Export-Import Bank: OMB's Method for Estimating Bank's Loss Rates Involves Challenges and Lacks Transparency
Published: 2004-09-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Export-Import Bank (Ex-Im Bank) facilitates U.S. exports by extending credit to foreign governments and corporations, mostly in developing countries. The Federal Credit Reform Act requires Ex-Im Bank to estimate its net future losses, called "subsidy costs," for budget purposes. Beginning with fiscal year 2003, the Office of Management and Budget (OMB) significantly changed its methodology for estimating a key subsidy cost component: the expected loss rates across a range of risk ratings of U.S.-provided international credits. In response to a congressional mandate, GAO agreed to (1) describe OMB's current and former methodologies and the rationale for the recent revisions, (2) determine the current methodology's impact on Ex-Im Bank, and (3) assess the methodology and how it was developed.
section_title: What GAO Found
paragraphs: OMB changed its method for determining expected loss rates for U.S. international credits, with one basis being that emerging finance literature indicated the former approach might overstate losses to the government. While it formerly used only interest rate differences across bonds to derive expected loss rates, it now uses corporate bond default data, adjusted for trends in interest rates, to predict defaults and makes assumptions regarding recoveries to estimate expected loss rates. As the figure shows, expected loss rates fell under the new approach: they were higher across risk rating categories in fiscal year 2002 (the last year that the former method was used) than in fiscal year 2005. This drop has contributed to lower Ex-Im Bank projections of subsidy costs and budget needs. OMB's current method for estimating expected loss rates involves challenges and lacks transparency. Estimating such losses on developing country financing is inherently difficult, and OMB's shift to using corporate default data has some basis, given the practices of some other financial institutions and limitations in other data sources. However, the corporate default data's coverage of developing countries has historically been limited, and their predictive value for Ex-Im Bank losses is not yet established. OMB's method generally predicts lower defaults than the corporate default data it used, whereas more recent corporate data show higher default rates. At the same time, OMB has assumed increasingly lower recovery rates, which serve to somewhat offset the lower default expectations, but the basis for the recovery rates and the changes over time has not been transparent. In addition, despite the method's complexity, OMB developed it independently and provided affected agencies with limited information about its basis or structure.

section_title: Letter
paragraphs: As the official U.S. export credit agency (ECA), charged with providing  financing to facilitate U.S. exports, the Export-Import Bank (Ex-Im Bank)  issues loans, guarantees, and insurance products to foreign governments  and corporations, primarily in developing countries. As of September 30,  2003, Ex-Im Bank had a portfolio of about $61 billion. Like any credit  institution, the bank expects that some of the credit it offers will not be  repaid, and it estimates these future losses for federal budget purposes  according to the Federal Credit Reform Act of 1990. The act requires that  prior to entering into loans or loan guarantees, Ex-Im Bank must have  budget authority for its “subsidy costs”—broadly speaking, estimates of net  losses on a present value basis.The Office of Management and Budget  (OMB) has overall responsibility for coordinating cost estimates under  credit reform and plays a unique role in determining the subsidy costs of  Ex-Im Bank and other federal agencies that offer international credit—it  provides these agencies with expected loss rates, a key component of their  subsidy costs. For the fiscal year 2003 budget, OMB significantly changed  its methodology for determining these rates.In its annual financial  statements, Ex-Im Bank also accounts for future expected losses by  establishing loss allowances in accordance with private sector accounting  standards.
The Export-Import Bank Reauthorization Act of 2002 directed GAO to  report on the bank’s “reserve practices,” which include its approach for  estimating subsidy costs. In response, we agreed to (1) describe OMB’s  current and former methodologies for estimating expected loss rates for  U.S. credit agencies’ international credit and the rationale for the recent  revisions, (2) determine the impacts of the current methodology on Ex-Im  Bank, and (3) assess the current methodology and the process by which it  was developed. We also agreed to provide information on foreign ECA and  commercial bank practices for estimating expected losses.
To describe and assess OMB’s current methodology for estimating  expected loss rates, we obtained and evaluated analytical papers and OMB  data and assumptions and discussed this information with OMB  representatives. We reviewed an OMB paper that described the current  methodology in theoretical terms and obtained more complete information  by, on several occasions, posing questions to technical staff through OMB’s  Office of General Counsel. While we obtained sufficient information to  generally describe and assess key aspects of the methodology, we did not  replicate or validate it. We also did not determine the reasonableness of  specific loss rates that OMB has estimated. We note in the report where our  description of certain aspects of the methodology is incomplete, but these  areas were not material to our conclusions. We discussed the development  of OMB’s loss estimation methodology with knowledgeable U.S.  government officials. We also reviewed relevant research and discussed  key issues with selected commercial banks, foreign ECAs and related  government agencies, and credit experts. To determine the impact of the  current methodology on Ex-Im Bank, we analyzed the bank’s budget and  financial statement documents and discussed them with bank officials.  Appendix I provides a more detailed description of our scope and  methodology; appendixes II and III contain descriptions of foreign ECA  and commercial bank practices for estimating expected losses. We  conducted our review from November 2002 through March 2004 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Established in 1934, Ex-Im Bank is an independent U.S. government  corporation that serves as the official ECA of the United States. Its mission  is to support the export of U.S. goods and services overseas, thereby  supporting U.S. export sector jobs. Ex-Im Bank’s mandate states that it  should not compete with the private sector but rather assume the credit  and country risks that the private sector is unable or unwilling to accept.  Ex-Im Bank offers various financial products, such as direct loans, loan  guarantees, export credit insurance, and working capital guarantees, to  foreign buyers of U.S. goods and services and to U.S. exporters. In the last  decade, new Ex-Im Bank authorizations of loans, guarantees, and  insurance averaged nearly $12 billion per year.
Because of its mandate, a large percentage of Ex-Im Bank’s business is with  developing country borrowers that are typically considered more risky  than borrowers in developed countries. Nearly 80 percent of Ex-Im Bank’s  medium- and long-term exposure at the end of fiscal year 2003 was to  borrowers from low- and middle-income countries. According to Ex-Im  Bank officials, the types of borrowers it finances within countries have  shifted over the last decade: whereas Ex-Im Bank historically financed  foreign government (sovereign) purchases of U.S. exports, its new  financing is now primarily for purchases by private sector borrowers. This  shift is gradually being reflected in Ex-Im Bank’s portfolio of outstanding  credits, which at the end of fiscal year 2003 included about 36 percent in  financing to sovereign governments, about 46 percent in financing to  foreign corporations, and about 18 percent in financing to public sector,  nonsovereign borrowers.
Both sovereign and private borrowers present some risk of failing to meet  payment obligations (i.e., defaulting), potentially causing a financial loss  for Ex-Im Bank and the U.S. government.In 1990, to more accurately  measure the cost of federal credit programs, the government enacted credit  reform, which required agencies that provide domestic or international  credit, including Ex-Im Bank, to estimate and request appropriations for  the long-term net losses, or subsidy costs, of their credit activities.According to credit reform, Ex-Im Bank incurs subsidy costs when  estimated payments by the government (such as loan disbursements)  exceed estimated payments to the government (such as principal  repayments, fees, interest payments, and recovered assets), on a present  value basis over the life of the loan. For each credit activity, Ex-Im Bank  assesses the potential future losses based on the risk of the activity. It  collects up-front fees or charges borrowers higher interest rates, or both, to  offset that loss and receives subsidy appropriations to cover remaining  losses.
Credit reform requires credit agencies to have budget authority to cover  subsidy costs before entering into loans or loan guarantees. Credit  agencies, in their annual appropriations requests, estimate the expected  subsidy costs of their credit programs for the coming fiscal year. Credit  reform also requires agencies to annually reestimate subsidy costs of  previous financing activity based on updated information. When  reestimated subsidy costs exceed agencies’ original subsidy cost estimates,  the additional subsidy costs are not covered by new appropriations but  rather are funded from permanent, indefinite budget authority.
To estimate their subsidy costs, credit agencies estimate the future  performance of direct and guaranteed loans. Agency management is  responsible for accumulating relevant, sufficient, and reliable data on  which to base these estimates. To estimate future loan performance,  agencies generally have cash flow models, or computer-based  spreadsheets, that include assumptions about defaults, prepayments,  recoveries, and the timing of these events and are based on the nature of  their own credit program. Agencies that provide credit to domestic  borrowers generally develop these cash flow assumptions, which OMB  reviews, based on their historical experiences. For U.S. international  credits, OMB provides the expected loss rates, which are composed of  default and recovery assumptions, that agencies should use to estimate  their subsidy costs.
The determination of expected loss rates for federal agencies that provide  international credit has two components: the assignment of risk ratings for  particular borrowers or transactions and the determination of loss rates for  each rating category, according to the maturity of the credit. Both of these  components, and their relationship to one another, are important in  determining overall expected losses. For Ex-Im Bank, risk ratings are  determined partly through an interagency process and partly by Ex-Im  Bank’s risk management division. The appropriateness of these ratings is a  key determinant in the overall appropriateness of Ex-Im Bank’s subsidy  cost estimations.
Through the Interagency Country Risk Assessment System (ICRAS),which OMB chairs, ICRAS agencies determine risk ratings that will be in  effect each fiscal year (see box 1 in fig. 1). There are two types of ICRAS  ratings—one for foreign government (sovereign) borrowers and one for the  private sector climates in foreign countries. Ratings range from 1 (least  risky) to 11 (most risky). Ratings for sovereign borrowers are based on  macroeconomic indicators, such as indebtedness levels; balance-of­ payments factors; and political and social factors. In determining ratings,  the agencies take into account country risk ratings assigned by private  sector ratings agencies and by the Organization for Economic Cooperation  and Development (OECD). Private sector ratings assigned through the  ICRAS process also take into account factors such as the banking system  and legal environment in a country. Ex-Im Bank generally authorizes, with  few exceptions, new business for borrowers with ICRAS ratings of 8 or  better. (App. IV contains more information about the ICRAS risk rating  process.)
For Ex-Im Bank’s financing with foreign governments, the ICRAS sovereign  risk rating applies. For Ex-Im Bank’s private sector lending, Ex-Im Bank  officials assign risk ratings. According to Ex-Im Bank officials, they use  private rating agency ratings for a corporation when the ratings are  available, which is the case for a minority of borrowers. For most private  sector borrowers, Ex-Im Bank officials use the private sector ICRAS rating  as a baseline and adjust that rating depending on their assessment of the  borrower’s creditworthiness.
For the second component, OMB plays a key role. It determines expected  loss rates for each ICRAS risk rating and maturity, which U.S. agencies that  provide international credit use in preparing their subsidy cost estimates  (see fig. 1, box 2). OMB provides these loss rates to ICRAS agencies each  fiscal year, in time to be used in preparing budget submissions. To  estimate future cash flows, ICRAS agencies use OMB’s expected loss rates  in their cash flow models. The loss rates are also used to allocate subsidy  costs during the fiscal year and to calculate subsidy cost reestimates at the  end of the fiscal year. OMB also provides agencies with a credit subsidy  calculator, which has been audited, that agencies use to convert agency­ estimated cash flows into present values.
The credit reform act resulted in the establishment of a special budget  accounting system to track inflows and outflows associated with agencies’  lending activities. Expected long-term subsidy costs for financing activities  in a fiscal year appear in an agency’s annual budget submission and are  subject to congressional approval. However, any increases over time in  expected subsidy costs for financing that took place in earlier years are  financed from permanent indefinite budget authority and do not have to be  appropriated in the annual appropriations process. In the case of Ex-Im  Bank, such changes could result, for example, from changes in the risk  assessment for certain countries or changes in loss assumptions for a given  risk level. (App. V contains additional information about the credit reform  budget accounting system.)
In addition to estimating expected losses for budgetary purposes, Ex-Im  Bank measures the expected loss of its portfolio in its own annual audited  financial statements. As a government corporation, Ex-Im Bank is required  to follow “principles and procedures applicable to commercial corporate  transactions.” Ex-Im Bank’s financial statements are prepared according  to private sector generally accepted accounting principles (GAAP) that  require Ex-Im Bank to follow Financial Accounting Standards Board  (FASB) accounting guidance when establishing allowances for future  expected credit losses.
section_title: OMB Developed New Method That Lowered Expected Loss Rates
paragraphs: OMB developed its current methodology for determining expected loss  rates for ICRAS agencies, which lowered these rates, based in part on  evidence that its former approach overstated likely defaults and losses. For  fiscal years 1992-2002, OMB based its expected loss estimates on  differences between interest rates on bonds of different risk levels. In  developing its current approach, OMB cited emerging academic literature  that indicated its former approach may have overestimated likely costs to  the government. Ex-Im Bank officials also said they believed, based on  their reestimates, that their subsidy cost appropriations had been too high  relative to their loss experience since the beginning of credit reform. OMB’s  current approach uses historical corporate bond default data, adjusted for  trends in interest rate spreads, to predict defaults and applies an  assumption regarding recovery rates to estimate expected loss rates. Under  the current approach, loss rates across most risk categories dropped  significantly.
subsections: section_title: OMB’s Former Methodology Based Expected Loss Estimates on Differences in Bond Interest Rates
paragraphs: The method that OMB used in fiscal years 1992-2002 based expected loss  rates for ICRAS agencies on interest rate spreads between publicly traded  U.S. corporate or foreign government bonds and low-risk bonds such as  U.S. Treasury bonds.Under this method, estimates of expected loss  shifted as the underlying spread data shifted. Interest rate spreads are an  indicator of expected loss, in that the size of a spread tends to widen as the  perceived risk increases. For example, when interest rates on a foreign  bond are 6 percent and U.S. Treasury bond interest rates are 5 percent, the  spread between the two is 1 percentage point. The foreign bond in this  example provides a higher rate of interest than the U.S. Treasury bond  because creditors require a higher return on their capital, at least in part  because they perceive that foreign bonds carry a higher risk of non­ repayment.
Spreads fluctuate over time depending in part on changes in market views  of borrowers’ creditworthiness. Figure 2 shows interest rate spreads for  Argentine, Russian, and Mexican government bonds over U.S. Treasury  bonds from 1999-2003, illustrating how spreads can fluctuate. Spreads  increased sharply in 2001 for the Argentine bonds, as Argentina’s default on  those bonds was imminent. Conversely, the spread for the Russian bonds  shown narrowed over the period as Russia’s economy improved, while the  spreads for the Mexican bonds were consistently the smallest of the three  countries.
OMB has used varying underlying instruments to calculate bond spreads  and expected losses for ICRAS agencies. In the beginning of credit reform,  OMB used the spreads on U.S. corporate bonds at different risk levels to  estimate risk premia (and thus expected loss). That is, OMB determined  the interest rate spread for U.S. corporate bonds within a risk rating  category and used those spreads to compute a risk premium for each  ICRAS category. In fiscal year 1997, OMB began using the interest rate  spreads on other instruments, including foreign government bonds.
After interest rates on some types of international bonds rose in the late  1990s, OMB determined that basing expected loss rates only on interest  rate spreads resulted in estimates that were too high. According to OMB, it  was decided in the discussions within the executive branch and with  Congress leading to credit reform that only the expected cost to the  government was relevant for estimating default losses to the government  under credit reform. OMB decided to change its method for determining  default losses, primarily because emerging research showed that factors  other than expected losses from defaults account for a significant portion  of interest rate spreads. According to this literature, differences in  liquidity and tax considerations, and an aspect of credit risk that OMB  termed “portfolio risk,” affect interest rates on international bonds.
Studies cited by OMB and other related literature indicate that factors  other than expected losses from defaults account for a high proportion of  interest rate spreads—in some cases, most of the spread—especially on  higher-quality bonds. For bonds with risk ratings that correspond to the  riskier ICRAS rating categories, 5 and higher (riskier), conclusions from the  literature that OMB cited and other literature that we reviewed are less  clear. One study cited by OMB found that differences in tax treatment, and  compensation for risk beyond expected losses, explained most of interest  rate spreads; however, because of limited data, that study did not include  bonds in risk categories higher than those corresponding to ICRAS  category 4. A second study cited by OMB found that market interest rate  spreads on bonds were greater than those that would be predicted based  on corporate default data. The differences were particularly apparent for  bonds in investment-grade categories and were smaller for speculative­ grade bonds.
For the fiscal year 2002 budget, OMB imposed an across-the-board  reduction in the expected loss estimates for ICRAS risk categories 1  through 8. OMB said that it did this to eliminate part of the spread  between other bonds and U.S. Treasury bonds to come closer to measuring  only default cost. The risk factors and expected loss estimates for the  bottom three categories did not change.
A further rationale for adjusting the expected loss rates, according to Ex- Im Bank officials, was that the bank had calculated several downward  reestimates of its subsidy costs since the inception of credit reform. They  viewed this as evidence that the bank’s original subsidy cost estimates were  conservative. According to Ex-Im Bank officials, several factors influence  the bank’s subsidy cost reestimates, including changes in the outstanding  balance of its cohorts (the term “cohort” refers to the financing extended in  a given fiscal year, which Ex-Im Bank further subdivides by product type);  changes in cohort performance or average riskiness; and changes in OMB’s  expected loss rates. Ex-Im Bank calculated a net downward reestimate of  about $368 million in fiscal year 1999, followed by a larger net downward  reestimate of about $1.4 billion in fiscal year 2000 and a subsequent net  downward reestimate of about $300 million in fiscal year 2001. (In these  years, upward reestimates of some cohorts were more than offset by larger  downward reestimates of other cohorts.) There were small net downward  and upward reestimates in fiscal years 1992 through 1995, and Ex-Im Bank  did not calculate reestimates in fiscal years 1996 through 1998. Ex-Im  Bank’s reestimates represent the bank’s ongoing assessment of the  riskiness of its post-credit reform financing at a given point in time and are  not a final assessment of the performance of cohorts that have not reached  maturity at the time of the reestimate. An Ex-Im Bank official noted that  future claims or defaults could occur on cohorts that have not reached  maturity, possibly causing upward reestimates to certain cohorts in the  future.
section_title: OMB’s Current Methodology Bases Expected Loss Rates on Corporate Default Data, Interest Rate Spreads, and Recovery Assumptions
paragraphs: OMB’s current methodology uses rating agency corporate default data and  interest rate spreads to estimate default probabilities and makes  assumptions about recoveries after default to estimate expected loss rates.  The methodology estimates default rates for federal international credits  using a complex model that OMB developed. These rates were generally  lower for fiscal years 2004 and 2005 than the underlying corporate default  rates that OMB used in estimating its rates. OMB introduced its current  methodology, which estimates expected loss rates for ICRAS categories 1  through 8, for use in fiscal year 2003, and made modifications for fiscal  years 2004 and 2005. (App. VI contains a technical description of the  methodology.)
subsections: section_title: OMB Model Bases Default Estimates on Corporate Default Data and Spreads
paragraphs: OMB uses rating agency corporate default data and information on interest  rate spreads to determine expected defaults through a complex model. The  model has two empirical relationships, one between ratings and defaults  and the other between interest rate spreads and defaults. The model  combines the relationships to arrive at OMB’s expected default rates across  ICRAS risk categories. Historical default rates on corporate bonds by risk  rating category are the key inputs to both components of the model.
The first component of the model bases the probability that ICRAS agency  borrowers will default on default rates for corporate bonds published in  2000 by a nationally recognized private rating agency, Moody’s Investors  Service. The risk categories associated with the Moody’s corporate default  probabilities are converted to ICRAS risk categories. OMB’s model uses  two Moody’s data series on U.S. corporate bond defaults, which OMB  combined into a single series. The data series used for the four lowest-risk  ICRAS categories (1-4) includes default rates on rated corporate bonds by  risk rating category during 1920-1999. The data series used for the next four  (higher risk) ICRAS categories (5-8) includes default rates on rated  corporate bonds by risk rating category during 1983-1999.
The second component of the model uses data on interest rate spreads to  make adjustments to the same Moody’s historical default data. The current  method does not use spread information as the primary indicator of default  risk, as OMB’s former method did. Instead, it uses spread information as a  signal of how current market conditions might differ from those reflected  in the Moody’s historical data. The model is designed to adjust historical  default rates by rating category up or down in cases where interest rate  spreads in a category are unusually high or low relative to the average  spreads for that category. The adjustment in the model gives greater  weights to more recent spreads in calculating the averages. To estimate this  relationship, OMB used interest rate data on international bonds from  Bloomberg.
The default probabilities reflected in OMB’s expected loss rates for fiscal  years 2004 and 2005 were generally lower than the corporate default rates  that OMB used in its model. Figure 3 illustrates OMB’s fiscal year 2004 and  2005 default probabilities for 1-8 years for three ICRAS ratings categories  and the Moody’s corporate default rates for corresponding risk  categories. The graph shows that OMB default probabilities are somewhat  lower than the corporate default rates for the ratings categories shown.  (App. VII presents similar comparisons for ICRAS categories 1-8.) Based on  information we obtained on OMB’s model, this difference would be  expected to result from interest rate spreads’ trending significantly  downward for some rating and maturity categories. It could also result  from features of the model specification. We could not determine the  reasons for the difference because we did not replicate OMB’s model and,  in response to our questions, OMB did not identify specific reasons for the  differences. (App. VI contains more information about model specification  issues.)
After determining expected default rates, OMB combines the default rates  with an assumption about the recovery rate—the percentage of defaulted  principal and interest that will be recovered over time—to obtain expected  loss rates.The assumed recovery rate is a key driver of the expected loss  rates. OMB assumed an across-the-board recovery rate of 17 percent for  the fiscal year 2003 budget—that is, the government was expected to lose  $830 and recover $170 for every $1,000 in defaulted credits. It assumed  lower recovery rates of 12 percent for the fiscal year 2004 budget and 9  percent for the fiscal year 2005 budget.
section_title: OMB’s Current Methodology Lowered Expected Loss Rates
paragraphs: OMB’s current methodology reduced the loss rates that U.S. credit agencies  are expected to incur on international credits they provide. Between fiscal  years 2002 and 2005, expected loss rates fell across ICRAS risk categories 1  through 8. As shown in figure 4, expected loss rates for credits of 8-year  maturity were, on average, about 58 percent lower on a present value basis  in fiscal year 2005 than 2002 (the last fiscal year in which OMB used its  former approach to develop the loss rates).The largest declines were in  risk categories 1 through 5. Expected loss rates for ICRAS agencies have  varied over the credit reform period. (See app. VIII for information on  trends in expected loss rates for ICRAS agencies between fiscal years 1997  and 2005.) fiscal year 2004 would be expected to push loss rates upward. Expected  loss rates in fiscal year 2005 were generally similar to those in fiscal year  2004, with slight declines for some risk categories. Although OMB’s model  generated lower default rates for fiscal year 2005 than for fiscal year 2004, a  further decrease in its recovery rate assumptions resulted in little change to  expected loss rates in fiscal year 2005.
section_title: Current OMB Methodology Has Lowered Ex-Im Bank’s Projected Subsidy Costs and Budgetary Needs
paragraphs: By lowering loss rates for most ICRAS risk categories, OMB’s current  methodology has contributed to lower Ex-Im Bank projections of subsidy  costs and, therefore, lower budgetary requirements. Ex-Im Bank’s  obligation of budget authority for new subsidy costs declined significantly  for fiscal year 2003, when the current methodology took effect. In addition,  Ex-Im Bank calculated a large downward reestimate of the subsidy costs of  its outstanding portfolio at the end of fiscal year 2002 using the new loss  rates. With lower loss rates, Ex-Im Bank’s fees are generally projected to  provide greater coverage of expected losses, fully offsetting losses in some  budget categories. Finally, during this period, Ex-Im Bank modified its  approach for calculating loss allowances in its financial statements. This  involved making certain changes to be more in line with applicable  accounting standards and, because of the changed nature of OMB’s loss  rates, using different and higher loss rates than it used in its budget  documents to calculate subsidy costs.
subsections: section_title: Lower OMB Loss Rates Reduce Ex-Im Bank Budget Authority Needed to Cover Subsidy Costs
paragraphs: Partially because of OMB’s lower loss rates, Ex-Im Bank required less  budget authority to cover its lower subsidy costs. Estimates and obligation  of budget authority for subsidy costs are determined by the amount and  risk of business the bank expects to, or does, undertake in a year, as well as  expected loss rates and fees charged to borrowers. Changes in any one of  those factors can alter budget needs. According to Ex-Im Bank officials,  OMB’s lower loss rates were a key determinant in the declines in its subsidy  cost estimates, its budget authority obligated for new subsidy costs, and its  2002 reestimate of subsidy costs. amount of budget authority carried over from the previous fiscal year. Ex- Im Bank requested no new subsidy budget authority in fiscal year 2004 but  anticipated $460 million in new subsidy cost obligations.The amount of  budget authority carried over from previous fiscal years was seen as  sufficient to cover anticipated fiscal year 2004 subsidy costs. Ex-Im Bank  requested $126 million for subsidy budget authority in fiscal year 2005, but  it anticipated $491 million in obligations for subsidy costs. The bank  continued to have a significant amount of budget authority carried over to  fund the difference.
In addition, Ex-Im Bank’s obligation, or usage, of budget authority for new  subsidy costs dropped when the current methodology took effect, as  shown in figure 5. The bank’s obligation of subsidy budget authority had  dropped in fiscal years 2001 and 2002, in part because of reductions in new  financing in those years. Its obligation of budget authority for new subsidy  costs in fiscal year 2003 was about 55 percent lower than in fiscal year  2002, even though the total amount of its new financing, and Ex-Im Bank’s  estimate of its average risk level, in these two fiscal years was similar.
According to Ex-Im Bank officials, OMB’s lower loss rates also contributed  to a significant downward reestimate of the subsidy costs of the bank’s  outstanding credits, based on its first subsidy cost reestimate that used the  lower rates. At the end of fiscal year 2002, using the OMB loss rates for  fiscal year 2004, Ex-Im Bank calculated a net downward reestimate of  about $2.7 billion, significantly lowering its estimated subsidy costs for  outstanding credits. Downward reestimates on long-term guarantees  represented about 72 percent of the reestimate. About 63 percent of the  reestimate was calculated on financing extended between fiscal years 1997  and 2001, much of which has likely not yet matured.
section_title: With Lower Loss Rates, Ex- Im Bank Fees Are Projected to Provide Greater Coverage of Losses
paragraphs: With the decline in OMB’s loss rates, Ex-Im Bank’s exposure fees are  projected to generally provide greater coverage of its expected losses.The determination of the relationship between exposure fees and expected  losses and, thus, the calculation of budget subsidy cost, depends on the risk  rating for specific Ex-Im Bank transactions. Ex-Im Bank generally sets its  exposure fees at, or in the case of some corporate transactions slightly  above, the minimum level required by an agreement among certain OECD  member countries.
This agreement among OECD countries was designed to increase  transparency and provide common benchmarks for ECA exposure fees,  thereby reducing fee competition among exporters. Participating ECAs  may charge fees above the OECD minimum if they do not view the fees as  sufficient to cover their expected losses on a given transaction, but they are  expected to charge at least the minimum. For private sector transactions,  participating ECAs that we spoke with often charge fees above the OECD  minimum fees. (See app. II for additional information on the OECD  minimum fee determination process.)
Using fiscal year 2005 expected loss rates, Ex-Im Bank exposure fees at the  OECD minimum fee level would be projected to fully cover expected losses  in ICRAS categories 1–5 in certain cases (see fig. 6). In comparison, using  fiscal year 2002 expected loss rates, Ex-Im Bank exposure fees at the  OECD minimum fee level were projected to cover expected losses only for  ICRAS category 1.
The degree to which Ex-Im Bank’s exposure fees are projected to cover its  expected losses may differ from this illustration, depending on the type of  borrower or transaction. For example, when Ex-Im Bank assigns a  corporate borrower a higher risk rating than that of the country where the  borrower is located, the bank may incur subsidy costs in more risk  categories or may incur larger subsidy costs for corporate borrowers rated  in categories 6 through 8. This is because Ex-Im Bank charges fees for  corporate transactions that are close to the OECD minimum fee for the  country in which the corporate borrower is located, even when the  transaction has a higher (riskier) rating than the country. In addition, the  OECD guidance does not apply to some transactions, notably aircraft  financing.
In generally setting exposure fees at or near the OECD minimum level, Ex- Im Bank charges fees that are among the lowest of ECAs. Ex-Im Bank’s low  pricing relative to other ECAs has been noted for some time. According to  U.S. and OECD officials, whereas Ex-Im Bank previously appeared to face  some pressure to charge higher fees because of its budget costs (and  appeared to support raising the minimum OECD fees as well), the lower  budgetary costs of Ex-Im Bank’s activities have lessened this pressure.
section_title: Ex-Im Bank Modified Its Method for Determining Financial Statement Loss Estimates, Generally Using Higher Loss Rates Than for Budget Calculations
paragraphs: Beginning with its 2002 financial statements, Ex-Im Bank modified its  approach for calculating loss allowances, which involved segmenting its  portfolio in line with applicable accounting standards and diverging from  its former practice of using OMB loss rates to calculate these allowances.  Because Ex-Im Bank prepares its financial statements according to private  sector, rather than federal, accounting principles, there has always been  some difference between the bank’s subsidy cost and loss allowance  estimates. This is because of differences in the treatment of fee income  between private sector and federal accounting approaches. While Ex-Im  Bank is not required to use OMB loss rates when calculating financial  statement loss allowances, Ex-Im Bank officials said that they had  historically chosen to do so in order to link the loss estimates prepared for  budget purposes with the financial statement loss allowances. However, in  its 2002 financial statement, Ex-Im Bank began applying higher loss rates  than OMB’s loss rates to most of its portfolio. Ex-Im Bank officials said that  with the modification, its approaches to calculating subsidy costs and loss  allowances differ not only in fee treatment but also in their expectations of  loss.
According to Ex-Im Bank officials, the bank modified its financial  statement loss allowance methodology for two reasons. First, Ex-Im Bank  discussed with its new auditors, Deloitte & Touche, the bank’s approach for  accounting for guarantees and insurance, which comprise a majority of the  bank’s portfolio. They determined that relevant accounting standards  suggested that it would be appropriate to record these credits at their fair  market value. This called for using different loss rates than those derived  using OMB’s current methodology, which focuses on credit loss. Second,  the bank determined that it should value its impaired credits in a manner  more consistent with relevant accounting standards. Deloitte & Touche  observed that Ex-Im Bank had not historically separated its portfolio into  impaired and unimpaired groupings in accordance with accounting  guidance, even though a significant portion of these loans and claims were  likely impaired. Total loans and claims represented, on average, about 24  percent of the bank’s total exposure during fiscal years 1999-2003.
In addition, when initially estimating its 2002 loss allowances using its  former approach and OMB’s fiscal year 2003 loss rates, Ex-Im Bank  determined that its allowances would have dropped substantially, from  about $10 billion for 2001 to about $6 billion for 2002, a decrease of about  40 percent. Because of the size of the reduction and the importance of loss  allowances as an overall reflection of an institution’s expected loss from  year to year, the bank’s auditor identified this as a key area to be reviewed.
Ex-Im Bank’s approach for calculating its loss allowances, beginning with  the 2002 financial statement, used different loss rate methodologies for  different parts of its portfolio and distinguished between impaired and  unimpaired credits. To determine the loss allowances for its impaired  loans and claims and for all of its loan guarantees and medium- and long­ term insurance, Ex-Im Bank applied higher loss rates than those that were  used in 2001. These higher rates were used to calculate about 95 percent of  the 2002 loss allowance. Ex-Im Bank had asked OMB to provide these  higher rates using its former, spread-based methodology. Ex-Im Bank  officials stated that the spread-based loss rates were more appropriate for  its outstanding guarantees and insurance because they provided a more  market-based valuation that was better suited to a fair value presentation.  To determine the 2002 loss allowances for its unimpaired loans and claims,  Ex-Im Bank applied OMB’s expected loss rates for the fiscal year 2004  budget. These rates were generally lower than the rates used to calculate  the loss allowance in 2001. For 2002, the bank’s loss allowances were about  6 percent higher than their 2001 level. For 2003, loss allowances were about  4 percent lower than their 2002 level.
section_title: Loss Estimation Involves Challenges and OMB Methodology Is Not Transparent
paragraphs: OMB’s methodology for estimating the expected loss rates for international  credits provided by U.S. agencies involves challenges, and it is not  transparent. Assessing the risk of such credit activity, particularly in  developing countries, is inherently difficult. Corporate default data similar  to those used by OMB are also used by other financial institutions to assess  risk, because of the data’s broad coverage and limitations in other data  sources. However, historically, the data have been based largely on the  default experiences of U.S. firms, and the data’s historical coverage of  developing countries has been limited. In addition, more recent Moody’s  data than were used in estimating OMB’s model show higher defaults in  some risk categories. In choosing this data to predict default, OMB  analyzed Ex-Im Bank defaults over a somewhat narrow period. In addition,  while OMB has assumed increasingly lower recovery rates since  implementing its method, its basis for the recovery rates and changes in  them has not been transparent. Finally, despite its complexity and the  changes it implied, OMB developed the current methodology  independently and provided ICRAS agencies with limited information  about the methodology.
subsections: section_title: Assessing ECA Financing Risk is Difficult, and Data Used by OMB May Have Inherent Limitations for Predicting Ex-Im Bank Risk
paragraphs: Assessing ECA financing risk presents data challenges. Available indicators  of default risk, including certain financial institutions’ own financing  histories, often have limitations. Historical data on corporate bond  defaults, while used by many institutions, may also have inherent  limitations for assessing risk in developing countries, because these data  have historically been based primarily on corporations in higher-income  countries. In addition, corporate default data now show higher defaults in  certain higher-risk categories than the data OMB used. OMB’s analysis  showing comparability between those data and Ex-Im Bank default  experience was based on Ex-Im Bank credits primarily from a relatively  narrow period in the 1990s and did not include other ICRAS agencies. OMB  representatives, in providing oral technical comments on a draft of this  report, said that they inquired about available default data at other ICRAS  agencies but were unable to obtain it. OMB’s staff paper noted the  desirability of adding data from other agencies to its analysis in the future.
Assessing ECA Financing Risk Is  Data limitations and changing environments present challenges for  Difficult  estimating the risk of ECA financing, according to experts and officials  with whom we spoke. Some noted that ECA risk may differ from private  bank risk, in that ECAs may be more exposed to emerging markets and  may have less diversified portfolios, in part because of concentrations of  exposure to particular industries. Officials said that many ECAs incurred  large losses during the 1980s debt crisis, and some did so in the 1990s  during the Asian financial crisis and other instances of sovereign default.  Moreover, the move among some ECAs, including Ex-Im Bank, toward  extending more credit to corporate or other nonsovereign borrowers,  rather than primarily providing financing to sovereign governments, adds  further complexity to estimating risk. According to several ECA officials,  corporate activity may involve different risks, which include potentially  greater difficulty in recovering assets in cases of default.
Some ECAs and other financial institutions lack data on their own  financing that are of sufficient historical coverage and reliability for  predicting the risk of future financing activities. In addition, a lack of risk  ratings for financing in earlier decades can complicate the use of available  historical data. Historical data on the default experience of sovereign bond  issuers might be useful in estimating ECA credit risk, and ratings agencies  now publish such data. However, according to several experts, the limited  risk rating history of sovereign bond issuers is a significant limitation to  relying on this data to assess risk in developing countries. Almost no  developing country sovereign bond issuers have ratings histories that begin  before the early 1990s.
subsections: section_title: Corporate Bond Default Data Are Widely Used but Lack Broad Historical Coverage of Developing Countries
paragraphs: Corporate bond default rates from nationally recognized rating agencies  are widely used by financial institutions in assessing risk but may have  certain inherent limitations for predicting defaults in developing countries.  Institutions use the data because of the large number of firms and long  historical coverage in the rating agencies’ databases. However, while  international corporations are now well represented in these data, the data  historically have included primarily U.S. firms. For data with international  coverage, the coverage has historically been largely of high-income country  borrowers. One study of a major rating agency database found, for  example, that 94 percent of the nonbank firms rated were in high-income  countries, 5 percent were in upper-middle-income countries, and 2 percent  were in lower-middle-income countries. The data’s more limited historical  coverage of developing country default experiences may limit the  predictive value of the data for such countries, according to some officials.  Officials from one institution said that although they used corporate bond  data in determining expected default rates, whether countries were in  emerging markets was a consideration in their adjustments of the default  rates to reflect their own performance expectations.
section_title: More Recent Moody’s Data Show Higher Defaults in Some Risk Categories
paragraphs: More recent Moody’s bond default rates are higher for some higher-risk  categories than the Moody’s data for 1983-1999 that OMB’s model uses to  estimate default rates. The more recent data show higher default rates for  risk levels that correspond to ICRAS categories 7 and 8, the highest risk  categories in which Ex-Im Bank undertakes new business. For example, for  fiscal year 2005, OMB’s model predicted a default rate for ICRAS category  8, assuming a maturity of 8 years, of 41 percent. The Moody’s default rate  for 1983-1999 was 48 percent, whereas the rate was 52 percent for 1983­ 2001, and 58 percent for 1983-2003. Based on our review of available  information on OMB’s default model, the model would be expected to  generate higher default rates for these categories if these more current  Moody’s data were used.
section_title: OMB Used Ex-Im Bank Data That Primarily Covered a Limited Period to Establish Comparability with Corporate Data
paragraphs: In deciding to use corporate default data to predict U.S. international credit  agencies’ defaults, OMB compared data on Ex-Im Bank historical defaults,  primarily from a limited period, with corporate default rates. Among ICRAS  agencies, Ex-Im Bank generally extends the largest portion of the U.S.  government’s new foreign credit exposure each year. OMB did not  compare other ICRAS agencies’ defaults with the corporate data. OMB  representatives, in providing oral technical comments on a draft of this  report, said they inquired at other ICRAS agencies about default data but  were unable to obtain additional data. OMB recognized in its staff paper the  value of adding other agencies’ data to its analysis in the future.
The Ex-Im Bank credits that OMB analyzed were primarily from a relatively  narrow historical period in the 1990s. OMB examined the default  probabilities of certain Ex-Im Bank transactions, sorted by risk rating, and  concluded that Ex-Im Bank default rates were generally somewhat lower  than those of corporate bonds across comparable rating categories.However, a comparison based primarily on lending activity over a relatively  short time frame may not be representative of Ex-Im Bank’s overall default  risk. In addition, according to several experts and officials, data that  reflected only the international business climate of the 1990s would not be  representative of the risk of international lending.
For this comparison, OMB used data from an Ex-Im Bank database  covering guarantees and medium-term insurance transactions from fiscal  years 1985-1999. This data set did not include loans, which comprised a  significant part of Ex-Im Bank financing through the early 1980s, and which  experienced substantial defaults during an international debt crisis that  began in the early 1980s. While we could not determine the specific data  that OMB analyzed,our analysis of the 1985-1999 database indicated that  the majority of observations in the overall database, and a strong majority  of observations for which risk ratings were available, were from the mid- to  late-1990s.
section_title: Recovery Rate Assumptions Have Not Been Transparent
paragraphs: The basis for OMB’s recovery rate assumptions and the changes over time  has not been transparent. During our audit work, OMB did not respond to  questions about the specific basis for its recovery rate assumptions of 17  and 12 percent, respectively, for fiscal years 2003-2004. OMB further  reduced assumed recovery rates to 9 percent for fiscal year 2005. In  discussing recovery rate assumptions during the audit work, OMB cited its  staff paper, which contained a recovery rate of 20 percent that OMB said  was based generally on the ratio of aggregate recoveries to aggregate  claims in Ex-Im Bank historical data. However, in discussions on a draft of  this report, OMB representatives said that the market price of credits with  the lowest ICRAS rating (category 11) was the predominant basis for  recovery rates, although they did initially also consider data on Ex-Im Bank  recoveries. OMB representatives said using the market price of the lowest­ rated credits is based on the assumption that this value represents the most  the U.S. government would recover in the event of a default. They provided  information to show that changes in OMB’s calculation of market prices of  these credits accounted for drops in the recovery rate assumptions over  time. Changes in OMB’s calculation of these prices resulted in part from  technical comments by Treasury officials.
Our analysis of the 1985-1999 Ex-Im Bank data indicates that the ratio of  aggregate recoveries to aggregate claims in that database is about 19  percent. Recovery rates that were based on aggregate data over a limited  time period would tend to underrepresent actual recoveries because of the  limited period for recoveries to be observed, especially those associated  with defaults occurring at the end of the period.
According to financial institution officials and rating agency analysis,  recovery rates tend to vary by borrower type and risk and can fluctuate  cyclically. OMB’s recovery rates assumptions appear to be conservative  compared with recovery rates assumed by other financial institutions.  Institutions we talked to generally assumed higher recovery rates than  OMB, and some tailored their recovery rate assumptions according to the  type of borrower. According to rating agency analysis, recovery rates are  generally lower for riskier credits and fall during periods when defaults are  higher.
If recovery rates assumed by OMB are lower than likely Ex-Im Bank  recoveries, they will offset, to some degree, lower expected defaults in the  calculation of expected losses. Because expected losses are calculated by  combining expected default and expected recovery rates, an unrealistically  low recovery rate would necessarily offset an unrealistically low expected  default rate, within certain ranges.
section_title: OMB Developed Method Independently and Provided Agencies Limited Information
paragraphs: Because of OMB’s unique role in developing the loss rates that ICRAS  agencies use to calculate subsidy costs, these agencies rely on OMB to  comply with credit reform requirements that address the agencies’  responsibilities for assuring the reliability of their subsidy cost estimates.  Despite the complexity of the current methodology and its implications for  ICRAS agencies’ subsidy costs, OMB developed the current methodology  predominantly on its own, receiving some input from one ICRAS agency.  Some ICRAS officials said that OMB provided agencies with limited  information about the methodology’s basis or structure.
Credit reform guidance on developing credit subsidy estimates addresses  the procedures and internal controls that agencies should have in place to  ensure that their estimates are reliable. It states that any changes in  factors and key assumptions, such as default and recovery rates, should be  fully explained, supported, and documented. The purpose of thorough  documentation is to enable independent parties to perform the same steps  and replicate the same results with little or no outside explanation or  assistance.
OMB representatives said that the current methodology was reviewed  within OMB and circulated among the ICRAS agencies, although several  ICRAS agency officials told us OMB had provided them limited  information. According to these officials, OMB presented its methodology  as an essentially completed approach and held several meetings during  2001 and early 2002 to discuss it. Officials who received information and  attended certain meetings told us that it was difficult to understand or  evaluate the methodology based on the information provided. For example,  prior to one meeting, OMB circulated a two-page discussion paper that  discussed OMB’s rationale for adopting the current methodology and  generally described its approach and a technical appendix to a staff paper  that contained numerous equations describing a theoretical model.
However, OMB representatives told us that some of the equations in this  appendix were not actually used in the methodology while other equations  not contained in the appendix were used. At one meeting, according to a  Department of Agriculture economist, OMB provided only the expected  loss rates for fiscal year 2003 and a graph that predicted a decline in Ex-Im  Bank subsidy rates. This official said it was not possible to understand the  methodology by only examining its results. She said that although she and  other ICRAS agencies representatives posed various questions about the  method’s underlying data and assumptions, OMB representatives did not  provide substantive responses and stated that the method was too complex  to explain. OMB representatives said the methodology was not reviewed  outside the U.S. government.
After presenting the methodology, OMB received comments on the  methodology from at least one ICRAS agency. Treasury officials told us that  when they examined the proposed expected loss rates for fiscal year 2003,  they objected to the substantially lower loss rates for the riskiest countries,  those in ICRAS categories 9 through 11; asked to see the underlying data  used; and raised methodological issues regarding how those rates were  calculated. The Treasury officials said that while they had some questions  about the expected loss rates for other ICRAS categories, they focused  their attention on the treatment of the riskiest countries. The reason, they  said, was that planned drops in expected loss estimates for these countries  would sharply increase the cost to the United States of forgiving existing  debt, such as through international agreements to forgive the debt of highly  indebted poor countries. According to Treasury officials, OMB revised its  approach for estimating expected losses in ICRAS categories 9 through 11,  which resulted in loss rates that were not significantly changed from those  in effect before fiscal year 2003.
We found that some financial institutions used outside experts or  consultants in developing their loss estimation methodologies. Some also  described procedures that exist to ensure their methodology’s ongoing  objectivity and reliability. For example, other government agencies, audit  organizations, and outside experts have been involved in developing or  reviewing the methodologies of two foreign ECAs that we contacted. Also,  regulatory bodies, audit organizations, and internal risk management  groups are involved in overseeing bank loss estimation methodologies.
section_title: Conclusions
paragraphs: In passing the Federal Credit Reform Act in 1990, Congress required  agencies to develop reasonable estimates about the long-term cost to the  government of federal credit programs, to ensure a sound basis for  decisions regarding program budgets. For international credit agencies  such as Ex-Im Bank, which finances activities in relatively risky markets,  predicting long-term costs and determining appropriate budget subsidy  amounts is especially challenging. Because of the importance of reasonable  program cost estimates under credit reform, such estimates need to be  made with appropriate data and using appropriate analytical techniques.  While ICRAS agency subsidy costs have several determinants, including the  particular risk ratings assigned to different borrowers, OMB’s directions to  ICRAS agencies regarding loss rates across risk levels are an important  element of estimating subsidy costs.
OMB’s shift to using historical corporate default data in its methodology for  estimating loss rates of ICRAS agency activities has some basis, given the  practices of other financial institutions and limitations in available  historical data. However, the predictive value of those corporate default  data for the financing undertaken by Ex-Im Bank or other ICRAS agencies  has not yet been established. Obtaining additional information on agencies’  default and repayment experiences over time will allow better assessments  of the suitability of using data such as corporate bond default rates.
The lack of transparency of OMB’s current loss rate methodology raises  questions about how it determines expected loss rates. Because of this lack  of transparency, combined with the method’s complexity, the multiple  ICRAS agencies that use the loss rates have incomplete information about  how those rates are determined and what factors are driving changes over  time. OMB’s unique role in setting ICRAS agency loss rates suggests that  greater transparency would be appropriate. In addition, other credit reform  tools that multiple credit agencies use to calculate subsidy costs, such as  OMB’s credit subsidy calculator, have been audited to assure users about  their accuracy. Independent review of OMB’s methodology would provide  similar assurance about the reliability of the loss rates and the subsidy  costs developed from these rates, and could help facilitate ICRAS agency  financial statement audits.
section_title: Recommendations for Executive Action
paragraphs: To improve the transparency of the subsidy cost estimation process and  help ensure the validity of estimates over time, we recommend that the  Director of the Office of Management and Budget take the following five  actions:
Provide ICRAS agencies and Congress a technical description of OMB’s  expected loss methodology, including the default model, the key  assumptions OMB made, and the data it used.
Provide similar information in the event of significant changes in its  method of calculating expected loss rates.
Ensure that data from nonagency sources—for example, rating  agencies’ corporate default data, which are used to estimate expected  loss rates—be updated as appropriate.
Request from Ex-Im Bank and other U.S. international lending agencies  the most complete and reliable data on their default and repayment  histories and periodically obtain updated information, so that the  validity of the data on which the current methodology is based can be  assessed as sufficient agency data are available.
Arrange for independent methodological review of OMB’s expected loss  rate model and assumptions and document that review.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report for formal comment to the Director,  Office of Management and Budget; the Chairman, Export-Import Bank; the  Secretary of the Treasury; the Chairman, Board of Governors of the Federal  Reserve System; the Comptroller of the Currency; and the Chairman,  Federal Deposit Insurance Corporation. We also provided a copy of the  draft report for technical review to the Chairman, Securities and Exchange  Commission, and officials at the Foreign Agricultural Service of the  Department of Agriculture. OMB provided written comments on the draft  report, which are reprinted in appendix IX. OMB, Ex-Im Bank, the  Comptroller of the Currency, and the Securities and Exchange Commission  provided technical comments, which we incorporated as appropriate.  Other agencies reviewed the report but had no comments. We also  obtained technical comments from bank and foreign ECA officials on our  descriptions of their practices.
OMB generally agreed to implement the report’s recommendations to make  more information available on its expected loss methodology, update the  nonagency data used in the model, obtain additional agency default data  over time, and obtain technical review. OMB also expressed concern about  the report’s statement that OMB’s method for determining loss rates was  not transparent, observing that our report generally describes the method.  We believe that, while we do present in this report a substantial amount of  information on OMB’s loss methodology, obtaining that information  required considerable resources and effort with certain information  provided only during the agency comment period despite repeated  inquiries by GAO, and that similar information should be more readily  available to affected agencies and Congress on an ongoing basis.
We are sending copies of this report to appropriate Congressional  Committees. We are also sending copies of this report to the Director,  Office of Management and Budget; the Chairman, Export-Import Bank; the Secretary of the Treasury; the Chairman, Board of Governors of the Federal  Reserve System; the Comptroller of the Currency; the Chairman, Federal  Deposit Insurance Corporation; the Chairman, Securities and Exchange  Commission; and the Administrator, Foreign Agricultural Service of the  Department of Agriculture. We also will make copies available to others  upon request. In addition, the report will be available at no charge on the  GAO Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  on (202) 512-4346. Additional GAO contacts and staff acknowledgments are  listed in appendix X.
section_title: Objectives, Scope, and Methodology
paragraphs: The Export-Import Bank Reauthorization Act of 2002 directed GAO to  report to the House of Representatives Committee on Financial Services  and the Senate Committee on Banking, Housing and Urban Affairs on the  reserve practices of the Export-Import Bank (Ex-Im Bank) as compared  with the reserve practices of private banks and foreign export credit  agencies (ECA). The committees were specifically interested in Ex-Im  Bank’s method for estimating the subsidy costs of its financial activities for  budgetary purposes in accordance with the Federal Credit Reform Act of  1990. Ex-Im Bank subsidy costs are determined, in part, on the basis of a  methodology established by the Office of Management and Budget (OMB);  OMB’s methodology changed substantially in fiscal year 2003.
In response to the mandate, we agreed to (1) describe OMB’s current and  former methodologies for estimating expected loss rates for international  credits and the rationale for the recent revisions, (2) determine the impacts  of the current OMB methodology on Ex-Im Bank, and (3) assess the current  methodology and the process by which it was developed. We also agreed to  provide information on the reserve practices of foreign ECAs and  commercial banks.
To describe OMB’s current and former methodologies for estimating  expected loss rates for U.S. credit agencies’ international credit and the  rationale for the recent revisions, we reviewed OMB descriptions of the  methodologies and discussed the rationale for the changes to the  methodology with OMB staff and Ex-Im Bank, Treasury, and Congressional  Budget Office officials. We also reviewed finance literature that OMB cited  as a basis for modifying its approach, as well as related literature, and  examined Ex-Im Bank information about trends in its subsidy cost  reestimates (discussed later). Our description of the former methodology is  also based on prior GAO work, on OMB memoranda to agencies that  participate in the Interagency Country Risk Assessment System (ICRAS)  announcing the risk premiums or expected loss rates to be used in  preparing budget estimates for upcoming fiscal years, and on our analysis  of expected loss rates for fiscal years 1997-2002, as described later. We  generally describe how ICRAS risk ratings are established and how Ex-Im  Bank rates private borrowers, and while we recognize that the assignment  of risk ratings is an important element in the overall reasonableness of  expected loss estimates, evaluating the reasonableness of the risk ratings  process and of specific ratings was beyond this scope of this engagement. several occasions through their Office of General Counsel, and held some  discussions with OMB staff about the methodology. The information and  documentation we obtained enabled us to generally understand and  describe the methodology and the underlying data, but did not explain all  aspects of the methodology or the specific reasons for certain results. We  note in the report where our description of certain aspects of the  methodology is incomplete. However, these areas were not material to our  conclusions.
The primary documentation we initially reviewed, an OMB paper entitled  “Proposal for modification of the ICRAS system,” describes (1) OMB’s  rationale for adopting its new methodology, (2) analysis OMB performed in  developing the methodology, and (3) certain assumptions and equations  that describe a general theoretical model. However, because the paper  describes a theoretical model and includes limited information on specific  analyses performed, data used, key assumptions, and results, and because  not all of the elements of the model described in the paper were used by  OMB, we required additional information from OMB. To obtain additional  information from OMB, we were required to submit written questions to an  attorney in OMB’s Office of General Counsel for transmission to OMB  technical staff. The attorney also reviewed the responses that the technical  staff prepared before they were provided to GAO. OMB staff provided a  combination of oral and written responses to our initial set of questions,  but because we still lacked important information, we sought additional  clarification from OMB. At OMB’s request, we provided OMB staff with a  Statement of Fact that (1) described our understanding of OMB’s expected  loss methodology based on information provided to that point and (2)  identified remaining questions. We met again with the OMB attorney and  technical staff, who responded to our questions. We requested an  electronic version of the methodology, which OMB did not agree to  provide. We attempted to further clarify certain issues, but OMB provided  limited responses. OMB representatives provided certain additional  technical information in comments on a draft of this report.
OMB provided to ICRAS agencies by dividing each rate by one minus the  recovery rate OMB assumed for each year. We confirmed that process with  OMB. To determine the extent to which the default probabilities estimated  by OMB’s default model differed from the rating agency corporate default  rates used as inputs to the model, we statistically compared the model’s  outputs for fiscal year 2004 and 2005 with the corporate default rates used.
We also determined the current methodology’s output in terms of expected  loss rates across the ICRAS risk categories. To do so, we obtained  electronic copies of Ex-Im Bank’s cash flow spreadsheets for guarantees as  well as copies of the OMB Credit Subsidy Calculator, which converts  agency cash-flow payments into present value terms. To isolate the default  or expected loss component of Ex-Im Bank subsidy costs from other  components (including fees and interest rate subsidies), we entered  consistent information into the Ex-Im Bank cash flow worksheets for each  ICRAS risk category for fiscal years 2002 through 2005 and conducted this  analysis for 5-year, 8-year, and 10-year credits. We conducted similar  analysis for 8-year credits for fiscal years 1997 through 2002. We  determined the present value of the results, based on a constant discount  rate, using OMB’s credit subsidy calculator. We discussed our analysis with  Ex-Im Bank officials, who generally confirmed our approach and output.
Supplement about the bank’s reestimates. Both sources of information  portrayed similar overall trends, but the Ex-Im Bank internal  information covered a longer period of time than the credit supplement  information. We also discussed with Ex-Im Bank officials the bank’s  process for calculating reestimates, and we examined auditor  workpapers for the 2002 audit of Ex-Im Bank’s financial statement, in  which the auditors examined and verified the bank’s reestimate for  fiscal year 2002. Thus, we determined that the Ex-Im Bank information  was sufficiently reliable for the purpose of showing trends in the bank’s  reestimates since the start of credit reform, as well as the magnitude of  the bank’s reestimates following the implementation of OMB’s current  methodology.
To determine the impact of the current methodology on the changing  relationship between Ex-Im Bank’s projection of expected losses and its  fee income, we compared our analysis of expected loss rates for fiscal  years 2002-2005 with the minimum fees that Ex-Im Bank can charge  under an agreement among participating Organization for Economic  Cooperation and Development’s (OECD) member countries. We  determined these fees using Ex-Im Bank’s Exposure Fee Calculator,  available on its Internet site. Ex-Im Bank officials confirmed our  analysis. To identify how the relationships between expected losses and  fee income could be different for corporate borrowers, we identified the  way that corporate ratings are assigned and fees determined, based on  interviews with Ex-Im Bank officials and on fee information from Ex-Im  Bank’s Internet site.
To determine the impact of the current methodology on Ex-Im Bank’s  financial statement loss allowances, we reviewed Ex-Im Bank’s audited  financial statements for fiscal years 2002 and 2003 and the auditor’s  workpapers supporting its audit of the 2002 financial statement. We  determined that the data in the audited financial statements were  reliable for the purposes of our analysis. We discussed the modification  in Ex-Im Bank’s methodology for calculating financial statement loss  allowances, including the impact of the current methodology’s lower  loss rates in calculating those loss allowances, with officials from Ex-Im  Bank and its auditor, Deloitte Touche. representatives from OMB, Ex-Im Bank, Treasury, and certain other  agencies that participate in the ICRAS process. We did not replicate or  validate the methodology because we lacked complete documentation and  did not have access to the computer programs that were used to estimate  OMB’s default model. We also did not determine the reasonableness of  specific loss rates that OMB has estimated.
To assess the methodology, we interviewed cognizant U.S. and foreign  officials and experts and reviewed relevant studies. For example, we  discussed loss estimation methodologies with credit experts and officials  from certain financial institutions, including commercial banks, foreign  export credit agencies, and other foreign officials. On the basis of these  discussions and this review, we identified challenges, concerns, and  practices, such as potential limitations in using certain data for projecting  future defaults and the degree to which institutions followed similar or  different practices in estimating default and loss.
To determine whether the corporate bond default rates used in OMB’s  default model have varied significantly since the model was created, we  compared the specific Moody’s Investors Service corporate bond default  rates used in OMB’s analysis with updated published versions of those  Moody’s rates.
We obtained information from OMB regarding its comparison of Ex-Im  Bank default rates to the corporate default data used in its model, and we  obtained from Ex-Im Bank the historical data sets that Ex-Im Bank said it  gave OMB. We obtained certain information from OMB about how it  analyzed the Ex-Im Bank data, and while we were able to determine the  time period primarily covered by this analysis, we were not able to  determine the specific data that OMB analyzed because we were unable to  reconcile certain information that OMB provided. In assessing the time  period covered by OMB’s analysis, we obtained historical country ratings  data from Moody’s and Standard & Poor’s documents and historical ICRAS  ratings information from Ex-Im Bank. We used these to determine the  proportion of observations in the Ex-Im Bank data sets for which risk  ratings at the time of the transaction were available. the underlying systems used to create the data with Ex-Im Bank officials,  who said they view the data they have compiled to be a reasonable  representation of their historical experiences and adequate for its intended  purposes, which were initially to provide information about Ex-Im Bank’s  activities to a potential private sector partner. The officials stated that the  reliability of data about individual transactions is considerably greater for  transactions initiated in 1996 and later because of changes that improved  data entry and verification. We determined the data were sufficiently  reliable for our purpose of comparing aggregate recovery rate information  in the datasets with the recovery rate assumptions used by OMB.
To broadly assess the technical features of OMB’s default model, we  evaluated information provided by OMB that described the model’s  equations and how they were estimated, based on standard econometric  criteria. We did not conduct a complete technical review because we did  not have access to full documentation of the model or the model in  electronic format.
To assess the process by which the current methodology was developed,  we discussed with OMB representatives and certain other ICRAS officials  the respective agencies’ role and degree of involvement in developing and  providing comment on the methodology. We also reviewed documents that  OMB had distributed to ICRAS agencies about its methodology and  discussed with ICRAS officials the general time frames in which the  methodology was developed and the nature of certain meetings that OMB  held to present information about its methodology. The ICRAS officials we  interviewed received information about the methodology’s development  and implementation and have had continuing participation in the ICRAS  process. We also reviewed credit reform guidance on preparing and  auditing subsidy costs.
To provide information on the reserve practices of foreign ECAs, we  judgmentally selected a sample of four ECAs that are key competitors of  Ex-Im Bank or that were identified by knowledgeable U.S. and private  sector officials as entities that had examined or changed their reserve  practices in recent years. These included Compagnie Française  d’Assurance pour le Commerce Extérieur in France, Euler Hermes  Kreditversicherungs-Aktiengesellschaft in Germany, the Export Credits  Guarantee Department in the United Kingdom, and Export Development  Canada. In each case, we discussed with officials, and reviewed available  documentation on, the ECA’s statutory mandate, financial activities, and  reserve practices. We also reviewed public financial statements where  available. We also met with officials from other government organizations  in these countries, including treasury or finance ministries. We met with  officials from the Office of the Auditor General of Canada, France’s Cours  des Comptes, and the U.K.’s National Audit Office, because those offices  audit the financial statements of the Canadian, French, and U.K. ECAs,  respectively. We obtained the perspectives of officials from ECAs and other  government agencies on the difficulties associated with developing loss  estimation methodologies and using available data. In addition, we  discussed these issues with an official from the export credit group of the  OECD, and officials at the Office National du Ducroire/Nationale  Delcrededienst in Belgium, including the chair of a group of OECD export  credit country risk experts.
To provide information on the reserve, or loan loss allowance, practices of  commercial banks, we judgmentally selected a sample of three U.S.  commercial banks with large lending portfolios totaling approximately  $800 billion, including large international exposures. For each bank, we  spoke with management involved in international lending and the  calculation of the bank’s loan loss allowance. In addition, we reviewed the  banks’ financial statements and any documentation that was provided. We  also met with several U.S. banking regulators—the Federal Reserve Board,  Office of the Comptroller of the Currency, and the Federal Deposit  Insurance Corporation—to discuss the loan loss allowance guidance banks  are required to follow. We reviewed both regulatory and accounting  guidance governing the calculation of the loan loss allowance by  commercial banks.
section_title: Loss Estimation Practices of Foreign Export Credit Agencies
paragraphs: Significant variation exists among the loss estimation, or reserve, practices  of foreign export credit agencies (ECA) that we consulted. Differences in  mission, structure, and accounting approaches help explain this variation.  Some of these ECAs are expected to avoid competing with private sector  financial institutions, which may result in more exposure to emerging  market borrowers and riskier portfolios as compared with other ECAs.  These ECAs’ financial relationships with their governments differed, as did  their individual responsibility for covering any losses that might result from  their activities. Some ECAs follow an accounting approach that prescribes  estimating probable losses over time, while others follow an accounting  approach that precludes such estimation. ECAs in Canada and the United  Kingdom (U.K.) have recently adopted or plan to implement new  methodologies for estimating the likelihood of default and loss associated  with their activities. ECAs in France and Germany follow a simpler  approach in which the fees they collect on a given transaction, in  accordance with an international agreement among export credit agencies,  are regarded as sufficient to cover any likely losses on the transaction. The  French ECA is studying a new accounting system that would enable it to  more closely align its loss expectations with its historical repayment  experiences. (App. I contains information about our objectives, scope, and  methodology for examining the reserve practices of foreign ECAs.)
subsections: section_title: ECAs in Canada and the United Kingdom Have Methodologies to Estimate Future Defaults and Losses in Determining Reserve Levels
paragraphs: have similar elements but differ in important respects. The new approaches  have been reviewed by specialists outside the ECA.
subsections: section_title: Mission, Structure, and Accounting Approaches Affect Reserve Practices
paragraphs: The Canadian and U.K. ECAs’ mission is to help facilitate national exports,  but their particular methods and structure for doing so differ. The Canadian  ECA is a wholly owned government corporation that was capitalized with  funds from the Canadian government and operates with the full faith and  credit of the Canadian government. According to officials of this ECA, the  entity is self-sustaining, in that it does not receive annual infusions of  budgetary support for its operations or losses. Its largest business activity  in terms of volume is short-term export insurance, but it also offers loans  and medium-term insurance and loan guarantees. According to the  Canadian ECA, it takes a commercial approach to managing its risks to  ensure its long-term financial health. This institution makes its own  decisions about the credits it will offer and is not prohibited from  competing with private sector financial institutions. Long-term  transactions that it determines are beyond its risk capacity and are  inconsistent with its long-term health may be referred to the government of  Canada for consideration. The Canadian government may accept and  manage those risks provided that there is sufficient national benefit to  Canada. confidence, that it will break even financially. Simultaneous attainment of  these two objectives suggests this ECA has to strike a balance in the types  of transactions and the nature of risks it shall undertake. The ECA’s risk  premia and larger transactions are subject to approval by the U.K. treasury  department. The level of treasury department control increased following  certain losses the ECA incurred in the late 1990s. Plans are under way to  convert the U.K. ECA into a separately capitalized, self-sustaining entity  that would operate at arm’s length from the U.K. government, responsible  for managing its own financial losses. expected losses. In comparison, the U.S. Export-Import Bank’s (Ex-Im  Bank) loss allowances have averaged about 18 percent of its total exposure  since fiscal year 1999.
Moreover, different degrees of government support affect the extent to  which ECAs are responsible for managing their own financial risk and  protecting taxpayers from loss. For example, as a self-sustaining entity, the  Canadian ECA does not receive annual budgetary support from its  government and would be expected to cover any losses it incurs. In  contrast, although the U.K. ECA is expected to break even over time, it  receives appropriations from the U.K. Parliament to cover anticipated  losses and administrative expenses. It also operates with a treasury  department guarantee of the obligations arising from its guarantees.
Both the Canadian and the U.K. ECAs follow accrual-based accounting  standards, in which revenue and expenses are recorded in the period they  are earned or incurred, even though they may not have been received or  paid. Under such accounting, loss reserves are an estimate of probable  losses in a portfolio as a whole. The reserves are normally recorded long  before actual defaults occur. This contrasts with cash flow accounting, in  which revenue is recognized when it is received and expenses when they  are paid. As discussed in the section on the French and German ECAs, this  method of accounting precludes the matching of revenue and expenses  over time.
section_title: Canadian and U.K. ECAs Have Recently Adopted, or Will Implement, New Reserve Methodologies
paragraphs: The Canadian and U.K. ECAs have recently revised their existing reserve  practices by adopting or moving toward implementing methodologies that  are designed to more precisely measure risk in their portfolios and ensure  that their reserves reflect those risks. In 2001, the Canadian ECA and the  Canadian Office of the Auditor General, who audits the ECA’s financial  statements, undertook a review of the ECA’s reserve methodology with the  goal of making it reflect current best practices. The ECA studied the  reserve practices of several leading U.S. and Canadian banks and other  ECAs, including Ex-Im Bank, and examined new developments in bank  regulatory and accounting guidance. According to Canadian ECA  officials, it adopted a new risk assessment model that follows the risk  assessment approaches used by some other financial institutions with  international risk exposures. The new methodology did not have a  substantial impact on the ECA’s level of reserves, although the entity  changed the process by which it calculated its reserves, specifically its  components and what it covers. For example, it began establishing  reserves for committed undisbursed credits, which it had not done  previously.
In 1999 the U.K. treasury department hired a private consulting firm with  credit risk expertise to review the effectiveness of the ECA’s risk  management systems because of concerns about the ECA’s financial  condition, given the larger than expected losses it incurred during the  Asian financial crisis. According to U.K. ECA officials, the consulting firm  concluded that the ECA’s process for estimating expected loss was  reasonable but recommended, among other things, that the U.K. ECA  should better assess the risk of, and establish capital to buffer against,  unexpected losses. The U.K. ECA is upgrading its existing risk assessment  models and processes in response to the review.
subsections: section_title: Determining Risk Ratings and Calculating Probability of Default
paragraphs: Standard & Poor’s when they are available; when these ratings are not  available, the Canadian ECA’s risk department assigns ratings using  standard rating agency criteria. They place credits into seven risk  categories. The Canadian ECA then estimates its default probabilities for  its corporate borrowers using published default rates from Moody’s  Investors Service and Standard & Poor’s, taking into account the maturity  of the credits. The Canadian ECA rates sovereign borrowers based on its  own research and country knowledge. Once these ratings are assigned, the  Canadian ECA uses the default probabilities associated with those ratings  from Standard & Poor’s and Moody’s in determining default probabilities.  For both corporate and sovereign borrowers, the Canadian ECA adjusts  rating agency default probabilities where it believes such adjustments are  necessary.
For determining sovereign default probabilities and risk ratings, the U.K.  ECA uses a model it developed in 1991 that assesses countries’ likelihood  of default, using macroeconomic data such as borrower country  indebtedness. Its analysts consider the model’s output and additional  factors, including other country data, rating agency sovereign ratings and  interest rate spreads, in the final assignment of sovereign ratings. For  determining expected loss, the expected duration of default periods and  the recovery rates when defaults occur are taken into account, along with  the probability of default.
For rating corporate transactions, the U.K. ECA uses rating agency  corporate risk ratings where they are available. For corporations that are  not rated by the major rating agencies, the U.K. ECA assigns ratings using  templates developed with a major rating agency. In both cases, once these  ratings are obtained, U.K. ECA officials adjust them, in some cases, based  on a comparison with country sovereign ratings. For assigning expected  losses to different risk ratings, U.K. ECA officials use a Standard & Poor’s  tool that is based on that rating agency’s historical data on ratings  transition and default rates and that incorporates other information such as  recovery rates.
U.K. ECA officials are moving toward a new modeling process that will  directly assess, not only the risk of expected loss, but also the capital  needed to cover unexpected losses or the risk of having greater losses  concentrated in certain periods. This model was developed in consultation  with a U.K. credit risk expert and uses a combination of private ratings  agency data on sovereign bond defaults from the 1990s and U.K. ECA data  on the 1980s default experience of the U.K. ECA.
section_title: Calculating Expected Loss
paragraphs: Once default probabilities have been determined, determining the expected  losses from the defaults involves determining the likely amount of loss  when defaults occur, based on expected recoveries. The Canadian ECA  uses its own historical data, where sufficient, to estimate recoveries for  sovereign and nonsovereign borrowers. The U.K. ECA determines its own  recovery rates for sovereign borrowers; for corporate borrowers, it makes  some use of rating agency recovery data. Both ECAs assume higher losses  (lower repayments) for corporate than sovereign defaults. The Canadian  ECA also assumes that higher losses will be incurred from defaults on  unsecured credits than on collateralized credits. The calculation of  expected loss forms these entities’ base reserves amount, to which certain  upward adjustments are made. These adjustments reflect the potential  unexpected losses that are affected by the portfolio effects of  concentration and correlation of financing activities.
section_title: Adjusting for Portfolio Risk
paragraphs: The Canadian ECA follows a portfolio approach in estimating loss and  calculating reserves. In such an approach, the base reserve amount is  adjusted upward because of additional risks related to concentrations of  exposure and correlations among credits. The Canadian ECA adds reserve  amounts for significant exposures to single borrowers, countries, or  industries. It also adjusts upward for the possibility that problems in one  area (for example, in one country) will spread to other parts of its portfolio.
The U.K. ECA’s current approach includes some judgmentally determined  upward adjustments to its base expected loss calculations for certain  concentrations of risk. These include upward adjustments for public,  nonsovereign borrowers, as well as certain systemic risks related to other  countries or industries. Its new risk management approach will make such  adjustments more systematically, as part of its loss model.
section_title: Determining Fees
paragraphs: jointly develop country risk ratings for the purposes of determining the  minimum fees to be charged at each risk rating. (More information about  this agreement is provided below.) However, according to Canadian and  U.K. ECA officials, they may apply higher fees if they determine that the  fees do not adequately reflect their own assessment of the potential loss on  a transaction. Officials from both ECAs stated that setting fee levels in  relation to expected loss is an important component of their financial  stability over time.
section_title: Canadian and U.K. Reserve Methodologies Were Subject to Internal and External Review
paragraphs: According to officials from the Canadian and U.K. ECAs, their reserve  methodologies (including key assumptions and computer models) have  been or are being reviewed extensively, both internally and externally,  before being adopted. The Canadian ECA’s new methodology was  positively reviewed by an independent national accounting firm with  significant experience in reviewing loan loss methodologies. The U.K.  ECA’s current reserve practices were subject to review by a private  consulting firm. In responding to the consulting firm’s recommendations,  the ECA has worked with the U.K. treasury, a prominent academic and  credit risk expert, and a private rating agency to develop its new approach.  Its new risk assessment model is based on a well-known credit risk model  that was developed by a leading U.S. bank.
section_title: ECAs in France and Germany Use Fees to Offset Loss
paragraphs: ECAs collect constitute these countries’ reserve against future loss. The  government ministries that oversee the ECAs conduct independent  assessments of country risk in setting or adjusting the risk thresholds that  specify the degree to which they will offer credit in certain countries.  Further, the French ECA is developing a method, not yet in place, to more  independently estimate future losses on the government’s export credit  activities and to track the actual losses incurred over time.
subsections: section_title: French and German ECAs Provide Export Insurance and Guarantees on Behalf of Their Governments and Follow Government Accounting Methods
paragraphs: France and Germany provide and account for their official export credit  business in similar ways. In both countries, the official ECA is a private  enterprise that insures or guarantees exports on behalf, and at the  direction, of the government. In addition to managing their government’s  export credit business (referred to in both cases as the state account), the  French and German ECAs also engage in business for their own account.  The French and German state accounts extend primarily medium- and  long-term export credit insurance, whereas the private enterprises that  manage the state accounts primarily sell short-term insurance. The ECAs  are not responsible for any profit or loss incurred on the state account,  which transfers to the government. The French and German ECAs both  receive administrative fees from the government for their services.
The government ministries that oversee the ECAs make decisions about  the degree to which the state accounts will offer export credits in certain  countries or to certain borrowers (exposure limits are discussed further  below). French and German state accounts are expected to operate in  riskier markets where private export credit insurance cannot be obtained.  In both countries, the government ministries can also direct the ECA to  undertake certain transactions, even if doing so will cause it to exceed  established exposure limits, if the government believes the transactions to  be in the country’s best interest. because both governments’ budgets are accounted for on a cash flow basis.  Under cash flow accounting, revenue is recognized when it is received, and  expenses are recognized when they are paid. Thus, revenue in a given year  is compared with expenses in that same year, regardless of when the  underlying transactions occurred. Under this system, it can be difficult to  know the degree to which the fees collected in a given year from providing  export credit insurance cover any claims made against that insurance in  later years. French and German ECA officials acknowledged that this  accounting practice limits their ability to fully analyze actual or potential  losses on the state account. The French ECA has been developing an  alternative accounting approach that would enable such analysis, as  discussed later.
section_title: French and German ECAs Follow Government- Determined Risk Thresholds and Use Fees to Cover Loss
paragraphs: The French and German approaches to evaluating risk are based primarily  on assessing country risk for the purpose of setting exposure limits and  using fees to cover losses. The French and German ECAs are not expected  to estimate expected losses in advance of undertaking transactions, but the  French ECA provides informal risk assessments to the oversight ministry  for it to consider when making decisions about undertaking transactions.  The French and German governments do not provide budgetary funds at  the beginning of a year to cover any losses that might be incurred during  the year, but any losses incurred on the state account are automatically  covered.
The government ministries that oversee the French and German ECAs  analyze borrower countries’ risk profiles when making their annual  decisions about the exposure limits that will be in effect for a given year.  This analysis may consider macroeconomic factors, OECD country risk  ratings, and the ECA’s experiences with other countries’ repayment  histories on previously extended credit. In France, the ECA also provides  input to this analysis. These exposure limits, or ceilings, are developed to  ensure portfolio diversification and constrain the accumulation of  excessive risk levels. In both countries, the government determines risk  ceilings and provides these to their ECAs to follow in operating the state  account. Country risk ceilings can be exceeded only at the government’s  direction. The German ECA also faces a statutory limit on the total  exposure it can undertake in a given year.
In both countries, the fees collected on the export credit business are  viewed as a reasonable approximation of the amount of loss likely to be  incurred. In setting fees, both ECAs follow the guidance agreed to by the  participating OECD countries for assigning risk ratings to sovereign  borrowers and charging premium rates. These ECAs add surcharges to the  OECD minimum fee rates for corporate borrowers, recognizing the higher  risk of corporate business. As discussed below, the OECD fees were  politically determined, and both entities have considered whether the  premia are sufficient to cover actual losses.
France and Germany differ in how they manage their fee revenue. In both  countries, the revenue belongs to the government. However, in France,  some fee revenue is kept with the French ECA for the purpose of paying  expenses that are incurred on the state account, such as paying a claim on  a defaulted credit. Officials of the French ministry that oversees the ECA  told us that the amount left on deposit with the ECA is based on their best  estimate of the losses that the ministry expects will materialize in a given  year. A German ECA official said that all fee revenue it collects is  immediately transferred to the German government. When the German  ECA has to pay a claim, it must request funds from the German  government.
French ECA and government officials told us that the French ECA is  developing a new accounting system for the state account that will enable  it to analyze, for each underwriting year, the collected fees and the claims  corresponding to the transactions covered during the same year. This  system will provide the ECA with historical data on payment experience in  order to calculate expected losses on a statistical basis. However, the  process is not complete, and the information it has produced is not used for  official purposes. The approach in development still uses OECD minimum  fees as the baseline for estimating loss but will add surcharges to take  account of increased risk, for example, when a default is pending.  Surcharges will also be added for risks other than sovereign risks.  According to French ECA and government officials, a key challenge in  developing this approach was compiling payment histories for individual  transactions. They also stated that before the French state account would  develop a reserve system that does not rely on the OECD minimum fees,  further accumulation of historical data on payment experiences will be  necessary, a process they expect will take some time.
section_title: OECD Participating Countries’ Risk Assessment and Fee Arrangement
paragraphs: The agreement of the participating OECD countries regarding country risk  classifies countries into seven risk categories on the basis of a country risk  assessment model. The model ranks countries according to which is most  likely to default, considering indicators of countries’ financial and  economic situations. It also uses data provided since 1999 by export credit  agencies on their payment experiences with countries. Quantitative scores  for each country determine its initial risk classification, which can be  adjusted by participating countries based on an assessment of political risk  and other factors not considered in the model itself.
While the model scores provide some indicator of default probabilities for  each country, they are not used in determining what the risk premiums, or  fees, should be to cover expected loss for financing to sovereign buyers in a  risk category. The fees result from a political agreement, an averaging of  fees in place in 1996 across member export credit agencies. Thus, the fees  reflect the expected loss of lending to sovereign borrowers at various risk  levels only to the extent that the average of 1996 fees across participating  countries reflect those expected losses. The minimum common fees are  not intended to reflect the generally higher risk of lending to nonsovereign,  or private, borrowers within the same country, according to OECD and  ECA officials.
Participating OECD countries are collecting data from their ECAs on their  financing and repayment experiences since 1999, in order to assess the  validity of the current fees as indicators of expected loss. According to an  ECA official who chairs a group of country risk expert from OECD  countries, collecting enough data to assess the current premiums will take  at least 10 years.
section_title: Loan Loss Allowance Guidance and Select Commercial Bank Practices
paragraphs: Loans are the largest component of most depository institutions’ assets;  therefore, the loan loss allowance is critical to understanding the financial  condition of a depository institution and changes in credit risks and  exposures. Given the importance of the loan loss allowance as an indicator  of financial condition, and because adjustments to the allowance affect an  institution’s earnings, the loan loss allowance is scrutinized by regulatory  agencies. Regulators and the accounting profession acknowledge that  calculating the loan loss allowance requires significant judgment and that  accounting and regulatory guidance are not prescriptive. For the past  several years, the organizations involved in developing U.S. private sector  accounting standards—the Financial Accounting Standards Board (FASB)  and the American Institute of Certified Public Accountants —have been in  the process of reviewing current loan loss allowance guidance. Likewise,  the U.S. federal banking regulators—the Federal Reserve Board (FRB),  Office of the Comptroller of the Currency (OCC), Federal Deposit  Insurance Corporation (FDIC), Office of Thrift Supervision, and the  National Credit Union Administration—and the Securities and Exchange  Commission have been updating regulatory guidance governing the loan  loss allowance. While the commercial banks we contacted follow the basic  concepts of accounting and regulatory guidance, specific aspects of these  banks’ allowance methodologies differ. Regulatory guidance requires U.S.  banks involved in international lending to address additional risks, in  addition to the accounting and loan loss allowance concepts that apply to  domestic lending.
subsections: section_title: Loan Loss Allowance Is an Important Factor in an Institution’s Financial Condition
paragraphs: the amount of estimated losses that have occurred in the loan portfolio but  have not yet been realized. The loan loss allowance, according to bank  regulatory guidance, must be appropriate to absorb estimated credit losses  inherent in the loan portfolio. When changes are made in the loan loss  allowance, these changes directly affect an institution’s earnings. The loan  loss allowance is established and maintained by charges against the bank’s  operating income, which reduces earnings, or by reversals of the  allowance that would increase earnings.
Given the loan loss allowance’s effect on earnings and the role the  allowance plays in allowing banks to cover probable and estimable losses,  U.S. financial regulatory agencies pay close attention to a bank’s loan loss  allowance. These regulators require banks to establish and regularly review  the adequacy of their allowance, and bank examiners assess the asset  quality of an institution’s loan portfolio and the adequacy of the loan loss  allowance. Because regulatory guidance is not prescriptive, bank  regulators told us that, through examinations, they assess the  “reasonableness” of a bank’s loan loss allowance by comparing a bank’s  loan loss allowance level with industry standards and looking for  justification for any methodology that could be considered an outlier. As  part of their assessment of public company filings, the Securities and  Exchange Commission also reviews banks’ loan loss allowance  disclosures.
section_title: Accounting and Regulatory Guidance Are Not Prescriptive; the Loan Loss Allowance Requires Significant Judgment
paragraphs: banks follow Statement of Financial Accounting Standards (SFAS) 114,  Accounting by Creditors for Impairment of a Loan, in estimating losses  from individual impaired loans. Further, SFAS 5, Accounting for  Contingencies,provides guidance to banks in their calculation of losses  for pools of loans, impaired or performing, which are evaluated  collectively.
The bank regulators we spoke with—FRB, OCC, and FDIC—stated that  regulatory guidance is coordinated across all the banking regulatory  agencies and is consistent with GAAP. On March 1, 2004 the banking  regulators issued an Update on Accounting for Loan and Lease Losses,  which addresses recent developments in accounting for the loan loss  allowance and presents a list of the current sources of GAAP and  supervisory guidance for accounting for the loan loss allowance. One of the  sources it lists is The Interagency Policy Statement on the Allowance for  Loan and Lease Loss, which was issued by FRB, OCC, FDIC, and the Office  of Thrift Supervision in 1993. This document discusses the nature and  purpose of the loan loss allowance, the responsibilities of a bank’s board of  directors and management, how banks should determine the adequacy of  their allowance and the factors that should be considered in their  estimates, and examiners’ responsibilities with regard to the loan loss  allowance. Prior to the March 2004 Update on Accounting for Loan and  Lease Losses, the 1993 interagency policy was supplemented by the 2001  Federal Financial Institutions Examination Council Policy Statement,  discussed later.
In addition to the interagency policy, OCC and FDIC issue their own loan  loss allowance policy statements that they distribute to banks under their  supervision. These statements are in line with the interagency policy.
Table 1 provides a summary of the relevant accounting and regulatory  guidance governing the loan loss allowance.
subsections: section_title: Additional Guidance on International Lending
paragraphs: additional risk that banks face when providing international loans is  “country risk,” or the risk that economic, social, and political conditions  and events might adversely affect a bank’s interests in a country. A specific  component of country risk is “transfer risk,” or the possibility that a loan  may not be repaid in the currency of payment because of restricted  availability of foreign exchange in the debtor’s country.
To address country risk, banks are expected to have country risk  management methodologies in place. A 1998 study by the Interagency  Country Exposure Review Committee (the “Committee”) found that all U.S.  banks conducting international lending had developed formal country risk  management programs and policies. The Committee also found that these  banks had formal internal country risk monitoring and reporting  mechanisms and that country risk management was typically integrated  with credit risk management. To address transfer risk, banks that lend to  specific countries must allocate additional allowances, called the Allocated  Transfer Risk Reserve.
Transfer risk is one component of the broader concept of country risk and  the only component specifically regulated by the bank regulators. The  International Lending Supervision Act of 1983 required banks to set up an  allocated allowance for assets subject to transfer risk, and the banking  regulators accordingly published regulations implementing the  requirement. The Committee is responsible for providing an assessment of  the degree of transfer risk in cross-border and cross-currency exposure of  U.S. banks and sets the minimum amount of the allocated transfer risk  reserve. The Committee bases its assessments and ratings on information  collected from a number of sources, including country analysis prepared by  economists at the Federal Reserve Bank of New York and discussions with  U.S. banks.
Bank regulators emphasized that the Committee’s transfer risk ratings are  primarily a supervisory tool and should not replace a bank’s own country  risk analysis process. FRB officials also told us that the allocated transfer  risk reserve is “narrowly prescribed” in that it applies only to a small  number of countries. U.S. commercial bank lending is primarily domestic,  and the international lending that is conducted by banks is concentrated in  the G-10 countries and Switzerland. The FRB officials stated that only  approximately 30 U.S. banks—a small portion of the total number of banks  in the United States—receive allocated transfer risk reserve statements.
section_title: Regulatory Guidance on Portfolio Segmentation and Risk Ratings
paragraphs: In addition to loan loss allowance guidance, banks must also follow  regulatory guidance regarding loan portfolio segmentation and risk  classification. Segmenting the bank’s loan portfolio into groups of loans  with similar characteristics, such as risk classification, past-due status,  type of loan and industry, or the existence of collateral, is the first step in  calculating the loan loss allowance for the SFAS 5 portion. Regulatory  guidance states that banks may segment their loan portfolios into as many  components as practical. Bank regulators do not prescribe the way that  banks should segment their loans; however, regulatory guidance states that  loan segmentations should be separately analyzed and provided for in the  loan loss allowance. Bank regulators do provide guidance on risk  classification, a characteristic by which loan portfolios can be segmented.  Table 2 provides definitions of the risk classifications, which are shared by  all of the banking regulatory agencies.
A pass asset presents no inherent loss (no formal  regulatory definition exists for “pass” credits).
A special mention asset has potential weaknesses that  deserve management’s close attention. If left uncorrected,  these potential weaknesses may result in deterioration of  repayment prospects for the asset or in the institution’s  credit position at some future date. Special mention assets  are not adversely classified and do not expose an  institution to sufficient risk to warrant adverse  classification.
A substandard asset is inadequately protected by the  current sound worth and paying capacity of the obligor or  of the collateral pledged, if any. Assets so classified must  have a well-defined weakness, or weaknesses, that  jeopardize the liquidation of the debt. They are  characterized by the distinct possibility that the bank will  sustain some loss if the deficiencies are not corrected.
An asset classified doubtful has all the weaknesses  inherent in one classified substandard with the added  characteristic that the weaknesses make collection or  liquidation in full, on the basis of currently existing facts,  conditions, and values, highly questionable and  improbable.
Assets classified loss are considered uncollectible and of  such little value that their continuance as bankable assets  is not warranted. This classification does not mean that the  asset has absolutely no recovery or salvage value, but  rather that it is not practical or desirable to defer writing off  this basically worthless asset even though partial recovery  may be effected in the future.
Bank regulatory guidance states that a bank’s rating system should reflect  the complexity of its lending activities and the overall level of risk involved;  the guidance also states that no single credit risk rating system is ideal for  every bank. Large banks typically require sophisticated rating systems with  multiple rating grades within the above broad risk classifications. One bank  regulator stated that some banks might have a 10-point rating system based  on the risk classifications, whereas other banks may have up to 25 different  ratings.
section_title: Regulatory Agencies and Accounting Organizations Have Been Reviewing Loan Loss Allowance Guidance
paragraphs: For the past several years, financial regulatory agencies and accounting  organizations have updated and continued reviewing U.S. private sector  accounting standards and regulatory guidance governing the loan loss  allowance.
subsections: section_title: Regulatory Agencies Supplement Existing Guidance
paragraphs: In the late-1990s, Securities and Exchange Commission staff noted in their  normal reviews of filings by financial institutions, including banks, that  there were inconsistencies between the disclosures about the credit quality  of registrant’s loan portfolios and the changes in the loan loss allowances  reported in the financial statements. The Securities and Exchange  Commission staff’s review was aimed at determining whether the  institutions were complying with GAAP for loan loss allowances. Securities  and Exchange Commission staff was concerned, as were some of the bank  regulators, that financial institutions were (1) not using procedural  discipline in developing loan loss allowance estimates; (2) not  documenting their evaluation of loan credit quality or their measurement of  loan impairment; or (3) not providing clear disclosure, in the financial  statements and management’s discussion and analysis, about the  provisioning process and allowance analysis.
As a result of the Securities and Exchange Commission staff’s review of  filings, one bank restated its financial results to reflect a reduction in its  loan loss allowance. According to a bank regulator, although the credit  quality of the bank’s loan portfolio was increasing, its loan loss allowance  was not decreasing.
Policy Statement was intended to provide further guidance on the design  and implementation of loan loss allowance methodologies and supporting  documentation practices. Securities and Exchange Commission staff  issued parallel guidance on this topic for public companies in Staff  Accounting Bulletin No. 102.
section_title: Accounting Guidance for the Loan Loss Allowance is Under Review
paragraphs: FASB is charged with establishing authoritative private sector accounting  principles for financial reporting.These accounting principles (GAAP) are  promulgated primarily through the SFAS issued by FASB. In the past, the  American Institute of Certified Public Accountants (the “Institute”) has  issued industry and auditing guides to provide accounting implementation  guidance, subject to clearance by FASB. of the financial community who commented on the draft. In January 2004,  after review of these comment letters, the Institute decided to proceed only  with guidance to improve disclosures.
section_title: Reviewed Banks Follow Basic Concepts in Accounting and Regulatory Guidance but Vary in Allowance Methodologies
paragraphs: We spoke with three U.S. commercial banks with large lending portfolios  totaling approximately $800 billion, including large international  exposures. The three banks we spoke with follow the basic accounting  and regulatory concepts outlined earlier but vary in specific loan loss  allowance methodologies, including the sources of and amount of  observable data on which their allowance calculations are based. FRB,  which is conducting a study to establish “core reserving practices” among  banks, confirmed that loan loss allowance practices among banks are not  universal. The loan loss allowance varies depending on the type of lending  done by the bank and its associated levels of risk. In addition, each bank  has a unique historical loan loss experience on which their reserve  calculation is based.
Despite specific differences in loan loss allowance methodologies, banks  follow the same basic steps in determining their loan loss allowance levels  for both domestic and international loan portfolios. These steps are  illustrated in figure 7.
Allowances for  classified loans  greater than a  specific dollar  amount (which  varies among  banks) are  calculated on  an individual  basis according  to accounting  guidance in  SFAS 114.
Allowances for  classified loans  less than the  specified dollar  amount are  pooled and  calculated  according to  accounting  guidance in  SFAS 5, using  a formula  based on  historical  information.
subsections: section_title: Assignment of Risk Ratings
paragraphs: All three banks stated that their loan portfolios are divided between their  commercial and consumer businesses. We focused on the commercial side  of the loan loss allowance process of these banks, as it was most relevant  to the business of the Export-Import Bank. Within their commercial loan  portfolios (including both domestic and international lending), regulatory  guidance allows banks to segment their loans according to various factors  but risk classification is a primary factor. The banks assign loans different  risk classifications, as defined by the bank regulators (see table 2), based  on the creditworthiness of the loan.
The calculation of the loan loss reserve is dependent on the risk ratings  assigned to loans. The assignment of risk ratings is based on an assessment  that includes evaluating an obligor’s credit risk based on the company or  project and also on external factors, such as country risk for international  lending.
The three banks’ approaches to the risk rating assignment and review  process are multilayered and performed by multiple units within the banks.  The banks we spoke with have risk management groups that are divided  into specific risk units. The groups charged with evaluating credit risk are  involved in assigning risk ratings. Ongoing analysis of the loan portfolio is  performed to ensure that risk ratings continue to be accurate. Units within  the risk management groups conduct reviews of selected loans in their  portfolios throughout the year, sometimes focusing on credits in certain  risk ratings ranges.
Factors that banks and bank examiners take into consideration when  analyzing risk in a credit exposure include industry risk; financial  indicators such as quality of cash flow, balance sheet, debt capacity, and  financial flexibility; and management. Officials at one bank told us that they  use agency ratings as benchmarks to test the reasonableness of their  internal credit risk grading system; however, the agency ratings are  considered but not specifically weighted into their rating decision.
All three banks we spoke with have committees that evaluate the country  risk levels of their lending portfolios and establish country risk ratings and  sometimes geographic exposure limits. Officials at one bank stated that  they have a formal model that assigns risk ratings to countries. The model  is based on economic, financial, social, and other factors. The three banks  incorporate information from external sources—for example, private  companies and ratings agency data—into these ratings. However, two  banks told us that, although they use external sources for data and  qualitative information, all of their analysis is internal.
Officials at one bank told us that their committee holds bimonthly meetings  and adjusts ratings monthly. Countries are placed on watch lists when  economic conditions are unstable. The watch list is based on triggers,  which include economic factors such as the pricing of debt, exchange  rates, and other political and social factors. foreign obligor is first rated based on the obligor’s creditworthiness,  according to the banks we interviewed, then the country risk rating is  incorporated to produce an overall rating for that loan. Both the banks and  the bank regulators stated that, for international loans, the rating assigned  to a loan generally will be no better than the country risk rating for the  country in which the debtor is located. However, if a loan is collateralized  or guaranteed by a third party, the loan may receive a rating better than the  country risk rating.
FRB officials stated that Interagency Country Exposure Review  Committee’s (the “Committee”) country risk ratings and the allocated  transfer risk reserve requirements often lag behind the ratings of the  ratings agencies and changes already made by the banks in their reserve  levels. The three banks stated that they make their own internal judgments  regarding the allocated transfer risk reserve and can decide to have a  higher allowance than the allocated transfer risk reserve requirement,  although they cannot have a lower allowance. The banks, as did FRB  officials, also stated that the allocated transfer risk reserve is a lagging  indicator and that many specific losses have already been incurred by the  time the allocated transfer risk reserve is issued by the Committee.
section_title: Calculation of Loan Loss Allowance
paragraphs: and accounting guidance require that support for these adjustments be well  documented.
subsections: section_title: Calculation of the General Allowance
paragraphs: In calculating the general allowance, loans are grouped into pools based on  similar characteristics—risk classification being a primary factor—and  collectively evaluated for impairment. The three banks we spoke with  generate expected loss factors for each loan pool by estimating such  factors as the probability of default, loss given default, and expected  exposure at default. The three banks use internal and external data to  estimate the probability of default and loss given default components. FRB  officials told us that banks tend to use external data to calculate the  probability of default and internal data to calculate the loss given default.  The practices of the three banks in our study for the most part conformed  to this view. The three banks primarily used internal data to calculate the  loss given default, sometimes validated by looking at external data or  supplemented with external data, and they primarily used external data  sources to calculate the probability of default.
With respect to the probability of default component, the banks weighted  external sources differently and used different time periods of analysis.  Officials at the three banks told us that they relied on external sources;  however, officials at one bank told us that they also internally adjusted the  data in their calculation.
The length of the historical loss experience under analysis for the banks we  interviewed varied among the loss given default components of the loan  loss allowance calculation. The three banks we spoke with used an average  of 16 years worth of data for the loss given default component.
section_title: Calculation of the Specific Allowance
paragraphs: the loan became nonperforming. The three banks periodically update their  analysis of expected loss factors. A bank regulator told us that in the SFAS  114 calculation, banks may develop best-, base-, and worst-case scenarios  in order to make their best estimate.
The three banks pool loans that are for less than the aforementioned dollar  amount threshold and estimate losses for the loan pools. The calculation  follows guidance in SFAS 5. Two of the banks we spoke with estimate the  loss factors used in this calculation based on internal statistical studies of  historical loss experience.
section_title: Review of the Loan Loss Allowance
paragraphs: The three banks we spoke with review their loan loss allowance at least  quarterly, as part of the quarterly financial disclosure statements required  by the Securities and Exchange Commission. However, the banks told us  that they review large impaired loans monthly but make allowance  decisions quarterly. The risk management groups within the three banks  have the responsibility for estimating and formulating the allowance  parameters and establishing the loan loss allowance. The  recommendations and the basis of their formulation are reviewed by senior  management, whose conclusions as to the appropriateness of the loan loss  allowance, as well as the supporting analysis, are then reviewed quarterly  by the bank’s board of directors.
section_title: Interagency Country Risk Assessment System
paragraphs: Following enactment of the Federal Credit Reform Act in 1990, the  Interagency Country Risk Assessment System (ICRAS)—a working group  of executive branch agencies engaged in international credit activities—  was formed to provide uniformity to the process for evaluating country risk  and estimating the program costs. The Export-Import Bank (Ex-Im Bank)  uses ICRAS ratings in determining the program costs of its sovereign  financing and as a factor in its own rating process for its nonsovereign, or  private, financing. The determination of expected loss rates under the  ICRAS system has two components: (1) the assignment of risk ratings for  particular borrowers or transactions and (2) the determination of loss rates  for each risk category. Both Ex-Im Bank and the Office of Management and  Budget (OMB) play key roles in the ICRAS process—OMB chairs ICRAS,  and Ex-Im Bank provides country risk assessments and risk rating  recommendations, which are then distributed to, and agreed on, by all the  ICRAS agencies. OMB is then responsible for determining the expected  loss rates associated with each ICRAS risk rating and maturity level.
subsections: section_title: Overview of the ICRAS Framework
paragraphs: become binding when OMB puts into effect the recommendations of a  “group” of country papers. This occurs twice each year.
Based on the results of this interagency process, OMB publishes two risk  ratings for each country—a sovereign rating and a nonsovereign, or private,  rating. Each sovereign borrower or guarantor is rated on an 11-category  scale, ranging from A through F- - (or their numerical counterparts,  categories 1-11). Category 1 (or A) is the most creditworthy and category  11 (or F- -) is the least creditworthy. According to Ex-Im Bank, four  categories, A through C-, are considered to be roughly equivalent to  creditworthy private bond ratings. The bottom three categories, F through  F- -, are used for countries that are insolvent or unwilling to make  payments. Categories in-between represent various degrees of repayment  difficulties. These ratings must be used in calculating the risk subsidy  charged to each agency’s budget when it undertakes a foreign transaction.  Each agency is free to set its own policies with respect to fees for different  risk categories and cover policy (which specifies the risk levels at which it  will undertake new business).
Under credit reform, OMB is responsible for determining the expected loss  rates associated with each ICRAS risk rating and maturity level. OMB  provides updated expected loss rates to the ICRAS agencies for them to use  each year in preparing budget submissions, calculating reestimates, and  allocating subsidy costs during the fiscal year.
section_title: Country Risk Assessments
paragraphs: In terms of extending export credits, country risks represent risks that  threaten the repayment of obligations, apart from the financial viability of  the transaction. In general terms, the degree of risk is measured as the  product of the probability of payment delays and the probability of  subsequent nonrecovery. A payment delay is any failure to make payments  of principal or interest on original contract terms. Nonrecovery occurs in  the event of default or debt forgiveness or when there are recurring or  extended arrears. burden, the government’s ability to acquire foreign exchange to repay  foreign obligations, macroeconomic environment, and political or social  constraints. In addition to indicators reflecting those factors, ICRAS  sovereign ratings are also based on ratings of private rating agencies and a  group of Organization for Economic Cooperation and Development  member countries, as well as information on a country’s payment arrears  history with the United States and other foreign creditors.
ICRAS ratings for private transactions in a country are based on qualitative  and quantitative assessments of the depth of private sector business  activity in a country and the strength of private sector institutions. In  addition to factors related to vulnerability to foreign exchange crises, the  ratings focus on a country’s banking system, legal system, foreign exchange  availability, business climate, and political stability. They can be either  higher or lower than ICRAS sovereign ratings.
section_title: Credit Reform Budgeting
paragraphs: The Federal Credit Reform Act of 1990 required that budget authority to  cover the cost to the government of new loans and loan guarantees (or  modifications to existing credits) be provided before the credits are made.  Credit reform requirements specified a net present value cost approach  using estimates for future loan repayments and defaults as elements of the  cost to be recorded in the budget. This permits policy makers to compare  the costs of credit programs with each other and with noncredit programs  in making budget decisions.
The credit reform act defines the subsidy cost of direct loans as the present  value of disbursements—over the loan’s life—by the government (loan  disbursements and other payments) minus estimated payments to the  government (repayments of principal, payments of interest, other  recoveries, and other payments). It defines the subsidy cost of loan  guarantees as the present value of cash flows from estimated payments by  the government (for defaults and delinquencies, interest rate subsidies, and  other payments) minus estimated payments to the government (for loan  origination and other fees, penalties, and recoveries).
Credit programs have a positive subsidy—that is, they lose money—when  the present value of estimated payments by the government exceeds the  present value of estimated receipts. Conversely, negative subsidy programs  are those in which the present value of estimated collections is expected to  exceed the present value of estimated payments; in other words, the  programs make money (aside from administrative expenses.) lives. It finances loan disbursements and the payments for loan guarantee  defaults with (1) the subsidy cost payment from the program account, (2)  loans from the Treasury, and (3) collections received by the government.  Figure 8 diagrams this cash flow.
Each year, as part of the President’s budget, agencies prepare estimates of  the expected subsidy costs of new lending activity for the coming year.  Agencies are also required to reestimate this cost annually. The Office of  Management and Budget (OMB) has oversight responsibility for federal  credit program compliance with credit reform act requirements and also  has responsibility for approving subsidy estimates and reestimates. In  addition, for international credits extended by U.S. agencies, OMB provides  agencies with specific guidance, including estimated defaults and  recoveries by risk rating category, to be used in determining expected  losses for financing activities.
All credit programs automatically receive any additional budget authority  that may be needed to fund reestimates. Thus, for discretionary programs,  original subsidy cost estimates receive different budget treatment than  subsidy cost reestimates. The original estimated subsidy cost must be  appropriated as part of the annual appropriation process. However, upward  reestimates of subsidy costs are financed from permanent indefinite budget  authority and do not have to be appropriated in the annual appropriations  process.
section_title: Technical Description of OMB Model for Estimating Expected Loss of U.S. International Credit Activities
paragraphs: The Office of Management and Budget (OMB) determines expected losses  for international credit activities through (1) a complex model that  includes two estimates of default probabilities by ratings category and a  rule for combining them and (2) an assumption about how much of the  value of defaulted credits will be recovered. The default rate estimates use  a statistical concept from finance literature that OMB terms “distance to  default.” The first estimated relationship—the spread-default  relationship—is between interest rate spreads on international bonds and  historical default rates of corporate debt. The second estimated  relationship—the ratings-default relationship—is between ratings on  corporate debt and the historical default rates of that debt. Historical  corporate default data are used in estimating both relationships. The model  is structured so that the overall estimates of default for different ratings  and maturities would be expected to be close to the underlying corporate  default rates used. They will differ from the underlying historical default  rates when interest rate spreads are higher or lower than their average over  the historical period of the data used in the analysis. In addition, available  information on the model suggests that there may be certain technical  biases in the model’s forecasts.
subsections: section_title: Distance to Default
paragraphs: OMB’s modeling approach uses a mathematical concept called “distance to  default,” a concept used in some finance models, which is a statistical  representation of the safety of a credit. The statistical variable has an  inverse relationship with default probability—the larger the distance to  default, the smaller the probability of default. OMB’s model, in common  with many models in academic finance journals, assumes that changes in  this variable follow a normal statistical distribution, with a mean of zero,  and that changes occur randomly with each time period. Using the  assumption of a normal distribution, and given an estimated standard  deviation, each distance to default implies a time pattern of annual default  rates. Distance to default is estimated by finding the default cost implied by  each distance to default and matching that cost to the prices at which  bonds of a given rating are trading. neutral distance to default,” which is related to interest rate spreads, refers  to default rates (and recovery rates on defaulted credits) that are  consistent with observed interest rates, assuming that interest rate spreads  are attributed only to expected default costs. Finance theory attributes the  difference between actual and risk-neutral distance to default to  components of the interest rate beyond those that are related purely to  default. For example, if lenders are risk averse, rather than risk neutral,  they may need to be compensated with more than $1 of extra interest to  bear a risk of loss that may, on average, be $1, but that may in some cases  be substantially more.
Given OMB’s estimated standard deviation of 3.79,a default rate of 25  percent for a 1-year bond implies an actual distance to default of 2.57. This  can be calculated from a standard normal distribution table. Thus, for a  given maturity, risk-free rate of interest, and standard deviation, knowledge  of any of the following factors—spread, risk-neutral distance to default, or  time pattern of default probabilities—allows the calculation of the other  two factors.
Spread-Default Relationship	 The spread-default relationship is an estimated relationship between  interest rate spreads on international bonds and historical default rates of  corporate debt, by rating and maturity. The relationship is structured so  that its estimated default rates will be close to the historical default rates  used when observed spreads are near their average levels and higher (or  lower) than the historical default rates when spreads are higher (or lower)  than average.
The spread-default relationship is estimated with a regression that uses  monthly observations on about 400 sovereign bonds and historical default  rates on corporate bonds from Moody’s Investors Service. The dependent  variable (the spread-related variable) is the risk-neutral distance to default,  which is calculated as a function of the monthly interest rate spreads on the  bonds in the sample. The independent variables are (1) the actual distance  to default in historical data (the default-related variable), which is  calculated for each rating and maturity as a function of the historical  corporate default rates used, and (2) the remaining maturity of each bond.
The data used for the spread-related variable in the regression, the risk­ neutral distance to default, are Bloomberg’s monthly observations on  foreign sovereign bonds, denominated in U.S. dollars and issued in 1987 or  later. The spread on each monthly observation was calculated and  transformed into an implied distance to default to be predicted by the  regression.
The key independent variable, based on a security’s rating, was calculated  as follows: ratings from Moody’s and two other private ratings firms,  Standard & Poor’s and Fitch Ratings, were linked to each monthly  observation. The average rating was calculated and used to link each  observation to an independent variable, the actual distance to default,  calculated as a function of historical default rates obtained from Moody’s.  The remaining maturity of each bond, the second independent variable,  was also taken from the Bloomberg data for each monthly observation. rate and the losses are discounted by the prevailing risk-free interest rate.  Thus, a given standard deviation and a mean “distance to default” will  generate a time pattern of default rates. This mean is chosen so that the  present value of the implied dollar losses equals the risk-neutral expected  loss.
The default-related independent variable, actual distance to default, is  calculated from Moody’s data on corporate defaults. Two Moody’s tables  showing cumulative defaults by risk rating category and maturity were  used, one for 1920-1999, and another for 1983-1999. The tables were  combined into one table with a default rate for each combination, using the  larger of the two default rates for each rating/maturity category. Missing  table entries, or reversals (such as a higher-rated category having a higher  default rate than the next lowest category) were handled by averaging table  entries. A calculation similar to that for the dependent variable is made,  finding a mean distance to default for each Moody’s rating category that  will generate a time pattern of defaults similar to that in the Moody’s tables.
Estimation of the regression produces the following parameters:  Risk-neutral distance to default = -0.26 - 0.0074 * maturity + 0.73 * actual  (Spread-related variable) distance to default  (Default-related variable) averaged to produce an estimated distance to default for that bond. The  weights, derived from the autoregressive parameter, are used to construct  the weighted average. The weights are calculated so that more recent  months have more weight when taking the average.
The actual distance to default predicted by this regression depends on the  interest spread on each bond relative to the average spread for its rating  category in the Bloomberg data used in the analysis. If the spread on a  particular bond is larger than the historical average spread in the database,  then the predicted actual distance to default will be smaller than the  historical average. This would imply that the projected defaults will be  larger than the historical average, because projected defaults move  inversely with distance to default. Because this part of the OMB model  bases default risk on a mixture of both current spreads and past spreads,  default risk estimates will change more slowly than will the market  assessment of risk, as reflected in changes in interest rate spreads.
section_title: Rating-Default Relationship
paragraphs: The relationship between ratings on corporate debt and the historical  default rates of that debt is estimated using the Moody’s corporate default  tables described above. The relationship is structured so that it predicts  cumulative default rates by ratings category and maturity that are almost  exactly the same as those in the combined Moody’s tables. As with the  spread-default relationship, it is assumed that distance to default is a  normally distributed variable whose mean and standard deviation  corresponds to a pattern of defaults over time. A mean for each rating  category is estimated, along with a common standard deviation for all  rating categories, that minimizes the sum of squared errors between the  cumulative default rates predicted by the means and standard deviation  and the actual data contained in the Moody’s corporate default database. A  different standard deviation is estimated for the first year than for  subsequent years. This allows the actual distance to default for any given  bond in a rating category to differ from the average distance to default for  all bonds within a rating category, in addition to allowing a bond’s distance  to default to change over time.
section_title: Aggregating the Estimates
paragraphs: The estimated actual distances to default for each bond from the spread­ default relationship are averaged together so that there is one estimated  distance to default for each rating category. The estimated mean distance  to default for each rating category obtained from the spread data is then  combined with the estimated mean distance to default from the rating data.  A Bayesian (type of statistical) weighting scheme is used, giving more  weight to the spread-default relationship. According to OMB, weights vary  by rating category, but generally a weight of about two-thirds is given to the  spread-default relationship and a weight of about one-third is given to the  rating-default relationship.
The result is a single actual distance to default number for each rating  category. This average value, combined with the common estimated  standard deviation for all ratings, is used to estimate annual default rates  for each rating category. An illustration of how spread changes can affect  OMB’s final default estimates is shown in figure 9.
section_title: Recovery Rates
paragraphs: To derive expected loss rates for each risk and maturity category from the  expected default rates generated by the model, OMB uses an assumption  about the percentage of defaulted credits that will be recovered. According  to OMB, a common recovery rate of 17 percent was used for fiscal year  2003, a common recovery rate of 12 percent was used for fiscal year 2004,  and a common recovery rate of 9 percent was used for fiscal year 2005.
section_title: Observations on Potential Technical Limitations of the Model
paragraphs: minimized. Using the regression to predict the risk-neutral distance to  default and then inverting the estimated relationship to predict actual  distance to default may result in greater errors in the projected  distances to default than estimating the regression with actual distance  to default as the dependent variable.
The relationships between risk-neutral distance to default and the two  independent variables—actual distance to default and maturity—may  not be linear. If this is the case, then spreads might provide an adequate  forecast of default probabilities near the means of the Bloomberg data  set used in the regression but not for values of spreads that depart from  the mean spread in the regression data. This issue could be important  for the reliability of estimates for credits with ratings several categories  below the average in the Bloomberg data. With sufficient data, the  potential for quantitatively important nonlinearities can be assessed by  estimating alternative specifications, such as including the squares and  cross-products of the independent variables.
section_title: Comparison of OMB Default Probabilities for Fiscal Years 2004 and 2005 with Corporate Default Rates Used in OMB Model
paragraphs: In fiscal year 2003, the Office of Management and Budget (OMB)  introduced its current methodology for estimating the expected loss rates  of international financing provided by U.S. credit agencies. This  methodology is used to estimate loss rates for 8 of the 11 risk-rating  categories established by the Interagency Country Risk Assessment System  (ICRAS).
OMB’s methodology includes two components that are used to estimate  default probabilities by ICRAS rating category. One component uses default  rates for corporate bonds published in 2000 by a nationally recognized  private rating agency, Moody’s Investors Service, to calculate the  probability that ICRAS agency borrowers will default. It estimates default  probabilities for each ICRAS rating category by using one or more  underlying Moody’s risk category. The other component uses data on  interest rate differences, or spreads, to vertically adjust the Moody’s  corporate default rates by rating category when interest rate spreads are  unusually high or low relative to average spreads in that rating category.  Once it has determined default probabilities by ICRAS rating category, the  methodology applies a recovery rate assumption to derive expected loss  rates by rating category.
We compared the default probabilities underlying OMB’s fiscal year 2004  and 2005 expected loss rates for ICRAS categories 1 through 8 with the  Moody’s corporate default data that OMB used in estimating these rates.  We determined that the OMB default probabilities were lower for each  ICRAS rating category in both fiscal years than were the underlying  Moody’s default rates. Figures 10 through 17 compare OMB’s default  probabilities for fiscal years 2004 and 2005 in a given ICRAS rating category  with the Moody’s corporate default rates used in OMB’s model that  correspond to each rating category. The figures show that the OMB default  rates were generally similar in fiscal years 2004 and 2005, with somewhat  lower rates in 2005 for certain ICRAS categories.
section_title: Trends in Interagency Country Risk Assessment System Expected Loss Rates
paragraphs: Through the Interagency Country Risk Assessment System (ICRAS), the  Office of Management and Budget (OMB) annually provides expected loss  rates to ICRAS agencies to use in preparing their budget submissions and  subsidy cost estimates. The expected loss rates, issued for each of the 11  ICRAS risk categories, have changed in percentage terms over time. Figure  18 shows the trends in expected loss rates for ICRAS categories 1 through 8  for credits of 8-year maturity, expressed in present value terms, for fiscal  years 1997 through 2005.
section_title: Comments from the Office of Management and Budget
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to those individuals named above, Allison Abrams, Nathan  Anderson, Dan Blair, Patrick Dynes, Reid Lowe, Ernie Jackson, Austin Kelly, Bruce Kutnick, Berel Spivack, and Roger Stoltz made major  contributions to this report.
section_title: GAO’s Mission
paragraphs: The Government Accountability Office, the audit, evaluation and  investigative arm of Congress, exists to support Congress in meeting its  constitutional responsibilities and to help improve the performance and  accountability of the federal government for the American people. GAO  examines the use of public funds; evaluates federal programs and policies;  and provides analyses, recommendations, and other assistance to help  Congress make informed oversight, policy, and funding decisions. GAO’s  commitment to good government is reflected in its core values of  accountability, integrity, and reliability.
section_title: Obtaining Copies of GAO Reports and Testimony
paragraphs: The fastest and easiest way to obtain copies of GAO documents at no cost  is through GAO’s Web site (www.gao.gov). Each weekday, GAO posts newly released reports, testimony, and correspondence on its Web site. To  have GAO e-mail you a list of newly posted products every afternoon, go to  www.gao.gov and select “Subscribe to Updates.”
subsections: section_title: Order by Mail or Phone
section_title: To Report Fraud, Waste, and Abuse in Federal Programs
section_title: Congressional Relations
section_title: Public Affairs