A prior post shows that a much smaller estimate of WIFIA’s likely interest rate re-estimate losses can be developed with a plausible-sounding methodology.  The realpolitik purpose is to provide the basis for a defensive narrative in case of ideological or political attack.

However, there might be another line of attack on WIFIA’s cost that doesn’t rely on the sticker shock of large numbers.  This one would be based on concepts that are close in spirit to the justifications put forward in 2020 by those in Congress who wanted to defund the WIFIA program about delayed criteria for lending to federally involved projects.  There was no discussion about the economic impact of the criteria (there isn’t any), the number of WIFIA loan applications that would be affected (very few – one or two annually) or the cause of the delay (almost certainly unintentional, perhaps pandemic-related).  Instead, the narrative centered on how WIFIA was violating sacred federal budgeting principles, opening the door to all sorts of abuse, disregarding Congressional intent, etc. etc.  None of it was particularly true or important, but that didn’t matter – the attack nearly succeeded.

A new version of the 2020 tactic would point out (with appropriate rhetoric) that WIFIA’s FYE 2022 portfolio will indisputably cost more than the discretionary appropriations allocated for it, and that oversight agencies should investigate the Program’s compliance with the Anti-deficiency Act.

The Anti-deficiency Act’s name is scary enough for plenty of soundbites, and the basic assertion is in fact correct, regardless of how the scale of the cost numbers might be packaged.  But on the surface, WIFIA’s defense is succinct and bulletproof:  FCRA law requires that the cost of interest rate estimates go into an off-budget account (for which permanent indefinite budget authority is provided) and the Anti-Deficiency Act explicitly excludes shortfalls of discretionary appropriations authorized by law.  Case closed, no?

It would seem so, and an attack along these lines is perhaps unlikely.  But I’m not entirely certain that the Program is permanently exempt from questions about the FYE 2022 portfolio’s obvious deficiency of discretionary appropriations.  There’s no doubt that the letter of the relevant law is being followed scrupulously, but is that true for its spirit or intent?  Did the lawmakers who wrote and passed the Anti-deficiency Act, FCRA and WIFIA’s statutes ever anticipate the possibility that a complex interaction of WIFIA loan terms, tax-exempt market rates and large public agency borrowers might check all their prudential boxes yet result in an unintended and massive cost to taxpayers?  Of course not.  And nothing prevents them from revisiting the law or its interpretations with better understanding of the implications of that interaction.

The FCRA Re-Estimate Loss Ratchet – A Predictable Outcome

I’ve often written about the tendency of FCRA re-estimates to be a “one-way ratchet of losses” when loan program borrowers have excellent financing alternatives.  If a borrower has a fixed-rate loan commitment from a loan program that can be drawn over a long construction period and cancelled without penalty at any time, they’ll only draw the loan when it’s cheaper than their current debt alternatives.  WIFIA borrowers are almost exclusively large, highly rated public agencies with excellent access to the tax-exempt bond market, where yields are close to, or even below, the Treasury curve on which WIFIA loans are priced.  Hence, WIFIA loans will only be drawn when their interest rates are below the Treasury rates that are used to calculate FCRA re-estimates, resulting in a loss.  Re-estimates gains at drawdown will be rare enough, but the loss ratchet doesn’t stop there — drawn loans that are more costly than the borrower’s then-current bond alternatives will likely be quickly refinanced.  The portfolio will relentlessly accumulate only those loans that result in a deficit between interest revenue and Treasury funding cost.  Regardless of other glittering metrics, it is a portfolio of interest rate losers.

And not small-time losers, either.  The deficit will be far larger than the Congressional appropriations authorized for the portfolio precisely because the borrowers have such high credit quality.  WIFIA’s discretionary appropriations are primarily allocated to a reserve for projected credit losses, which will be infrequent and minor for highly rated public agencies.  These losses are expected to be less than one percent of the loan amount, which in effect allows a leverage of discretionary appropriations (net of administrative costs) of about 100:1.  But funding losses arise from the entire loan amount.  In effect, the high leverage of the Program’s portfolio, combined with the loss ratchet described above, will result in funding losses that are orders of magnitude higher than discretionary appropriations. 

Obviously, this outcome was not the intent of the lawmakers who passed WIFIA’s statutes.  Did WIFIA’s program managers cynically plan to exploit a FCRA loophole and create a massive portfolio of loss-making loans to highly rated public agencies because loan volume itself is a measure of bureaucratic success?  Almost certainly not.  More likely, they just went with what apparently produced apparently great results in complete compliance with the law and didn’t seem to cost any budget resources.  But original intent, after five years of actual outcomes, is not especially relevant.  The FCRA loss ratchet is now a predictable outcome if WIFIA persists in lending to public-sector borrowers with excellent financing alternatives. The important question is whether anything can or should be done about it.

Re-examining the Law, and Application Thereof

Predictable losses from a federal loan program are naturally consistent with many policy objectives.  But such subsidies require discretionary appropriations – that’s the point of precisely calculating the future expected credit losses of WIFIA loans and allocating current appropriations as a reserve to cover them.  Credit losses are of course a well-understood aspect of making loans, especially for public-sector loan programs that are intended to support worthy but risky borrowers that might not have great access to private-sector alternatives.  Likewise, funding losses from loans are that explicitly priced at less than Treasury yields for policy objectives will require discretionary appropriations.  The FCRA loss ratchet, however, is a relatively complex financial concept that will apply in specific circumstances, and (so far) apparently in scale only at the WIFIA Program.  Apart from the specific losses at WIFIA, is it a problem worth focusing on with respect to fundamental, permanent solutions?

I think it is, for two reasons.  First, if there is a Solyndra-style ideological or political attack, bureaucratic fear will probably curtail interest rate management products at the Program and chill innovation in this area (or anything remotely related) at other programs.  That’s aside from the general discrediting effect on all future infrastructure loan programs.  But if WIFIA’s specific losses are characterized in terms of a larger problem encountered in a new (and very promising) area of federal infrastructure support, and fundamental fixes are being developed, a principle-based defense will deflect a (supposedly) principle-based attack.  The approach also goes beyond WIFIA.  Developing fundamental solutions to loan program budgeting ambiguities are both a useful short-term defensive tactic and a valuable long-term framework to keep the focus on loan program potential.

Second, even if there isn’t an attack, reliance on budgeting loopholes should be discouraged at WIFIA and other infrastructure loan programs.  Resource misallocation is ultimately not sustainable, regardless of the ability to hide federal losses, because it doesn’t produce real-world improvements.  Offering a free version of a loan feature that infrastructure agencies would ordinarily buy in the private sector might be a fun and easy way to build loan volume at a program, but it’s essentially a minor subsidy payment, unlikely to change much in terms of real-world infrastructure outcomes.  If the actual cost of that “free” feature had to be considered, other ways to deploy federal lending strengths would need to be explored by a program and its stakeholders, a path more likely to have a transformative effect.  Impactful policy development at loan programs requires budget discipline.  That discipline and its policy effects are improved if budget guidance is updated with depth and nuance when new situations arise.  

Fundamental solutions should start with the most fundamental law in this case, the Anti-deficiency Act.  Here is a core passage from a 2006 GAO report, Principles of Federal Appropriations Law:

The combined effect of the Anti-deficiency Act, in conjunction with the other funding statutes discussed throughout this publication, was summarized in a 1962 decision. The summary has been quoted in numerous later Anti-deficiency Act cases and bears repeating here:

“These statutes evidence a plain intent on the part of the Congress to prohibit executive officers, unless otherwise authorized by law, from making contracts involving the Government in obligations for expenditures or liabilities beyond those contemplated and authorized for the period of availability of and within the amount of the appropriation under which they are made….”

WIFIA loan commitments that, when drawn as loans, will predictably cause funding losses far in excess of the Program’s appropriations would clearly be prohibited if such losses were not in effect authorized by FCRA law.  I can see why there is an exception to Act’s overall “plain intent” for certain types of federal laws, those pertaining to core obligations like Social Security for example.  But does FCRA naturally belong in that category?  The lawmakers who wrote and passed the FCRA law obviously didn’t think that making loans was a core obligation of the federal government to its citizens.  In fact, FCRA is all about correctly assessing the amount of appropriations required to cover the cost of federal loans.  Yet there’s clear and succinct language in FCRA that provides ‘permanent indefinite budget authority’ (PIA) for interest rate re-estimates.  In effect, FCRA’s exclusion here creates the legal authorization for the Anti-deficiency Act’s exclusion — which in turn exempts WIFIA’s FCRA re-estimate loss ratchet from budget discipline and has allowed the Program to rack up billions in future mandatory appropriations.  How did PIA even get added to the FCRA law?  What was the intent?  How was it meant to be used?

FCRA law itself doesn’t give any indication on the intent of the PIA provision.  But that law is also silent on another budget topic that has arisen at WIFIA, the extent to which loans to federally involved projects can receive FCRA treatment.  To develop criteria for such loans, OMB was instructed by Congress to refer to a foundational document of current federal budgeting, the 1967 Report of the President’s Commission on Budget Concepts.  There’s an entire chapter on federal credit programs in that report which outlines the principles on which FCRA was ultimately closely based.  That seems like the right place to start.

The Commission makes it very clear that the full funding cost of federal loans needs to be calculated and paid for (emphasis added):

It is the Commission’s recommendation that the full amount of the interest subsidy on loans compared to Treasury borrowing costs be reflected and specifically disclosed in the expenditure account of the budget, and furthermore, that it be measured on a capitalized basis at the time the loans are made.

The phrase “at the time the loans are made” is more ambiguous.  Is the loan ‘made’ at the time of commitment?  Or when the loan commitment is drawn?  I think the Commission meant the latter.  Logic would suggest that “Treasury borrowing costs” are most relevant when the loan is being funded, not at the time of commitment, though the basis of future drawdowns (i.e., the loan’s fixed interest rate) is defined at that point.

Yet a loan commitment does create a federal obligation whose full cost requires the allocation of budgeted resources when the commitment is executed.  Since loans intrinsically include future variable factors, their cost is necessarily an estimate.  The Commission put some thought into that, most likely in connection with credit losses:

The Commission also recommends that effective measures be developed to reflect (in the expenditure rather than the loan account of the budget) the further subsidy involved in the fact that Federal loans have a larger element of risk than borrowing. This should be done by creation of allowances for losses and making appropriate credits to those allowances and charges to expense as new loans are extended.

Importantly, note that although the risk of future funding losses is not explicitly mentioned here, such losses are not conceptually different than future credit losses in the context of the Commission’s recommendation.  Federal loans that are drawn many years after commitment have repayment and funding risk.  The extent to which these risks will result in future losses is obviously not known at the time of commitment.  Hence, “effective measures” must be developed to reflect the expected cost as accurately as possible.  Such measures, customized for each borrower and individual loan, have been developed and are in full operation at WIFIA for individual loan credit losses.  “Allowances” for such losses are where the Program’s discretionary appropriations go.  Could equivalent measures be developed for estimating funding losses due to the length of time over which the WIFIA loan commitment can be drawn and considering the borrower’s financing alternatives?  The short answer is ‘yes’ even in the early-computer times of 1967 and certainly now.  Well, why didn’t it happen?

The clear intent of the relevant laws was to include the full cost of a loan in the discretionary budget.  Perhaps the lawmakers didn’t think that post-commitment funding losses would be material, and that the most efficient way to deal with such ‘noise’ was to dump it in an off-budget account with PIA, segregating it from the true budget ‘signal’.  That perspective makes sense given the typical characteristics of federal loans:  

• Federal loan program borrowers don’t usually have good private-sector debt alternatives, never mind excellent ones at near-Treasury rates.  Isn’t the lack of private-sector alternatives the point of loan programs in the first place?  Loan commitments to the typical federal borrower will be drawn (and sincerely appreciated) regardless of whether Treasury rates have risen of fallen.

• The time between loan commitment and drawdown is usually relatively short.  Infrastructure loan programs are rare and relatively recent in the total federal picture.  And even for these, construction loan commitments will be drawn as quickly as possible, regardless of alternative interest rates, because the project simply needs the money.  Likewise, construction loan commitments will only be cancelled if the project failed to proceed, an outcome not usually correlated with interest rates.

• With the two above factors, interest rate re-estimate gains will be about as frequent as losses.  On a portfolio basis, these would generally balance each other over interest rate cycles.  The re-estimate off-budget account might rise and fall at various points, but overall, it will tend to zero.  In that context, FCRA’s PIA for the re-estimate account is simply a smoothing mechanism.

As it turned out over the past five years, WIFIA Program’s typical loans have almost the opposite characteristics to those listed.  I don’t think anybody could have anticipated this outcome, least of all the lawmakers who created the Program. This is reflected in the short interest rate section of WIFIA’s statute, which clearly show the intention that WIFIA loans would at least cover Treasury’s cost of funding them, and discretionary appropriations were required solely for expected credit losses.  The lawmakers would have justifiably assumed that FCRA law, voluminous specific OMB methodology, and the overall intent of the Anti-deficiency Act and its legal framework would take care of the details.

Yet, like flowing water finding unexpected paths and causing hidden damage, WIFIA’s current FYE 2022 portfolio will ultimately cost federal taxpayers far more than Congress ever intended.  What can be done to mitigate the current damage and prevent more in future?

 A Simple, Wrong Answer

The simple answer is to limit (by law or policy) WIFIA’s ability to lend to borrowers that have efficient, near-Treasury alternatives.  The FCRA re-estimate mechanisms will then work as intended.  Future re-estimate gains will occur, and higher yielding drawn loans will stay in the portfolio.  That will stop further accumulation of losses and, over time, could offset some of the FYE 2022 portfolio’s future losses.

As noted above, that limitation is a naturally occurring element of basic policy rationale for federal lending in the first place – if borrowers have such alternatives, they don’t need federal loans, right?  It’s also indirectly indicated in OMB’s Circular A-129, which (among other guidance for federal credit) requires loan program reviews to address:

Why [program objectives] cannot be achieved without Federal credit assistance, including:

(I) A description of existing and potential private sources of credit by type of institution, and the availability, terms and conditions, and cost of credit to borrowers.

(II) An explanation as to whether and why these private sources of financing must be supplemented and/or subsidized.

The simple answer, however, is wrong, or at least an unnecessarily bad policy direction.  In the US, almost all basic public infrastructure is built and operated by state and local public-sector agencies which inevitably have high credit ratings and access to the tax-exempt bond market.  To take these borrowers out of the federal credit policy equation would practically guarantee that essential infrastructure loan programs will not have a significant impact in this critical economic sector.

A Better Approach

Instead of excluding important infrastructure borrowers, improve the programs.  For that objective, WIFIA’s specific issues provide a good framework to refine budgeting methodology and deepen policy rationale for highly rated federal borrowers – a lemonade from lemons approach.  The Program’s past and current travails with federally involved project criteria also provide some guidance as to how the re-estimate issue could play out, but this time towards a positive goal.  A Congressional directive to examine WIFIA’s future funding losses explicitly in the context of solutions that will allow the Program to keep lending to highly rated public agencies would be ideal.  For the immediate future, perhaps budget oversight agencies like OMB and CBO should be involved.  There’s a pre-emptive element to this, of course, but more optimistically they might be helpful in developing solutions that they know they’ll need to sign off on anyway for political reasons.

What might near-term solutions look like?  I can think of three directions that would seem to address WIFIA’s specific issues while laying the groundwork for more universal principles for improving federal infrastructure loan programs:

• Disclosure:  As always, more disclosure is a good place to start, especially with respect to program cost.  But it should not be limited to (or even focused on) FCRA estimates of economic cost, which are important but easily misunderstood in a political context.  Instead, other types of cash-based analyses in the most relevant budgeting period can be highlighted, and other factors (e.g., WIFIA loans’ effect on tax revenue) included.

• Treasury hedging:  If federal infrastructure loan programs are going to offer interest rate management products, Treasury should explore ways to actively manage their risk and cost to taxpayers.  In some ways, WIFIA’s current funding losses could have been substantially reduced if Treasury (working with input from the Program) had hedged loan commitment exposure.  WIFIA itself might not justify an extensive operation, but in the expectation of much-increased federal infrastructure lending, a pilot-scale initiative would be valuable for larger-scale development.  Active hedging at Treasury will likely incur a measurable budgetary cost, but that’s as it should be.  Since Treasury will have vast economies of scale and efficiencies relative to any private sector hedging alternatives, true economic gains are possible.

• Develop unique loan features:  This is the most important and substantive type of solution for both the budget and policy issues of federal lending to highly rated public agencies.  If programs can offer loans with valuable features that have no near-alternatives in the private-sector (a very long term relative to the municipal bond market, for example), borrowers will be reluctant to cancel commitments or refinance drawn debt of such loans simply because interest rates have fallen.  To the extent that such features are also based on relative federal lending strengths (there are a few, and they’re real) net economic gains are also possible.  In many ways, this ought to be overall goal of improving federal infrastructure loan programs.