The Republican presidential primary elections have sparked a show trial about whether a candidate’s experience as a private equity investor effectively disqualifies him to be the president of the United States. In this debate, private equity experience is linked to some of the industry’s failed investments, lay-offs at restructured companies, or lucrative distributions from successful investments. It is held up as an example of privilege, income inequality and evidence that private equity’s business model is anathema to the role or mission of the federal government.
But there is at least one area where Washington is in desperate need of someone with private equity experience. “Only in Washington” accounting rules have helped fuel an explosion in the size of federal government’s loan programs, particularly those that subsidize housing. The rules make these programs appear to generate huge profits for the government, even though they make loans at below-market rates. Someone with private equity experience would be shocked to learn that loan programs appear profitable because official cost estimates systematically exclude the market risk taxpayers bear when the government guarantees loans or makes them directly. A private equity investor is acutely aware that investors charge a premium to bear market risk – the risk that loan defaults will be higher during times of economic stress when resources are scarce and the market prices of assets are depressed – and knows that it cannot simply be ignored when valuing a loan.
Official cost estimates for loan programs exclude market risk because the government’s accounting regime requires that expected loan performance be discounted at risk-free U.S. Treasury interest rates. Thus the government values risky investments using risk-free discount rates, which gives lawmakers a perverse incentive to expand rather than limit the government’s loan programs. In short, more subsidized lending actually appears to reduce government spending (creates more fictitious profits) and less subsidized lending increases government spending (reduces the same “profits”), on net.
A good example is the Federal Housing Administration, a government program that provides private lenders with a 100% guarantee against the default on qualified mortgage loans. The FHA has been around since 1934 and while it has traditionally been a sleepy backwater in D.C. policy circles, the aggregate insurance that the FHA has in force over the last 5 years has tripled from just over $300 billion to more than $ 1 trillion. The increase reflects the fact that during the financial crisis – and over the subsequent few years – the government’s share of the market for new mortgages has climbed all the way to 97% (including Fannie, Freddie, and FHA).
Under the accounting rules the government established for itself in the early 1990s, the FHA’s newly issued loan guarantees appear profitable, so a proposal to reduce FHA-backed lending would be treated on Capitol Hill as a cost (i.e. a reduction in the government’s apparent profits). Not surprisingly, this special accounting treatment enabled Congress to authorize FHA to back especially large mortgage loans, or those between 625 -700k in size, and expand its reverse mortgage program toward the end of 2011 without revealing the true level of taxpayer subsidies. Unfortunately, many in Washington take it as fact that the government can subsidize everything from home mortgages and student loans to nuclear power plant construction at no cost to taxpayers. In fact, many – including the Obama Administration – see the government’s purported loan profits as proof of an inherent advantage the government has over the private sector, rather than the result of a less-than-full accounting of the risks taxpayers have been made to bear.
Before a Congressional hearing late last year, Shaun Donovan, the Secretary of the Housing and Urban Development Department (HUD), defended the flawed accounting rules arguing that the FHA can guarantee low-down payment home loans, take on default risk, charge less than private companies, and still make a profit because the FHA is fundamentally different than a private company. In his words, FHA “doesn’t have shareholders,” and it doesn’t “have a need for return on equity.”
But Secretary Donovan’s explanation doesn’t carry water. When the government makes or guarantees loans, taxpayers become the equity investors in those transactions. After all, it’s taxpayers who will be called on to make up for any loss on the loans over time, not Treasury bond investors. Arguing then that the government doesn’t “have a need for return on equity” is like saying taxpayers are willing to be equity investors and risk their capital for free (i.e. “no return”). Of course, no one puts his money at risk assuming a zero rate of return and there’s no reason that same person acting as a taxpayer would either.
If taxpayers really were willing to be equity investors at no charge – as the Obama Administration assumes in defending accounting rules that exclude a market risk premium – why settle for the current level of government interference? Using its source of free equity and risk-free cost of borrowing, the government could lower costs in every area of the private sector, investing in energy exploration to keep oil prices low, or buying up hospitals to lower health care costs. Or it could buy all outstanding corporate bonds and book a huge profit, refinancing them with Treasury bonds and putting the default risk on taxpayers – who supposedly charge less than the private market to bear it.
Someone with private equity experience would understand, however, that the market risk inherent in any loan doesn’t magically disappear when the government makes it instead of a private company. In other words, there is only one cost of capital – the price investors charge in the market – and government accounting rules must reflect this fact. A president or cabinet secretary who understands this point would be a great benefit to taxpayers. Executive leadership on this topic would also help Congress update the law so that their official accounting rules for loan programs reflect fair value and include market risk.
A president with private equity experience would surely see this arcane accounting flaw for what it really is: Washington’s favorite way to subsidize more and more of the market without having to spell out the full costs to taxpayers. It’s time for Washington to end this artificial advantage for government-run programs, if for no other reason than to clarify the roles of the government and private sector in the U.S. economy.
Jason Delisle is a project director at the New America Foundation. Christopher Papagianis is Managing Director of e21's New York office.