In the last few months, the federal government has intervened in financial markets to an extent unparalleled in U.S. history. A partial tally includes the $29 billion, no-recourse loan from the Fed to rescue Bear Stearns; the federal takeover of Fannie Mae and Freddie Mac and their exposure to the credit risk on $5 trillion of residential mortgages; loans in excess of $100 billion to insurance giant AIG, and of course, open-ended Congressional authority for U.S. Treasury Secretary Henry Paulson to purchase up to $700 billion in troubled assets from financial institutions, part of which has already financed the purchase of over $250 billion of preferred bank stock.
Whatever you think about the wisdom of these interventions, one fact is indisputable: The government is not saying how much it expects all of this to cost us. The dearth of official estimates has, on one hand, led to Pollyannaish claims like “taxpayers could actually make money on this.”. On the other hand, it has stoked fears that taxpayers may be on the hook for trillions of dollars in losses.
More worrisome: Without hard numbers, not only is the initial cost of these interventions obscured, but it will be nearly impossible to assess the government’s performance as it manages these huge new commitments going forward.
Producing credible cost estimates is not easy, but it is necessary. Private-sector entities have to comply with strict and often frustrating accounting standards so that investors can make informed decisions. Taxpayers and policymakers need just as good data if they are to be equally well equipped.
What is insufficiently appreciated is that the government holds itself to a much less stringent accounting standard that what it imposes on the private sector. Importantly, the principles of fair value accounting are largely absent from federal budgeting for risk. I would single out two accounting rules that create serious distortions in accounting for federal ownership of financial securities.
The first is in the treatment of the market price of credit risk, which is omitted from the pricing of federal credit obligations. By law, projected net cash flows must be discounted at maturity-matched Treasury rates. This causes the value to the government of a loan to risky borrowers like Ford Motor Co., AIG or Morgan Stanley to be systematically overstated. Thankfully, this byzantine rule was waived temporarily for the $700 billion bailout bill, but it remains a problem for most security purchases.
The second is that the value of equity investments, like the recent purchases of preferred bank stock, are systematically understated initially because these are accounted for on a cash basis, which means the full purchase price of stock is counted as an outlay, with no offset for the value of the claim received. In later years any positive cash flows from dividends and principal repayments reduce the reported budget deficit, even if the recoveries fall far short, in present value terms, of the initial value expended.
Some might argue that in the middle of a crisis the last thing we have to worry about is bean counting. But we should remember that lax government accounting rules—such as those that kept Fannie and Freddie off the federal budget despite their longstanding federal ties—are among the culprits responsible for getting us into the current mess, and failing to strengthen them will make it harder to get out of it. Just imagine how difficult it will be in a few years for the government to re-privatize banks if, because of accounting distortions, it looks like they are making money for taxpayers instead of losing it.
Note: This is an expanded version of my editorial that appeared last week in Crain’s Chicago Business.