Imagine a Federal Program in which an Eligible Participant can bet on a coin flip. The Program pays $1 if it shows heads, but the Participant pays $1 to the Program if tails. [1] The Program is thought to be essentially costless for taxpayers because while individual coin flips are unpredictable, it is assumed that the fair coin has the usual 50/50 probability, and in time payouts and receipts will net to zero. [2] Of course, the Program will need Permanent Indefinite Authority to incur Mandatory Appropriations to pay Participants if there’s a run of heads in the short term — that’s ok, they’ll be balanced by gains from tails eventually. [3] There’ll also be a careful apportionment of a very small amount of Discretionary Appropriation for costs to cover Program admin and in the unlikely event that a Participant fails to pay up after a run of tails. Everything is done strictly the by book. [4]
Eligible Participants, who are large creditworthy entities capable of undertaking big projects, aren’t initially interested. They don’t gamble. But then their sophisticated Coin Flip Advisors analyze the legislative fine print and realize that under most circumstances, the flip can be cancelled if the coin shows tails whereas payout is certain if it shows heads. [5] Moreover, they think that such a cancellation would be a bit embarrassing for the Program, and that political pressure might be brought to bear on the Program to re-execute the flip (a ‘reflip’) whenever it comes up tails. [6]
Soon Eligible Participants are lining up at the door. For obvious reasons, they don’t exactly advertise their precise motivation, and nobody asks — they’re eligible, after all. The Program looks like a smashing success.
At first, there’s a brief run of tails. But these are reflipped into heads. Then there’s a longer run of heads. The payouts at this point are large — over ten times the Program’s Discretionary Appropriations for the period. However, the cost is covered by off-budget Mandatory Appropriations buried in arcane accounts. If questions are asked, the huge payouts can simply be explained as an ‘unpredictable run of bad luck in the short run that will be balanced by commensurate gains in the long run’. [7]
The Program comes up for reauthorization. The Eligible Participants’ lobbyists do their job. They use the Program’s Official Budget Numbers, and everything looks great. The reauthorizing legislation passes without any discussion or debate — why should there be any? [8]
After ten years, a Serious Audit is done in connection with an impending federal bankruptcy. The Audit finds that the Program consistently made transfer payments from taxpayers to Eligible Participants in annual amounts approximately five times the Program’s Discretionary Appropriations on average, all through Mandatory Appropriations. No material gains were recorded. It was also unclear what, if any, real-world policy objectives were achieved by the coin-flipping Program.
The Auditors ask the Program’s Budget Oversight Officials some awkward questions:
- If the asymmetrical payout built into Program legislation was understood by the Coin-Flip Advisors, why was this not also understood by Budget Oversight Officials? It was clearly possible, per Program statutes. Why did you assume the Program was essentially costless?
- The asymmetrical payout was obviously the primary motivation for Eligible Participants to use the Program. Why else would they use the Program? Why did you not ask the Program to investigate and report on Participant motivation as part of the annual reviews required under your Budget Circulars?
- As the Mandatory Appropriations built up to a very large amount relative to Discretionary Appropriations, why did you not re-examine your assumptions?
- Did you rely on the off-budget and automatic nature of PIA Mandatory Appropriations to obscure what was happening? If so, why? [At this point, the Auditors advise the Budget Officials to be careful in their answers, noting that violations of the Anti-Deficiency Act carry both civil and criminal penalties.]
It is not known how the Budget Officials responded. Shortly thereafter, the impending federal bankruptcy caused a major financial crisis and economic collapse. In the civil disturbances that followed, issues arising from the federal Coin Flip Program were considered unimportant.
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Notes
[1] A WIFIA fixed-rate loan commitment is executed at a UST rate several years before it is drawn and funded at then-current UST rates. Interest rates are essentially unpredictable in that time frame — UST rates might rise (the commitment rate is an in-the-money ‘heads’ relative to the borrower’s alternatives, a funding loss for the Program) or fall (the commitment is an out-of-the-money ‘tails’, funding gain). A coin flip.
[2] UST rates are cyclical and revert to the mean, so over time rises and falls will roughly balance out. In theory, therefore, Program funding losses and gains will likewise balance out, if the ‘payout’ is equally certain for losses and gains.
[3] FCRA budgeting bases a loan’s cost on its net present value as discounted by the then-current UST curve — (1) the PV of the loan’s debt service (less expected credit losses) compared to (2) the PV of the Treasuries that would hypothetically be issued to fund the specific loan, the debt service on which would be exactly matched to the loan’s debt service. For loans that have a delayed drawdown, part of the challenge is to separate the ‘noise’ of random interest rate movements from the true ‘signal’ of the loan’s cost for policy purposes. FCRA technical re-estimates accomplish this with PIA to cover ‘random’ funding losses, which are expected to be balanced by equally ‘random’ funding gains over time. The same idea works for random runs of heads or tails in the Coin Flip Program.
[4] In WIFIA Program, credit loss reserve is a miniscule 0.71% of loan commitment amount — Program admin costs are about half that, 0.30% of commitments. Nearly free, right?
[5] At WIFIA, the legislative print isn’t actually very fine — explicit and often advertised by the Program. But I’m sure that sophisticated water system financial staff and their advisors understood the implications and did the numbers in the context of their tax-exempt bond alternatives. Since the bonds had near-UST rates highly correlated to the Treasury curve, these borrowers could cancel a loan commitment that was even slightly out-of-the-money (a ‘tails’) because the bond alternative was better.
[6] WIFIA did the first resets (essentially, a re-flip of the interest rate coin) in 2020 after some large borrowers with commitments executed in 2018 at higher rates ‘suggested’ them. I have no doubt that the threat of cancellation was implied, and perhaps some political pressure.
[7] WIFIA reset the ‘tails’ outcomes from 2018-2020 and thereafter UST rates more-or-less steadily rose to current levels, a run of ‘heads’ and funding losses for the Program. Losses totaled $2.1b for the whole period FY22-FY25, about ten times the discretionary appropriations. No one seems concerned, at least not publicly.
[8] This is where we are now — I expect that ‘rubber stamp’ reauthorization is most likely outcome. But…maybe not.