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. 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. 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.