Fair-Value Budgeting: Practical Issues: Working Paper 2021-08

Fair-Value Budgeting: Practical Issues

Michael Falkenheim

Congressional Budget Office [e-mail]

Working Paper 2021-08

July 2021

To enhance the transparency of the work of the Congressional Budget Office and to encourage external review of that work, CBO's working paper series includes papers that provide technical descriptions of official CBO analyses as well as papers that represent independent research by CBO analysts. Papers in that series are available at http://go.usa.gov/ULE.

I thank Sebastien Gay, Justin Humphrey, Wendy Kiska, Jeffrey Kling, John McClelland, Sam Papenfuss, and David Torregrosa for valuable comments and suggestions. Sarah Cunningham, Deborah Lucas, Donald Marron, Damien Moore, and Lorzenzo Rasetti also offered useful input. Gabe Waggoner was the editor.

www.cbo.gov/publication/57264

Abstract

Fair-value budgeting represents a more comprehensive measure of cost for government activities than the measure required under current law. However, fair-value budgeting raises practical questions: Which government activities would benefit from fair-value estimates? How might they be used? How can agencies estimate fair value without observing market prices for government risks? The use of fair value could depend on three criteria:

• Commitment, whether the government makes commitments that it cannot shed through future legislation;
• Feasibility, whether fair-value costs can be estimated with accuracy; and
• Relevance, whether fair-value estimates convey meaningful additional information about costs.

Federal credit programs fulfill all three criteria in that they involve binding contractual commitments, their fair-value cost can be estimated with established methods, and the fair-value cost estimates for credit programs often differ in sign and magnitude from official cost estimates. The estimation of fair value for credit programs is subject to uncertainty because of the reliance on private proxies and the difficulty in disentangling credit risk and liquidity premiums. Nonetheless, fair-value estimates offer useful additional information to supplement official estimates.

Keywords: federal credit programs, fair value, discounting, uncertainty, risk premiums

JEL Classification: G00, H50, H81, H83

Contents
Which Activities Would Benefit From Fair-Value Estimates? ......................................................	2
Past and Present Use of Fair Value in Cost Estimates ................................................................	3
Criteria for Using Fair Value: Commitment, Feasibility, and Relevance...................................	3
How Could Fair-Value Estimates Be Used?...................................................................................	7
Budget Execution ........................................................................................................................	8
Cost Estimates.............................................................................................................................	8
Estimates of Baseline Spending, Deficits, and Debt...................................................................	8
Estimates for Informational Purposes .........................................................................................	9
How Can Agencies Estimate Fair Value Without Observable Market Prices? ..............................	9
CBO's Usual Approach for Estimating Fair-Value Cost of Federal Credit Programs .............	10
Using Market Proxies ...............................................................................................................	11
Disentangling Liquidity and Credit Risk Premiums .................................................................	12
Assessing Quality of Fair-Value Estimates ..............................................................................	13
Institutional Roles in Estimating Fair Value.............................................................................	14
Appendix: Reconciling Fair-Value Estimates With Projections of Federal Debt ........................	15
Approach Taken in Emergency Economic Stabilization Act ...................................................	15
Other Approaches .....................................................................................................................	16

Financial risk is involved in many of the federal government's activities:

• Making loans and loan guarantees, at the risk of higher-than-expected rates of default;
• Insuring bank deposits and pension funds, running the risk of higher costs if many banks fail or if pension investments perform poorly; and
• Levying taxes, which generate revenues that fluctuate with the performance of the economy.

Likewise, spending automatically varies with economic variables in safety-net programs. Those activities lead to larger-than-expected deficits when the economy is weak. That risk is passed on to both beneficiaries of government programs and taxpayers for whom, as investors, it would have a cost.

The measures required under current law are governed by the Federal Credit Reform Act of 1990 (FCRA). Under FCRA, federal government agencies estimate the budgetary costs of loans and loan guarantees by discounting projected future cash flows to the present with Treasury rates. That present-value, or accrual, approach recognizes costs at the time that loans are made instead of when cash flows occur-as is done in budgeting for most other activities. Accrual measures succinctly convey whether policy changes are expected to increase or decrease the deficit over the long term. That approach facilitates comparisons of the net cost of programs with cash flows that differ in timing and potentially improves lawmakers' opportunity to control long-term costs when commitments are initially made. Agencies project future cash flows as averages of their possible values, weighting different outcomes by their probability.

Fair-value budgeting, by contrast, measures the costs of loans and loan guarantees more fully by using market prices-and could be used for other activities as well. Fair-value estimates include market risk, the cost associated with assets' tendency to perform well in good economic times and poorly otherwise. Fair-value estimates reflect people's tendency to place greater weight on scenarios in which the economy is underperforming.1

Some analysts have raised both conceptual and practical concerns with using fair value in budgeting. Separate publications address conceptual concerns.2 This working paper answers the following questions:

1. See Congressional Budget Office, Measuring the Cost of Government Activities That Involve Financial Risk (March 2021),www.cbo.gov/publication/56778.
2. See Michael Falkenheim, Fair-Value Cost Estimation and Government Cash Flows, Working Paper 2021-05(Congressional Budget Office, April 2021),www.cbo.gov/publication/57062, and Governmental Risk Taking Under Market Imperfections, Working Paper 2021-07(Congressional Budget Office, June 2021),www.cbo.gov/publication/57255.

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• Which government activities would benefit from fair-value estimates?
• How could fair-value estimates be used?
• How can agencies estimate fair value without observable market prices?

Together, those questions cover most practical concerns that the Congressional Budget Office and other parties have raised about fair value. Although CBO has shown how fair-value estimates may be produced for federal credit programs to provide a more comprehensive measure of their costs, the agency has recognized that producing those estimates is more complex for other agencies with more limited analytical resources.3 Some analysts have raised concerns that fair-value estimates may tip the scales against government activities for which they are used.4 Those concerns are mainly related to the fact that fair-value estimates take into account the cost of market risk, which cannot be diversified away by investors and therefore adds to the cost estimate for any credit program.

Which Activities Would Benefit From Fair-Value Estimates?

By law, CBO has been required to use fair value as the official cost measure for a few activities in baseline projections of the federal budget. The agency also has produced fair-value estimates of legislative proposals as an alternative cost measure at the request of the Congress. Fair-value estimates can take significant effort to produce. For many types of government activity not involving financial risk, fair-value estimates might not differ much from traditional estimates. Thus, generating fair-value estimates for those government activities would be impractical. Ideally, clear and transparent criteria would determine when to estimate the fair-value cost of government activities involving financial risks. One trigger for estimating fair value could be the presence of binding commitments, such as the contractual obligations in federal credit programs. Fair value also could be reserved for situations in which it affects the cost estimate's sign and magnitude. Estimates under FCRA most often suggest the presence of a "free lunch," in which the government produces something of value to households or businesses at no budgetary cost, unlike fair-value estimates. Similarly, fair-value cost estimates avoid the impression that the government can reduce deficits by purchasing risky financial assets at market prices. A final criterion is whether fair-value estimates are feasible to produce.

1. For example, see Congressional Budget Office, Answers to Questions for the Record Following a Hearing on the Oversight of the Congressional Budget Office Conducted by the Senate Committee on the Budget (November 18, 2016), pp. 14-17,www.cbo.gov/publication/52155, and testimony of Douglas W. Elmendorf, Director, Congressional Budget Office, before the House Committee on Financial Services, Estimates of the Cost of the Credit Programs of the Export-Import Bank (June 25, 2014), www.cbo.gov/publication/45468.
2. See Paul N. Van de Water and Joan Huffer, House "Budget Transparency" Bill Would Make Budget More Opaque
   (Center on Budget and Policy Priorities, June 2013), https://tinyurl.com/vhuwteuf.

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