on this default risk without charging borrowers sky-high interest rates. Second, the federal government can borrow money at a lower rate than private companies; adding a market premium under fair value would add costs to lending for which the government does not actually have to pay. Finally, and most importantly, the FCRA is doing a good job estimating the expected budgetary costs of federal credit programs and has proven accurate over the past two decades. Instead of improving federal budgeting, fair-value accounting would add costs to budgetary estimates, thus overestimating the cost of federal credit programs and encouraging a scaling back of lending programs.

Federal student loans

Under current accounting methods, the Congressional Budget Office (CBO) estimates that federal student loans will save taxpayers $72 billion between 2018 and 2027, mostly from borrower interest and fee payments. But under fair-value accounting estimates, student loans would cost taxpayers $161 billion over the same period. In other words, the switch would appear to add an additional $233 billion to the federal deficit overnight.

The need to pay for massive self-created increases in program costs would give Congress cover to enact substantial cuts to student loans, particularly loan programs targeted toward low-income students. Switching to fair-value accounting has different budgetary impacts depending on the type of student loan. For example, the subsidized loan program, which provides loans primarily to low-income students, is the biggest driver in added costs to the federal deficit under fair value, which makes it particularly vulnerable to cuts. In academic year 2015-16, the subsidized loan program provided more than $23 billion in interest-free loans to more than 6 million students from families with financial need. Under current accounting methods, the subsidized loan program costs the federal government roughly $18 billion per fiscal year, but under fair-value accounting, it would jump to nearly $72 billion. On the other hand, Parent PLUS loans, which are higher-cost loans made to parents to help cover college costs, generate savings under both current accounting and fair-value accounting, making them harder to cut.

Alternatively, Congress could choose to offset costs by cutting student-funded benefits such as income-driven repayment programs and Public Service Loan Forgiveness, programs that help ease the burden of student loan repayment. Income-driven repayment programs allow borrowers to make affordable payments on their loans based on a percentage of their income, and this lowers monthly payments. Public Service Loan Forgiveness is a program that would forgive borrowers’ loans in exchange for public service after 10 years of repayment, and applies to teachers, firefighters, nurses, and other occupations.

Subsidized loans, income-based repayment, and Public Service Loan Forgiveness programs are all targets for cuts proposed in President Donald Trump’s budget but would require congressional approval. Under the president’s budget, subsidized loans and Public Service Loan Forgiveness would be eliminated entirely. While Congress’ 2017 budget largely rejected these cuts, inflated costs under fair-value accounting create a stronger argument for cuts.

FHA-guaranteed mortgage loans

FHA-guaranteed mortgage loans would also be affected. The FHA provides access to affordable credit for many underserved communities by guaranteeing mortgages to creditworthy homebuyers who might have difficulty obtaining loans in the conventional market. In 2016, the FHA insured 1,258,063 loans, 82 percent of which were for first-time homebuyers. According to the CBO’s 2014 estimates, FHA-guaranteed single-family home purchase loans would cost taxpayers $30 billion on a fair-value basis over a 10-year period, instead of raising $63 billion in revenue under FCRA accounting. A switch under this program would add $93 billion to the deficit. Higher prices for FHA insurance could put homeownership out of reach for thousands of low- and moderate-income potential borrowers. For instance, if fair-value accounting standards induced an increase in mortgage insurance premiums of 100 basis points, the higher premiums could translate into roughly 2 million fewer homeowners over the next 10 years. In addition, fair-value accounting could result in budget cuts to other Department of Housing and Urban Development programs to compensate for the loss of funding that commonly comes from FHA net receipts.

Conclusion

To date, the congressional agenda and the proposed House budget have focused on cutting important programs on which millions of Americans depend, all with the goal of cutting taxes for the wealthy. Switching to fair-value accounting is just another back-door attempt at rewarding the top 1 percent at the expense of the middle class and the rest of the country, and further widening the wealth gap.

Antoinette Flores is a senior policy analyst on the Postsecondary Education Policy team at the Center for American Progress. Michela Zonta is a senior policy analyst for the Housing and Consumer Finance Policy team at the Center.