When a loss is not a loss (4 of 5)

The government would like to have the recent securitisation of student loans and the transfer of their ownership to Income Contingent Student Loans 1 (2002-2006) Plc classified as a sale that achieved market price without any implicit subsidy or support for the sale process, have ICSL1 classified as a private sector body independent of government, and thereby have the relevant transactions recorded in the national accounts as a ‘revaluation’. This would avoid any of the transactions recorded as income and expenditure and thereby avoid recording losses against the deficit, the headline measure capturing the difference between the two and the focus of the government’s fiscal mandate.

By losses here we mean two aspects – whether the asset was sold for less than it’s worth and what the decision to issue loans (that were later sold) cost, i.e. the cost of the policy overall. While a ‘revaluation’ might give you some truth about the first of those (the market told you the loans were worth less than you thought), it ignores the historic aspect: you would not be able to use income and expenditure to capture what’s going on with loans as a policy. If the sale precipitates future anticipated write-offs, then losses associated with the original policy never show up in the deficit.

This is pretty attractive to government and could be seen as a driving factor behind the sale. As we will see a loss-making loan that is sold at further loss would not be recognised. But there is a broader problem with income contingent loans. They don’t fit the conventions governing “financial transactions” – as such, the Office for National Statistics should now be reviewing more broadly what is transpiring with pre- and post-2012 loans.

Although government officials insist that they have not chosen the accounting conventions in use, the current treatment of financial transactions was not designed for loans with such long lifetimes, such large balances or with such large subsidies or losses built in. ICR loans have been crowbarred into place and a fundamental review is now overdue.

As with company accounts, you can look at the cashflow, the balance sheet and the income/expenditure statement to get an overall sense of the UK’s fiscal position. When writing about student loans I have tended to focus on the cashflows and the impact on the balance sheet as it is relatively straightforward.

The problems arise when it comes to determining what counts as income or expenditure for loans, and thereby what impact policy has upon the deficit.

The government loans money to students (cash outlay) and collects repayments from borrowers (cash receipts). Currently, annual loan issuance is about £15billion and annual repayments from all previous borrowers about £2.5bn. The Treasury elects to fund the shortfall between the two by issuing gilts. This form of borrowing adds to the nation’s stock of debt. Although the balance sheet has had added assets (new loans issued) and a liabilities (new gilts issued), only the latter is captured in the headline measure of Public Sector Net Debt. One presentational reason for preferring to sell student loans, it that the cash generated can be used to offset liabilities (or reduce the need for new borrowing) and so lower PSND.

The manner in which a sale impacts on the balance sheet and cashflow is clear. Cash is received in return for transferring ownership of the assets (moving them off the public balance sheet). There’s no problem there, but that’s not where the focus is. The government asks the public to judge its economic competence on reducing the deficit. There is a huge presentational gain from keeping as much out of income and expenditure as possible. This leads us to the problem: we should want the accounts to capture the proper impact of decisions.

As things currently stand, outlay on student loans – the lending – does not count as expenditure; nor do repayments count as income. (National accounts are run on a cash in, cash out basis. The cash value of transactions is recorded when they occur. None of this discussion applies to departmental accounts, which are accruals).

Ignoring outlay and repayments, income and expenditure deals with only write-offs and interest. Write-offs, when they occur, count as capital expenditure using the face value of the balances expunged, while interest accruing annually counts as income.

The latter in particular seems odd. Income accruing is income receivable, not income received, which would be repayments and so is excluded. That is, interest is only what is accumulating against outstanding balances.

This works for most financial assets, because there is a basic accounting identity at work.

In cash terms,

Loan Outlay + Interest Accrued = Repayments + Outstanding Balance

Through a bit of jiggery-pokery that means that

Loan Outlay – Repayments = Outstanding Balance – Interest Accrued

Either side of the second equation can be used as a definition of profit/loss. If Interest Accruing scores as income and Balances written off as expenditure, then the loss or gain on issuing loans is effectively captured in the deficit by the time the accounts are closed. (Note that the right-hand side of the equation is what you get with “financial transactions”, the left-hand side of the equation is what you get with graduate or general taxation.)

For normal loans, interest is repaid as it arises and it is recorded as income; there are no planned write-offs; if all goes well that financial transaction treatment accurately captures the gains made from issuing a loan.

The same cannot be said of income contingent loans with loss exemplified through large, planned subsidies when accounts are closed and where interest accruing against the balance may never be paid.

You can see the effects. Interest accruing is recorded as income every year. This flatters the income/expenditure statement until the policy write-offs occur decades in the future.

That is, as things currently stand (and in the absence of a concerted sale policy), we will start to see large write-offs score as expenditure after the mid-2030’s. These hits will relate to policy decisions made decades before. This does seem ridiculous: the current deficit simply doesn’t capture the impact of issuing tens of billions of student loans today.

You might expect a sale to clarify things. We know that student loans are offered on soft terms and make a loss for government. This is accurately captured in departmental accounts. A sale precipitates that loss – crystallises it today – and possibly adds additional losses if the loans are sold for less than the accounts say they are worth. An accounting treatment consistent with what was outlined above would set the price received against the balances written off and determine an appropriate expenditure mark. That is, if you raise £1.7bn from balances of £3.7bn then you would expect capital expenditure to take a £2bn hit.

Something akin to that would result were the ONS to classify the sale as a “capital transfer”. The government doesn’t want this and instead wants the transaction to be classified as a “revaluation” – the sale shows that the loans were really worth £1.7bn. That might or might not be the case, but such an interpretation loses the connection to the fundamental accounting identity that allows the overall cost of HE policy to be recognised, albeit imperfectly in very attenuated fashion.

What worries people about the ‘revaluation’ classification is that any losses on loans as a policy would no longer show up anywhere in expenditure. A fundamental aspect of double-entry bookkeeping would have been lost.

You could issue £10bn of loans in the expectation that you would get £8bn in return, but avoid recognising that £2bn loss by selling on the loans. As long as the sale is classified as ‘revaluation’, outlay, repayments and price received would never appear in income and expenditure and nor would any equivalents. You would have no record in income and expenditure of the difference between loan value and price received and no record of the cost of HE policy. A generalised loan policy would evaporate the cost of HE leaving nothing in the deficit, but interest accruing as income.

Only the “capital transfer” treatment, would keep this relation to losses.

Whatever the Manual of Government Deficit and Debt allows you to conclude about the sale, trying to shoehorn ICR loans into these existing treatments needs its own revaluation. What we have is a mess.

Whatever you think about accounting, it should capture the full fiscal impact of policy decisions. The ONS needs to review the accounting treatment for ICR loans, not simply decide how to classify the sale.