Barclays is the latest entity to perpetuate the myth that the federal government can earn higher returns on investments than private businesses because it finances them with U.S. Treasury debt. An investment bank should know better.
The government can indeed borrow at the lowest interest rates, and while that looks like an obvious advantage to some, those rates do not reflect the government’s full cost of capital. The Congressional Budget Office explained that fact in a number of recent papers, as have financial economists. They say that valuing government loans (i.e. discounting their expected performance) using only a U.S. Treasury interest rate understates costs to the government, and that the loans should instead be valued with discount rates that match the riskiness of the loan (i.e. fair-value method).
Nevertheless, those arguments are lost on analysts at Barclays. In a recent report (Student Loans: The Dark Side of Good Debt) the bank writes:
We do not necessarily believe that the government should switch to the fair-value method of loan valuation… discounting at Treasury rates is reasonable, given that it is how these projects are actually funded...
Yes, it is reasonable if the loans are funded only with U.S. Treasury debt, but they aren’t. Government loan programs must always be funded in part with taxpayer equity, and that equity has a cost.
Imagine that the federal government sets up a trust to issue bonds that finance its student loan programs. The bonds are backed only by the cash flow from the student loans. The trust cannot tap the federal government for extra funds to repay bondholders should the student loans perform worse than expected.
Investors would certainly charge a higher interest rate to buy the student loan bonds than to buy U.S. Treasury bonds. Investors demand a higher rate because the student loan bonds could default if cash flows from the loans are insufficient to repay bondholders due to higher-than-expected rates of default and delinquency on the loans. A U.S. Treasury bond, on the other hand, is backed by the federal government’s claim on taxpayers’ earnings and will be repaid no matter what happens to the student loans.
Put another way, when the government finances its loan programs with U.S. Treasury debt instead of the hypothetical approach described above, it does not reduce the risks inherent in the student loans – it merely shifts the risks from student loan bondholders to taxpayers. But counting low interest rates on the U.S. Treasury debt as a savings incorrectly treats a shift in risk as a net reduction in risk.
Here is another way to understand that point. Suppose that the government provides a credit enhancement on its hypothetical student loan bonds at no cost to the bondholders in the form of a 100 percent guarantee against default. The interest rates investors demand to buy the bonds would drop to match U.S. Treasury bonds since both are backed by the same guarantee, and bondholders need not worry about the performance of the student loans.
Note that the credit enhancement did not make the student loans less risky – it merely shifted the risk inherent in those loans from student loan bondholders to taxpayers. That makes taxpayers equity investors in the loans. They bear all of the default risk (expected or unexpected) inherent in the student loans while bondholders bear none.
Now assume that taxpayers can charge the federal government for putting their money at risk under the credit enhancement the government offers on the student loan bonds. If taxpayers hired Barclays for advice on what to charge, would the investment bank advise them to charge nothing? In other words, would Barclays tell its taxpayer clients – who assume all of the risk on the student loans – that the risk they are bearing has no cost?
Not a chance. But when it comes to how the government reports the cost of its loan programs, Barclays seems to believe that the government earns its low-cost financing without imposing an equal cost on taxpayers. In essence, the investment bank does not see the government and taxpayers as two sides of the same coin.
Fair-value accounting is meant to guard against exactly that kind of faulty reasoning.
Jason Delisle is the Director of the Federal Education Budget Project at the New America Foundation.