Design and Implementation of Federal Credit and Insurance Programs

Public Policy: The Second Best, Political Compromise, and Social Welfare (Chapter 5), Amazon Kindle, 2019.

38 Pages Posted: 29 Apr 2019 Last revised: 2 Jan 2021

Date Written: April 8, 2019

Abstract

The effectiveness and the efficiency of a credit or an insurance program critically depend on the design of the program.In designing a program, the government should carefully consider various factors, including incentives of private parties, possible information advantages of private parties, and competition and liquidity in the target market. Due to failures to reflect these factors in the program design fully, many credit and insurance programs may not be serving their target populations effectively and efficiently.

Some partial loan guarantee programs allow private lenders to set the lending rate within a range. In these programs, lenders can increase the profit by lending more to high-risk borrowers who pay a high interest rate. Resulting inefficiencies include underserving of low-risk borrowers, excessive profits for lenders, and excessive costs to the government. Possible solutions include tying the guarantee fee to the lending rate and taking a partial ownership of loans. A main problem with direct loans and full loan guarantees is prepayments by low-risk borrowers. Two main ways to recapture the value of the prepayment option are a prepayment penalty and a high lending rate. The preferable way is a prepayment penalty because a high lending rate may further prompt low-risk borrower to prepay. To finance highly risky activities, such as technology start-ups, the government should take an equity position. Without sharing a few "jackpots," the government cannot recoup its investment. Nevertheless, the government takes a debt position in venture capital investments. The consequence is either that the government suffers large losses or that the government fails to finance truly high-risk, high-return projects. In some insurance programs, the government shares risk with private parties in a way that favors private parties. Private insurers have opportunities to take advantage of mispricing of insurance policies. Policyholders underpay during good times, but they don't necessarily make up the underpayment during bad times. An efficient way of sharing risk is that the government bears all of catastrophic risk and let private insurers bear policy-specific risk. The government implicitly guarantees GSE debts. Since GSEs have incentive to take excessive risk, the government is providing a very expensive guarantee free of charge. An explicit guarantee made available to both GSEs and private entities at a fee should lower the cost to the government, make the market more competitive, and contain financial crises effectively.

For proper budget discipline and efficient management, it is important to estimate the costs of credit programs accurately. The cost estimation for credit programs has two main steps: estimating future cashflows and discounting future cashflows to arrive at the net present value of cashflows. Some models estimating future cashflows do not fully consider the effects of economic fluctuations. The consequence can be a systematic underestimation of the cost of a credit program. Some also argue that discounting uncertain cashflows with Treasury rates leads to an underestimation of the cost to taxpayers by ignoring the risk premium. This argument is off the mark. Discounting with Treasury rates is appropriate, considering that budgeting is more about accounting accuracy than economic optimization and that the costs of other government programs do not include the risk premium. The focus should be on estimating cashflows more accurately, fully taking into account the possibilities of extraordinary losses cause by economic downturns.

Keywords: government credit, catastrophe insurance, government sponsored enterprises, fair value budgeting

JEL Classification: H81, H42, G18, G22

Suggested Citation

Park, Sangkyun, Design and Implementation of Federal Credit and Insurance Programs (April 8, 2019). Public Policy: The Second Best, Political Compromise, and Social Welfare (Chapter 5), Amazon Kindle, 2019., Available at SSRN: https://ssrn.com/abstract=3367966 or http://dx.doi.org/10.2139/ssrn.3367966

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