Fair-Value Cost Estimation and Government Cash Flows: Working Paper 2021-05

By Michael Falkenheim

Under current law, federal agencies estimate the budgetary costs of loans and loan guarantees using the projected yields on Treasury securities to discount future cash flows to the present. That approach recognizes costs when loans originate instead of when cash flows occur, the approach agencies use to account for most other items in the federal budget. Agencies project the future cash flows of loans and loan guarantees as the average of their possible values, weighting different outcomes by their probability. Fair-value budgeting—an alternative to the approach used under current law—measures the costs of loans and loan guarantees more comprehensively by using market prices. Fair-value estimates incorporate market risk, the cost associated with the tendency of assets to perform well when the economy is strong and poorly when the economy is underperforming. People place greater weight on scenarios in which the economy is underperforming. As a result, negative deviations from the average amount of future cash flows outweigh positive deviations if market participants consider the risks associated with future outcomes. Market risk can be understood as the difference between two weighted averages of the same set of possible cash flows. Fair values reflect cash flows that are weighted by the value market participants would place on different scenarios.