Export-Import Bank
OMB's Method for Estimating Bank's Loss Rates Involves Challenges and Lacks Transparency Gao ID: GAO-04-531 September 30, 2004The 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.
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.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-04-531, Export-Import Bank: OMB's Method for Estimating Bank's Loss Rates Involves Challenges and Lacks Transparency
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Report to Congressional Committees:
September 2004:
EXPORT-IMPORT BANK:
OMB's Method for Estimating Bank's Loss Rates Involves Challenges and
Lacks Transparency:
GAO-04-531:
GAO Highlights:
Highlights of GAO-04-531, a report to congressional committees.
Why GAO Did This Study:
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.
What GAO Found:
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.
OMB Expected Loss Rates for U.S. Government International Credits by
Risk Rating Category (Present Value Basis), Fiscal Years 2002 and
2005:
[See PDF for image]
[End of figure]
What GAO Recommends:
GAO recommends that the Director of OMB provide affected U.S. agencies
and Congress with technical descriptions of its current expected loss
methodology and update this information when there are changes. GAO
also recommends that the Director arrange for independent review of
the methodology and ask U.S. international credit agencies for their
most complete, reliable data on default and repayment histories, so
that the validity of the data on which the methodology is based can be
assessed over time.
www.gao.gov/cgi-bin/getrpt?GAO-04-531.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Celia Thomas, (202-512-
8987), thomasc@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
OMB Developed New Method That Lowered Expected Loss Rates:
Current OMB Methodology Has Lowered Ex-Im Bank's Projected Subsidy
Costs and Budgetary Needs:
Loss Estimation Involves Challenges and OMB Methodology Is Not
Transparent:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: Loss Estimation Practices of Foreign Export Credit
Agencies:
ECAs in Canada and the United Kingdom Have Methodologies to Estimate
Future Defaults and Losses in Determining Reserve Levels:
ECAs in France and Germany Use Fees to Offset Loss:
OECD Participating Countries' Risk Assessment and Fee Arrangement:
Appendix III: Loan Loss Allowance Guidance and Select Commercial Bank
Practices:
Loan Loss Allowance Is an Important Factor in an Institution's
Financial Condition:
Accounting and Regulatory Guidance Are Not Prescriptive; the Loan Loss
Allowance Requires Significant Judgment:
Regulatory Agencies and Accounting Organizations Have Been Reviewing
Loan Loss Allowance Guidance:
Reviewed Banks Follow Basic Concepts in Accounting and Regulatory
Guidance but Vary in Allowance Methodologies:
Appendix IV: Interagency Country Risk Assessment System:
Appendix V: Credit Reform Budgeting:
Appendix VI: Technical Description of OMB Model for Estimating Expected
Loss of U.S. International Credit Activities:
Appendix VII: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 with Corporate Default Rates Used in OMB Model:
Appendix VIII: Trends in Interagency Country Risk Assessment System
Expected Loss Rates:
Appendix IX: Comments from the Office of Management and Budget:
Appendix X: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Staff Acknowledgments:
Tables:
Table 1: Summary of Accounting and Regulatory Guidance Followed by
Banks in Their Loan Loss Allowance Calculation:
Table 2: Regulatory Agencies' Risk Rating Scale:
Figures:
Figure 1: Components of the ICRAS Process:
Figure 2: Trends in Interest Rate Spreads for Argentine, Russian, and
Mexican Government Bonds as Compared to U.S. Treasury Bonds, 1999-2003:
Figure 3: Comparison of OMB Default Probabilities for Fiscal Years 2004
and 2005 and Moody's Corporate Default Rates Used in OMB Model for
Selected Rating Categories:
Figure 4: Comparison of OMB's Expected Loss Rates, in Present Value
Terms, for ICRAS Risk Categories 1-8, Fiscal Years 2002-2005:
Figure 5: Ex-Im Bank Obligation of Budget Authority for New Subsidy
Costs, Fiscal Years 1992-2003:
Figure 6: Comparison of Ex-Im Bank Exposure Fees and Expected Loss
Rates by ICRAS Category, Fiscal Years 2002 and 2005:
Figure 7: Example of a Commercial Bank's Loan Loss Allowance Process
for Corporate Loans:
Figure 8: Program and Finance Account Budgeting for Ex-Im Bank under
Credit Reform:
Figure 9: Illustration of How Spread Changes Can Affect the Final
Expected Default Estimates:
Figure 10: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 1 with Moody's Corporate Default Rates Used
in OMB Model:
Figure 11: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 2 with Moody's Corporate Default Rates
Used in OMB Model:
Figure 12: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 3 with Moody's Corporate Default Rates Used
in OMB Model:
Figure 13: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 4 with Moody's Corporate Default
Rates Used in OMB Model:
Figure 14: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 5 with Moody's Corporate Default
Rates Used in OMB Model:
Figure 15: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 6 with Moody's Corporate Default
Rates Used in OMB Model:
Figure 16: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 7 with Moody's Corporate Default
Rates Used in OMB Model:
Figure 17: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 8 with Moody's Corporate Default
Rates Used in OMB Model:
Figure 18: Trends in ICRAS Expected Loss Rates for 8-Year Maturity
Credits, in Present Value Terms, Fiscal Years 1997-2005:
Abbreviations:
EL: expected loss:
ECA: export credit agency:
Ex-Im Bank: Export-Import Bank:
FDIC: Federal Deposit Insurance Corporation:
FRB: Federal Reserve Board:
FASB: Financial Accounting Standards Board:
GAAP: generally accepted accounting principles:
ICRAS: Interagency Country Risk Assessment System:
LGD: loss given default:
OCC: Office of the Comptroller of the Currency:
OMB: Office of Management and Budget:
OECD: Organization for Economic Cooperation and Development:
PD: probability of default:
SEC: Securities and Exchange Commission:
SFAS: Statement of Financial Accounting Standards:
U.K.: United Kingdom:
Letter September 30, 2004:
The Honorable Richard C. Shelby:
Chairman:
The Honorable Paul S. Sarbanes:
Ranking Minority Member:
Committee on Banking, Housing and Urban Affairs:
United States Senate:
The Honorable Michael G. Oxley:
Chairman:
The Honorable Barney Frank:
Ranking Minority Member:
Committee on Financial Services:
House of Representatives:
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.[Footnote 1] 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.[Footnote 2] 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.[Footnote 3] 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.[Footnote 4] For the
fiscal year 2003 budget, OMB significantly changed its methodology for
determining these rates.[Footnote 5] 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.[Footnote 6]
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.[Footnote 7] 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.
Results in Brief:
OMB developed its current methodology for determining expected loss
rates, which lowered them, in part because of finance literature
indicating that its former approach likely overstated losses to the
government. OMB's former methodology for estimating loss rates relied
on interest rate differences--"spreads"--between bonds at different
risk levels and low-risk bonds such as U.S. Treasury bonds. The former
methodology assumed that higher interest rates on bonds at different
risk levels signaled the extent to which they presented higher
probabilities of default and expected loss. The finance literature
indicated that other factors in addition to expected losses, such as
tax and liquidity considerations, influence interest rate differences.
OMB's current methodology uses rating agency corporate default data and
interest rate spreads in a model it developed to estimate default
probabilities and makes assumptions about recoveries after default to
estimate expected loss rates. This methodology has generally predicted
default rates somewhat lower than the underlying corporate rates it
uses. Under the current methodology, expected loss rates for 8-year
maturity credits were on average about 58 percent lower in fiscal year
2005 than in fiscal year 2002, in risk categories in which Ex-Im Bank
generally undertakes new financing.
With lower loss rates, OMB's current methodology has contributed to Ex-
Im Bank projections of lower subsidy costs and budgetary requirements
and influenced a modification in the way the bank calculates loss
allowances for its financial statements. OMB's new loss rates
contributed to the bank's request of smaller budget authority in fiscal
years 2003 through 2005 to cover its anticipated subsidy costs. In
addition, in fiscal year 2003, Ex-Im Bank's obligation of budget
authority for subsidy costs dropped by almost half from fiscal year
2002, while the amount and estimated average risk of the bank's new
financing in those years was similar. When Ex-Im Bank reestimated the
subsidy cost of its outstanding portfolio at the end of fiscal year
2002 using the new rates, these costs dropped by $2.7 billion, a
decrease attributed by Ex-Im Bank officials primarily to OMB's lower
loss rates. Further, the fees that Ex-Im Bank charges to compensate for
risk are now projected to generally provide greater coverage of its
expected losses. During this period, Ex-Im Bank modified its approach
for calculating financial statement loss allowances to be more in line
with applicable accounting standards. This involved, among other
things, diverging from its former practice of using the same loss rates
to calculate loss allowances and subsidy costs. To maintain consistency
in its loss allowance estimation and because of the changed nature of
OMB's loss rates, Ex-Im Bank generally began using higher loss rates
for its loss allowances than it did for its subsidy costs.
The OMB's current methodology for estimating expected loss rates for
U.S. agencies' international credits involves challenges and is not
transparent. 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. More recent corporate default data than
what OMB used shows higher defaults in some risk categories. In
deciding to use this data to predict default, OMB analyzed Ex-Im Bank
historical defaults over a somewhat narrow period. The default data
analyzed did not cover other U.S. international credit agencies. OMB's
recovery rate assumptions have dropped twice since the methodology was
implemented. The lower rates serve to offset lower default projections
in the overall estimation of expected loss, but the basis for the
recovery rates and the changes over time has not been transparent.
Finally, despite the complexity and implications of the current
methodology, OMB developed it independently and provided affected
agencies with limited information about its basis or structure.
To improve the transparency of the subsidy cost estimation process and
help ensure its validity, we are recommending that the Director of the
Office of Management and Budget take five actions. First, we recommend
that the Director provide affected U.S. agencies and Congress technical
descriptions of OMB's current method of determining expected loss
rates. Second, we recommend that the Director provide similar
information in the event of significant changes to its method for
calculating expected loss rates. Third, we recommend that the Director
ensure that OMB periodically update data from nonagency sources, such
as the corporate default data used to estimate expected loss rates.
Fourth, we recommend that the Director request from Ex-Im Bank and
other U.S. international credit agencies the most complete and reliable
information available on their default and repayment histories, so that
the validity of the information on which the current methodology is
based can be assessed over time. Finally, we recommend that the
Director provide for, and document, independent methodological review
of OMB's expected loss model.
Commenting on a draft of this report, OMB generally agreed to implement
these recommendations. OMB also expressed concern about the report's
statement that its 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, and similar
information should be more readily available on an ongoing basis to
affected agencies and Congress. Ex-Im Bank and the Comptroller of the
Currency reviewed the report and made technical comments, which we
incorporated where appropriate. The Department of the Treasury, the
Federal Reserve Board, and the Federal Deposit Insurance Corporation
did not have comments on the report. The Securities and Exchange
Commission and the Department of Agriculture's Foreign Agricultural
Service reviewed parts of the report for technical accuracy; the
Securities and Exchange Commission provided technical comments, which
we incorporated where appropriate. We also obtained technical comments
from bank and foreign ECA officials on our descriptions of their
practices.
Background:
Established in 1934, Ex-Im Bank is an independent U.S. government
corporation that serves as the official ECA of the United
States.[Footnote 8] 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.[Footnote 9]
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.[Footnote 10] 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.[Footnote 11] 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.[Footnote 12] 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.[Footnote 13]
Through the Interagency Country Risk Assessment System
(ICRAS),[Footnote 14] which OMB chairs, ICRAS agencies determine risk
ratings that will be in effect each fiscal year (see box 1 in fig.
1).[Footnote 15] 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).[Footnote 16] 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.[Footnote 17] (App. IV contains more
information about the ICRAS risk rating process.)
Figure 1: Components of the ICRAS Process:
[See PDF for image]
[End of figure]
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.
[Footnote 18]
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.[Footnote 19] 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.[Footnote 20]
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.[Footnote 21] 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."[Footnote 22] 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 New Method That Lowered Expected Loss Rates:
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.
OMB's Former Methodology Based Expected Loss Estimates on Differences
in Bond Interest Rates:
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.[Footnote 23] 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.
Figure 2: Trends in Interest Rate Spreads for Argentine, Russian, and
Mexican Government Bonds as Compared to U.S. Treasury Bonds, 1999-2003:
[See PDF for image]
[End of figure]
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).[Footnote 24]
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.[Footnote 25]
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.[Footnote
26] 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.[Footnote 27]
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.[Footnote 28] 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.[Footnote 29]
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.[Footnote 30] 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.[Footnote 31] 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.[Footnote 32] (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.
OMB's Current Methodology Bases Expected Loss Rates on Corporate
Default Data, Interest Rate Spreads, and Recovery Assumptions:
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.[Footnote
33] (App. VI contains a technical description of the methodology.)
OMB Model Bases Default Estimates on Corporate Default Data and
Spreads:
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.[Footnote 34] 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.[Footnote 35]
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.[Footnote 36] 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.)
Figure 3: Comparison of OMB Default Probabilities for Fiscal Years 2004
and 2005 and Moody's Corporate Default Rates Used in OMB Model for
Selected Rating Categories:
[See PDF for image]
Note: OMB default probabilities were calculated from the expected loss
rates that OMB generated for the fiscal year 2004 and fiscal year 2005
budgets. The OMB default probabilities are calculated by removing the
recovery rate adjustments (12 percent for fiscal year 2004 and 9
percent for fiscal year 2005) from the net default probability tables
provided by OMB, which had recovery rates factored in.
[End of figure]
Methodology Combines Default Rates and Recovery Rates to Determine
Expected Losses:
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.[Footnote 37] 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.
OMB's Current Methodology Lowered Expected Loss Rates:
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.[Footnote 38] 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).[Footnote 39]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.)
Figure 4: Comparison of OMB's Expected Loss Rates, in Present Value
Terms, for ICRAS Risk Categories 1-8, Fiscal Years 2002-2005:
[See PDF for image]
Note: The figure compares loss expectations that were in place in each
fiscal year, in present value terms, for each ICRAS risk category based
on guarantees of 8-year maturity. We based the analysis on 8-year
maturities because this maturity is representative of many Ex-Im Bank
credits.
[End of figure]
For fiscal year 2003, the first year for which OMB's current
methodology was used to develop expected loss rates, rates declined
sharply across most ICRAS risk categories. Loss rates for fiscal year
2004 rose for several risk categories, with the biggest change being an
increase in the loss rate for ICRAS risk category 6. According to OMB,
the expected loss rates changed from fiscal year 2003 to 2004 because
of updated country ratings and interest rate data. OMB did not provide
more specific information to explain those changes. Also, the lower
recovery rate assumptions used in 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.
Current OMB Methodology Has Lowered Ex-Im Bank's Projected Subsidy
Costs and Budgetary Needs:
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.
Lower OMB Loss Rates Reduce Ex-Im Bank Budget Authority Needed to Cover
Subsidy Costs:
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.
Ex-Im Bank's requests for budget authority for subsidy costs have
dropped since it began using the lower loss rates to estimate subsidy
costs. The bank's request for subsidy budget authority in fiscal year
2003 was about 30 percent lower than the average of its requests in the
previous 5 years, partly because of lower OMB loss rates and partly
because of a substantial amount of budget authority carried over from
the previous fiscal year.[Footnote 40] Ex-Im Bank requested no new
subsidy budget authority in fiscal year 2004 but anticipated $460
million in new subsidy cost obligations.[Footnote 41] The amount of
budget authority carried over from previous fiscal years was seen as
sufficient to cover anticipated fiscal year 2004 subsidy costs.
[Footnote 42] Ex-Im Bank requested $126 million for subsidy budget
authority in fiscal year 2005, but it anticipated $491 million in
obligations for subsidy costs.[Footnote 43] 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.[Footnote 44]
Figure 5: Ex-Im Bank Obligation of Budget Authority for New Subsidy
Costs, Fiscal Years 1992-2003:
[See PDF for image]
Note: Figure excludes subsidy budget authority obligated for purposes
of tied-aid (government-to-government concessional financing of public
sector capital projects in developing countries that is linked to the
procurement of goods and services from the donor country).
[End of figure]
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.[Footnote 45] 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.[Footnote 46] 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.[Footnote
47]
With Lower Loss Rates, Ex-Im Bank Fees Are Projected to Provide Greater
Coverage of Losses:
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.[Footnote 48] 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.[Footnote
49]
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.
Figure 6: Comparison of Ex-Im Bank Exposure FeesA and Expected Loss
Rates by ICRAS Category, Fiscal Years 2002 and 2005:
[See PDF for image]
[A] Figure compares Ex-Im Bank exposure fees at the minimum OECD fee
level with GAO's analysis of expected loss for credits of 8-year
maturity in fiscal years 2002 and 2005 (see fig. 4).
[End of figure]
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.[Footnote 50] 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.[Footnote 51]
Ex-Im Bank Modified Its Method for Determining Financial Statement Loss
Estimates, Generally Using Higher Loss Rates Than for Budget
Calculations:
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.[Footnote 52] 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.[Footnote 53] 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.[Footnote 54] Second, the
bank determined that it should value its impaired credits in a manner
more consistent with relevant accounting standards.[Footnote 55]
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[Footnote 56] and unimpaired credits.[Footnote 57] 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.[Footnote 58] 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.[Footnote 59] 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.[Footnote 60]
Loss Estimation Involves Challenges and OMB Methodology Is Not
Transparent:
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.
Assessing ECA Financing Risk is Difficult, and Data Used by OMB May
Have Inherent Limitations for Predicting Ex-Im Bank Risk:
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.[Footnote 61] OMB's staff paper noted the desirability of
adding data from other agencies to its analysis in the future.
Assessing ECA Financing Risk Is Difficult:
Data limitations and changing environments present challenges for
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.[Footnote 62]
Corporate Bond Default Data Are Widely Used but Lack Broad Historical
Coverage of Developing Countries:
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.[Footnote 63] 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.[Footnote 64] 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.
More Recent Moody's Data Show Higher Defaults in Some Risk Categories:
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.
OMB Used Ex-Im Bank Data That Primarily Covered a Limited Period to
Establish Comparability with Corporate Data:
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.[Footnote 65] 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.[Footnote 66] 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.[Footnote 67] While we could not
determine the specific data that OMB analyzed,[Footnote 68] 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.[Footnote 69]
Recovery Rate Assumptions Have Not Been Transparent:
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.[Footnote 70] 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.[Footnote 71] 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.[Footnote 72]
OMB Developed Method Independently and Provided Agencies Limited
Information:
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.[Footnote 73] 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.[Footnote 74] 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.[Footnote 75] 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.
Conclusions:
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.
Recommendations for Executive Action:
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.
Agency Comments and Our Evaluation:
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
[Hyperlink, 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.
Signed by:
Loren Yager, Director:
International Affairs and Trade Issues:
[End of section]
Appendixes:
Appendix I: Objectives, Scope, and Methodology:
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.
To describe the current methodology, we examined OMB's written
descriptions of its methodology, posed specific questions to OMB staff
on 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.[Footnote 76]
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.
To determine the estimated default probabilities generated by the
default component of OMB's methodology for fiscal years 2004 and 2005,
we adjusted the expected loss rates for each rating and maturity
category that 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.
To determine the impacts of the current OMB methodology on Ex-Im Bank,
we examined changes in the components of Ex-Im Bank's subsidy costs and
financial statement loss allowances. Specifically, we examined the
following:
* To determine the effect of the current methodology on Ex-Im Bank's
budget needs, we reviewed Ex-Im Bank budget information from fiscal
years 1992-2005 and analyzed changes in the bank's requests for subsidy
cost authorization and its obligation of budget authority for subsidy
costs over that time period. We also interviewed Ex-Im Bank officials
regarding their views on how changes in expected loss rates affected
the bank's subsidy costs. We determined that Ex-Im Bank's budget
information was sufficiently reliable for the purpose of documenting
the bank's changing budget needs and confirmed our analyses with Ex-Im
Bank officials. We also examined Ex-Im Bank information, contained in
internal documents, on its reestimate calculations for fiscal years
1992-1995 and 1999-2003 and interviewed Ex-Im Bank officials regarding
their views on how changes in expected loss rates affected the bank's
reestimates. Ex-Im Bank's internal reestimate information differed
slightly in some years from information contained in the Federal Credit
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.
To assess the current methodology and the process by which it was
developed, we identified and evaluated the basis for key OMB
assumptions, methodological components, and data used. We also examined
OMB documentation of the process and discussed the process with
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.
We examined OMB's assumptions about recovery rates and compared these
with aggregate recovery rates that we calculated on Ex-Im Bank datasets
covering guarantees and some insurance for 1985-1999 and 1985-2001, as
well as with recovery rate assumptions made by other financial
institutions. We discussed the reliability of the Ex-Im Bank data sets
and of 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.[Footnote 77]
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.
[End of section]
Appendix II: Loss Estimation Practices of Foreign Export Credit
Agencies:
Significant variation exists among the loss estimation, or reserve,
practices of foreign export credit agencies (ECA) that we
consulted.[Footnote 78] 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.)
ECAs in Canada and the United Kingdom Have Methodologies to Estimate
Future Defaults and Losses in Determining Reserve Levels:
ECAs in Canada and the United Kingdom determine their required level of
loss reserves by estimating the extent of probable losses in their
portfolio at a point in time, some of which may result from future
defaults. These ECAs' missions, structures, and accounting approaches
lend important context to their reserve practices. The Canadian and
U.K. ECAs have recently revised (or are in the process of revising)
their risk assessment and reserve practices to more precisely measure
future losses. In developing their approaches, these two ECAs examined
the risk assessment and reserve practices of leading financial
institutions and worked with private sector risk assessment
specialists. Their approaches have similar elements but differ in
important respects. The new approaches have been reviewed by
specialists outside the ECA.
Mission, Structure, and Accounting Approaches Affect Reserve Practices:
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.[Footnote 79] 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.[Footnote 80]
In contrast, the U.K. ECA is a government department that receives
annual budgetary support (subject to Parliamentary approval) to help
fund its operations and cover its losses. The U.K. ECA is in a time of
transition. The ECA's operations were streamlined in 1991, when new
legislative authority required it to sell its short-term insurance
business and focus on medium-and long-term project finance.[Footnote
81] The U.K. ECA is expected to avoid direct competition with U.K.
private insurers and banks. It is also expected to undertake and manage
its activities to ensure, with a high degree of confidence, that it
will break even financially.[Footnote 82] 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.[Footnote 83]
Different ECA missions and structures can have implications for ECA
risk profiles and, thereby, reserve practices. For example, with its
broader mandate, about 60 percent of the Canadian ECA's 2003 portfolio
exposure was to U.S. and Canadian borrowers. In contrast, most of the
U.K. ECA's ten most active markets in fiscal years 2001 and 2002 were
emerging markets, representing about three-fourths of its activity in
these years.[Footnote 84] These different risk profiles affect the
level of loss reserves that these ECAs hold. According to the Canadian
ECA's financial statements, its allowances for loss averaged about 10
percent of its total exposure during calendar years 2000-2003.
According to the U.K. ECA, its allowances for loss averaged about 20
percent of total exposure between fiscal years 2000-2003.[Footnote 85]
It is important to note that, for business undertaken since 1991, the
U.K. ECA is expected to maintain reserves equal to at least 150 percent
of expected losses.[Footnote 86] 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.[Footnote 87] 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.[Footnote 88] 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.
Canadian and U.K. ECAs Have Recently Adopted, or Will Implement, New
Reserve Methodologies:
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.[Footnote 89]
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.[Footnote 90] The U.K. ECA is upgrading its
existing risk assessment models and processes in response to the
review.
Determining Risk Ratings and Calculating Probability of Default:
The Canadian and U.K. ECAs each use a combination of rating agency data
and their own analyses and adjustments in determining ratings levels
and default probabilities. For rating corporate risk, the Canadian ECA
uses ratings from major rating agencies such as Moody's Investors
Service and 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.
Calculating Expected Loss:
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.[Footnote 91] Both ECAs assume higher losses (lower repayments)
for corporate than sovereign defaults.[Footnote 92] 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.
Adjusting for Portfolio Risk:
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.
Determining Fees:
Canadian and U.K. ECA officials both said that their loss estimation
methodologies help them determine what fees to charge borrowers for
their products. Both ECAs agree to follow a risk rating and pricing
agreement developed by participating Organization for Economic
Cooperation and Development (OECD) countries, in which participants
jointly develop country risk ratings for the purposes of determining
the minimum fees to be charged at each risk rating.[Footnote 93] (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.
Canadian and U.K. Reserve Methodologies Were Subject to Internal and
External Review:
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.[Footnote 94]
ECAs in France and Germany Use Fees to Offset Loss:
ECAs in France and Germany base their reserve practices primarily on
the fees they collect for their products rather than on systematic
estimations of their probable losses. These ECAs are private companies
that offer export credit insurance on behalf of their respective
governments, following certain risk thresholds that their governments
establish for these accounts. Their governments expect these accounts
to break even in the long run. The French and German ECAs are not
expected to estimate future losses when transacting new business but
rely instead on the OECD participating countries' guidance in setting
their fees. Neither France nor Germany annually appropriates budgetary
funds to cover loss; instead, the fees the 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.
French and German ECAs Provide Export Insurance and Guarantees on
Behalf of Their Governments and Follow Government Accounting Methods:
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.[Footnote 95] The ECAs are not responsible for any
profit or loss incurred on the state account, which transfers to the
government.[Footnote 96] 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.
The French and German state accounts are both directed to break even
over the long term, meaning they should incur neither large gains nor
losses. However, assessing compliance with this mandate is difficult,
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.
French and German ECAs Follow Government-Determined Risk Thresholds and
Use Fees to Cover Loss:
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.[Footnote 97]
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.
OECD Participating Countries' Risk Assessment and Fee Arrangement:
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.
[End of section]
Appendix III: Loan Loss Allowance Guidance and Select Commercial Bank
Practices:
Loans are the largest component of most depository institutions'
assets; therefore, the loan loss allowance[Footnote 98] 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.
Loan Loss Allowance Is an Important Factor in an Institution's
Financial Condition:
The loan loss allowance plays a key role in the financial condition of
a bank.[Footnote 99] It reflects a bank's judgment of the overall
collectibility of its loan portfolio; that is, the higher the
percentage of a bank's loan loss allowance to its total loan portfolio,
the lower the estimated collectibility of the loan portfolio and the
higher the estimated level of credit risk.[Footnote 100] It also
reflects 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,[Footnote 101] 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.
Accounting and Regulatory Guidance Are Not Prescriptive; the Loan Loss
Allowance Requires Significant Judgment:
Regulatory agencies told us that their guidance is not prescriptive,
and accounting and regulatory guidance states that the loan loss
allowance requires a significant amount of judgment. Because no single
approach has been determined to encompass the wide variety of banks'
loan portfolios and their varying degree of risk and unique historical
loss experience, regulatory and accounting guidance provide principles
and guidelines for banks to follow, rather than specific formulas and
factors for banks to use in their allowance calculations. The bank
regulators direct institutions to follow U.S. generally accepted
accounting principles (GAAP), as it applies to the loan loss allowance,
for regulatory reporting purposes. Specifically, banks follow Statement
of Financial Accounting Standards (SFAS) 114, Accounting by Creditors
for Impairment of a Loan, in estimating losses from individual
impaired[Footnote 102] loans. Further, SFAS 5, Accounting for
Contingencies,[Footnote 103] 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[Footnote 104] 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.
Table 1: Summary of Accounting and Regulatory Guidance Followed by
Banks in Their Loan Loss Allowance Calculation:
Individual impaired loans: Accounting guidance: Conditions: Under SFAS
114, a loan is impaired when it is probable that the bank will be
unable to collect amounts due according to the terms of the loan.
Banks determine impairment using normal loan review procedures;
Individual impaired loans: Regulatory guidance: Conditions: Banks
determine impairment using their loan review procedures. Generally, a
loan is impaired for the purposes of SFAS 114 if it exhibits the same
level of weaknesses and probability of loss as loans (or portions of
loans) classified as "doubtful" or "loss." (See table 2 for risk
classifications.).
Individual impaired loans: Accounting guidance: Measurement of
impairment: Under SFAS 114, one of the following methods must be used:
* present value of expected future cash flows discounted at the loan's
effective interest rate,
* loan's observable market price, and;
* fair value of collateral if the loan is collateral dependent;
Individual impaired loans: Regulatory guidance: Measurement of
impairment: SFAS 114 guidance should be followed. Regulators expect
that loan loss allowances for all impaired, collateral dependent loans
will be based on the fair value of the collateral for purposes of
regulatory reports.
Pools of loans: Accounting guidance: Conditions: Under SFAS 5, the
following conditions must be met: (1) it is probable that a loan has
been impaired at the financial statement date and (2) the amount of
loss can be reasonably estimated. Under SFAS 114, some impaired loans
may have risk characteristics in common with other impaired loans, as
such a bank may aggregate those loans for evaluation of impairment;
Pools of loans: Regulatory guidance: Conditions: Banks should follow
guidance in SFAS 5 for measuring losses for pools of loans.
Pools of loans: Accounting guidance: Measurement of impairment:
According to SFAS 5, whether the amount of loss can be reasonably
estimated will depend on, among other things, the experience of the
bank, information about the ability of individual debtors to pay, and
analysis of the loans in light of the current economic environment. In
the case of a bank with no relevant experience, reference to the
experience of other enterprises in the same business may be
appropriate. According to the interpretation of SFAS 5 (FASB
interpretation 14), when a reasonable estimate of a loss is a range
and when some amount within the range appears at the time to be a
better estimate than any other amount within the range, that amount
will be accrued. When no amount within the range is a better estimate
than any other amount, the minimum amount in the range will be accrued;
Pools of loans: Regulatory guidance: Measurement of impairment: Because
no single approach has been determined to be appropriate for all banks,
a specific method to determine historical loss experience is not
required;
* The method a bank uses will depend to a large degree on the
capabilities of its information systems;
* Acceptable methods range from a simple average of the bank's
historical loss experience over a period of years to more complex
"migration" analysis;
* There is no fixed historical period that should be analyzed by banks
to determine average historical loss experience.
Source: GAO analysis of accounting and regulatory guidance.
[End of table]
Additional Guidance on International Lending:
According to bank regulators, the accounting and regulatory guidance
discussed above and described in table 1 applies to both domestic and
international lending. However, bank regulators stated that because
international lending involves more risk than domestic lending, banks
that lend internationally must follow additional guidance. The primary
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.[Footnote 105] 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.[Footnote 106]
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.[Footnote 107] 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.[Footnote 108]
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[Footnote 109]
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.
Regulatory Guidance on Portfolio Segmentation and Risk Ratings:
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.
Table 2: Regulatory Agencies' Risk Rating Scale:
Risk category: Pass;
Definition: A pass asset presents no inherent loss (no formal
regulatory definition exists for "pass" credits).
Risk category: Special mention;
Definition: 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.
Risk category: Substandard;
Definition: 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-
efined 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.
Risk category: Doubtful;
Definition: 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.
Risk category: Loss;
Definition: 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.
Source: OCC guidance.
[End of table]
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.
Regulatory Agencies and Accounting Organizations Have Been Reviewing
Loan Loss Allowance Guidance:
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.
Regulatory Agencies Supplement Existing Guidance:
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.
Financial regulatory agencies issued additional guidance on the loan
loss allowance. In March 1999, the FDIC, FRB, OCC, Office of Thrift
Supervision, and Securities and Exchange Commission issued a joint
letter to financial institutions on the loan loss allowance, in which
they agreed to establish a joint working group to study the loan loss
allowance and provide improved guidance focusing on appropriate
methodologies and supporting documentation and enhanced disclosures. In
2001, the Federal Financial Institutions Examination Council finalized
and issued its Policy Statement on Allowance for Loan and Lease Losses
Methodology and Documentation, which supplements existing regulatory
guidance. The 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.
Accounting Guidance for the Loan Loss Allowance is Under Review:
FASB is charged with establishing authoritative private sector
accounting principles for financial reporting.[Footnote 110] 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.[Footnote 111]
The Institute organized a loan loss task force with observers from the
OCC, Securities and Exchange Commission and FASB on accounting for loan
losses to "narrow the boundaries" of what is acceptable under GAAP. The
Institute's exposure draft of a proposed Statement of Position,
"Allowance for Credit Losses," was released for public comment in June
2003 and discussed the following: the distinction between current and
future losses; how to reconcile acceptable methods for measuring loss
incurred for specific loans versus pools of loans that are collectively
evaluated; disclosure requirements; and the appropriate use of
observable data in the loan loss allowance calculation. As discussed in
the March 2004 Update on Accounting for Loan and Lease Losses, the
proposed Statement of Position raised concerns among the banking
regulators and other members 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.[Footnote 112]
Reviewed Banks Follow Basic Concepts in Accounting and Regulatory
Guidance but Vary in Allowance Methodologies:
We spoke with three U.S. commercial banks with large lending portfolios
totaling approximately $800 billion, including large international
exposures.[Footnote 113] 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.
Figure 7: Example of a Commercial Bank's Loan Loss Allowance Process
for Corporate Loans:
[See PDF for image]
[End of figure]
Assignment of Risk Ratings:
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.
For international lending, the three banks factor their country risk
rating, determined internally, into the rating that they assign a loan.
A loan to a 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.
Calculation of Loan Loss Allowance:
Based on direction from regulatory and accounting guidance, the three
banks calculate loan loss allowances by grouping loans with similar
characteristics into pools and calculating an allowance for each pool
(which will be referred to as the "general allowance"). In other cases,
banks calculate the loan loss allowance for certain loans on an
individual basis (which will be referred to as the "specific
allowance"). (Examples of general and specific allowance calculations
are illustrated in figure 7, Step B.) In calculating the loan loss
allowance, banks also consider and adjust for various factors including
imprecision in the financial models used and changing economic
conditions that may affect forecasted loan losses.[Footnote 114] As
with all aspects of a bank's loan loss allowance methodology,
regulatory and accounting guidance require that support for these
adjustments be well documented.
Calculation of the General Allowance:
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.
Calculation of the Specific Allowance:
In their specific allowance calculation, the three banks told us that
they calculate loan loss allowance for impaired loans that are larger
than a specific dollar amount on an individual basis. Among the banks
with whom we spoke, this amount ranged from hundreds of thousands of
dollars to millions of dollars. This calculation follows the guidance
in SFAS 114. For individual impaired loans, banks typically use the
present value of discounted cash flows. One bank told us that expected
loss factors based on an assessment of the loans' loss potential are
determined by consultation between loan officers and members of the
risk management group. The discounted expected future cash flows are
generated using expected loss factors, the remaining number of months
that the loan is estimated to be nonperforming, the monthly interest
rate when the obligation became nonperforming, and the gross principal
balance when 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.
Review of the Loan Loss Allowance:
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.
[End of section]
Appendix IV: Interagency Country Risk Assessment System:
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.
Overview of the ICRAS Framework:
ICRAS was formed to satisfy the requirement of the Federal Credit
Reform Act of 1990 that common standards for country risk assessments
be established for all U.S. government agencies and programs providing
cross-border loans, guarantees, or insurance. OMB chairs
ICRAS,[Footnote 115] Ex-Im Bank serves as the secretariat, and several
other agencies that undertake foreign lending serve as contributing
members. Economists with Ex-Im Bank draft country papers that examine
economic, political, and institutional variables. These papers present
preliminary ratings on the creditworthiness of sovereign and
nonsovereign borrowers in a country. These papers are sent to OMB,
which distributes them to other ICRAS agencies for comment.
Occasionally, agencies make major written comments indicating
disagreement with an Ex-Im Bank-recommended rating. If the agency and
Ex-Im Bank continue to disagree after discussion, OMB schedules a
meeting of all ICRAS representatives to debate the unresolved issue(s).
If there is no disagreement on its contents, or when agreement has been
reached, the recommendations of a country paper 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.
Country Risk Assessments:
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.
Sovereign transactions are those that carry the full faith and credit
of the central government receiving the export credit. These would
typically include transactions guaranteed by the Central Bank,
Treasury, or Ministry of Finance. On a country-by-country basis, other
institutions may also be designated as sovereign institutions, acting
on behalf of the state. According to ICRAS documents, the ability of a
country to service its foreign debt depends on the following major
factors: foreign debt service 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.
[End of section]
Appendix V: Credit Reform Budgeting:
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.)
The Federal Credit Reform Act of 1990 set up a special budget
accounting system to record the budget information necessary to
implement credit reform. It provides for three types of accounts to
handle credit transactions. The program and financing accounts are used
by credit obligations made since 1991. The program account receives
appropriations for adminstrative and subsidy costs of a credit activity
and is included in budget totals. When a direct loan or a loan
guarantee is disbursed, the program account pays the associated subsidy
cost for that loan to the financing account. The financing account,
which is nonbudgetary, is used to record the cash flow associated with
loans or loan guarantees over their lives.[Footnote 116] 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.
Figure 8: Program and Finance Account Budgeting for Ex-Im Bank under
Credit Reform:
[See PDF for image]
[End of figure]
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.[Footnote 117]
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.[Footnote 118]
[End of section]
Appendix VI: Technical Description of OMB Model for Estimating Expected
Loss of U.S. International Credit Activities:
The Office of Management and Budget (OMB) determines expected losses
for international credit activities[Footnote 119] 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.
Distance to Default:
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.
Two forms of distance to default are used in the modeling effort.
"Actual distance to default" relates to the actual probabilities of
default. "Risk-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,[Footnote 120] 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.[Footnote 121] 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[Footnote 122] 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.
This spread-related variable, risk-neutral distance to default, is
calculated by taking the spread on a bond of a given maturity and
converting it to a risk-neutral expected loss. Specifically, the
calculation determines the difference between the present value of the
payments of the bond, assuming that the bond does not default, and the
market price of the bond implied by the bond's yield. The risk-neutral
expected loss is turned into a risk-neutral expected default by solving
an equation that relates expected loss to expected default rate. This
equation calculates the present value of the losses implied by a series
of default probabilities, where defaults are converted into a series of
dollar losses by multiplying by a constant loss rate[Footnote 123] 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 (Spread-related variable)=
-0.26 - 0.0074 * maturity + 0.73 * actual distance to default (Default-
related variable).
The above relationship is then inverted to produce a forecast of the
default-related variable, based on the value of the spread-related
variable, resulting in the following equation:
Actual distance to default = (0.26/0.73) + (0.0074/0.73) * maturity +
(1/0.73) * risk-neutral distance to default:
An autoregressive parameter is estimated from the residuals of the
above regression. This parameter is used to estimate a set of weights
for combining distance to default estimates. For every observed month,
each bond has a spread and maturity--hence, a predicted actual distance
to default. The predicted actual distance to default for each bond/
month is 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.[Footnote 124] 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.
Rating-Default Relationship:
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.
Aggregating the Estimates:
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.
Figure 9: Illustration of How Spread Changes Can Affect the Final
Expected Default Estimates:
[See PDF for image]
[End of figure]
Recovery Rates:
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.
Observations on Potential Technical Limitations of the Model:
Available information on the model suggests several potential technical
limitations, including the following:
* The independent variable in the regression, actual distance to
default, may be measured with error. The model assumes that a
particular observation may have a distance to default that is different
from the average implied by the rating category. Additionally, the
distance to default implied by the rating category does not change over
time, while risk may change over time, even within a rating category.
Measurement error in an independent variable generally results in a
downward bias in the coefficient for that variable.[Footnote 125] When
the estimated relationship is reversed so that spreads are used to
predict default rates, as in the OMB model, this bias will affect the
projected default rates.
* As noted, the actual distance to default implied by a rating category
remains constant over time, while the risk neutral distance to default,
implied by the interest rate spreads on bonds, changes over time. Thus,
the regression uses the relationship between spreads and defaults
across rating categories to produce an estimated coefficient. This
coefficient is then used to estimate default probabilities for a given
rating category, which change over time. The supporting documentation
for the model does not demonstrate a correspondence between changes in
default probability over time within a rating category and changes in
default probability across rating categories.
* A regression is designed to predict the dependent variable in such a
way that the squared errors in the prediction of the dependent variable
are 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.
[End of section]
Appendix VII: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 with Corporate Default Rates Used in OMB Model:
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.
Figure 10: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 1 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 11: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 2 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 12: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 3 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 13: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 4 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 14: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 5 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 15: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 6 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 16: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 7 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
Figure 17: Comparison of OMB Default Probabilities for Fiscal Years
2004 and 2005 for ICRAS Category 8 with Moody's Corporate Default Rates
Used in OMB Model:
[See PDF for image]
[End of figure]
[End of section]
Appendix VIII: Trends in Interagency Country Risk Assessment System
Expected Loss Rates:
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.[Footnote 126]
Figure 18: Trends in ICRAS Expected Loss Rates for 8-Year Maturity
Credits, in Present Value Terms, Fiscal Years 1997-2005:
[See PDF for image]
Note: The present values were calculated for credits of 8-year maturity
using OMB's credit subsidy calculator based on a discount rate of 5
percent in each fiscal year.
[End of figure]
[End of section]
Appendix IX: Comments from the Office of Management and Budget:
EXECUTIVE OFFICE OF THE PRESIDENT:
OFFICE OF MANAGEMENT AND BUDGET:
WASHINGTON, D.C. 20503:
SEP 21 2004:
Mr. Loren Yager:
Director:
International Affairs and Trade:
Government Accountability Office:
Washington, DC 20548:
Dear Mr. Yager:
Thank you for the opportunity to comment on your draft report
addressing OMB's method for calculating the expected losses of
international credits and its impact on the Export-Import Bank.
We appreciate the effort GAO has put into the report and that GAO
highlights the reasons for our change in method. Our previous method
reflected the best information and theory available at the time of its
implementation, but more recent theoretical and empirical evidence
suggests that the previous method overstated expected losses. Our new
method represents a substantial advance, though we continue to look for
theoretical advances and new empirical evidence that may improve the
methodology. GAO's report will add to the body of information that will
help us to refine the methodology further.
We are, however, concerned by the draft report's statement that the
method was not transparent. In this regard, the draft report itself
notes that GAO could "generally describe and assess key aspects of the
methodology," and the draft report includes a technical appendix that
describes our methodology (with calculations of how its estimates
respond to changes in interest rates). We readily acknowledge that the
model's estimation process is complex, but this complexity was
necessary to produce estimates that are as accurate as possible.
Complexity when necessary for accuracy should not be deemed to reflect
a lack of transparency. The best way to produce accurate estimates was
to retain the most compelling feature of our previous method (which was
its use of private market prices as a measure of risk) while relating
our default estimates to a long-term historical average benchmark.
OMB will continue to press agencies to collect additional data on the
performance of their credits. We will also update our corporate default
data, and re-estimate the model, addressing the comments made in the
draft report's technical appendix. Further, we will rewrite our
technical description of the model to include the results of the
updated estimation and all the information we included in our responses
to GAO's technical questions during the course of our consultation, and
provide that description to affected agencies and Congress. We expect
to update our corporate data and agency data on a regular basis.
While we will continue to solicit feedback from U.S. agencies that use
or are affected by ICRAS, we also plan to make the description of the
model available and to seek feedback on the model from a range of
academics and finance professionals outside of government.
Thank you again for the opportunity to comment on your draft report.
Sincerely,
Signed by:
J. D. Foster:
Associate Director for Economic Policy:
Office of Management and Budget:
[End of section]
Appendix X: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Celia Thomas, 202-512-8987 Shirley Brothwell, 202-512-3865:
Staff Acknowledgments:
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.
(320161):
FOOTNOTES
[1] This portfolio valuation includes guarantees, loans receivable,
insurance, receivables from subrogated claims, and undisbursed loans.
Claims are made to Ex-Im Bank when a loan that it has guaranteed or an
insurance policy that it has issued becomes overdue or defaults.
[2] Pub. L. No. 101-508.
[3] The Federal Credit Reform Act defines the cost of a direct loan as
the net present value (at the time of loan disbursement) of loan
disbursements, principal repayments, and interest payments, adjusted
for estimated defaults, prepayments, fees, penalties, and other
recoveries. It defines the cost of a loan guarantee as the net present
value (at the time the underlying loan is disbursed) of estimated
payments by the government (for defaults and delinquencies, interest
rate subsidies, and other payments) minus estimated payments to the
government (for origination and other fees, penalties, and recoveries).
When the present value of payments exceeds the present value of
receipts--that is, when a credit program loses money--a positive
subsidy exists. When the converse is true, a negative subsidy exists.
[4] The risk ratings assigned to transactions are also an important
determinant of subsidy costs. Information on how risk ratings are
determined for Ex-Im Bank is presented in the background section of
this report, although an assessment of the appropriateness of ratings
was outside the scope of this review.
[5] OMB made a small across-the-board downward adjustment to its
expected loss rates for the fiscal year 2002 budget, but this did not
entail a change in its basic methodology.
[6] Financial statement loss allowances consist of allowances for
losses on loans and claims receivable and liabilities for losses on
insurance and guarantee programs. These allowances are a measurement
that reflects probable and estimable uncollectible loan balances or
potential future liabilities, as required under private sector
accounting standards. They are not tied directly to a funding request.
[7] Pub. L. No. 107-189, Sec. 14 (12 U.S.C. 635 note).
[8] Ex-Im Bank, which is subject to reauthorization every 4 to 5 years,
was last reauthorized in June 2002.
[9] In grouping the countries for which Ex-Im Bank reported exposure in
its 2003 financial statement, we used World Bank and Organization for
Economic Cooperation and Development income classifications.
[10] On a direct loan, default occurs when payments due to Ex-Im Bank
are not made as scheduled. On a guaranteed loan, default occurs when
payments due to the private sector lender are not made as scheduled,
causing the lender to file a claim with Ex-Im Bank.
[11] Federal agencies that provide credit to the domestic market
include the Departments of Agriculture, Education, Housing and Urban
Development, and Veterans Affairs and the Small Business
Administration. Federal agencies that provide international credit
include the Departments of Agriculture and Defense and the Agency for
International Development, Ex-Im Bank, and the Overseas Private
Investment Corporation.
[12] These expected losses are estimates, based on available
information, of the mean, or average, level of future losses expected
from particular credit activities. Actual losses can be higher or lower
than the expected losses.
[13] Evaluating the risk rating process or the reasonableness of
specific ratings was beyond the scope of this engagement.
[14] ICRAS was established in 1991 to create uniformity among the
federal agencies involved in providing international credit. According
to OMB, these agencies had previously used separate methodologies for
estimating their subsidy costs, which often produced different default
expectations for the same debtor. The ICRAS working group is chaired by
OMB and includes representatives from the cross-border financing
agencies, including Ex-Im Bank, the Departments of Agriculture and
Transportation, the Overseas Private Investment Corporation, the Agency
for International Development, and the Defense Security Assistance
Administration. Other interested government organizations, including
the Departments of Treasury, State, and Commerce; the Federal Reserve;
the Council of Economic Advisors; and the National Security Council are
also represented.
[15] The ICRAS ratings for some countries are reviewed yearly, while
others are reviewed less frequently. Some ratings may be revised more
frequently depending on circumstances.
[16] These comparisons are made based on a table, or concordance, that
sets up a cross-walk between ICRAS ratings and the ratings of major
private rating agencies, such as Moody's Investors Service and Standard
& Poor's, as well as between ICRAS ratings and OECD ratings.
[17] Ex-Im Bank's Country Limitation Schedule identifies the countries
for which the bank's support is not available or for which limitations
on available credit length exist. See http://ww.exim.gov/tools/
country/country_limits.html.
[18] For medium-term transactions of less than $10 million (which
represent less than 10 percent of Ex-Im Bank's portfolio), the bank
uses a portfolio approach to assign rating categories, assigning an
overall category to a country. According to Ex-Im Bank officials, the
category assigned to these transactions is generally one risk category
higher than the private sector ICRAS rating for the country.
[19] For credit programs, OMB also provides the discount rates that are
used to calculate subsidy estimates. These rates are built into OMB's
credit subsidy calculator.
[20] PricewaterhouseCoopers LLP audited the credit subsidy calculator
in December 1999 to ensure that the calculations it is designed to make
are done correctly. The calculator was audited because users, as well
as the accountants and auditors who prepare and audit agency financial
statements, need to have assurance that it calculates reliable subsidy
costs in compliance with applicable legislation and accounting
standards.
[21] Permanent budget authority is available as the result of
previously enacted legislation and does not require new legislation for
the current year. Indefinite budget authority is budget authority of an
unspecified amount of money.
[22] The Government Corporation Control Act of 1945 required wholly
owned government corporations, including Ex-Im Bank, to follow private
sector principles and procedures. Since 1990, the act has required such
corporations to undergo annual audits by independent public
accountants.
[23] In these years, OMB presented its loss rates, for most ICRAS
categories, in terms of risk premiums, which were estimated average
differences between the interest rates on traded bonds in a risk
category and the U.S. Treasury bond rate. The default costs, or
expected losses, associated with those risk premiums were estimated to
be the difference between the present value of the loan or loan
guarantee's expected cash flows discounted at the Treasury interest
rate and the expected cash flows discounted at the risk-adjusted
interest rates.
[24] Initially, the spreads were computed relative to the lowest risk,
or AAA, corporate bonds. Later, OMB computed the spreads relative to
U.S. Treasury bonds.
[25] We reported in 1994 that expected losses using this method were
based on small numbers of spread observations in some ICRAS categories.
See GAO, Credit Reform: U.S. Needs Better Method for Estimating Cost of
Foreign Loans and Guarantees, NSIAD/GGD-95-31 (Washington, D.C.: Dec.
19, 1994).
[26] Literature cited by OMB included, in part, Jerome S. Fons, "Using
Default Rates to Model the Term Structure of Credit Risk," Financial
Analysts Journal 50 (1994): 25-32; and Edwin Elton, Martin J. Gruber,
Deepak Agrawal, and Chrisotopher Mann, "Explaining the Rate Spread for
Corporate Bonds," Journal of Finance 56 (2001): 247-277.
[27] "Portfolio risk" is the risk associated with the variability of
default rates--the likelihood that losses from defaults will be higher
in some periods than others. This portfolio risk, although related to
default costs, is not included in OMB's calculation of expected losses
because, according to OMB, it is not considered to be a cost to the
government and, thus, is not a cost for which the U.S. government would
need to budget.
[28] Elton et.al., "Explaining the Rate Spread for Corporate Bonds."
[29] Fons, "Using Default Rates to Model the Term Structure of Credit
Risk."
[30] This amount of the reduction was based on the amount by which the
default probability implied by interest rate spreads for ICRAS A-rated
credits was greater than published default probabilities for AA and
AAA-rated corporations.
[31] According to an Ex-Im Bank official, the bank calculates subsidy
cost reestimates at the end of the fiscal year using an approach that
is similar but not identical to one of the two approaches specified
under credit reform. Ex-Im Bank officials said that to reestimate the
subsidy cost of each cohort, they determine the outstanding principal
balance at the end of the fiscal year, the weighted average remaining
term to maturity, and the weighted average risk rating. They apply the
most current OMB expected loss rate that corresponds to each cohort's
average risk rating to the cohort's outstanding principal balance to
determine the cohort's reestimated subsidy cost. They compare that
amount with the amount already set aside for the cohort. If reestimated
subsidy costs are less than the amounts set aside the previous fiscal
year, this would result in a downward reestimate, the amount of which
is transferred from Ex-Im Bank's financing account to the Treasury.
[32] Information in this report about Ex-Im Bank's reestimates is based
on information that the bank provided for each year in which it
calculated reestimates. This information differs slightly in some years
from information about the bank's reestimates that is reported in the
Federal Credit Supplement to the budget. These figures reflect only the
subsidy cost portion of the reestimates cited. Ex-Im Bank also
calculates interest costs on the subsidy costs, but these costs are not
included in the figures.
[33] Expected losses for ICRAS categories 9 through 11 are calculated
differently. They are based on market prices (interest rates) on debt
issues of countries in these categories. According to OMB, it averaged
the limited interest rate observations of international debt for
countries in each category. OMB obtained the data from the
International Finance Review and WesBruin Capital. OMB changed its
method for fiscal year 2004 (1) to exclude collateralized instruments;
(2) for performing bonds, to adjust for the difference between bond
coupon rates and Treasury rates, excluding issues with unknown coupon
rates; and (3) to apply a discount to each ratings category (5 percent
for category 9, 10 percent for category 10, and 25 percent for category
11) to reflect that countries with high ratios of bilateral debt (debt
owed to other countries) to private debt are more likely to expect debt
reduction.
[34] Moody's ratings are themselves determined by the likelihood of
default (default rates) and the severity of default (recovery rates),
according to a Moody's official and agency documents.
[35] OMB converted the default probabilities in the Moody's tables to
default probabilities for ICRAS ratings by averaging certain values
within each table and making some judgmental decisions, which,
according to OMB, generally resulted in choosing values on the higher
side of the Moody's ratings when there was not a straight match with
ICRAS categories.
[36] We compared the Moody's and OMB's default rates for maturities of
1-8 years because the combined Moody's series that OMB used had only 8
years of default rates for ICRAS categories 5 through 8.
[37] Expected loss is equal to expected default multiplied by one minus
the recovery rate. Thus, an expected default rate of 15 percent and a
recovery rate of 20 percent would result in an expected loss rate of 12
percent. (This is expressed mathematically as 15 (1 - .20) =15 (.80) =
12.)
[38] Loss expectations rose slightly between fiscal years 2002 and 2005
for ICRAS categories 9 and 10 and declined slightly for category 11.
[39] We compared the loss expectations in place for 8-year guarantees
at ICRAS risk ratings 1-8 using Ex-Im Bank's cash flow worksheets and
determined their present value using OMB's credit subsidy calculator.
We selected 8-year credits because this maturity is representative of
many Ex-Im Bank credits. Specific loss expectations per ICRAS category
differ depending on the maturity of the credit, but the general trend
and average reduction over the period were similar for the other
maturity bands we analyzed.
[40] The bank's appropriations in a given fiscal year can be carried
over for up to 3 years if they are not completely obligated. This would
happen, for example, in years when the actual amount and risk ratings
of new financing the bank undertook in a fiscal year were lower than
had been anticipated for that year.
[41] The figure includes anticipated obligations of $440 million for
direct and guaranteed loan subsidies and $20 million for direct and
guaranteed loan modifications.
[42] The carryover resulted in part from Ex-Im Bank obligating
substantially less budget authority in fiscal year 2003 than it
expected. In its budget submission, the bank expected to obligate about
$655 million for new subsidy costs and modifications. However, it
obligated about $334 million of the $513 million it was authorized for
subsidy costs in fiscal year 2003.
[43] The bank anticipated obligations of $471 million for direct and
guaranteed loan subsidies and $20 million for direct and guaranteed
loan modifications.
[44] In 2002, Ex-Im Bank authorized about $10.1 billion in new
financing, with an average ICRAS risk weight of 4.9; its obligation of
subsidy budget authority that year was about $738 million. In fiscal
year 2003, Ex-Im Bank authorized about $10.5 billion in new financing,
with an average ICRAS risk weight of 5.0; its obligation of subsidy
budget authority that year was about $334 million.
[45] When calculating its reestimates, Ex-Im Bank uses the most current
OMB loss rates available. According to Ex-Im Bank officials, its
reestimate in fiscal year 2002 was calculated using fiscal year 2004
loss rates. The officials said that the fiscal year 2003 loss rates
were not used for any reestimate calculations.
[46] The total downward reestimate that Ex-Im Bank calculated in fiscal
year 2002 was about $3.5 billion, of which $2.7 billion was reestimated
subsidy cost and $0.8 billion was interest cost. At the end of fiscal
year 2003, Ex-Im Bank calculated a net downward reestimate of about
$1.9 billion, of which about $1.4 billion was reestimated subsidy costs
and about $0.5 billion was interest costs.
[47] Percentages on the 2002 reestimates were calculated on subsidy and
interest costs combined because information on the trends by cohort was
available only in this format.
[48] Exposure fees are fees that Ex-Im Bank charges borrowers to cover
the risk that the transaction will not be repaid. These fees vary
depending on the risk and tenor of the credit being offered. Ex-Im Bank
also charges other fees, including application processing fees and
commitment fees.
[49] This agreement was among Participants to the Arrangement on
Officially Supported Export Credits. Participants to the Arrangement
are Australia, Canada, the members of the European Community, Japan,
the Republic of Korea, New Zealand, Norway, Switzerland, and the United
States. The fee agreement, sometimes called the Knaepen Package after
the Belgian official instrumental in its formation, was concluded in
1997 and took effect in 1999. The fees in the agreement result from a
political agreement, an averaging of fees in place in 1996 across
certain export credit agencies.
[50] For corporate borrowers that Ex-Im Bank rates as riskier than the
OECD sovereign rating for the country where the corporation is located,
the bank charges fees that are higher than the OECD fee by 10 percent
increments for each difference in rating level. Thus, if Ex-Im Bank
rated a corporation in Country A at ICRAS category 5 when Country A is
rated at ICRAS category 3, the bank would charge that corporation an
exposure fee 20 percent higher than the OECD fee corresponding to ICRAS
category 3. However, because that fee would not cover expected loss in
ICRAS category 5, Ex-Im Bank would incur subsidy costs in this example.
[51] A foreign government official noted that Ex-Im Bank exhibits a
greater degree of transparency than other members of the export credit
group by explicitly disclosing the subsidy cost of its export credit
activities in its budget documents.
[52] Private sector accounting does not recognize future fee income
before it is received. In contrast, for budget purposes, the present
value of future fee income is recognized as an offset to expected
losses when a loan or guarantee is made.
[53] 2002 was the first year Deloitte & Touche served as Ex-Im Bank's
external auditor.
[54] FASB Interpretation Number 45 addresses Guarantors' Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others, an interpretation of FASB Statements Nos. 5,
57, and 107 and rescission of FASB interpretation No. 34.
[55] Ex-Im Bank officials cited Statement of Financial Accounting
Standard 114, which addresses Accounting by Creditors for Impairment of
Loan.
[56] Ex-Im Bank defined as impaired any loans or claims that are 90
days or more in arrears, that are rated in ICRAS categories 9-11, or
that have been rescheduled. The bank determined that about 34 percent
of the loans and about 95 percent of the claims it reported in its 2002
financial statement were impaired. For fiscal year 2003, about 23
percent of its loans and 95 percent of its claims were impaired.
[57] Ex-Im Bank discloses detailed information about its loss allowance
calculation, including the different loss rates it uses, in its Annual
Portfolio Review, which is compiled by its Portfolio Management and
Review Division.
[58] Ex-Im Bank also applied different loss rates depending on whether
the exposures were outstanding or undisbursed. To discount the effect
of exposure of cancellations and suspension of disbursements, Ex-Im
Bank set the loss percentage for each ICRAS category of undisbursed
exposure 15 percent lower than the loss percentage for outstanding
exposures.
[59] Usually, the loss rates that Ex-Im Bank applies to its financial
statements are the rates that will be in effect in the coming fiscal
year. According to an Ex-Im Bank official, fiscal year 2003 expected
loss rates were not used in the 2002 financial statement because OMB
made the fiscal year 2004 rates available sooner than expected.
[60] Ex-Im Bank's financial statement loss allowances have averaged
about 18 percent of its total exposure since fiscal year 1999. Ex-Im
Bank did not establish any allowances for credit losses on its loans
and loan guarantees through fiscal year 1988, suggesting that no
expected losses were associated with any of these credits. As the
bank's independent auditor at this time, GAO expressed adverse opinions
about the bank's financial statements for fiscal years 1983-1988,
noting that the financial statements were not fairly presented in
accordance with GAAP. Ex-Im Bank established financial statement loss
allowances for the first time in 1989, in the amount of $4.8 billion.
[61] Assessing the availability of default data at other ICRAS agencies
was beyond the scope of this review.
[62] For example, in 1985, Moody's and Standard & Poor's rated a total
of 15 sovereigns, with 14 of the countries rated in categories
corresponding to ICRAS category 1 and 1 corresponding to ICRAS category
5. In 1991, they rated a total of 34 countries, with 21 of the
countries rated in categories corresponding to ICRAS category 1, 6
rated in categories corresponding to ICRAS category 2, and 7 rated in
categories corresponding to ICRAS categories below 2. By 1999, these
rating agencies rated a total of 91 countries, with 58 rated in
categories below those corresponding to ICRAS category 2. (These
figures use an average of the two agencies' ratings, in cases where
they rated a country differently in a given year.)
In addition to the limited coverage of ratings, experts have noted that
countries historically have often given preferential treatment to
payments on their bonds compared with their loans because bonds
represented a relatively small share of a country's international debt.
[63] For example, in 1980, a very small percentage of bond issuers
rated by Moody's were located outside the United States; the non-U.S.
share grew to about 18 percent by 1990 and 40 percent by 2000.
[64] The study examined Standard & Poor's data on rated corporations as
of 1999. See Giovanni Ferri, Li-Gang Liu, and Giovanni Majnoni,"The
Role of Rating Agency Assessments in Less Developed Countries: Impact
of the Proposed Basel Guidelines," Journal of Banking and Finance 25
(2001): 115-148.
[65] Since credit reform, the value of Ex-Im Bank's annual loans and
loan guarantees have been the largest among ICRAS agencies, followed by
the Commodity Credit Corporation and the Overseas Private Investment
Corporation. On a total exposure basis, at the end of fiscal year 2002,
Ex-Im Bank represented 40 percent of the U.S. government's credit
exposure to sovereign and other official foreign borrowers; the Agency
for International Development and the Departments of Agriculture and
Defense represented most of the remainder. At that time, Ex-Im Bank
also represented about 70 percent of the U.S. government's credit
exposure to private foreign borrowers, with the remainder held
primarily by the Overseas Investment Protection Corporation and the
Department of Agriculture.
[66] OMB initially calculated default probabilities directly for
different risk categories. Because of the relatively small number of
observations in the database, the patterns shown were somewhat erratic,
with higher percentages of defaults in some lower-risk categories than
in higher-risk categories. OMB then used a statistical model to smooth
the patterns of historical defaults across ratings categories for ICRAS
categories 1-6.
[67] According to Ex-Im Bank officials, in 2000, they provided OMB a
database of the bank's guarantees and medium-and long-term insurance
financing activities covering fiscal years 1985-1999, which Ex-Im Bank
had created to provide information to a private bank with which they
were considering joint financing. According to Ex-Im Bank officials,
they did not include loans in the creation of that data set in 1999
because loans had become less important in the bank's financing. Ex-Im
Bank officials told us that the reliability of this data is
considerably greater for transactions initiated in 1996 or later.
Beginning in 1996, the key component databases were updated to increase
automatic data entry and verification.
[68] In a written response to our questions, OMB provided information
indicating that its analysis was based on data from 1993 and later, but
OMB staff stated subsequently that the analysis had used all
observations in the data set. Within the data set, credits prior to
fiscal year 1992 lack ICRAS risk ratings. OMB staff stated that they
assigned ratings by using risk ratings from private rating agencies.
However, we determined that very few countries below the highest rating
categories were rated by private rating agencies before 1992. This is
discussed in footnote 62.
[69] We obtained the 1985-1999 data set from Ex-Im Bank and examined
the distribution of transactions across the period covered. We
determined that, depending on how one defines the unit of analysis,
from two-thirds to over three-fourths of the observations in the data
set for which Moody's Investors Service, Standard & Poor's, or ICRAS
country ratings were available were from 1994-1999. We also determined
that, irrespective of which observations had ratings associated with
them, between slightly more than half and two-thirds of them were from
1994 or later. Between 85 and 91 percent of all the observations in the
database were from 1990 or later.
[70] Footnote 33 provides more information on how OMB uses market
prices in calculating expected losses for ICRAS categories 9-11.
[71] We analyzed the Ex-Im Bank data sets primarily at the aggregate
level. Recovery amounts in this data set represent recoveries received
directly by Ex-Im Bank and do not include payments to the U.S.
government through reschedulings of sovereign credits. Ex-Im Bank
provided us a second data set that updated the 1985-1999 data through
fiscal year 2001. Our analysis showed that the ratio of aggregate
recoveries to aggregate claims in the second data set is about 35
percent. Ex-Im Bank officials said that, when recoveries through
reschedulings are included, their total recovery rates are higher. Our
analysis showed that, when recoveries through reschedulings are
included, total recovery rates were about 26 percent for 1985-1999
period and about 43 percent for the 1985-2001 period.
[72] For example, in a hypothetical situation where the true default
probability was known to be 20 percent and the true recovery rate was
30 percent (corresponding to a loss rate of 70 percent), the true
expected loss rate would be 14.0 percent (20 x .70=14.0). However, an
overly low default rate of 15 percent combined with an overly low
recovery rate of 10 percent (corresponding to a loss rate of 90
percent) would yield a similar expected loss rate, 13.5 percent (15 x
.90=13.5).
[73] Federal Accounting Standards Advisory Board, Federal Financial
Accounting and Auditing Technical Release 6--Preparing Estimates for
Direct Loan and Loan Guarantee Subsidies under the Federal Credit
Reform Act, Amendments to Technical Release 3: Preparing and Auditing
Direct Loan and Loan Guarantee Subsidies Under the Federal Credit
Reform Act (Washington, D.C.: January 2004). This guidance was
developed by the Accounting and Auditing Policy Committee, a permanent
committee of the Federal Accounting Standards Advisory Board. The
committee was organized by OMB, GAO, the Department of Treasury, the
Chief Financial Officers' Council, and the President's Council on
Integrity and Efficiency as a body to research accounting and auditing
issues requiring guidance.
[74] Treasury officials determined, for example, that some credits that
were being used to determine the market value and implicitly the
riskiness of lower-rated country data were backed with collateral,
which would be expected to result in lower risk and higher prices.
[75] When the U.S. government forgives a country's debt, the budgetary
cost of the debt relief is determined by the estimated value of the
debt under credit reform terms. Thus, the lower the estimated value of
the debt, the lower the budgetary cost of debt forgiveness.
[76] The paper that OMB provided was marked "Draft: For Discussion
Purposes Only," but OMB representatives told us there were no
subsequent versions and it should be considered a final paper.
[77] Federal Accounting Standards Advisory Board, Federal Financial
Accounting and Auditing Technical Release 6--Preparing Estimates for
Direct Loan and Loan Guarantee Subsidies under the Federal Credit
Reform Act, Amendments to Technical Release 3: Preparing and Auditing
Direct Loan and Loan Guarantee Subsidies Under the Federal Credit
Reform Act (Washington, D.C.: January 2004). This guidance was
developed by the Accounting and Auditing Policy Committee, a permanent
committee of the Federal Accounting Standards Advisory Board. The
committee was organized by OMB, GAO, the Department of the Treasury,
the Chief Financial Officers' Council, and the President's Council on
Integrity and Efficiency, to research accounting and auditing issues
requiring guidance.
[78] We discussed reserve practices with Export Development Canada,
Compagnie Française d'Assurance pour le Commerce Extérieur in France,
Euler Hermes Kreditversicherungs-AG in Germany, the Export Credits
Guarantee Department in the United Kingdom, and the Office National du
Ducroire/Nationale Delcrederedienst in Belgium. For ease of reference,
we do not use these entities' proper names in this appendix. We
recognize that "reserves" is not a technical term, but we use it in
this appendix because each ECA used different terminology to refer to
its practices.
[79] The majority of business the Canadian ECA undertakes annually is
transacted in what it calls its Corporate Account.
[80] These are known as Canada Account transactions and are undertaken
infrequently. The Canadian ECA executes the transaction on behalf of
the government.
[81] Export and Investment Guarantees Act 1991.
[82] According to U.K. officials, a mandate to break even over the long
term has been in effect since the ECA's inception, but over time this
has been translated into quantifiable objectives. This mandate
currently applies to all business undertaken since 1991 that meets the
ECA's underwriting criteria. The mandate does not apply to business
that the ECA is directed to undertake on the basis of national
interests but that does not meet its underwriting criteria.
[83] According to U.K. ECA officials, the conversion of their entity to
a self-sustaining "Trading Fund" is scheduled to take place by 2007.
[84] The U.K. ECA's fiscal year begins on April 1 and ends on March 31.
The above figure represents the ECA's activity for the fiscal years
ending March 31, 2002 and 2003.
[85] This figure reflect allowances on the U.K. ECA's pre-1991 and
post-1991 activities and includes allowances on paid claims and future
amounts at risk.
[86] The U.K. ECA must achieve a "Reserve Coverage Ratio" of at least
1.5 times the level of future expected losses in its portfolio. Because
the U.K. ECA is expected to generally break even, including during
periods when losses are concentrated and thus unusually high, it is
expected to reserve at a level that is higher than would be needed to
cover expected losses on average over a long period. The extra reserves
are to cover what are sometimes called "unexpected losses." With these
higher reserve levels, reserves should be adequate to cover losses 75
percent of the time, according to U.K. ECA officials.
[87] According to the Canadian ECA, its overall operations have
resulted in a profit in every year but one.
[88] The Canadian ECA is required to follow Canadian Generally Accepted
Accounting Principles (GAAP), which are similar to U.S. private-sector
GAAP and include the use of accrual-based accounting. The U.K. ECA
follows U.K. government accounting standards, which are accrual-based
standards. This ECA practiced cash flow accounting for many years but
switched to accrual-based accounting several years ago.
[89] The Canadian ECA examined the Ex-Im Bank loss estimation
methodology in place at the time of its benchmarking exercise that
began in 1999, which differed from the loss estimation methodology
implemented by the Office of Management and Budget for fiscal year 2003
that is described in this report.
[90] Risk Management Review for HM Treasury and ECGD, KPMG, December
1999.
[91] For aircraft financing, the U.K. ECA uses data on the recovery or
second-hand value of aircraft.
[92] For the Canadian ECA, secured commercial debt has a lower
probability of loss given default than does sovereign debt.
[93] This group, the Participants to the Arrangement on Officially
Supported Export Credits, is not an official OECD body, but receives
support from the OECD Secretariat. Its members include Australia,
Canada, the European Community, Japan, Korea, New Zealand, Norway,
Sweden, and the United States.
[94] The underlying model, CreditMetrics, was introduced by JP Morgan
in 1997.
[95] The French and German state accounts do not directly finance
exports. Private financial institutions handle this instead.
[96] According to French and German ECA and government officials, the
state accounts are operated separately from ECAs' private account.
Profit on the private account is not used to fund the state account.
[97] A German ECA official told us that the statutory limit has never
precluded it from undertaking any business that it wanted to undertake
for the state account.
[98] Different phrases are used interchangeably when discussing credit
loss reserves, including loan loss reserves, allowance for loan and
lease losses, and allowance for credit losses. We will use the phrase
"loan loss allowance."
[99] Loan loss allowance guidance applies to banks and other financial
institutions. We discuss banks in this appendix because our review
focuses on lending done by commercial banks for purposes of comparison
with the Export-Import Bank.
[100] Credit risk is the potential for financial loss resulting from
the failure of the borrower or counterparty to perform on an
obligation.
[101] The management of a bank adjusts the level of its loan loss
allowance through periodic provisioning to offset charge-offs to
reflect the level of estimated losses in the loan portfolio. Provisions
are an expense charged against an institution's current earnings and
represent the amount necessary to adjust the loan loss allowance to
reflect probable and estimable uncollectible loan balances.
[102] A loan is impaired when, based on current information and events,
it is probable that a creditor will be unable to collect all amounts
due according to the contractual terms of the loan agreement.
[103] SFAS 5 defines a contingency as an existing condition, situation,
or set of circumstances involving uncertainty as to possible gain or
loss to an enterprise that will ultimately be resolved when one or more
future events occur or fail to occur.
[104] The Federal Financial Institutions Examination Council is an
interagency body empowered to prescribe uniform principles, standards,
and report forms for the federal examination of financial institutions
by the federal banking regulators and to make recommendations to
promote uniformity in the supervision of financial institutions.
[105] The Committee is composed of representatives of the OCC, FDIC,
and FRB.
[106] The allocated transfer risk reserve is a specific allowance that
is created by a charge to current income. The allocated transfer risk
reserve is separate from the loan loss allowance and is deducted from
gross loans and leases. As far as financial statement reporting, FRB
officials told us that the allocated transfer risk reserve normally
appears as part of the loan loss allowance, that is, it is not
identified separate of the allowance.
[107] The Committee meets three times a year to review countries to
which U.S. banks have had an aggregate exposure of $1 billion or more
for at least two consecutive quarters.
[108] Two of the three banks that we spoke with stated that they were
included in the Committee's process.
[109] The G-10 countries (in addition to the United States) are
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the
Netherlands, Sweden, and the United Kingdom.
[110] Since 1973, FASB has been the designated private sector
organization responsible for establishing standards of financial
accounting and reporting, which govern the preparation of private
sector financial statements. FASB accounting standards are recognized
as authoritative by the Securities and Exchange Commission and the
Institute.
[111] The Securities and Exchange Commission has statutory authority to
establish accounting principles but, as a matter of policy, it
generally has relied on FASB to provide leadership in establishing and
improving accounting principles and standards. The Securities and
Exchange Commission issued a Policy Statement on April 25, 2003
recognizing FASB as a designated accounting standard setter.
[112] The Institute's loan loss task force will evaluate existing loan
loss allowance disclosure requirements and disclosure recommendations
received through the comment process and will develop a document on
list of recommended disclosure enhancements.
[113] See appendix I for a further discussion of our methodology.
[114] The recent exposure draft Statement of Position by the American
Institute of Certified Public Accountants emphasizes that the loan loss
allowance consists of only these two components. While the term
"unallocated reserves" is commonly used in the banking industry, its
specific meaning may vary. For some, it refers to adjustments to
historical experience factors, while others believe that those
adjustments are an element of the allocated allowance for loan losses.
Others believe that unallocated refers to allowances for credit losses
that are not attributable to individual loans, referred to as the
"general allowance" in this appendix.
[115] The ICRAS working group is chaired by OMB and includes
representatives from the cross-border financing agencies, including Ex-
Im Bank, the Departments of Agriculture and Transportation, the
Overseas Private Investment Corporation, the Agency for International
Development, and the Defense Security Assistance Administration. Other
interested government organizations, including the Departments of
Treasury, State, and Commerce; the Federal Reserve; the Council of
Economic Advisors; and the National Security Council are also
represented.
[116] Nonbudgetary accounts may appear in the budget document for
information purposes but are not included in the budget totals for
budget authority or budget outlay. They do not belong in the budget,
because they show only how something is financed and do not represent
the use of resources.
[117] Discretionary programs are those controlled through the annual
appropriations process.
[118] Permanent budget authority is available as the result of
previously enacted legislation and does not require new legislation for
the current year. Indefinite budget authority is budget authority of an
unspecified amount.
[119] This description is based on our analysis of information that OMB
provided about its current methodology as well as discussions with key
OMB officials. We did not review any formal documentation of the
methodology.
[120] This is the standard deviation for the first year of the
forecast. OMB's methodology for estimating the standard deviation is
discussed later in this appendix.
[121] These bonds constitute the universe of foreign sovereign bonds
from Bloomberg from 1987 or later. According to OMB, observations where
the difference between the price bid and the price asked for the bond
(the bid-ask spread) of more than 10 basis points (for fiscal year
2003) or 40 basis points (for fiscal year 2004) were eliminated because
these observations may have been for illiquid instruments. This
resulted in removing about half of the observations because of large
differences between the bid and asked price for the bonds. This left
2,184 monthly observations.
[122] Rating categories are those of the nationally recognized
statistical rating organizations, which are developed by the private
sector and are widely available in financial reporting. OMB translates
these ratings organizations' ratings categories into ICRAS categories.
[123] OMB used an "investor loss rate" for this calculation, which OMB
said differed from the U.S. government loss rates (or recovery rates)
it used to transform its final estimates of default rates into expected
loss rates. According to OMB, the investor loss rate it used was based
on the market prices of F- - (F double minus) credits.
[124] In regression analysis, when the independent variables are at
their mean values, the dependent variable will be at its mean value.
Conversely, if a bond is near the average of the spreads observed in
the data, then the predicted actual distance to default will be close
to the average observed in the Moody's data.
[125] See Peter Kennedy, A Guide to Econometrics, 4TH ed. (Cambridge,
MA: The MIT Press, 1998), 140-142 and 148. In the case of one
independent variable, measurement error always leads to a downward
bias. With more than one independent variable, the analysis more
complicated. See M. Levi, "Errors in Variables Bias in the Presence of
Correctly Measured Variables," Econometrica vol. 41, #5 (September
1973).
[126] During the period analyzed, the format in which OMB presented
expected loss rates varied. For fiscal years 1997 through 2002, OMB
presented risk premiums for ICRAS categories 1 through 8, which were
grouped into several maturity bands. From these premiums, an expected
loss rate could be derived. Beginning in fiscal year 2003, OMB changed
its presentation into expected loss rates for ICRAS categories 1
through 8, across different maturities. To show trends over time, we
converted the risk premiums into expected loss rates.
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