Does Uncle Sam make money lending to students?


Commencement at the University of Delaware in May. (Emily Varisco/AP)

In May, the Congressional Budget Office issued a report stating that federal student loans programs would either cost the federal government $88 billion over the next ten years or make the government $135 billion, depending on which accounting method they employed. This conclusion occasioned some impassioned commentary from a small group of concerned observers here in Washington and was largely ignored by everyone else.

The issue is the "fair-value" accounting debate, and it centers on how CBO should treat uncertainty. The CBO, of course, is required to report how much it expects the government to pay for a given program. And the CBO is required to measure that against the government's cost of borrowing (rates on Treasuries.)

But some, like Rep. Paul Ryan (R-Wis.), think the CBO should use a different system to measure market uncertainty, as do accountants who work for banks and corporations. That system is called fair-value accounting. The federal government's loan programs for students and others would appear more expensive than they do now using fair-value accounting.

The CBO estimated that the government was owed about $2.7 trillion in outstanding loans in 2012 — excluding Fannie Mae and Freddie Mac, which guarantee about two in three home mortgages. "When Washington makes or guarantees a loan, it puts taxpayers at risk," Ryan said in April, arguing that the risk itself should be quantified and placed on the government's books.

This debate is especially worth revisiting with President Obama signing an executive order on the problem of student debt Monday, but the controversy also raises a few questions that are fascinating in their own right. We'll do our best to answer those here.

So, does the federal government make money on student loans or not?

The short answer is yes. The CBO predicts that the student loans the government will make over the next decade will ultimately yield $135 billion over the term of those loans as graduates pay back their debt with interest. The office developed that estimate using the procedures it is currently required to follow by law, taking into account how many students can be expected to default on their debt and the cost of interest on Treasury bonds to fund the loans initially.

But the CBO isn't necessarily 100 percent comfortable with this estimate. When ordinary people or businesses make investments, they don't simply ask whether they're likely to make money. They also ask themselves, "How much can I afford to lose here?" That's the origin of the saying, "Don't bet the farm on it." The CBO expects that the student loan program will net the government somewhere around $135 billion, but, remember, that's just an estimate.

Well, that's all there is to it, then. The CBO expects the government to make billions off student loans. Why wouldn't they leave it at that?

Perhaps they should, but how would taxpayers feel about the government taking on that risk in their names? It is ultimately taxpayers who will have to foot the bill if repayments fall short.

So here's where fair-value accounting comes into play.  The global financial system lets banks and other private companies measure and hedge against risk of all stripes. Still, in a financial panic, all of an investor's bets can go wrong at once, and all of her careful calculations to protect her assets become useless.  That unavoidable risk is usually called "market risk," and even though it's balanced by a risk that the economy will do exceptionally well, it's always made investors nervous. It's the reason that when banks make loans themselves, they demand a slightly higher rate of interest.

Fair-value accounting relies on this higher interest rate, set by the market. The CBO has argued for using fair-value accounting in its formal recommendations to Congress, but the office would need legislators to pass a law first. According to the CBO, the market interest rate reflects the true costs of the loans, because taxpayers in the private sector would prefer that the government avoid taking risks with their money, other things being equal.

Using fair-value accounting, those same student loans would cost the government $88 billion. In other words, no one is quite sure how those borrowers will do when it comes time for them to start making payments, and because of that risk, banks, people or corporations would perceive the loans as more costly.

The Washington Post's editorial writers have argued (repeatedly) that fair-value accounting more accurately reflects the risks the government assumes when it makes loans. Are you saying that's wrong?

It is at best misleading, Jared Bernstein, Vice President Biden's former chief economic adviser, wrote. "The full likelihood of defaults or late payments and the probability of changes in interest rates need to be taken account of – as they already are," Bernstein writes.

The CBO accounts for the fact that some borrowers will default on their loans, explained Richard Kogan of the Center on Budget and Policy Priorities. "The current approach is supposed to use the best estimates that are possible," he said. Both approaches use the same estimate of the default rate, so it isn't that one is more realistic.

Fair-value accounting also attaches a cost to the uncertainty itself, because uncertainty makes people uncomfortable.

Accounting shouldn't be about what people feel or perceive. Why shouldn't the CBO focus on the actual numbers?

That sounds straightforward enough,  but the CBO doesn't just have a $135-billion estimate — it has a whole bunch of predictions surrounding that number about how likely it is that borrowers will pay their loans back in varying amounts. Those predictions are really a range of possible outcomes, and they look something like this:

This graph is a joke, of course, and it is not intended to accurately reflect CBO's data. In particular, the graph really should have a third dimension for time.

With a graph like this, shouldn't the CBO just point lawmakers to the average?

Uncle Sam 2

Uncle Sam 3

That might seem like the simplest thing to do, but that's not in fact how ordinary people (or banks) would think about this sort of graph. If this was your money you were gambling with, you'd be more worried about the other side of the graph. You'd be worried about the likelihood you could lose money: 

That's completely insane! Look at the graph you just drew. It says that on average, Uncle Sam will get paid. 

On average, yes. The likelihood that the government will probably make money in the long term isn't disputed. The fair-value accounting debate is about how much to worry about the risk that the government loses money instead. If there is another financial panic and mass unemployment, many graduates will stop paying off their loans. Proponents of fair-value accounting argue the government should give that risk additional weight in its calculations, as people do in the private sector.

Think about this: Let's flip a coin. If it comes up tails, you'll pay me $100. But if it comes up heads, I'll pay you $100. The odds are even, but economists have long known that most people wouldn't take that bet. People hate losing money more than they like getting more of it.

Wait, but I'm just a disembodied voice posing polemical questions about accounting standards. I'm not affected by the irrational aversion to risk that you humans seem to share.

On the contrary, there is nothing irrational about it. For every dollar I lose, the dollars I have left are more valuable to me. For every dollar I gain, I have less use for the next dollar after that.  Avoiding risk can be an entirely sensible way of dealing with the fact that the future can't be predicted with absolute certainty.

The goal of fair-value accounting is to use the market to determine what prices are fair. It's possible to quantify people's dislike of risk with an exact dollar value based on the behavior of financial markets.

Once you stop using the market to assign prices, you can reach just about any conclusion you want, argued Deborah Lucas, an economist at the Massachusetts Institute of Technology. What's to stop the CBO from inventing its own reality for the cost of gasoline or lawyers or bananas if it doesn't base its estimates on the prices prevailing in the market?

"It strains credulity, if you think about it carefully," Lucas said. "The government isn't supposed to make up prices."

If people start defaulting on their student loans during the next financial crisis, that is just fine by me. Instead of mailing checks to Washington, they'll have the money to spend on themselves, which will help the economy recover.

You might have a point there. In an interview, Kogan and his CBPP colleague economist Paul Van de Water argued that the government doesn't behave the same way as ordinary people do during a recession. Instead of saving money, the government spends more on things like food stamps, unemployment insurance and fiscal stimulus, helping to stabilize the economy.

Many people feel that the government is little more than a steward of the public's money and that it should balance its checkbook just like businesses and families do. If, like economist Paul Krugman, you think that's too narrow a description of the government's responsibilities, you might doubt that the government should approach risk in the same way as the private sector.

There are, obviously, a range of arguments for and against fair-value accounting, only a few of which have been addressed here. If you'd like to read more, see this paper against and this one in favor.

The unsatisfying but surprising conclusion is that it just doesn't seem possible to resolve the dispute either way without making a few assumptions about economic theory and the nature of government. As a result, different people will have different opinions on the exact amount of money the government can claim to have at any point in time, or on whether Uncle Sam makes money on student loans.

Max Ehrenfreund is a blogger on the Financial desk and writes for Know More and Wonkblog.
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