SPRING 2017 VOL. 66, NO.

Sustainability
 Measuring Risk in
Federal Credit Programs

40 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT SPRING 2017

By: Timothy Lee, MBA
I
magine two federal loan portfolios,
each with $1 billion of exposure.
The first, Program M, consists of ten
thousand $100,000 home mortgages.
The second, Program C, consists of
twenty $50 million commercial loans.
Program M sustains a consistent
credit loss rate of one percent each
year, or $10 million, in each of the first
five years of its existence. Program C,
initiated at the same time, appears
to do much better at first, sustaining
no credit losses at all for the first four
years of its life. But it suffers a much
larger $50 million loss in its fifth year.
Clearly, these are two ver y
different programs. Program M may
be oriented to individuals, while
Program C targets large businesses.
Program M may be granular (i.e. char-
acterized by many small loans), while
Program C consists of only a handful
of much larger loans. Program M may
involve borrowers from communities
nationwide, while Program C targets
a specific industry or region.
Under the provisions of the Federal
Credit Reform Act of 1990 (FCRA),
both programs must calculate and
report a credit subsidy cost (CSC),
an estimate of the present value
of future program costs (including
credit default losses).1 However, given
FCRA’s guidance, the CSC figures for
these two very different programs
may look alike. That’s because the
CSC, as defined, represents only a
single, base-case expected value in
a world where the unexpected often
happens.
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Figure 1. Volatility vs. Expected Loss
SAME EXPECTED LOSS, DIFFERENT VOLATILITY
Probability of Value, Percent
8
7
6
5
4
3
2
1
0
0.0
The CSC tells us what we should
lose. But it doesn’t tell us something
equally essential but very different:
what we could lose.
The Safety Factor
In the engineering world, designers
calculate the specifications for
bridges, airplane parts and wiring
around a projected maximum design
load, such as weight or electrical
current. But they don’t stop with
that expected value. They expect
the unexpected: overloaded trucks,
evasive maneuvers and voltage
surges. And then, with the benefit of
experienced judgment, they construct
their products to withstand a certain
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Potential Default Rate, Percent
Less Volatile Portfolio More Volatile Portfolio
multiple over and above the design
load: the safety factor.
The analogous “load” for loan port-
folios is the prospect of credit losses. A
federal credit program can — indeed,
it should — expect losses on a certain
portion of its loans; some degree of
risk is inherent to the mission. But
excessive, unexpected losses can
break a program’s budget as certainly
as overloading can collapse a bridge
or melt a wire — with results, in their
own way, equally catastrophic.
Figure 1 illustrates the key distinc-
tion between expected losses and loss
volatility, tracking the possible default
rate outcomes of two federal credit
portfolios that share an expected
default rate of 0.5 percent. One, with
JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 41
 a higher standard deviation, or vola-
S I D E B A R
tility, has a much larger chance that
losses may in fact prove substantially
APPROACHES TO CREDIT PORTFOLIO RISK MANAGEMENT higher (or lower) than expected. By
contrast, we can be much more confi-
dent that the lower-volatility portfolio
Among private-sector portfolio managers and their regulators, common will exhibit a default rate close to the
approaches to gauge the risk of excessive default losses include: projected value.
To manage this risk, financial
• Tranched credit ratings. Using approaches developed for asset regulators and other stakeholders
have developed metrics and meth-
securitization, analysts use Monte Carlo simulation or binomial
odologies, including tranched credit
expansion techniques to gauge the likelihood of portfolio defaults ratings, value at risk and portfolio
exceeding certain specified levels. stress testing (see Sidebar). While
each has advantages and draw-
• Value at risk estimates potential portfolio losses at the 95–99% backs, a consensus has developed
confidence level within a given time interval, typically assuming among private-sector lenders that
losses are normally distributed. applying some combination of these
approaches to gauge the risk of
• Stress tests. Brought into widespread regulatory use post-financial exceptional default losses is essential
to credible risk management. This
crisis, stress tests (like their engineering analogues) analyze portfolio has been especially true since the
responses to specified, extreme-case scenarios of key drivers like financial crisis, which highlighted
default rates or macroeconomic downturn indicators. the consequences of underestimating
the prospect of financial stresses and
catastrophic losses.
However, no such consensus
has yet emerged with respect to
federal credit programs. And by
having only the expected value of
losses — the CSC — as a benchmark,
the federal government has no shared
framework to gauge the likelihood
across its programs of catastrophic
losses. Despite $3 trillion of federal
direct loans and loan guarantees at
stake — more than the balance sheets
of JPMorgan, Wells Fargo, Citigroup
or Bank of America2 — the federal
government has not yet fully devel-
oped the language for this essential
conversation.
Drawing on current practices in
the private sector, a combination of
widely used risk measurements, such
as value at risk and stress tests, could
be incorporated into a single measure
of how much a federal program could
lose in a plausible adverse scenario.
Such a loss volatility (LV) metric

42 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT SPRING 2017

would be a valuable complement to
the credit subsidy cost. Ideally, the
methodology for calculating LV would
combine analytical value, widespread
acceptance among relevant practitio-
ners, and compatibility with existing
sources of borrower, loan perfor-
mance and macroeconomic data.
The Loss Volatility Metric
As a starting point for discussion,
consider a two-component LV statistic
that incorporates both:
• the observed standard deviation of
portfolio default rates, measured
monthly over the past five years;
and
• the expected credit loss given
an immediate three-standard-
deviation increase in default
rates.
These two factors align with
the call in Office of Management
and Budget (OMB) Circular A-123,
Management’s Responsibility for Enter-
prise Risk Management and Internal
Control (Circular A-123) for agencies
to measure risk in terms of both likeli-
hood and impact. How likely is this
program to lose exceptional amounts
of money? And how much, in a truly
adverse scenario, could it plausibly
lose? Equally important, development
of such a metric should be within reach
of federal credit programs of all sizes.
It requires a limited set of supporting
information, namely current exposure
and historical data on default rates and
losses given default.
Incorporating such a metric into
federal credit program management
would have three important benefits,
aligned with three core principles of
enterprise risk management (ERM)
described in recent federal
ERM guidance.3
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Establishing risk appetite
1 is key.
By adding the dimension of risk
to the existing metric of expected
losses, a consistent LV metric for
federal loan programs can expand
the framework for agencies to
identify and compare the finan-
cial risks of their credit programs.
This supports managers’ ability to
prioritize risk management efforts;
identify the policies, borrowers
and originators that drive portfolio
credit risk; and benchmark their
levels of risk against appropriate
comparison points.
The incorporation of an LV metric
can also serve as a starting point
for more rigorous risk manage-
ment efforts, such as in-depth
stress testing and documentation
of procedures for calculating risk
metrics.
Planning fosters a culture
2 Transparency supports
of resilience.
A rigorous, standing metric to
measure the prospective risk
of exceptional losses ensures it
remains constantly visible, even
when portfolio performance is
good. Because of its objectiveness
and visibility, it can catalyze proac-
tive measures to mitigate such risks
and their consequences — the core
goal of sound risk management.
This is particularly important
because of the unique character-
istics of federal credit programs.
They are, as previously noted,
immense in terms of credit
exposure, and reach across many
sectors of the American economy.
Federal credit programs occupy
a unique role in the nation’s
financial system; they are both
stewards of taxpayer dollars and
an instrument of public policy.
Their risk management framework
should take this dual mission into
account.
For example, during the financial
crisis, with previous mortgage
f unding sources essentially
shutting down, Federal Housing
Administration (FHA) annual
loan volume skyrocketed from
$55 billion in 2006 to $358 billion
in 2009.4 Increasing FHA origina-
tion served an essential role in
contributing to the continued
functioning of the home-lending
market during that downturn.
While management of financial
risks is a core component of federal
credit program risk management,
policy goals and prospective
increased demand during times
of economic stress may also be
essential considerations.
3 informed decision making.
A well-designed LV conveys an
important component of risk infor-
mation to managers and policy-
makers at all levels. It facilitates the
informed development of neces-
sary strategic balances between
mission accomplishment and the
inherent risks — not only financial,
but operational and reputational —
of federal credit programs.
The implementation of an LV metric
can catalyze further evolution of
program managers’ efforts to measure,
prioritize and manage the inherent
credit risk of federal loan programs
before problems arise. In the spirit of
the holistic, proactive approach to risk
management envisioned by OMB guid-
ance, the LV metric would empower
JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT 43
Figure 2. Sample LV Development and Implementation Schedule
1 2
Data Collection
Metric Development
Leadership and Strategic Impact
Training
Governance
federal credit program managers to
focus on identifying and addressing
emerging issues proactively, rather
than scrambling to respond to full-
blown crises after the fact.
Integrating Loss Volatility
into Federal Credit Risk
Management
The effort to incorporate an
LV metric into federal credit risk
management, of course, extends
well beyond the simple development
and calculation of a formula. Getting
the most from this new metric will
require involvement and expertise
across functions in the agency and
the department, including:
• Data collection. The practical
foundation of accurate, meaning-
ful LV metrics is the agency’s
ability to obtain and analyze the
necessary data to calculate them
directly. For agencies that wish
44 JOURNAL OF GOVERNMENT FINANCIAL MANAGEMENT
Month
3 4 5 6 7 8
to stress test their portfolios,
this will extend to identifying
and gathering data on the stress
parameters that drive credit
performance.
• Metric development. This
means developing the necessary
models and methodologies
to calculate the LV metric
appropriately. In addition to the
calculation model, this should
include procedures for verifying
and recording the parameters
and results in an audit-compliant
fashion, along with written
documentation for all steps
involved.
• Leadership and strategic
impact. This centers on incorpo-
rating the new LV metric into the
program’s overall risk manage-
ment framework, identifying its
drivers and interpreting changes
over time. Ideally, the LV metric
can catalyze focused efforts to
identify risk factors, such as
lender compliance weaknesses,
gaps in policies and procedures,
or nascent economic trends. It
may also drive additional risk
management and planning
efforts, such as portfolio stress
tests or operational contingency
planning.
• Training. To maximize the
effectiveness of the LV metric,
the implementation effort should
involve educating stakeholders
(including program managers,
agency leadership, and oversight
bodies such as OMB and IG
offices) on its conceptual basis,
significance and practical uses.
• Governance. Key to governance
is identification of responsible
leadership within the federal
loan program, along with
CRO/CFO at the agency
level. Additionally, formal
coordination through bodies
like the Federal Credit Policy
Council allows interagency
dialogue, standardization and
dissemination of best practices.
As federal credit program managers
seek insights into world-class risk
management practices, they might
look to counterparts in other such
programs; colleagues in the federal
regulatory space, including FDIC
and OCC; private-sector managers
of comparable loan portfolios; and
third-party academic and consulting
SPRING 2017
experts. One possibility may be
formal establishment of an advisory
committee charged with briefing
the Federal Credit Policy Council on
relevant developments.
As indicated in Figure 2, for the
implementation of such an LV metric
at the agency level, eight months may
represent a reasonable planning
timeline, subject to factors such as
the availability of historical data and
the desired extent of supplemental
metrics such as stress tests. The LV
metric, as contemplated, is deliber-
ately straightforward in concept and
aligned with well-established finan-
cial risk management approaches.
Therefore, development of an LV
metric can likely be done quickly and
responsively in an agile framework,
with basic measurements of loss vola-
tility as an initial objective, followed
by subsequent refinements suited to
the particular needs of the program
and agency.
The most significant portion of
agency managers’ efforts to incor-
porate an LV metric may not lie in
the development of the metric itself,
which is straightforward given the
availability of appropriate data.
Rather, the real work is likely to
involve integrating the LV metric,
and the foresight it affords into
program and portfolio managers’
overall risk management efforts.
Loss volatility should be viewed as
part of the overall transformation of
federal program risk culture. That
transformation will demand deeper
reflection on program policies, orga-
nizational strategies and training
efforts. But the potential payoff
goes to the heart of what federal
agencies can become: organizations
that consciously develop program
risk appetites, build a culture of
resilience, and lay the foundation
for better-informed and transparent
decision making.
Endnotes
1. Federal Credit Reform Act of 1990,
Section 504(a).
2. The cumulative exposure figure for
federal credit programs is taken from
GAO-16-269, “Key Agencies Should Better
Document Procedures for Estimating
Subsidy Costs,” July 13, 2016. Balance sheet
data for JPMorganChase, Bank of America,
Wells Fargo, and Citigroup are from 10K
filings for FY 2015 from each institution.
3. Playbook: Enterprise Risk Management
for the U.S. Federal Government.
4. U.S. Department of Housing and
Urban Development, “FHA Percent Share by
Dollar Value: All Loans,” www.huduser.gov/
portal/ushmc/fi_FHAShareVol.html;
Accessed Jan. 30, 2017.
Timothy Lee, MBA
is a director at
Grant Thornton LLP
and co-leader of the
Financial Business
Analytics team
within the firm’s
Public Sector
practice.

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