Both sovereign and private borrowers present some risk of failing to meet  payment obligations (i.e., defaulting), potentially causing a financial loss  for Ex-Im Bank and the U.S. government.In 1990, to more accurately  measure the cost of federal credit programs, the government enacted credit  reform, which required agencies that provide domestic or international  credit, including Ex-Im Bank, to estimate and request appropriations for  the long-term net losses, or subsidy costs, of their credit activities.According to credit reform, Ex-Im Bank incurs subsidy costs when  estimated payments by the government (such as loan disbursements)  exceed estimated payments to the government (such as principal  repayments, fees, interest payments, and recovered assets), on a present  value basis over the life of the loan. 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. 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. Assessing the risk of such credit activity, particularly in  developing countries, is inherently difficult. 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. In addition, corporate default data now show higher defaults in  certain higher-risk categories than the data OMB used. 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. 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. expected losses. 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.
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.