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Report to Congressional Committees:

September 2004:

EXPORT-IMPORT BANK:

OMB's Method for Estimating Bank's Loss Rates Involves Challenges and 
Lacks Transparency:

GAO-04-531:

GAO Highlights:

Highlights of GAO-04-531, a report to congressional committees.

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.

OMB Expected Loss Rates for U.S. Government International Credits by 
Risk Rating Category (Present Value Basis), Fiscal Years 2002 and 
2005: 

[See PDF for image]

[End of figure]

What GAO Recommends:

GAO recommends that the Director of OMB provide affected U.S. agencies 
and Congress with technical descriptions of its current expected loss 
methodology and update this information when there are changes. GAO 
also recommends that the Director arrange for independent review of 
the methodology and ask U.S. international credit agencies for their 
most complete, reliable data on default and repayment histories, so 
that the validity of the data on which the methodology is based can be 
assessed over time.

www.gao.gov/cgi-bin/getrpt?GAO-04-531.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Celia Thomas, (202-512-
8987), thomasc@gao.gov.

[End of section]

Contents:

Letter:

Results in Brief:

Background:

OMB Developed New Method That Lowered Expected Loss Rates:

Current OMB Methodology Has Lowered Ex-Im Bank's Projected Subsidy 
Costs and Budgetary Needs:

Loss Estimation Involves Challenges and OMB Methodology Is Not 
Transparent:

Conclusions:

Recommendations for Executive Action:

Agency Comments and Our Evaluation:

Appendixes:

Appendix I: Objectives, Scope, and Methodology:

Appendix II: Loss Estimation Practices of Foreign Export Credit 
Agencies:

ECAs in Canada and the United Kingdom Have Methodologies to Estimate 
Future Defaults and Losses in Determining Reserve Levels:

ECAs in France and Germany Use Fees to Offset Loss:

OECD Participating Countries' Risk Assessment and Fee Arrangement:

Appendix III: Loan Loss Allowance Guidance and Select Commercial Bank 
Practices:

Loan Loss Allowance Is an Important Factor in an Institution's 
Financial Condition:

Accounting and Regulatory Guidance Are Not Prescriptive; the Loan Loss 
Allowance Requires Significant Judgment:

Regulatory Agencies and Accounting Organizations Have Been Reviewing 
Loan Loss Allowance Guidance:

Reviewed Banks Follow Basic Concepts in Accounting and Regulatory 
Guidance but Vary in Allowance Methodologies:

Appendix IV: Interagency Country Risk Assessment System:

Appendix V: Credit Reform Budgeting:

Appendix VI: Technical Description of OMB Model for Estimating Expected 
Loss of U.S. International Credit Activities:

Appendix VII: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 with Corporate Default Rates Used in OMB Model:

Appendix VIII: Trends in Interagency Country Risk Assessment System 
Expected Loss Rates:

Appendix IX: Comments from the Office of Management and Budget:

Appendix X: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Staff Acknowledgments:

Tables:

Table 1: Summary of Accounting and Regulatory Guidance Followed by 
Banks in Their Loan Loss Allowance Calculation:

Table 2: Regulatory Agencies' Risk Rating Scale:

Figures:

Figure 1: Components of the ICRAS Process:

Figure 2: Trends in Interest Rate Spreads for Argentine, Russian, and 
Mexican Government Bonds as Compared to U.S. Treasury Bonds, 1999-2003:

Figure 3: Comparison of OMB Default Probabilities for Fiscal Years 2004 
and 2005 and Moody's Corporate Default Rates Used in OMB Model for 
Selected Rating Categories:

Figure 4: Comparison of OMB's Expected Loss Rates, in Present Value 
Terms, for ICRAS Risk Categories 1-8, Fiscal Years 2002-2005:

Figure 5: Ex-Im Bank Obligation of Budget Authority for New Subsidy 
Costs, Fiscal Years 1992-2003:

Figure 6: Comparison of Ex-Im Bank Exposure Fees and Expected Loss 
Rates by ICRAS Category, Fiscal Years 2002 and 2005:

Figure 7: Example of a Commercial Bank's Loan Loss Allowance Process 
for Corporate Loans:

Figure 8: Program and Finance Account Budgeting for Ex-Im Bank under 
Credit Reform:

Figure 9: Illustration of How Spread Changes Can Affect the Final 
Expected Default Estimates:

Figure 10: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 1 with Moody's Corporate Default Rates Used 
in OMB Model:

Figure 11: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 2 with Moody's Corporate Default Rates 
Used in OMB Model:

Figure 12: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 3 with Moody's Corporate Default Rates Used 
in OMB Model:

Figure 13: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 4 with Moody's Corporate Default 
Rates Used in OMB Model:

Figure 14: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 5 with Moody's Corporate Default 
Rates Used in OMB Model:

Figure 15: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 6 with Moody's Corporate Default 
Rates Used in OMB Model:

Figure 16: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 7 with Moody's Corporate Default 
Rates Used in OMB Model:

Figure 17: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 8 with Moody's Corporate Default 
Rates Used in OMB Model:

Figure 18: Trends in ICRAS Expected Loss Rates for 8-Year Maturity 
Credits, in Present Value Terms, Fiscal Years 1997-2005:

Abbreviations:

EL: expected loss:

ECA: export credit agency:

Ex-Im Bank: Export-Import Bank:

FDIC: Federal Deposit Insurance Corporation:

FRB: Federal Reserve Board:

FASB: Financial Accounting Standards Board:

GAAP: generally accepted accounting principles:

ICRAS: Interagency Country Risk Assessment System:

LGD: loss given default:

OCC: Office of the Comptroller of the Currency:

OMB: Office of Management and Budget:

OECD: Organization for Economic Cooperation and Development:

PD: probability of default:

SEC: Securities and Exchange Commission:

SFAS: Statement of Financial Accounting Standards:

U.K.: United Kingdom: 

Letter September 30, 2004:

The Honorable Richard C. Shelby: 
Chairman: 
The Honorable Paul S. Sarbanes: 
Ranking Minority Member: 
Committee on Banking, Housing and Urban Affairs: 
United States Senate:

The Honorable Michael G. Oxley: 
Chairman: 
The Honorable Barney Frank: 
Ranking Minority Member: 
Committee on Financial Services: 
House of Representatives:


As the official U.S. export credit agency (ECA), charged with providing 
financing to facilitate U.S. exports, the Export-Import Bank (Ex-Im 
Bank) issues loans, guarantees, and insurance products to foreign 
governments and corporations, primarily in developing countries. As of 
September 30, 2003, Ex-Im Bank had a portfolio of about $61 
billion.[Footnote 1] Like any credit institution, the bank expects that 
some of the credit it offers will not be repaid, and it estimates these 
future losses for federal budget purposes according to the Federal 
Credit Reform Act of 1990.[Footnote 2] The act requires that prior to 
entering into loans or loan guarantees, Ex-Im Bank must have budget 
authority for its "subsidy costs"--broadly speaking, estimates of net 
losses on a present value basis.[Footnote 3] The Office of Management 
and Budget (OMB) has overall responsibility for coordinating cost 
estimates under credit reform and plays a unique role in determining 
the subsidy costs of Ex-Im Bank and other federal agencies that offer 
international credit--it provides these agencies with expected loss 
rates, a key component of their subsidy costs.[Footnote 4] For the 
fiscal year 2003 budget, OMB significantly changed its methodology for 
determining these rates.[Footnote 5] In its annual financial 
statements, Ex-Im Bank also accounts for future expected losses by 
establishing loss allowances in accordance with private sector 
accounting standards.[Footnote 6]

The Export-Import Bank Reauthorization Act of 2002 directed GAO to 
report on the bank's "reserve practices," which include its approach 
for estimating subsidy costs.[Footnote 7] In response, we agreed to (1) 
describe OMB's current and former methodologies for estimating expected 
loss rates for U.S. credit agencies' international credit and the 
rationale for the recent revisions, (2) determine the impacts of the 
current methodology on Ex-Im Bank, and (3) assess the current 
methodology and the process by which it was developed. We also agreed 
to provide information on foreign ECA and commercial bank practices for 
estimating expected losses.

To describe and assess OMB's current methodology for estimating 
expected loss rates, we obtained and evaluated analytical papers and 
OMB data and assumptions and discussed this information with OMB 
representatives. We reviewed an OMB paper that described the current 
methodology in theoretical terms and obtained more complete information 
by, on several occasions, posing questions to technical staff through 
OMB's Office of General Counsel. While we obtained sufficient 
information to generally describe and assess key aspects of the 
methodology, we did not replicate or validate it. We also did not 
determine the reasonableness of specific loss rates that OMB has 
estimated. We note in the report where our description of certain 
aspects of the methodology is incomplete, but these areas were not 
material to our conclusions. We discussed the development of OMB's loss 
estimation methodology with knowledgeable U.S. government officials. We 
also reviewed relevant research and discussed key issues with selected 
commercial banks, foreign ECAs and related government agencies, and 
credit experts. To determine the impact of the current methodology on 
Ex-Im Bank, we analyzed the bank's budget and financial statement 
documents and discussed them with bank officials. Appendix I provides a 
more detailed description of our scope and methodology; appendixes II 
and III contain descriptions of foreign ECA and commercial bank 
practices for estimating expected losses. We conducted our review from 
November 2002 through March 2004 in accordance with generally accepted 
government auditing standards.

Results in Brief:

OMB developed its current methodology for determining expected loss 
rates, which lowered them, in part because of finance literature 
indicating that its former approach likely overstated losses to the 
government. OMB's former methodology for estimating loss rates relied 
on interest rate differences--"spreads"--between bonds at different 
risk levels and low-risk bonds such as U.S. Treasury bonds. The former 
methodology assumed that higher interest rates on bonds at different 
risk levels signaled the extent to which they presented higher 
probabilities of default and expected loss. The finance literature 
indicated that other factors in addition to expected losses, such as 
tax and liquidity considerations, influence interest rate differences. 
OMB's current methodology uses rating agency corporate default data and 
interest rate spreads in a model it developed to estimate default 
probabilities and makes assumptions about recoveries after default to 
estimate expected loss rates. This methodology has generally predicted 
default rates somewhat lower than the underlying corporate rates it 
uses. Under the current methodology, expected loss rates for 8-year 
maturity credits were on average about 58 percent lower in fiscal year 
2005 than in fiscal year 2002, in risk categories in which Ex-Im Bank 
generally undertakes new financing.

With lower loss rates, OMB's current methodology has contributed to Ex-
Im Bank projections of lower subsidy costs and budgetary requirements 
and influenced a modification in the way the bank calculates loss 
allowances for its financial statements. OMB's new loss rates 
contributed to the bank's request of smaller budget authority in fiscal 
years 2003 through 2005 to cover its anticipated subsidy costs. In 
addition, in fiscal year 2003, Ex-Im Bank's obligation of budget 
authority for subsidy costs dropped by almost half from fiscal year 
2002, while the amount and estimated average risk of the bank's new 
financing in those years was similar. When Ex-Im Bank reestimated the 
subsidy cost of its outstanding portfolio at the end of fiscal year 
2002 using the new rates, these costs dropped by $2.7 billion, a 
decrease attributed by Ex-Im Bank officials primarily to OMB's lower 
loss rates. Further, the fees that Ex-Im Bank charges to compensate for 
risk are now projected to generally provide greater coverage of its 
expected losses. During this period, Ex-Im Bank modified its approach 
for calculating financial statement loss allowances to be more in line 
with applicable accounting standards. This involved, among other 
things, diverging from its former practice of using the same loss rates 
to calculate loss allowances and subsidy costs. To maintain consistency 
in its loss allowance estimation and because of the changed nature of 
OMB's loss rates, Ex-Im Bank generally began using higher loss rates 
for its loss allowances than it did for its subsidy costs.

The OMB's current methodology for estimating expected loss rates for 
U.S. agencies' international credits involves challenges and is not 
transparent. 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. More recent corporate default data than 
what OMB used shows higher defaults in some risk categories. In 
deciding to use this data to predict default, OMB analyzed Ex-Im Bank 
historical defaults over a somewhat narrow period. The default data 
analyzed did not cover other U.S. international credit agencies. OMB's 
recovery rate assumptions have dropped twice since the methodology was 
implemented. The lower rates serve to offset lower default projections 
in the overall estimation of expected loss, but the basis for the 
recovery rates and the changes over time has not been transparent. 
Finally, despite the complexity and implications of the current 
methodology, OMB developed it independently and provided affected 
agencies with limited information about its basis or structure.

To improve the transparency of the subsidy cost estimation process and 
help ensure its validity, we are recommending that the Director of the 
Office of Management and Budget take five actions. First, we recommend 
that the Director provide affected U.S. agencies and Congress technical 
descriptions of OMB's current method of determining expected loss 
rates. Second, we recommend that the Director provide similar 
information in the event of significant changes to its method for 
calculating expected loss rates. Third, we recommend that the Director 
ensure that OMB periodically update data from nonagency sources, such 
as the corporate default data used to estimate expected loss rates. 
Fourth, we recommend that the Director request from Ex-Im Bank and 
other U.S. international credit agencies the most complete and reliable 
information available on their default and repayment histories, so that 
the validity of the information on which the current methodology is 
based can be assessed over time. Finally, we recommend that the 
Director provide for, and document, independent methodological review 
of OMB's expected loss model.

Commenting on a draft of this report, OMB generally agreed to implement 
these recommendations. OMB also expressed concern about the report's 
statement that its method for determining loss rates was not 
transparent, observing that our report generally describes the method. 
We believe that, while we do present in this report a substantial 
amount of information on OMB's loss methodology, obtaining that 
information required considerable resources and effort, and similar 
information should be more readily available on an ongoing basis to 
affected agencies and Congress. Ex-Im Bank and the Comptroller of the 
Currency reviewed the report and made technical comments, which we 
incorporated where appropriate. The Department of the Treasury, the 
Federal Reserve Board, and the Federal Deposit Insurance Corporation 
did not have comments on the report. The Securities and Exchange 
Commission and the Department of Agriculture's Foreign Agricultural 
Service reviewed parts of the report for technical accuracy; the 
Securities and Exchange Commission provided technical comments, which 
we incorporated where appropriate. We also obtained technical comments 
from bank and foreign ECA officials on our descriptions of their 
practices.

Background:

Established in 1934, Ex-Im Bank is an independent U.S. government 
corporation that serves as the official ECA of the United 
States.[Footnote 8] Its mission is to support the export of U.S. goods 
and services overseas, thereby supporting U.S. export sector jobs. Ex-
Im Bank's mandate states that it should not compete with the private 
sector but rather assume the credit and country risks that the private 
sector is unable or unwilling to accept. Ex-Im Bank offers various 
financial products, such as direct loans, loan guarantees, export 
credit insurance, and working capital guarantees, to foreign buyers of 
U.S. goods and services and to U.S. exporters. In the last decade, new 
Ex-Im Bank authorizations of loans, guarantees, and insurance averaged 
nearly $12 billion per year.

Because of its mandate, a large percentage of Ex-Im Bank's business is 
with developing country borrowers that are typically considered more 
risky than borrowers in developed countries. Nearly 80 percent of Ex-Im 
Bank's medium-and long-term exposure at the end of fiscal year 2003 was 
to borrowers from low-and middle-income countries.[Footnote 9] 
According to Ex-Im Bank officials, the types of borrowers it finances 
within countries have shifted over the last decade: whereas Ex-Im Bank 
historically financed foreign government (sovereign) purchases of U.S. 
exports, its new financing is now primarily for purchases by private 
sector borrowers. This shift is gradually being reflected in Ex-Im 
Bank's portfolio of outstanding credits, which at the end of fiscal 
year 2003 included about 36 percent in financing to sovereign 
governments, about 46 percent in financing to foreign corporations, and 
about 18 percent in financing to public sector, nonsovereign borrowers.

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.[Footnote 10] 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.[Footnote 11] 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. For each credit activity, Ex-Im Bank assesses the 
potential future losses based on the risk of the activity. It collects 
up-front fees or charges borrowers higher interest rates, or both, to 
offset that loss and receives subsidy appropriations to cover remaining 
losses.

Credit reform requires credit agencies to have budget authority to 
cover subsidy costs before entering into loans or loan guarantees. 
Credit agencies, in their annual appropriations requests, estimate the 
expected subsidy costs of their credit programs for the coming fiscal 
year. Credit reform also requires agencies to annually reestimate 
subsidy costs of previous financing activity based on updated 
information. When reestimated subsidy costs exceed agencies' original 
subsidy cost estimates, the additional subsidy costs are not covered by 
new appropriations but rather are funded from permanent, indefinite 
budget authority.

To estimate their subsidy costs, credit agencies estimate the future 
performance of direct and guaranteed loans. Agency management is 
responsible for accumulating relevant, sufficient, and reliable data on 
which to base these estimates. To estimate future loan performance, 
agencies generally have cash flow models, or computer-based 
spreadsheets, that include assumptions about defaults, prepayments, 
recoveries, and the timing of these events and are based on the nature 
of their own credit program. Agencies that provide credit to domestic 
borrowers generally develop these cash flow assumptions, which OMB 
reviews, based on their historical experiences. For U.S. international 
credits, OMB provides the expected loss rates, which are composed of 
default and recovery assumptions, that agencies should use to estimate 
their subsidy costs.

The determination of expected loss rates for federal agencies that 
provide international credit has two components: the assignment of risk 
ratings for particular borrowers or transactions and the determination 
of loss rates for each rating category, according to the maturity of 
the credit.[Footnote 12] Both of these components, and their 
relationship to one another, are important in determining overall 
expected losses. For Ex-Im Bank, risk ratings are determined partly 
through an interagency process and partly by Ex-Im Bank's risk 
management division. The appropriateness of these ratings is a key 
determinant in the overall appropriateness of Ex-Im Bank's subsidy cost 
estimations.[Footnote 13]

Through the Interagency Country Risk Assessment System 
(ICRAS),[Footnote 14] which OMB chairs, ICRAS agencies determine risk 
ratings that will be in effect each fiscal year (see box 1 in fig. 
1).[Footnote 15] There are two types of ICRAS ratings--one for foreign 
government (sovereign) borrowers and one for the private sector 
climates in foreign countries. Ratings range from 1 (least risky) to 11 
(most risky). Ratings for sovereign borrowers are based on 
macroeconomic indicators, such as indebtedness levels; balance-of-
payments factors; and political and social factors. In determining 
ratings, the agencies take into account country risk ratings assigned 
by private sector ratings agencies and by the Organization for Economic 
Cooperation and Development (OECD).[Footnote 16] Private sector ratings 
assigned through the ICRAS process also take into account factors such 
as the banking system and legal environment in a country. Ex-Im Bank 
generally authorizes, with few exceptions, new business for borrowers 
with ICRAS ratings of 8 or better.[Footnote 17] (App. IV contains more 
information about the ICRAS risk rating process.)

Figure 1: Components of the ICRAS Process:

[See PDF for image] 

[End of figure] 

For Ex-Im Bank's financing with foreign governments, the ICRAS 
sovereign risk rating applies. For Ex-Im Bank's private sector lending, 
Ex-Im Bank officials assign risk ratings. According to Ex-Im Bank 
officials, they use private rating agency ratings for a corporation 
when the ratings are available, which is the case for a minority of 
borrowers. For most private sector borrowers, Ex-Im Bank officials use 
the private sector ICRAS rating as a baseline and adjust that rating 
depending on their assessment of the borrower's creditworthiness.
[Footnote 18]

For the second component, OMB plays a key role. It determines expected 
loss rates for each ICRAS risk rating and maturity, which U.S. agencies 
that provide international credit use in preparing their subsidy cost 
estimates (see fig. 1, box 2). OMB provides these loss rates to ICRAS 
agencies each fiscal year, in time to be used in preparing budget 
submissions.[Footnote 19] To estimate future cash flows, ICRAS agencies 
use OMB's expected loss rates in their cash flow models. The loss rates 
are also used to allocate subsidy costs during the fiscal year and to 
calculate subsidy cost reestimates at the end of the fiscal year. OMB 
also provides agencies with a credit subsidy calculator, which has been 
audited, that agencies use to convert agency-estimated cash flows into 
present values.[Footnote 20]

The credit reform act resulted in the establishment of a special budget 
accounting system to track inflows and outflows associated with 
agencies' lending activities. Expected long-term subsidy costs for 
financing activities in a fiscal year appear in an agency's annual 
budget submission and are subject to congressional approval. However, 
any increases over time in expected subsidy costs for financing that 
took place in earlier years are financed from permanent indefinite 
budget authority and do not have to be appropriated in the annual 
appropriations process.[Footnote 21] In the case of Ex-Im Bank, such 
changes could result, for example, from changes in the risk assessment 
for certain countries or changes in loss assumptions for a given risk 
level. (App. V contains additional information about the credit reform 
budget accounting system.)

In addition to estimating expected losses for budgetary purposes, Ex-Im 
Bank measures the expected loss of its portfolio in its own annual 
audited financial statements. As a government corporation, Ex-Im Bank 
is required to follow "principles and procedures applicable to 
commercial corporate transactions."[Footnote 22] Ex-Im Bank's 
financial statements are prepared according to private sector generally 
accepted accounting principles (GAAP) that require Ex-Im Bank to follow 
Financial Accounting Standards Board (FASB) accounting guidance when 
establishing allowances for future expected credit losses.

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. For fiscal years 1992-2002, OMB based its expected loss 
estimates on differences between interest rates on bonds of different 
risk levels. In developing its current approach, OMB cited emerging 
academic literature that indicated its former approach may have 
overestimated likely costs to the government. Ex-Im Bank officials also 
said they believed, based on their reestimates, that their subsidy cost 
appropriations had been too high relative to their loss experience 
since the beginning of credit reform. 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.

OMB's Former Methodology Based Expected Loss Estimates on Differences 
in Bond Interest Rates:

The method that OMB used in fiscal years 1992-2002 based expected loss 
rates for ICRAS agencies on interest rate spreads between publicly 
traded U.S. corporate or foreign government bonds and low-risk bonds 
such as U.S. Treasury bonds.[Footnote 23] Under this method, estimates 
of expected loss shifted as the underlying spread data shifted. 
Interest rate spreads are an indicator of expected loss, in that the 
size of a spread tends to widen as the perceived risk increases. For 
example, when interest rates on a foreign bond are 6 percent and U.S. 
Treasury bond interest rates are 5 percent, the spread between the two 
is 1 percentage point. The foreign bond in this example provides a 
higher rate of interest than the U.S. Treasury bond because creditors 
require a higher return on their capital, at least in part because they 
perceive that foreign bonds carry a higher risk of non-repayment.

Spreads fluctuate over time depending in part on changes in market 
views of borrowers' creditworthiness. Figure 2 shows interest rate 
spreads for Argentine, Russian, and Mexican government bonds over U.S. 
Treasury bonds from 1999-2003, illustrating how spreads can fluctuate. 
Spreads increased sharply in 2001 for the Argentine bonds, as 
Argentina's default on those bonds was imminent. Conversely, the spread 
for the Russian bonds shown narrowed over the period as Russia's 
economy improved, while the spreads for the Mexican bonds were 
consistently the smallest of the three countries.

Figure 2: Trends in Interest Rate Spreads for Argentine, Russian, and 
Mexican Government Bonds as Compared to U.S. Treasury Bonds, 1999-2003:

[See PDF for image] 

[End of figure] 

OMB has used varying underlying instruments to calculate bond spreads 
and expected losses for ICRAS agencies. In the beginning of credit 
reform, OMB used the spreads on U.S. corporate bonds at different risk 
levels to estimate risk premia (and thus expected loss).[Footnote 24] 
That is, OMB determined the interest rate spread for U.S. corporate 
bonds within a risk rating category and used those spreads to compute a 
risk premium for each ICRAS category. In fiscal year 1997, OMB began 
using the interest rate spreads on other instruments, including 
foreign government bonds.[Footnote 25]

After interest rates on some types of international bonds rose in the 
late 1990s, OMB determined that basing expected loss rates only on 
interest rate spreads resulted in estimates that were too high. 
According to OMB, it was decided in the discussions within the 
executive branch and with Congress leading to credit reform that only 
the expected cost to the government was relevant for estimating default 
losses to the government under credit reform. OMB decided to change its 
method for determining default losses, primarily because emerging 
research showed that factors other than expected losses from defaults 
account for a significant portion of interest rate spreads.[Footnote 
26] According to this literature, differences in liquidity and tax 
considerations, and an aspect of credit risk that OMB termed "portfolio 
risk," affect interest rates on international bonds.[Footnote 27]

Studies cited by OMB and other related literature indicate that factors 
other than expected losses from defaults account for a high proportion 
of interest rate spreads--in some cases, most of the spread--especially 
on higher-quality bonds. For bonds with risk ratings that correspond to 
the riskier ICRAS rating categories, 5 and higher (riskier), 
conclusions from the literature that OMB cited and other literature 
that we reviewed are less clear. One study cited by OMB found that 
differences in tax treatment, and compensation for risk beyond expected 
losses, explained most of interest rate spreads; however, because of 
limited data, that study did not include bonds in risk categories 
higher than those corresponding to ICRAS category 4.[Footnote 28] A 
second study cited by OMB found that market interest rate spreads on 
bonds were greater than those that would be predicted based on 
corporate default data. The differences were particularly apparent for 
bonds in investment-grade categories and were smaller for speculative-
grade bonds.[Footnote 29]

For the fiscal year 2002 budget, OMB imposed an across-the-board 
reduction in the expected loss estimates for ICRAS risk categories 1 
through 8.[Footnote 30] OMB said that it did this to eliminate part of 
the spread between other bonds and U.S. Treasury bonds to come closer 
to measuring only default cost. The risk factors and expected loss 
estimates for the bottom three categories did not change.

A further rationale for adjusting the expected loss rates, according to 
Ex-Im Bank officials, was that the bank had calculated several downward 
reestimates of its subsidy costs since the inception of credit reform. 
They viewed this as evidence that the bank's original subsidy cost 
estimates were conservative. According to Ex-Im Bank officials, several 
factors influence the bank's subsidy cost reestimates, including 
changes in the outstanding balance of its cohorts (the term "cohort" 
refers to the financing extended in a given fiscal year, which Ex-Im 
Bank further subdivides by product type); changes in cohort performance 
or average riskiness; and changes in OMB's expected loss 
rates.[Footnote 31] Ex-Im Bank calculated a net downward reestimate of 
about $368 million in fiscal year 1999, followed by a larger net 
downward reestimate of about $1.4 billion in fiscal year 2000 and a 
subsequent net downward reestimate of about $300 million in fiscal year 
2001.[Footnote 32] (In these years, upward reestimates of some cohorts 
were more than offset by larger downward reestimates of other cohorts.) 
There were small net downward and upward reestimates in fiscal years 
1992 through 1995, and Ex-Im Bank did not calculate reestimates in 
fiscal years 1996 through 1998. Ex-Im Bank's reestimates represent the 
bank's ongoing assessment of the riskiness of its post-credit reform 
financing at a given point in time and are not a final assessment of 
the performance of cohorts that have not reached maturity at the time 
of the reestimate. An Ex-Im Bank official noted that future claims or 
defaults could occur on cohorts that have not reached maturity, 
possibly causing upward reestimates to certain cohorts in the future.

OMB's Current Methodology Bases Expected Loss Rates on Corporate 
Default Data, Interest Rate Spreads, and Recovery Assumptions:

OMB's current methodology uses rating agency corporate default data and 
interest rate spreads to estimate default probabilities and makes 
assumptions about recoveries after default to estimate expected loss 
rates. The methodology estimates default rates for federal 
international credits using a complex model that OMB developed. These 
rates were generally lower for fiscal years 2004 and 2005 than the 
underlying corporate default rates that OMB used in estimating its 
rates. OMB introduced its current methodology, which estimates expected 
loss rates for ICRAS categories 1 through 8, for use in fiscal year 
2003, and made modifications for fiscal years 2004 and 2005.[Footnote 
33] (App. VI contains a technical description of the methodology.)

OMB Model Bases Default Estimates on Corporate Default Data and 
Spreads:

OMB uses rating agency corporate default data and information on 
interest rate spreads to determine expected defaults through a complex 
model. The model has two empirical relationships, one between ratings 
and defaults and the other between interest rate spreads and defaults. 
The model combines the relationships to arrive at OMB's expected 
default rates across ICRAS risk categories. Historical default rates on 
corporate bonds by risk rating category are the key inputs to both 
components of the model.

The first component of the model bases the probability that ICRAS 
agency borrowers will default on default rates for corporate bonds 
published in 2000 by a nationally recognized private rating agency, 
Moody's Investors Service. The risk categories associated with the 
Moody's corporate default probabilities are converted to ICRAS risk 
categories.[Footnote 34] OMB's model uses two Moody's data series on 
U.S. corporate bond defaults, which OMB combined into a single series. 
The data series used for the four lowest-risk ICRAS categories (1-4) 
includes default rates on rated corporate bonds by risk rating category 
during 1920-1999. The data series used for the next four (higher risk) 
ICRAS categories (5-8) includes default rates on rated corporate bonds 
by risk rating category during 1983-1999.[Footnote 35]

The second component of the model uses data on interest rate spreads to 
make adjustments to the same Moody's historical default data. The 
current method does not use spread information as the primary indicator 
of default risk, as OMB's former method did. Instead, it uses spread 
information as a signal of how current market conditions might differ 
from those reflected in the Moody's historical data. The model is 
designed to adjust historical default rates by rating category up or 
down in cases where interest rate spreads in a category are unusually 
high or low relative to the average spreads for that category. The 
adjustment in the model gives greater weights to more recent spreads in 
calculating the averages. To estimate this relationship, OMB used 
interest rate data on international bonds from Bloomberg.

The default probabilities reflected in OMB's expected loss rates for 
fiscal years 2004 and 2005 were generally lower than the corporate 
default rates that OMB used in its model. Figure 3 illustrates OMB's 
fiscal year 2004 and 2005 default probabilities for 1-8 years for three 
ICRAS ratings categories and the Moody's corporate default rates for 
corresponding risk categories.[Footnote 36] The graph shows that OMB 
default probabilities are somewhat lower than the corporate default 
rates for the ratings categories shown. (App. VII presents similar 
comparisons for ICRAS categories 1-8.) Based on information we obtained 
on OMB's model, this difference would be expected to result from 
interest rate spreads' trending significantly downward for some rating 
and maturity categories. It could also result from features of the 
model specification. We could not determine the reasons for the 
difference because we did not replicate OMB's model and, in response to 
our questions, OMB did not identify specific reasons for the 
differences. (App. VI contains more information about model 
specification issues.)

Figure 3: Comparison of OMB Default Probabilities for Fiscal Years 2004 
and 2005 and Moody's Corporate Default Rates Used in OMB Model for 
Selected Rating Categories:

[See PDF for image] 

Note: OMB default probabilities were calculated from the expected loss 
rates that OMB generated for the fiscal year 2004 and fiscal year 2005 
budgets. The OMB default probabilities are calculated by removing the 
recovery rate adjustments (12 percent for fiscal year 2004 and 9 
percent for fiscal year 2005) from the net default probability tables 
provided by OMB, which had recovery rates factored in.

[End of figure] 

Methodology Combines Default Rates and Recovery Rates to Determine 
Expected Losses:

After determining expected default rates, OMB combines the default 
rates with an assumption about the recovery rate--the percentage of 
defaulted principal and interest that will be recovered over time--to 
obtain expected loss rates.[Footnote 37] The assumed recovery rate is a 
key driver of the expected loss rates. OMB assumed an across-the-board 
recovery rate of 17 percent for the fiscal year 2003 budget--that is, 
the government was expected to lose $830 and recover $170 for every 
$1,000 in defaulted credits. It assumed lower recovery rates of 12 
percent for the fiscal year 2004 budget and 9 percent for the fiscal 
year 2005 budget.

OMB's Current Methodology Lowered Expected Loss Rates:

OMB's current methodology reduced the loss rates that U.S. credit 
agencies are expected to incur on international credits they provide. 
Between fiscal years 2002 and 2005, expected loss rates fell across 
ICRAS risk categories 1 through 8.[Footnote 38] As shown in figure 4, 
expected loss rates for credits of 8-year maturity were, on average, 
about 58 percent lower on a present value basis in fiscal year 2005 
than 2002 (the last fiscal year in which OMB used its former approach 
to develop the loss rates).[Footnote 39]The largest declines were in 
risk categories 1 through 5. Expected loss rates for ICRAS agencies 
have varied over the credit reform period. (See app. VIII for 
information on trends in expected loss rates for ICRAS agencies between 
fiscal years 1997 and 2005.)

Figure 4: Comparison of OMB's Expected Loss Rates, in Present Value 
Terms, for ICRAS Risk Categories 1-8, Fiscal Years 2002-2005:

[See PDF for image] 

Note: The figure compares loss expectations that were in place in each 
fiscal year, in present value terms, for each ICRAS risk category based 
on guarantees of 8-year maturity. We based the analysis on 8-year 
maturities because this maturity is representative of many Ex-Im Bank 
credits.

[End of figure] 

For fiscal year 2003, the first year for which OMB's current 
methodology was used to develop expected loss rates, rates declined 
sharply across most ICRAS risk categories. Loss rates for fiscal year 
2004 rose for several risk categories, with the biggest change being an 
increase in the loss rate for ICRAS risk category 6. According to OMB, 
the expected loss rates changed from fiscal year 2003 to 2004 because 
of updated country ratings and interest rate data. OMB did not provide 
more specific information to explain those changes. Also, the lower 
recovery rate assumptions used in fiscal year 2004 would be expected to 
push loss rates upward. Expected loss rates in fiscal year 2005 were 
generally similar to those in fiscal year 2004, with slight declines 
for some risk categories. Although OMB's model generated lower default 
rates for fiscal year 2005 than for fiscal year 2004, a further 
decrease in its recovery rate assumptions resulted in little change to 
expected loss rates in fiscal year 2005.

Current OMB Methodology Has Lowered Ex-Im Bank's Projected Subsidy 
Costs and Budgetary Needs:

By lowering loss rates for most ICRAS risk categories, OMB's current 
methodology has contributed to lower Ex-Im Bank projections of subsidy 
costs and, therefore, lower budgetary requirements. Ex-Im Bank's 
obligation of budget authority for new subsidy costs declined 
significantly for fiscal year 2003, when the current methodology took 
effect. In addition, Ex-Im Bank calculated a large downward reestimate 
of the subsidy costs of its outstanding portfolio at the end of fiscal 
year 2002 using the new loss rates. With lower loss rates, Ex-Im Bank's 
fees are generally projected to provide greater coverage of expected 
losses, fully offsetting losses in some budget categories. Finally, 
during this period, Ex-Im Bank modified its approach for calculating 
loss allowances in its financial statements. This involved making 
certain changes to be more in line with applicable accounting standards 
and, because of the changed nature of OMB's loss rates, using different 
and higher loss rates than it used in its budget documents to calculate 
subsidy costs.

Lower OMB Loss Rates Reduce Ex-Im Bank Budget Authority Needed to Cover 
Subsidy Costs:

Partially because of OMB's lower loss rates, Ex-Im Bank required less 
budget authority to cover its lower subsidy costs. Estimates and 
obligation of budget authority for subsidy costs are determined by the 
amount and risk of business the bank expects to, or does, undertake in 
a year, as well as expected loss rates and fees charged to borrowers. 
Changes in any one of those factors can alter budget needs. According 
to Ex-Im Bank officials, OMB's lower loss rates were a key determinant 
in the declines in its subsidy cost estimates, its budget authority 
obligated for new subsidy costs, and its 2002 reestimate of subsidy 
costs.

Ex-Im Bank's requests for budget authority for subsidy costs have 
dropped since it began using the lower loss rates to estimate subsidy 
costs. The bank's request for subsidy budget authority in fiscal year 
2003 was about 30 percent lower than the average of its requests in the 
previous 5 years, partly because of lower OMB loss rates and partly 
because of a substantial amount of budget authority carried over from 
the previous fiscal year.[Footnote 40] Ex-Im Bank requested no new 
subsidy budget authority in fiscal year 2004 but anticipated $460 
million in new subsidy cost obligations.[Footnote 41] The amount of 
budget authority carried over from previous fiscal years was seen as 
sufficient to cover anticipated fiscal year 2004 subsidy costs.
[Footnote 42] Ex-Im Bank requested $126 million for subsidy budget 
authority in fiscal year 2005, but it anticipated $491 million in 
obligations for subsidy costs.[Footnote 43] The bank continued to have 
a significant amount of budget authority carried over to fund the 
difference.

In addition, Ex-Im Bank's obligation, or usage, of budget authority for 
new subsidy costs dropped when the current methodology took effect, as 
shown in figure 5. The bank's obligation of subsidy budget authority 
had dropped in fiscal years 2001 and 2002, in part because of 
reductions in new financing in those years. Its obligation of budget 
authority for new subsidy costs in fiscal year 2003 was about 55 
percent lower than in fiscal year 2002, even though the total amount of 
its new financing, and Ex-Im Bank's estimate of its average risk level, 
in these two fiscal years was similar.[Footnote 44]

Figure 5: Ex-Im Bank Obligation of Budget Authority for New Subsidy 
Costs, Fiscal Years 1992-2003:

[See PDF for image] 

Note: Figure excludes subsidy budget authority obligated for purposes 
of tied-aid (government-to-government concessional financing of public 
sector capital projects in developing countries that is linked to the 
procurement of goods and services from the donor country).

[End of figure] 

According to Ex-Im Bank officials, OMB's lower loss rates also 
contributed to a significant downward reestimate of the subsidy costs 
of the bank's outstanding credits, based on its first subsidy cost 
reestimate that used the lower rates.[Footnote 45] At the end of fiscal 
year 2002, using the OMB loss rates for fiscal year 2004, Ex-Im Bank 
calculated a net downward reestimate of about $2.7 billion, 
significantly lowering its estimated subsidy costs for outstanding 
credits.[Footnote 46] Downward reestimates on long-term guarantees 
represented about 72 percent of the reestimate. About 63 percent of 
the reestimate was calculated on financing extended between fiscal 
years 1997 and 2001, much of which has likely not yet matured.[Footnote 
47]

With Lower Loss Rates, Ex-Im Bank Fees Are Projected to Provide Greater 
Coverage of Losses:

With the decline in OMB's loss rates, Ex-Im Bank's exposure fees are 
projected to generally provide greater coverage of its expected 
losses.[Footnote 48] The determination of the relationship between 
exposure fees and expected losses and, thus, the calculation of budget 
subsidy cost, depends on the risk rating for specific Ex-Im Bank 
transactions. Ex-Im Bank generally sets its exposure fees at, or in the 
case of some corporate transactions slightly above, the minimum level 
required by an agreement among certain OECD member countries.[Footnote 
49]

This agreement among OECD countries was designed to increase 
transparency and provide common benchmarks for ECA exposure fees, 
thereby reducing fee competition among exporters. Participating ECAs 
may charge fees above the OECD minimum if they do not view the fees as 
sufficient to cover their expected losses on a given transaction, but 
they are expected to charge at least the minimum. For private sector 
transactions, participating ECAs that we spoke with often charge fees 
above the OECD minimum fees. (See app. II for additional information on 
the OECD minimum fee determination process.)

Using fiscal year 2005 expected loss rates, Ex-Im Bank exposure fees at 
the OECD minimum fee level would be projected to fully cover expected 
losses in ICRAS categories 1-5 in certain cases (see fig. 6). In 
comparison, using fiscal year 2002 expected loss rates, Ex-Im Bank 
exposure fees at the OECD minimum fee level were projected to cover 
expected losses only for ICRAS category 1.

Figure 6: Comparison of Ex-Im Bank Exposure FeesA and Expected Loss 
Rates by ICRAS Category, Fiscal Years 2002 and 2005:

[See PDF for image] 

[A] Figure compares Ex-Im Bank exposure fees at the minimum OECD fee 
level with GAO's analysis of expected loss for credits of 8-year 
maturity in fiscal years 2002 and 2005 (see fig. 4).

[End of figure] 

The degree to which Ex-Im Bank's exposure fees are projected to cover 
its expected losses may differ from this illustration, depending on the 
type of borrower or transaction. For example, when Ex-Im Bank assigns a 
corporate borrower a higher risk rating than that of the country where 
the borrower is located, the bank may incur subsidy costs in more risk 
categories or may incur larger subsidy costs for corporate borrowers 
rated in categories 6 through 8.[Footnote 50] This is because Ex-Im 
Bank charges fees for corporate transactions that are close to the OECD 
minimum fee for the country in which the corporate borrower is located, 
even when the transaction has a higher (riskier) rating than the 
country. In addition, the OECD guidance does not apply to some 
transactions, notably aircraft financing.

In generally setting exposure fees at or near the OECD minimum level, 
Ex-Im Bank charges fees that are among the lowest of ECAs. Ex-Im Bank's 
low pricing relative to other ECAs has been noted for some time. 
According to U.S. and OECD officials, whereas Ex-Im Bank previously 
appeared to face some pressure to charge higher fees because of its 
budget costs (and appeared to support raising the minimum OECD fees as 
well), the lower budgetary costs of Ex-Im Bank's activities have 
lessened this pressure.[Footnote 51]

Ex-Im Bank Modified Its Method for Determining Financial Statement Loss 
Estimates, Generally Using Higher Loss Rates Than for Budget 
Calculations:

Beginning with its 2002 financial statements, Ex-Im Bank modified its 
approach for calculating loss allowances, which involved segmenting its 
portfolio in line with applicable accounting standards and diverging 
from its former practice of using OMB loss rates to calculate these 
allowances. Because Ex-Im Bank prepares its financial statements 
according to private sector, rather than federal, accounting 
principles, there has always been some difference between the bank's 
subsidy cost and loss allowance estimates. This is because of 
differences in the treatment of fee income between private sector and 
federal accounting approaches.[Footnote 52] While Ex-Im Bank is not 
required to use OMB loss rates when calculating financial statement 
loss allowances, Ex-Im Bank officials said that they had historically 
chosen to do so in order to link the loss estimates prepared for budget 
purposes with the financial statement loss allowances. However, in its 
2002 financial statement, Ex-Im Bank began applying higher loss rates 
than OMB's loss rates to most of its portfolio. Ex-Im Bank officials 
said that with the modification, its approaches to calculating subsidy 
costs and loss allowances differ not only in fee treatment but also in 
their expectations of loss.

According to Ex-Im Bank officials, the bank modified its financial 
statement loss allowance methodology for two reasons. First, Ex-Im Bank 
discussed with its new auditors, Deloitte & Touche, the bank's approach 
for accounting for guarantees and insurance, which comprise a majority 
of the bank's portfolio.[Footnote 53] They determined that relevant 
accounting standards suggested that it would be appropriate to record 
these credits at their fair market value. This called for using 
different loss rates than those derived using OMB's current 
methodology, which focuses on credit loss.[Footnote 54] Second, the 
bank determined that it should value its impaired credits in a manner 
more consistent with relevant accounting standards.[Footnote 55] 
Deloitte & Touche observed that Ex-Im Bank had not historically 
separated its portfolio into impaired and unimpaired groupings in 
accordance with accounting guidance, even though a significant portion 
of these loans and claims were likely impaired. Total loans and claims 
represented, on average, about 24 percent of the bank's total exposure 
during fiscal years 1999-2003.

In addition, when initially estimating its 2002 loss allowances using 
its former approach and OMB's fiscal year 2003 loss rates, Ex-Im Bank 
determined that its allowances would have dropped substantially, from 
about $10 billion for 2001 to about $6 billion for 2002, a decrease of 
about 40 percent. Because of the size of the reduction and the 
importance of loss allowances as an overall reflection of an 
institution's expected loss from year to year, the bank's auditor 
identified this as a key area to be reviewed.

Ex-Im Bank's approach for calculating its loss allowances, beginning 
with the 2002 financial statement, used different loss rate 
methodologies for different parts of its portfolio and distinguished 
between impaired[Footnote 56] and unimpaired credits.[Footnote 57] To 
determine the loss allowances for its impaired loans and claims and for 
all of its loan guarantees and medium-and long-term insurance, Ex-Im 
Bank applied higher loss rates than those that were used in 2001. These 
higher rates were used to calculate about 95 percent of the 2002 loss 
allowance. Ex-Im Bank had asked OMB to provide these higher rates using 
its former, spread-based methodology.[Footnote 58] Ex-Im Bank officials 
stated that the spread-based loss rates were more appropriate for its 
outstanding guarantees and insurance because they provided a more 
market-based valuation that was better suited to a fair value 
presentation. To determine the 2002 loss allowances for its unimpaired 
loans and claims, Ex-Im Bank applied OMB's expected loss rates for the 
fiscal year 2004 budget.[Footnote 59] These rates were generally lower 
than the rates used to calculate the loss allowance in 2001. For 2002, 
the bank's loss allowances were about 6 percent higher than their 2001 
level. For 2003, loss allowances were about 4 percent lower than their 
2002 level.[Footnote 60]

Loss Estimation Involves Challenges and OMB Methodology Is Not 
Transparent:

OMB's methodology for estimating the expected loss rates for 
international credits provided by U.S. agencies involves challenges, 
and it is not transparent. Assessing the risk of such credit activity, 
particularly in developing countries, is inherently difficult. 
Corporate default data similar to those used by OMB are also used by 
other financial institutions to assess risk, because of the data's 
broad coverage and limitations in other data sources. However, 
historically, the data have been based largely on the default 
experiences of U.S. firms, and the data's historical coverage of 
developing countries has been limited. In addition, more recent Moody's 
data than were used in estimating OMB's model show higher defaults in 
some risk categories. In choosing this data to predict default, OMB 
analyzed Ex-Im Bank defaults over a somewhat narrow period. 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.

Assessing ECA Financing Risk is Difficult, and Data Used by OMB May 
Have Inherent Limitations for Predicting Ex-Im Bank Risk:

Assessing ECA financing risk presents data challenges. Available 
indicators of default risk, including certain financial institutions' 
own financing histories, often have limitations. Historical data on 
corporate bond defaults, while used by many institutions, may also have 
inherent limitations for assessing risk in developing countries, 
because these data have historically been based primarily on 
corporations in higher-income countries. In addition, corporate default 
data now show higher defaults in certain higher-risk categories than 
the data OMB used. OMB's analysis showing comparability between those 
data and Ex-Im Bank default experience was based on Ex-Im Bank credits 
primarily from a relatively narrow period in the 1990s and did not 
include other ICRAS agencies. OMB representatives, in providing oral 
technical comments on a draft of this report, said that they inquired 
about available default data at other ICRAS agencies but were unable to 
obtain it.[Footnote 61] OMB's staff paper noted the desirability of 
adding data from other agencies to its analysis in the future.

Assessing ECA Financing Risk Is Difficult:

Data limitations and changing environments present challenges for 
estimating the risk of ECA financing, according to experts and 
officials with whom we spoke. Some noted that ECA risk may differ from 
private bank risk, in that ECAs may be more exposed to emerging markets 
and may have less diversified portfolios, in part because of 
concentrations of exposure to particular industries. Officials said 
that many ECAs incurred large losses during the 1980s debt crisis, and 
some did so in the 1990s during the Asian financial crisis and other 
instances of sovereign default. Moreover, the move among some ECAs, 
including Ex-Im Bank, toward extending more credit to corporate or 
other nonsovereign borrowers, rather than primarily providing financing 
to sovereign governments, adds further complexity to estimating risk. 
According to several ECA officials, corporate activity may involve 
different risks, which include potentially greater difficulty in 
recovering assets in cases of default.

Some ECAs and other financial institutions lack data on their own 
financing that are of sufficient historical coverage and reliability 
for predicting the risk of future financing activities. In addition, a 
lack of risk ratings for financing in earlier decades can complicate 
the use of available historical data. Historical data on the default 
experience of sovereign bond issuers might be useful in estimating ECA 
credit risk, and ratings agencies now publish such data. However, 
according to several experts, the limited risk rating history of 
sovereign bond issuers is a significant limitation to relying on this 
data to assess risk in developing countries. Almost no developing 
country sovereign bond issuers have ratings histories that begin before 
the early 1990s.[Footnote 62]

Corporate Bond Default Data Are Widely Used but Lack Broad Historical 
Coverage of Developing Countries:

Corporate bond default rates from nationally recognized rating agencies 
are widely used by financial institutions in assessing risk but may 
have certain inherent limitations for predicting defaults in developing 
countries. Institutions use the data because of the large number of 
firms and long historical coverage in the rating agencies' databases. 
However, while international corporations are now well represented in 
these data, the data historically have included primarily U.S. 
firms.[Footnote 63] For data with international coverage, the coverage 
has historically been largely of high-income country borrowers. One 
study of a major rating agency database found, for example, that 94 
percent of the nonbank firms rated were in high-income countries, 5 
percent were in upper-middle-income countries, and 2 percent were in 
lower-middle-income countries.[Footnote 64] The data's more limited 
historical coverage of developing country default experiences may limit 
the predictive value of the data for such countries, according to some 
officials. Officials from one institution said that although they used 
corporate bond data in determining expected default rates, whether 
countries were in emerging markets was a consideration in their 
adjustments of the default rates to reflect their own performance 
expectations.

More Recent Moody's Data Show Higher Defaults in Some Risk Categories:

More recent Moody's bond default rates are higher for some higher-risk 
categories than the Moody's data for 1983-1999 that OMB's model uses to 
estimate default rates. The more recent data show higher default rates 
for risk levels that correspond to ICRAS categories 7 and 8, the 
highest risk categories in which Ex-Im Bank undertakes new business. 
For example, for fiscal year 2005, OMB's model predicted a default rate 
for ICRAS category 8, assuming a maturity of 8 years, of 41 percent. 
The Moody's default rate for 1983-1999 was 48 percent, whereas the rate 
was 52 percent for 1983-2001, and 58 percent for 1983-2003. Based on 
our review of available information on OMB's default model, the model 
would be expected to generate higher default rates for these categories 
if these more current Moody's data were used.

OMB Used Ex-Im Bank Data That Primarily Covered a Limited Period to 
Establish Comparability with Corporate Data:

In deciding to use corporate default data to predict U.S. international 
credit agencies' defaults, OMB compared data on Ex-Im Bank historical 
defaults, primarily from a limited period, with corporate default 
rates. Among ICRAS agencies, Ex-Im Bank generally extends the largest 
portion of the U.S. government's new foreign credit exposure each 
year.[Footnote 65] OMB did not compare other ICRAS agencies' defaults 
with the corporate data. OMB representatives, in providing oral 
technical comments on a draft of this report, said they inquired at 
other ICRAS agencies about default data but were unable to obtain 
additional data. OMB recognized in its staff paper the value of adding 
other agencies' data to its analysis in the future.

The Ex-Im Bank credits that OMB analyzed were primarily from a 
relatively narrow historical period in the 1990s. OMB examined the 
default probabilities of certain Ex-Im Bank transactions, sorted by 
risk rating, and concluded that Ex-Im Bank default rates were generally 
somewhat lower than those of corporate bonds across comparable rating 
categories.[Footnote 66] However, a comparison based primarily on 
lending activity over a relatively short time frame may not be 
representative of Ex-Im Bank's overall default risk. In addition, 
according to several experts and officials, data that reflected only 
the international business climate of the 1990s would not be 
representative of the risk of international lending.

For this comparison, OMB used data from an Ex-Im Bank database covering 
guarantees and medium-term insurance transactions from fiscal years 
1985-1999. This data set did not include loans, which comprised a 
significant part of Ex-Im Bank financing through the early 1980s, and 
which experienced substantial defaults during an international debt 
crisis that began in the early 1980s.[Footnote 67] While we could not 
determine the specific data that OMB analyzed,[Footnote 68] our 
analysis of the 1985-1999 database indicated that the majority of 
observations in the overall database, and a strong majority of 
observations for which risk ratings were available, were from the mid-
to late-1990s.[Footnote 69]

Recovery Rate Assumptions Have Not Been Transparent:

The basis for OMB's recovery rate assumptions and the changes over time 
has not been transparent. During our audit work, OMB did not respond to 
questions about the specific basis for its recovery rate assumptions of 
17 and 12 percent, respectively, for fiscal years 2003-2004. OMB 
further reduced assumed recovery rates to 9 percent for fiscal year 
2005. In discussing recovery rate assumptions during the audit work, 
OMB cited its staff paper, which contained a recovery rate of 20 
percent that OMB said was based generally on the ratio of aggregate 
recoveries to aggregate claims in Ex-Im Bank historical data. However, 
in discussions on a draft of this report, OMB representatives said that 
the market price of credits with the lowest ICRAS rating (category 11) 
was the predominant basis for recovery rates, although they did 
initially also consider data on Ex-Im Bank recoveries. OMB 
representatives said using the market price of the lowest-rated credits 
is based on the assumption that this value represents the most the U.S. 
government would recover in the event of a default. They provided 
information to show that changes in OMB's calculation of market prices 
of these credits accounted for drops in the recovery rate assumptions 
over time.[Footnote 70] Changes in OMB's calculation of these prices 
resulted in part from technical comments by Treasury officials.

Our analysis of the 1985-1999 Ex-Im Bank data indicates that the ratio 
of aggregate recoveries to aggregate claims in that database is about 
19 percent.[Footnote 71] Recovery rates that were based on aggregate 
data over a limited time period would tend to underrepresent actual 
recoveries because of the limited period for recoveries to be observed, 
especially those associated with defaults occurring at the end of the 
period.

According to financial institution officials and rating agency 
analysis, recovery rates tend to vary by borrower type and risk and can 
fluctuate cyclically. OMB's recovery rates assumptions appear to be 
conservative compared with recovery rates assumed by other financial 
institutions. Institutions we talked to generally assumed higher 
recovery rates than OMB, and some tailored their recovery rate 
assumptions according to the type of borrower. According to rating 
agency analysis, recovery rates are generally lower for riskier credits 
and fall during periods when defaults are higher.

If recovery rates assumed by OMB are lower than likely Ex-Im Bank 
recoveries, they will offset, to some degree, lower expected defaults 
in the calculation of expected losses. Because expected losses are 
calculated by combining expected default and expected recovery rates, 
an unrealistically low recovery rate would necessarily offset an 
unrealistically low expected default rate, within certain 
ranges.[Footnote 72]

OMB Developed Method Independently and Provided Agencies Limited 
Information:

Because of OMB's unique role in developing the loss rates that ICRAS 
agencies use to calculate subsidy costs, these agencies rely on OMB to 
comply with credit reform requirements that address the agencies' 
responsibilities for assuring the reliability of their subsidy cost 
estimates. Despite the complexity of the current methodology and its 
implications for ICRAS agencies' subsidy costs, OMB developed the 
current methodology predominantly on its own, receiving some input from 
one ICRAS agency. Some ICRAS officials said that OMB provided agencies 
with limited information about the methodology's basis or structure.

Credit reform guidance on developing credit subsidy estimates addresses 
the procedures and internal controls that agencies should have in place 
to ensure that their estimates are reliable.[Footnote 73] It states 
that any changes in factors and key assumptions, such as default and 
recovery rates, should be fully explained, supported, and documented. 
The purpose of thorough documentation is to enable independent parties 
to perform the same steps and replicate the same results with little or 
no outside explanation or assistance.

OMB representatives said that the current methodology was reviewed 
within OMB and circulated among the ICRAS agencies, although several 
ICRAS agency officials told us OMB had provided them limited 
information. According to these officials, OMB presented its 
methodology as an essentially completed approach and held several 
meetings during 2001 and early 2002 to discuss it. Officials who 
received information and attended certain meetings told us that it was 
difficult to understand or evaluate the methodology based on the 
information provided. For example, prior to one meeting, OMB circulated 
a two-page discussion paper that discussed OMB's rationale for adopting 
the current methodology and generally described its approach and a 
technical appendix to a staff paper that contained numerous equations 
describing a theoretical model. However, OMB representatives told us 
that some of the equations in this appendix were not actually used in 
the methodology while other equations not contained in the appendix 
were used. At one meeting, according to a Department of Agriculture 
economist, OMB provided only the expected loss rates for fiscal year 
2003 and a graph that predicted a decline in Ex-Im Bank subsidy rates. 
This official said it was not possible to understand the methodology by 
only examining its results. She said that although she and other ICRAS 
agencies representatives posed various questions about the method's 
underlying data and assumptions, OMB representatives did not provide 
substantive responses and stated that the method was too complex to 
explain. OMB representatives said the methodology was not reviewed 
outside the U.S. government.

After presenting the methodology, OMB received comments on the 
methodology from at least one ICRAS agency. Treasury officials told us 
that when they examined the proposed expected loss rates for fiscal 
year 2003, they objected to the substantially lower loss rates for the 
riskiest countries, those in ICRAS categories 9 through 11; asked to 
see the underlying data used; and raised methodological issues 
regarding how those rates were calculated.[Footnote 74] The Treasury 
officials said that while they had some questions about the expected 
loss rates for other ICRAS categories, they focused their attention on 
the treatment of the riskiest countries. The reason, they said, was 
that planned drops in expected loss estimates for these countries would 
sharply increase the cost to the United States of forgiving existing 
debt, such as through international agreements to forgive the debt of 
highly indebted poor countries.[Footnote 75] According to Treasury 
officials, OMB revised its approach for estimating expected losses in 
ICRAS categories 9 through 11, which resulted in loss rates that were 
not significantly changed from those in effect before fiscal year 2003.

We found that some financial institutions used outside experts or 
consultants in developing their loss estimation methodologies. Some 
also described procedures that exist to ensure their methodology's 
ongoing objectivity and reliability. For example, other government 
agencies, audit organizations, and outside experts have been involved 
in developing or reviewing the methodologies of two foreign ECAs that 
we contacted. Also, regulatory bodies, audit organizations, and 
internal risk management groups are involved in overseeing bank loss 
estimation methodologies.

Conclusions:

In passing the Federal Credit Reform Act in 1990, Congress required 
agencies to develop reasonable estimates about the long-term cost to 
the government of federal credit programs, to ensure a sound basis for 
decisions regarding program budgets. For international credit agencies 
such as Ex-Im Bank, which finances activities in relatively risky 
markets, predicting long-term costs and determining appropriate budget 
subsidy amounts is especially challenging. Because of the importance of 
reasonable program cost estimates under credit reform, such estimates 
need to be made with appropriate data and using appropriate analytical 
techniques. While ICRAS agency subsidy costs have several determinants, 
including the particular risk ratings assigned to different borrowers, 
OMB's directions to ICRAS agencies regarding loss rates across risk 
levels are an important element of estimating subsidy costs.

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. Obtaining 
additional information on agencies' default and repayment experiences 
over time will allow better assessments of the suitability of using 
data such as corporate bond default rates.

The lack of transparency of OMB's current loss rate methodology raises 
questions about how it determines expected loss rates. Because of this 
lack of transparency, combined with the method's complexity, the 
multiple ICRAS agencies that use the loss rates have incomplete 
information about how those rates are determined and what factors are 
driving changes over time. OMB's unique role in setting ICRAS agency 
loss rates suggests that greater transparency would be appropriate. In 
addition, other credit reform tools that multiple credit agencies use 
to calculate subsidy costs, such as OMB's credit subsidy calculator, 
have been audited to assure users about their accuracy. Independent 
review of OMB's methodology would provide similar assurance about the 
reliability of the loss rates and the subsidy costs developed from 
these rates, and could help facilitate ICRAS agency financial statement 
audits.

Recommendations for Executive Action:

To improve the transparency of the subsidy cost estimation process and 
help ensure the validity of estimates over time, we recommend that the 
Director of the Office of Management and Budget take the following five 
actions:

* Provide ICRAS agencies and Congress a technical description of OMB's 
expected loss methodology, including the default model, the key 
assumptions OMB made, and the data it used.

* Provide similar information in the event of significant changes in 
its method of calculating expected loss rates.

* Ensure that data from nonagency sources--for example, rating 
agencies' corporate default data, which are used to estimate expected 
loss rates--be updated as appropriate.

* Request from Ex-Im Bank and other U.S. international lending agencies 
the most complete and reliable data on their default and repayment 
histories and periodically obtain updated information, so that the 
validity of the data on which the current methodology is based can be 
assessed as sufficient agency data are available.

* Arrange for independent methodological review of OMB's expected loss 
rate model and assumptions and document that review.

Agency Comments and Our Evaluation:

We provided a draft of this report for formal comment to the Director, 
Office of Management and Budget; the Chairman, Export-Import Bank; the 
Secretary of the Treasury; the Chairman, Board of Governors of the 
Federal Reserve System; the Comptroller of the Currency; and the 
Chairman, Federal Deposit Insurance Corporation. We also provided a 
copy of the draft report for technical review to the Chairman, 
Securities and Exchange Commission, and officials at the Foreign 
Agricultural Service of the Department of Agriculture. OMB provided 
written comments on the draft report, which are reprinted in appendix 
IX. OMB, Ex-Im Bank, the Comptroller of the Currency, and the 
Securities and Exchange Commission provided technical comments, which 
we incorporated as appropriate. Other agencies reviewed the report but 
had no comments. We also obtained technical comments from bank and 
foreign ECA officials on our descriptions of their practices.

OMB generally agreed to implement the report's recommendations to make 
more information available on its expected loss methodology, update the 
nonagency data used in the model, obtain additional agency default data 
over time, and obtain technical review. OMB also expressed concern 
about the report's statement that OMB's method for determining loss 
rates was not transparent, observing that our report generally 
describes the method. We believe that, while we do present in this 
report a substantial amount of information on OMB's loss methodology, 
obtaining that information required considerable resources and effort 
with certain information provided only during the agency comment period 
despite repeated inquiries by GAO, and that similar information should 
be more readily available to affected agencies and Congress on an 
ongoing basis.

We are sending copies of this report to appropriate Congressional 
Committees. We are also sending copies of this report to the Director, 
Office of Management and Budget; the Chairman, Export-Import Bank; the 
Secretary of the Treasury; the Chairman, Board of Governors of the 
Federal Reserve System; the Comptroller of the Currency; the Chairman, 
Federal Deposit Insurance Corporation; the Chairman, Securities and 
Exchange Commission; and the Administrator, Foreign Agricultural 
Service of the Department of Agriculture. We also will make copies 
available to others upon request. In addition, the report will be 
available at no charge on the GAO Web site at 
[Hyperlink, http://www.gao.gov].

If you or your staff have any questions about this report, please 
contact me on (202) 512-4346. Additional GAO contacts and staff 
acknowledgments are listed in appendix X.

Signed by: 

Loren Yager, Director: 
International Affairs and Trade Issues:

[End of section]

Appendixes:

Appendix I: Objectives, Scope, and Methodology:

The Export-Import Bank Reauthorization Act of 2002 directed GAO to 
report to the House of Representatives Committee on Financial Services 
and the Senate Committee on Banking, Housing and Urban Affairs on the 
reserve practices of the Export-Import Bank (Ex-Im Bank) as compared 
with the reserve practices of private banks and foreign export credit 
agencies (ECA). The committees were specifically interested in Ex-Im 
Bank's method for estimating the subsidy costs of its financial 
activities for budgetary purposes in accordance with the Federal Credit 
Reform Act of 1990. Ex-Im Bank subsidy costs are determined, in part, 
on the basis of a methodology established by the Office of Management 
and Budget (OMB); OMB's methodology changed substantially in fiscal 
year 2003.

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. We also agreed to provide information on the reserve 
practices of foreign ECAs and commercial banks.

To describe OMB's current and former methodologies for estimating 
expected loss rates for U.S. credit agencies' international credit and 
the rationale for the recent revisions, we reviewed OMB descriptions of 
the methodologies and discussed the rationale for the changes to the 
methodology with OMB staff and Ex-Im Bank, Treasury, and Congressional 
Budget Office officials. We also reviewed finance literature that OMB 
cited as a basis for modifying its approach, as well as related 
literature, and examined Ex-Im Bank information about trends in its 
subsidy cost reestimates (discussed later). Our description of the 
former methodology is also based on prior GAO work, on OMB memoranda to 
agencies that participate in the Interagency Country Risk Assessment 
System (ICRAS) announcing the risk premiums or expected loss rates to 
be used in preparing budget estimates for upcoming fiscal years, and on 
our analysis of expected loss rates for fiscal years 1997-2002, as 
described later. We generally describe how ICRAS risk ratings are 
established and how Ex-Im Bank rates private borrowers, and while we 
recognize that the assignment of risk ratings is an important element 
in the overall reasonableness of expected loss estimates, evaluating 
the reasonableness of the risk ratings process and of specific ratings 
was beyond this scope of this engagement.

To describe the current methodology, we examined OMB's written 
descriptions of its methodology, posed specific questions to OMB staff 
on several occasions through their Office of General Counsel, and held 
some discussions with OMB staff about the methodology. The information 
and documentation we obtained enabled us to generally understand and 
describe the methodology and the underlying data, but did not explain 
all aspects of the methodology or the specific reasons for certain 
results. We note in the report where our description of certain aspects 
of the methodology is incomplete. However, these areas were not 
material to our conclusions.

The primary documentation we initially reviewed, an OMB paper entitled 
"Proposal for modification of the ICRAS system," describes (1) OMB's 
rationale for adopting its new methodology, (2) analysis OMB performed 
in developing the methodology, and (3) certain assumptions and 
equations that describe a general theoretical model.[Footnote 76] 
However, because the paper describes a theoretical model and includes 
limited information on specific analyses performed, data used, key 
assumptions, and results, and because not all of the elements of the 
model described in the paper were used by OMB, we required additional 
information from OMB. To obtain additional information from OMB, we 
were required to submit written questions to an attorney in OMB's 
Office of General Counsel for transmission to OMB technical staff. The 
attorney also reviewed the responses that the technical staff prepared 
before they were provided to GAO. OMB staff provided a combination of 
oral and written responses to our initial set of questions, but because 
we still lacked important information, we sought additional 
clarification from OMB. At OMB's request, we provided OMB staff with a 
Statement of Fact that (1) described our understanding of OMB's 
expected loss methodology based on information provided to that point 
and (2) identified remaining questions. We met again with the OMB 
attorney and technical staff, who responded to our questions. We 
requested an electronic version of the methodology, which OMB did not 
agree to provide. We attempted to further clarify certain issues, but 
OMB provided limited responses. OMB representatives provided certain 
additional technical information in comments on a draft of this report.

To determine the estimated default probabilities generated by the 
default component of OMB's methodology for fiscal years 2004 and 2005, 
we adjusted the expected loss rates for each rating and maturity 
category that OMB provided to ICRAS agencies by dividing each rate by 
one minus the recovery rate OMB assumed for each year. We confirmed 
that process with OMB. To determine the extent to which the default 
probabilities estimated by OMB's default model differed from the rating 
agency corporate default rates used as inputs to the model, we 
statistically compared the model's outputs for fiscal year 2004 and 
2005 with the corporate default rates used.

We also determined the current methodology's output in terms of 
expected loss rates across the ICRAS risk categories. To do so, we 
obtained electronic copies of Ex-Im Bank's cash flow spreadsheets for 
guarantees as well as copies of the OMB Credit Subsidy Calculator, 
which converts agency cash-flow payments into present value terms. To 
isolate the default or expected loss component of Ex-Im Bank subsidy 
costs from other components (including fees and interest rate 
subsidies), we entered consistent information into the Ex-Im Bank cash 
flow worksheets for each ICRAS risk category for fiscal years 2002 
through 2005 and conducted this analysis for 5-year, 8-year, and 10-
year credits. We conducted similar analysis for 8-year credits for 
fiscal years 1997 through 2002. We determined the present value of the 
results, based on a constant discount rate, using OMB's credit subsidy 
calculator. We discussed our analysis with Ex-Im Bank officials, who 
generally confirmed our approach and output.

To determine the impacts of the current OMB methodology on Ex-Im Bank, 
we examined changes in the components of Ex-Im Bank's subsidy costs and 
financial statement loss allowances. Specifically, we examined the 
following:

* To determine the effect of the current methodology on Ex-Im Bank's 
budget needs, we reviewed Ex-Im Bank budget information from fiscal 
years 1992-2005 and analyzed changes in the bank's requests for subsidy 
cost authorization and its obligation of budget authority for subsidy 
costs over that time period. We also interviewed Ex-Im Bank officials 
regarding their views on how changes in expected loss rates affected 
the bank's subsidy costs. We determined that Ex-Im Bank's budget 
information was sufficiently reliable for the purpose of documenting 
the bank's changing budget needs and confirmed our analyses with Ex-Im 
Bank officials. We also examined Ex-Im Bank information, contained in 
internal documents, on its reestimate calculations for fiscal years 
1992-1995 and 1999-2003 and interviewed Ex-Im Bank officials regarding 
their views on how changes in expected loss rates affected the bank's 
reestimates. Ex-Im Bank's internal reestimate information differed 
slightly in some years from information contained in the Federal Credit 
Supplement about the bank's reestimates. Both sources of information 
portrayed similar overall trends, but the Ex-Im Bank internal 
information covered a longer period of time than the credit supplement 
information. We also discussed with Ex-Im Bank officials the bank's 
process for calculating reestimates, and we examined auditor workpapers 
for the 2002 audit of Ex-Im Bank's financial statement, in which the 
auditors examined and verified the bank's reestimate for fiscal year 
2002. Thus, we determined that the Ex-Im Bank information was 
sufficiently reliable for the purpose of showing trends in the bank's 
reestimates since the start of credit reform, as well as the magnitude 
of the bank's reestimates following the implementation of OMB's current 
methodology.

* To determine the impact of the current methodology on the changing 
relationship between Ex-Im Bank's projection of expected losses and its 
fee income, we compared our analysis of expected loss rates for fiscal 
years 2002-2005 with the minimum fees that Ex-Im Bank can charge under 
an agreement among participating Organization for Economic Cooperation 
and Development's (OECD) member countries. We determined these fees 
using Ex-Im Bank's Exposure Fee Calculator, available on its Internet 
site. Ex-Im Bank officials confirmed our analysis. To identify how the 
relationships between expected losses and fee income could be different 
for corporate borrowers, we identified the way that corporate ratings 
are assigned and fees determined, based on interviews with Ex-Im Bank 
officials and on fee information from Ex-Im Bank's Internet site.

* To determine the impact of the current methodology on Ex-Im Bank's 
financial statement loss allowances, we reviewed Ex-Im Bank's audited 
financial statements for fiscal years 2002 and 2003 and the auditor's 
workpapers supporting its audit of the 2002 financial statement. We 
determined that the data in the audited financial statements were 
reliable for the purposes of our analysis. We discussed the 
modification in Ex-Im Bank's methodology for calculating financial 
statement loss allowances, including the impact of the current 
methodology's lower loss rates in calculating those loss allowances, 
with officials from Ex-Im Bank and its auditor, Deloitte Touche.

To assess the current methodology and the process by which it was 
developed, we identified and evaluated the basis for key OMB 
assumptions, methodological components, and data used. We also examined 
OMB documentation of the process and discussed the process with 
representatives from OMB, Ex-Im Bank, Treasury, and certain other 
agencies that participate in the ICRAS process. We did not replicate or 
validate the methodology because we lacked complete documentation and 
did not have access to the computer programs that were used to estimate 
OMB's default model. We also did not determine the reasonableness of 
specific loss rates that OMB has estimated.

To assess the methodology, we interviewed cognizant U.S. and foreign 
officials and experts and reviewed relevant studies. For example, we 
discussed loss estimation methodologies with credit experts and 
officials from certain financial institutions, including commercial 
banks, foreign export credit agencies, and other foreign officials. On 
the basis of these discussions and this review, we identified 
challenges, concerns, and practices, such as potential limitations in 
using certain data for projecting future defaults and the degree to 
which institutions followed similar or different practices in 
estimating default and loss.

To determine whether the corporate bond default rates used in OMB's 
default model have varied significantly since the model was created, we 
compared the specific Moody's Investors Service corporate bond default 
rates used in OMB's analysis with updated published versions of those 
Moody's rates.

We obtained information from OMB regarding its comparison of Ex-Im Bank 
default rates to the corporate default data used in its model, and we 
obtained from Ex-Im Bank the historical data sets that Ex-Im Bank said 
it gave OMB. We obtained certain information from OMB about how it 
analyzed the Ex-Im Bank data, and while we were able to determine the 
time period primarily covered by this analysis, we were not able to 
determine the specific data that OMB analyzed because we were unable to 
reconcile certain information that OMB provided. In assessing the time 
period covered by OMB's analysis, we obtained historical country 
ratings data from Moody's and Standard & Poor's documents and 
historical ICRAS ratings information from Ex-Im Bank. We used these to 
determine the proportion of observations in the Ex-Im Bank data sets 
for which risk ratings at the time of the transaction were available.

We examined OMB's assumptions about recovery rates and compared these 
with aggregate recovery rates that we calculated on Ex-Im Bank datasets 
covering guarantees and some insurance for 1985-1999 and 1985-2001, as 
well as with recovery rate assumptions made by other financial 
institutions. We discussed the reliability of the Ex-Im Bank data sets 
and of the underlying systems used to create the data with Ex-Im Bank 
officials, who said they view the data they have compiled to be a 
reasonable representation of their historical experiences and adequate 
for its intended purposes, which were initially to provide information 
about Ex-Im Bank's activities to a potential private sector partner. 
The officials stated that the reliability of data about individual 
transactions is considerably greater for transactions initiated in 1996 
and later because of changes that improved data entry and verification. 
We determined the data were sufficiently reliable for our purpose of 
comparing aggregate recovery rate information in the datasets with the 
recovery rate assumptions used by OMB.

To broadly assess the technical features of OMB's default model, we 
evaluated information provided by OMB that described the model's 
equations and how they were estimated, based on standard econometric 
criteria. We did not conduct a complete technical review because we did 
not have access to full documentation of the model or the model in 
electronic format.

To assess the process by which the current methodology was developed, 
we discussed with OMB representatives and certain other ICRAS officials 
the respective agencies' role and degree of involvement in developing 
and providing comment on the methodology. We also reviewed documents 
that OMB had distributed to ICRAS agencies about its methodology and 
discussed with ICRAS officials the general time frames in which the 
methodology was developed and the nature of certain meetings that OMB 
held to present information about its methodology. The ICRAS officials 
we interviewed received information about the methodology's development 
and implementation and have had continuing participation in the ICRAS 
process. We also reviewed credit reform guidance on preparing and 
auditing subsidy costs.[Footnote 77]

To provide information on the reserve practices of foreign ECAs, we 
judgmentally selected a sample of four ECAs that are key competitors of 
Ex-Im Bank or that were identified by knowledgeable U.S. and private 
sector officials as entities that had examined or changed their reserve 
practices in recent years. These included Compagnie Française 
d'Assurance pour le Commerce Extérieur in France, Euler Hermes 
Kreditversicherungs-Aktiengesellschaft in Germany, the Export Credits 
Guarantee Department in the United Kingdom, and Export Development 
Canada. In each case, we discussed with officials, and reviewed 
available documentation on, the ECA's statutory mandate, financial 
activities, and reserve practices. We also reviewed public financial 
statements where available. We also met with officials from other 
government organizations in these countries, including treasury or 
finance ministries. We met with officials from the Office of the 
Auditor General of Canada, France's Cours des Comptes, and the U.K.'s 
National Audit Office, because those offices audit the financial 
statements of the Canadian, French, and U.K. ECAs, respectively. We 
obtained the perspectives of officials from ECAs and other government 
agencies on the difficulties associated with developing loss estimation 
methodologies and using available data. In addition, we discussed these 
issues with an official from the export credit group of the OECD, and 
officials at the Office National du Ducroire/Nationale Delcrededienst 
in Belgium, including the chair of a group of OECD export credit 
country risk experts.

To provide information on the reserve, or loan loss allowance, 
practices of commercial banks, we judgmentally selected a sample of 
three U.S. commercial banks with large lending portfolios totaling 
approximately $800 billion, including large international exposures. 
For each bank, we spoke with management involved in international 
lending and the calculation of the bank's loan loss allowance. In 
addition, we reviewed the banks' financial statements and any 
documentation that was provided. We also met with several U.S. banking 
regulators--the Federal Reserve Board, Office of the Comptroller of the 
Currency, and the Federal Deposit Insurance Corporation--to discuss the 
loan loss allowance guidance banks are required to follow. We reviewed 
both regulatory and accounting guidance governing the calculation of 
the loan loss allowance by commercial banks.

[End of section]

Appendix II: Loss Estimation Practices of Foreign Export Credit 
Agencies:

Significant variation exists among the loss estimation, or reserve, 
practices of foreign export credit agencies (ECA) that we 
consulted.[Footnote 78] Differences in mission, structure, and 
accounting approaches help explain this variation. Some of these ECAs 
are expected to avoid competing with private sector financial 
institutions, which may result in more exposure to emerging market 
borrowers and riskier portfolios as compared with other ECAs. These 
ECAs' financial relationships with their governments differed, as did 
their individual responsibility for covering any losses that might 
result from their activities. Some ECAs follow an accounting approach 
that prescribes estimating probable losses over time, while others 
follow an accounting approach that precludes such estimation. ECAs in 
Canada and the United Kingdom (U.K.) have recently adopted or plan to 
implement new methodologies for estimating the likelihood of default 
and loss associated with their activities. ECAs in France and Germany 
follow a simpler approach in which the fees they collect on a given 
transaction, in accordance with an international agreement among export 
credit agencies, are regarded as sufficient to cover any likely losses 
on the transaction. The French ECA is studying a new accounting system 
that would enable it to more closely align its loss expectations with 
its historical repayment experiences. (App. I contains information 
about our objectives, scope, and methodology for examining the reserve 
practices of foreign ECAs.)

ECAs in Canada and the United Kingdom Have Methodologies to Estimate 
Future Defaults and Losses in Determining Reserve Levels:

ECAs in Canada and the United Kingdom determine their required level of 
loss reserves by estimating the extent of probable losses in their 
portfolio at a point in time, some of which may result from future 
defaults. These ECAs' missions, structures, and accounting approaches 
lend important context to their reserve practices. The Canadian and 
U.K. ECAs have recently revised (or are in the process of revising) 
their risk assessment and reserve practices to more precisely measure 
future losses. In developing their approaches, these two ECAs examined 
the risk assessment and reserve practices of leading financial 
institutions and worked with private sector risk assessment 
specialists. Their approaches have similar elements but differ in 
important respects. The new approaches have been reviewed by 
specialists outside the ECA.

Mission, Structure, and Accounting Approaches Affect Reserve Practices:

The Canadian and U.K. ECAs' mission is to help facilitate national 
exports, but their particular methods and structure for doing so 
differ. The Canadian ECA is a wholly owned government corporation that 
was capitalized with funds from the Canadian government and operates 
with the full faith and credit of the Canadian government. According to 
officials of this ECA, the entity is self-sustaining, in that it does 
not receive annual infusions of budgetary support for its operations or 
losses. Its largest business activity in terms of volume is short-term 
export insurance, but it also offers loans and medium-term insurance 
and loan guarantees. According to the Canadian ECA, it takes a 
commercial approach to managing its risks to ensure its long-term 
financial health. This institution makes its own decisions about the 
credits it will offer and is not prohibited from competing with private 
sector financial institutions.[Footnote 79] Long-term transactions 
that it determines are beyond its risk capacity and are inconsistent 
with its long-term health may be referred to the government of Canada 
for consideration. The Canadian government may accept and manage those 
risks provided that there is sufficient national benefit to 
Canada.[Footnote 80]

In contrast, the U.K. ECA is a government department that receives 
annual budgetary support (subject to Parliamentary approval) to help 
fund its operations and cover its losses. The U.K. ECA is in a time of 
transition. The ECA's operations were streamlined in 1991, when new 
legislative authority required it to sell its short-term insurance 
business and focus on medium-and long-term project finance.[Footnote 
81] The U.K. ECA is expected to avoid direct competition with U.K. 
private insurers and banks. It is also expected to undertake and manage 
its activities to ensure, with a high degree of confidence, that it 
will break even financially.[Footnote 82] Simultaneous attainment of 
these two objectives suggests this ECA has to strike a balance in the 
types of transactions and the nature of risks it shall undertake. The 
ECA's risk premia and larger transactions are subject to approval by 
the U.K. treasury department. The level of treasury department control 
increased following certain losses the ECA incurred in the late 1990s. 
Plans are under way to convert the U.K. ECA into a separately 
capitalized, self-sustaining entity that would operate at arm's length 
from the U.K. government, responsible for managing its own financial 
losses.[Footnote 83]

Different ECA missions and structures can have implications for ECA 
risk profiles and, thereby, reserve practices. For example, with its 
broader mandate, about 60 percent of the Canadian ECA's 2003 portfolio 
exposure was to U.S. and Canadian borrowers. In contrast, most of the 
U.K. ECA's ten most active markets in fiscal years 2001 and 2002 were 
emerging markets, representing about three-fourths of its activity in 
these years.[Footnote 84] These different risk profiles affect the 
level of loss reserves that these ECAs hold. According to the Canadian 
ECA's financial statements, its allowances for loss averaged about 10 
percent of its total exposure during calendar years 2000-2003. 
According to the U.K. ECA, its allowances for loss averaged about 20 
percent of total exposure between fiscal years 2000-2003.[Footnote 85] 
It is important to note that, for business undertaken since 1991, the 
U.K. ECA is expected to maintain reserves equal to at least 150 percent 
of expected losses.[Footnote 86] In comparison, the U.S. Export-Import 
Bank's (Ex-Im Bank) loss allowances have averaged about 18 percent of 
its total exposure since fiscal year 1999.

Moreover, different degrees of government support affect the extent to 
which ECAs are responsible for managing their own financial risk and 
protecting taxpayers from loss. For example, as a self-sustaining 
entity, the Canadian ECA does not receive annual budgetary support from 
its government and would be expected to cover any losses it 
incurs.[Footnote 87] In contrast, although the U.K. ECA is expected to 
break even over time, it receives appropriations from the U.K. 
Parliament to cover anticipated losses and administrative expenses. It 
also operates with a treasury department guarantee of the obligations 
arising from its guarantees.

Both the Canadian and the U.K. ECAs follow accrual-based accounting 
standards, in which revenue and expenses are recorded in the period 
they are earned or incurred, even though they may not have been 
received or paid.[Footnote 88] Under such accounting, loss reserves are 
an estimate of probable losses in a portfolio as a whole. The reserves 
are normally recorded long before actual defaults occur. This contrasts 
with cash flow accounting, in which revenue is recognized when it is 
received and expenses when they are paid. As discussed in the section 
on the French and German ECAs, this method of accounting precludes the 
matching of revenue and expenses over time.

Canadian and U.K. ECAs Have Recently Adopted, or Will Implement, New 
Reserve Methodologies:

The Canadian and U.K. ECAs have recently revised their existing reserve 
practices by adopting or moving toward implementing methodologies that 
are designed to more precisely measure risk in their portfolios and 
ensure that their reserves reflect those risks. In 2001, the Canadian 
ECA and the Canadian Office of the Auditor General, who audits the 
ECA's financial statements, undertook a review of the ECA's reserve 
methodology with the goal of making it reflect current best practices. 
The ECA studied the reserve practices of several leading U.S. and 
Canadian banks and other ECAs, including Ex-Im Bank, and examined new 
developments in bank regulatory and accounting guidance.[Footnote 89] 
According to Canadian ECA officials, it adopted a new risk assessment 
model that follows the risk assessment approaches used by some other 
financial institutions with international risk exposures. The new 
methodology did not have a substantial impact on the ECA's level of 
reserves, although the entity changed the process by which it 
calculated its reserves, specifically its components and what it 
covers. For example, it began establishing reserves for committed 
undisbursed credits, which it had not done previously.

In 1999 the U.K. treasury department hired a private consulting firm 
with credit risk expertise to review the effectiveness of the ECA's 
risk management systems because of concerns about the ECA's financial 
condition, given the larger than expected losses it incurred during the 
Asian financial crisis. According to U.K. ECA officials, the consulting 
firm concluded that the ECA's process for estimating expected loss was 
reasonable but recommended, among other things, that the U.K. ECA 
should better assess the risk of, and establish capital to buffer 
against, unexpected losses.[Footnote 90] The U.K. ECA is upgrading its 
existing risk assessment models and processes in response to the 
review.

Determining Risk Ratings and Calculating Probability of Default:

The Canadian and U.K. ECAs each use a combination of rating agency data 
and their own analyses and adjustments in determining ratings levels 
and default probabilities. For rating corporate risk, the Canadian ECA 
uses ratings from major rating agencies such as Moody's Investors 
Service and Standard & Poor's when they are available; when these 
ratings are not available, the Canadian ECA's risk department assigns 
ratings using standard rating agency criteria. They place credits into 
seven risk categories. The Canadian ECA then estimates its default 
probabilities for its corporate borrowers using published default rates 
from Moody's Investors Service and Standard & Poor's, taking into 
account the maturity of the credits. The Canadian ECA rates sovereign 
borrowers based on its own research and country knowledge. Once these 
ratings are assigned, the Canadian ECA uses the default probabilities 
associated with those ratings from Standard & Poor's and Moody's in 
determining default probabilities. For both corporate and sovereign 
borrowers, the Canadian ECA adjusts rating agency default probabilities 
where it believes such adjustments are necessary.

For determining sovereign default probabilities and risk ratings, the 
U.K. ECA uses a model it developed in 1991 that assesses countries' 
likelihood of default, using macroeconomic data such as borrower 
country indebtedness. Its analysts consider the model's output and 
additional factors, including other country data, rating agency 
sovereign ratings and interest rate spreads, in the final assignment of 
sovereign ratings. For determining expected loss, the expected duration 
of default periods and the recovery rates when defaults occur are taken 
into account, along with the probability of default.

For rating corporate transactions, the U.K. ECA uses rating agency 
corporate risk ratings where they are available. For corporations that 
are not rated by the major rating agencies, the U.K. ECA assigns 
ratings using templates developed with a major rating agency. In both 
cases, once these ratings are obtained, U.K. ECA officials adjust them, 
in some cases, based on a comparison with country sovereign ratings. 
For assigning expected losses to different risk ratings, U.K. ECA 
officials use a Standard & Poor's tool that is based on that rating 
agency's historical data on ratings transition and default rates and 
that incorporates other information such as recovery rates.

U.K. ECA officials are moving toward a new modeling process that will 
directly assess, not only the risk of expected loss, but also the 
capital needed to cover unexpected losses or the risk of having greater 
losses concentrated in certain periods. This model was developed in 
consultation with a U.K. credit risk expert and uses a combination of 
private ratings agency data on sovereign bond defaults from the 1990s 
and U.K. ECA data on the 1980s default experience of the U.K. ECA.

Calculating Expected Loss:

Once default probabilities have been determined, determining the 
expected losses from the defaults involves determining the likely 
amount of loss when defaults occur, based on expected recoveries. The 
Canadian ECA uses its own historical data, where sufficient, to 
estimate recoveries for sovereign and nonsovereign borrowers. The U.K. 
ECA determines its own recovery rates for sovereign borrowers; for 
corporate borrowers, it makes some use of rating agency recovery 
data.[Footnote 91] Both ECAs assume higher losses (lower repayments) 
for corporate than sovereign defaults.[Footnote 92] The Canadian ECA 
also assumes that higher losses will be incurred from defaults on 
unsecured credits than on collateralized credits. The calculation of 
expected loss forms these entities' base reserves amount, to which 
certain upward adjustments are made. These adjustments reflect the 
potential unexpected losses that are affected by the portfolio effects 
of concentration and correlation of financing activities.

Adjusting for Portfolio Risk:

The Canadian ECA follows a portfolio approach in estimating loss and 
calculating reserves. In such an approach, the base reserve amount is 
adjusted upward because of additional risks related to concentrations 
of exposure and correlations among credits. The Canadian ECA adds 
reserve amounts for significant exposures to single borrowers, 
countries, or industries. It also adjusts upward for the possibility 
that problems in one area (for example, in one country) will spread to 
other parts of its portfolio.

The U.K. ECA's current approach includes some judgmentally determined 
upward adjustments to its base expected loss calculations for certain 
concentrations of risk. These include upward adjustments for public, 
nonsovereign borrowers, as well as certain systemic risks related to 
other countries or industries. Its new risk management approach will 
make such adjustments more systematically, as part of its loss model.

Determining Fees:

Canadian and U.K. ECA officials both said that their loss estimation 
methodologies help them determine what fees to charge borrowers for 
their products. Both ECAs agree to follow a risk rating and pricing 
agreement developed by participating Organization for Economic 
Cooperation and Development (OECD) countries, in which participants 
jointly develop country risk ratings for the purposes of determining 
the minimum fees to be charged at each risk rating.[Footnote 93] (More 
information about this agreement is provided below.) However, according 
to Canadian and U.K. ECA officials, they may apply higher fees if they 
determine that the fees do not adequately reflect their own assessment 
of the potential loss on a transaction. Officials from both ECAs stated 
that setting fee levels in relation to expected loss is an important 
component of their financial stability over time.

Canadian and U.K. Reserve Methodologies Were Subject to Internal and 
External Review:

According to officials from the Canadian and U.K. ECAs, their reserve 
methodologies (including key assumptions and computer models) have been 
or are being reviewed extensively, both internally and externally, 
before being adopted. The Canadian ECA's new methodology was positively 
reviewed by an independent national accounting firm with significant 
experience in reviewing loan loss methodologies. The U.K. ECA's current 
reserve practices were subject to review by a private consulting firm. 
In responding to the consulting firm's recommendations, the ECA has 
worked with the U.K. treasury, a prominent academic and credit risk 
expert, and a private rating agency to develop its new approach. Its 
new risk assessment model is based on a well-known credit risk model 
that was developed by a leading U.S. bank.[Footnote 94]

ECAs in France and Germany Use Fees to Offset Loss:

ECAs in France and Germany base their reserve practices primarily on 
the fees they collect for their products rather than on systematic 
estimations of their probable losses. These ECAs are private companies 
that offer export credit insurance on behalf of their respective 
governments, following certain risk thresholds that their governments 
establish for these accounts. Their governments expect these accounts 
to break even in the long run. The French and German ECAs are not 
expected to estimate future losses when transacting new business but 
rely instead on the OECD participating countries' guidance in setting 
their fees. Neither France nor Germany annually appropriates budgetary 
funds to cover loss; instead, the fees the ECAs collect constitute 
these countries' reserve against future loss. The government ministries 
that oversee the ECAs conduct independent assessments of country risk 
in setting or adjusting the risk thresholds that specify the degree to 
which they will offer credit in certain countries. Further, the French 
ECA is developing a method, not yet in place, to more independently 
estimate future losses on the government's export credit activities and 
to track the actual losses incurred over time.

French and German ECAs Provide Export Insurance and Guarantees on 
Behalf of Their Governments and Follow Government Accounting Methods:

France and Germany provide and account for their official export credit 
business in similar ways. In both countries, the official ECA is a 
private enterprise that insures or guarantees exports on behalf, and at 
the direction, of the government. In addition to managing their 
government's export credit business (referred to in both cases as the 
state account), the French and German ECAs also engage in business for 
their own account. The French and German state accounts extend 
primarily medium-and long-term export credit insurance, whereas the 
private enterprises that manage the state accounts primarily sell 
short-term insurance.[Footnote 95] The ECAs are not responsible for any 
profit or loss incurred on the state account, which transfers to the 
government.[Footnote 96] The French and German ECAs both receive 
administrative fees from the government for their services.

The government ministries that oversee the ECAs make decisions about 
the degree to which the state accounts will offer export credits in 
certain countries or to certain borrowers (exposure limits are 
discussed further below). French and German state accounts are expected 
to operate in riskier markets where private export credit insurance 
cannot be obtained. In both countries, the government ministries can 
also direct the ECA to undertake certain transactions, even if doing so 
will cause it to exceed established exposure limits, if the government 
believes the transactions to be in the country's best interest.

The French and German state accounts are both directed to break even 
over the long term, meaning they should incur neither large gains nor 
losses. However, assessing compliance with this mandate is difficult, 
because both governments' budgets are accounted for on a cash flow 
basis. Under cash flow accounting, revenue is recognized when it is 
received, and expenses are recognized when they are paid. Thus, revenue 
in a given year is compared with expenses in that same year, regardless 
of when the underlying transactions occurred. Under this system, it can 
be difficult to know the degree to which the fees collected in a given 
year from providing export credit insurance cover any claims made 
against that insurance in later years. French and German ECA officials 
acknowledged that this accounting practice limits their ability to 
fully analyze actual or potential losses on the state account. The 
French ECA has been developing an alternative accounting approach that 
would enable such analysis, as discussed later.

French and German ECAs Follow Government-Determined Risk Thresholds and 
Use Fees to Cover Loss:

The French and German approaches to evaluating risk are based primarily 
on assessing country risk for the purpose of setting exposure limits 
and using fees to cover losses. The French and German ECAs are not 
expected to estimate expected losses in advance of undertaking 
transactions, but the French ECA provides informal risk assessments to 
the oversight ministry for it to consider when making decisions about 
undertaking transactions. The French and German governments do not 
provide budgetary funds at the beginning of a year to cover any losses 
that might be incurred during the year, but any losses incurred on the 
state account are automatically covered.

The government ministries that oversee the French and German ECAs 
analyze borrower countries' risk profiles when making their annual 
decisions about the exposure limits that will be in effect for a given 
year. This analysis may consider macroeconomic factors, OECD country 
risk ratings, and the ECA's experiences with other countries' repayment 
histories on previously extended credit. In France, the ECA also 
provides input to this analysis. These exposure limits, or ceilings, 
are developed to ensure portfolio diversification and constrain the 
accumulation of excessive risk levels. In both countries, the 
government determines risk ceilings and provides these to their ECAs to 
follow in operating the state account. Country risk ceilings can be 
exceeded only at the government's direction. The German ECA also faces 
a statutory limit on the total exposure it can undertake in a given 
year.[Footnote 97]

In both countries, the fees collected on the export credit business are 
viewed as a reasonable approximation of the amount of loss likely to be 
incurred. In setting fees, both ECAs follow the guidance agreed to by 
the participating OECD countries for assigning risk ratings to 
sovereign borrowers and charging premium rates. These ECAs add 
surcharges to the OECD minimum fee rates for corporate borrowers, 
recognizing the higher risk of corporate business. As discussed below, 
the OECD fees were politically determined, and both entities have 
considered whether the premia are sufficient to cover actual losses.

France and Germany differ in how they manage their fee revenue. In both 
countries, the revenue belongs to the government. However, in France, 
some fee revenue is kept with the French ECA for the purpose of paying 
expenses that are incurred on the state account, such as paying a claim 
on a defaulted credit. Officials of the French ministry that oversees 
the ECA told us that the amount left on deposit with the ECA is based 
on their best estimate of the losses that the ministry expects will 
materialize in a given year. A German ECA official said that all fee 
revenue it collects is immediately transferred to the German 
government. When the German ECA has to pay a claim, it must request 
funds from the German government.

French ECA and government officials told us that the French ECA is 
developing a new accounting system for the state account that will 
enable it to analyze, for each underwriting year, the collected fees 
and the claims corresponding to the transactions covered during the 
same year. This system will provide the ECA with historical data on 
payment experience in order to calculate expected losses on a 
statistical basis. However, the process is not complete, and the 
information it has produced is not used for official purposes. The 
approach in development still uses OECD minimum fees as the baseline 
for estimating loss but will add surcharges to take account of 
increased risk, for example, when a default is pending. Surcharges will 
also be added for risks other than sovereign risks. According to French 
ECA and government officials, a key challenge in developing this 
approach was compiling payment histories for individual transactions. 
They also stated that before the French state account would develop a 
reserve system that does not rely on the OECD minimum fees, further 
accumulation of historical data on payment experiences will be 
necessary, a process they expect will take some time.

OECD Participating Countries' Risk Assessment and Fee Arrangement:

The agreement of the participating OECD countries regarding country 
risk classifies countries into seven risk categories on the basis of a 
country risk assessment model. The model ranks countries according to 
which is most likely to default, considering indicators of countries' 
financial and economic situations. It also uses data provided since 
1999 by export credit agencies on their payment experiences with 
countries. Quantitative scores for each country determine its initial 
risk classification, which can be adjusted by participating countries 
based on an assessment of political risk and other factors not 
considered in the model itself.

While the model scores provide some indicator of default probabilities 
for each country, they are not used in determining what the risk 
premiums, or fees, should be to cover expected loss for financing to 
sovereign buyers in a risk category. The fees result from a political 
agreement, an averaging of fees in place in 1996 across member export 
credit agencies. Thus, the fees reflect the expected loss of lending to 
sovereign borrowers at various risk levels only to the extent that the 
average of 1996 fees across participating countries reflect those 
expected losses. The minimum common fees are not intended to reflect 
the generally higher risk of lending to nonsovereign, or private, 
borrowers within the same country, according to OECD and ECA officials.

Participating OECD countries are collecting data from their ECAs on 
their financing and repayment experiences since 1999, in order to 
assess the validity of the current fees as indicators of expected loss. 
According to an ECA official who chairs a group of country risk expert 
from OECD countries, collecting enough data to assess the current 
premiums will take at least 10 years.

[End of section]

Appendix III: Loan Loss Allowance Guidance and Select Commercial Bank 
Practices:

Loans are the largest component of most depository institutions' 
assets; therefore, the loan loss allowance[Footnote 98] is critical to 
understanding the financial condition of a depository institution and 
changes in credit risks and exposures. Given the importance of the loan 
loss allowance as an indicator of financial condition, and because 
adjustments to the allowance affect an institution's earnings, the loan 
loss allowance is scrutinized by regulatory agencies. Regulators and 
the accounting profession acknowledge that calculating the loan loss 
allowance requires significant judgment and that accounting and 
regulatory guidance are not prescriptive. For the past several years, 
the organizations involved in developing U.S. private sector accounting 
standards--the Financial Accounting Standards Board (FASB) and the 
American Institute of Certified Public Accountants --have been in the 
process of reviewing current loan loss allowance guidance. Likewise, 
the U.S. federal banking regulators--the Federal Reserve Board (FRB), 
Office of the Comptroller of the Currency (OCC), Federal Deposit 
Insurance Corporation (FDIC), Office of Thrift Supervision, and the 
National Credit Union Administration--and the Securities and Exchange 
Commission have been updating regulatory guidance governing the loan 
loss allowance. While the commercial banks we contacted follow the 
basic concepts of accounting and regulatory guidance, specific aspects 
of these banks' allowance methodologies differ. Regulatory guidance 
requires U.S. banks involved in international lending to address 
additional risks, in addition to the accounting and loan loss allowance 
concepts that apply to domestic lending.

Loan Loss Allowance Is an Important Factor in an Institution's 
Financial Condition:

The loan loss allowance plays a key role in the financial condition of 
a bank.[Footnote 99] It reflects a bank's judgment of the overall 
collectibility of its loan portfolio; that is, the higher the 
percentage of a bank's loan loss allowance to its total loan portfolio, 
the lower the estimated collectibility of the loan portfolio and the 
higher the estimated level of credit risk.[Footnote 100] It also 
reflects the amount of estimated losses that have occurred in the loan 
portfolio but have not yet been realized. The loan loss allowance, 
according to bank regulatory guidance, must be appropriate to absorb 
estimated credit losses inherent in the loan portfolio. When changes 
are made in the loan loss allowance, these changes directly affect an 
institution's earnings. The loan loss allowance is established and 
maintained by charges against the bank's operating income, which 
reduces earnings,[Footnote 101] or by reversals of the allowance that 
would increase earnings.

Given the loan loss allowance's effect on earnings and the role the 
allowance plays in allowing banks to cover probable and estimable 
losses, U.S. financial regulatory agencies pay close attention to a 
bank's loan loss allowance. These regulators require banks to establish 
and regularly review the adequacy of their allowance, and bank 
examiners assess the asset quality of an institution's loan portfolio 
and the adequacy of the loan loss allowance. Because regulatory 
guidance is not prescriptive, bank regulators told us that, through 
examinations, they assess the "reasonableness" of a bank's loan loss 
allowance by comparing a bank's loan loss allowance level with industry 
standards and looking for justification for any methodology that could 
be considered an outlier. As part of their assessment of public company 
filings, the Securities and Exchange Commission also reviews banks' 
loan loss allowance disclosures.

Accounting and Regulatory Guidance Are Not Prescriptive; the Loan Loss 
Allowance Requires Significant Judgment:

Regulatory agencies told us that their guidance is not prescriptive, 
and accounting and regulatory guidance states that the loan loss 
allowance requires a significant amount of judgment. Because no single 
approach has been determined to encompass the wide variety of banks' 
loan portfolios and their varying degree of risk and unique historical 
loss experience, regulatory and accounting guidance provide principles 
and guidelines for banks to follow, rather than specific formulas and 
factors for banks to use in their allowance calculations. The bank 
regulators direct institutions to follow U.S. generally accepted 
accounting principles (GAAP), as it applies to the loan loss allowance, 
for regulatory reporting purposes. Specifically, banks follow Statement 
of Financial Accounting Standards (SFAS) 114, Accounting by Creditors 
for Impairment of a Loan, in estimating losses from individual 
impaired[Footnote 102] loans. Further, SFAS 5, Accounting for 
Contingencies,[Footnote 103] provides guidance to banks in their 
calculation of losses for pools of loans, impaired or performing, which 
are evaluated collectively.

The bank regulators we spoke with--FRB, OCC, and FDIC--stated that 
regulatory guidance is coordinated across all the banking regulatory 
agencies and is consistent with GAAP. On March 1, 2004 the banking 
regulators issued an Update on Accounting for Loan and Lease Losses, 
which addresses recent developments in accounting for the loan loss 
allowance and presents a list of the current sources of GAAP and 
supervisory guidance for accounting for the loan loss allowance. One of 
the sources it lists is The Interagency Policy Statement on the 
Allowance for Loan and Lease Loss, which was issued by FRB, OCC, FDIC, 
and the Office of Thrift Supervision in 1993. This document discusses 
the nature and purpose of the loan loss allowance, the responsibilities 
of a bank's board of directors and management, how banks should 
determine the adequacy of their allowance and the factors that should 
be considered in their estimates, and examiners' responsibilities with 
regard to the loan loss allowance. Prior to the March 2004 Update on 
Accounting for Loan and Lease Losses, the 1993 interagency policy was 
supplemented by the 2001 Federal Financial Institutions Examination 
Council[Footnote 104] Policy Statement, discussed later.

In addition to the interagency policy, OCC and FDIC issue their own 
loan loss allowance policy statements that they distribute to banks 
under their supervision. These statements are in line with the 
interagency policy.

Table 1 provides a summary of the relevant accounting and regulatory 
guidance governing the loan loss allowance.

Table 1: Summary of Accounting and Regulatory Guidance Followed by 
Banks in Their Loan Loss Allowance Calculation:

Individual impaired loans: Accounting guidance: Conditions: Under SFAS 
114, a loan is impaired when it is probable that the bank will be 
unable to collect amounts due according to the terms of the loan. 
Banks determine impairment using normal loan review procedures; 

Individual impaired loans: Regulatory guidance: Conditions: Banks 
determine impairment using their loan review procedures. Generally, a 
loan is impaired for the purposes of SFAS 114 if it exhibits the same 
level of weaknesses and probability of loss as loans (or portions of 
loans) classified as "doubtful" or "loss." (See table 2 for risk 
classifications.).

Individual impaired loans: Accounting guidance: Measurement of 
impairment: Under SFAS 114, one of the following methods must be used: 
* present value of expected future cash flows discounted at the loan's 
effective interest rate, 
* loan's observable market price, and; 
* fair value of collateral if the loan is collateral dependent; 

Individual impaired loans: Regulatory guidance: Measurement of 
impairment: SFAS 114 guidance should be followed. Regulators expect 
that loan loss allowances for all impaired, collateral dependent loans 
will be based on the fair value of the collateral for purposes of 
regulatory reports.

Pools of loans: Accounting guidance: Conditions: Under SFAS 5, the 
following conditions must be met: (1) it is probable that a loan has 
been impaired at the financial statement date and (2) the amount of 
loss can be reasonably estimated. Under SFAS 114, some impaired loans 
may have risk characteristics in common with other impaired loans, as 
such a bank may aggregate those loans for evaluation of impairment; 

Pools of loans: Regulatory guidance: Conditions: Banks should follow 
guidance in SFAS 5 for measuring losses for pools of loans.

Pools of loans: Accounting guidance: Measurement of impairment: 
According to SFAS 5, whether the amount of loss can be reasonably 
estimated will depend on, among other things, the experience of the 
bank, information about the ability of individual debtors to pay, and 
analysis of the loans in light of the current economic environment. In 
the case of a bank with no relevant experience, reference to the 
experience of other enterprises in the same business may be 
appropriate. According to the interpretation of SFAS 5 (FASB 
interpretation 14), when a reasonable estimate of a loss is a range 
and when some amount within the range appears at the time to be a 
better estimate than any other amount within the range, that amount 
will be accrued. When no amount within the range is a better estimate 
than any other amount, the minimum amount in the range will be accrued; 

Pools of loans: Regulatory guidance: Measurement of impairment: Because 
no single approach has been determined to be appropriate for all banks, 
a specific method to determine historical loss experience is not 
required; 
* The method a bank uses will depend to a large degree on the 
capabilities of its information systems; 
* Acceptable methods range from a simple average of the bank's 
historical loss experience over a period of years to more complex 
"migration" analysis; 
* There is no fixed historical period that should be analyzed by banks 
to determine average historical loss experience. 

Source: GAO analysis of accounting and regulatory guidance.

[End of table]

Additional Guidance on International Lending:

According to bank regulators, the accounting and regulatory guidance 
discussed above and described in table 1 applies to both domestic and 
international lending. However, bank regulators stated that because 
international lending involves more risk than domestic lending, banks 
that lend internationally must follow additional guidance. The primary 
additional risk that banks face when providing international loans is 
"country risk," or the risk that economic, social, and political 
conditions and events might adversely affect a bank's interests in a 
country. A specific component of country risk is "transfer risk," or 
the possibility that a loan may not be repaid in the currency of 
payment because of restricted availability of foreign exchange in the 
debtor's country.

To address country risk, banks are expected to have country risk 
management methodologies in place. A 1998 study by the Interagency 
Country Exposure Review Committee (the "Committee") found that all U.S. 
banks conducting international lending had developed formal country 
risk management programs and policies.[Footnote 105] The Committee also 
found that these banks had formal internal country risk monitoring and 
reporting mechanisms and that country risk management was typically 
integrated with credit risk management. To address transfer risk, banks 
that lend to specific countries must allocate additional allowances, 
called the Allocated Transfer Risk Reserve.[Footnote 106]

Transfer risk is one component of the broader concept of country risk 
and the only component specifically regulated by the bank regulators. 
The International Lending Supervision Act of 1983 required banks to set 
up an allocated allowance for assets subject to transfer risk, and the 
banking regulators accordingly published regulations implementing the 
requirement. The Committee is responsible for providing an assessment 
of the degree of transfer risk in cross-border and cross-currency 
exposure of U.S. banks and sets the minimum amount of the allocated 
transfer risk reserve.[Footnote 107] The Committee bases its 
assessments and ratings on information collected from a number of 
sources, including country analysis prepared by economists at the 
Federal Reserve Bank of New York and discussions with U.S. 
banks.[Footnote 108]

Bank regulators emphasized that the Committee's transfer risk ratings 
are primarily a supervisory tool and should not replace a bank's own 
country risk analysis process. FRB officials also told us that the 
allocated transfer risk reserve is "narrowly prescribed" in that it 
applies only to a small number of countries. U.S. commercial bank 
lending is primarily domestic, and the international lending that is 
conducted by banks is concentrated in the G-10 countries[Footnote 109] 
and Switzerland. The FRB officials stated that only approximately 30 
U.S. banks--a small portion of the total number of banks in the United 
States--receive allocated transfer risk reserve statements.

Regulatory Guidance on Portfolio Segmentation and Risk Ratings:

In addition to loan loss allowance guidance, banks must also follow 
regulatory guidance regarding loan portfolio segmentation and risk 
classification. Segmenting the bank's loan portfolio into groups of 
loans with similar characteristics, such as risk classification, past-
due status, type of loan and industry, or the existence of collateral, 
is the first step in calculating the loan loss allowance for the SFAS 5 
portion. Regulatory guidance states that banks may segment their loan 
portfolios into as many components as practical. Bank regulators do not 
prescribe the way that banks should segment their loans; however, 
regulatory guidance states that loan segmentations should be separately 
analyzed and provided for in the loan loss allowance. Bank regulators 
do provide guidance on risk classification, a characteristic by which 
loan portfolios can be segmented. Table 2 provides definitions of the 
risk classifications, which are shared by all of the banking regulatory 
agencies.

Table 2: Regulatory Agencies' Risk Rating Scale:

Risk category: Pass; 
Definition: A pass asset presents no inherent loss (no formal 
regulatory definition exists for "pass" credits).

Risk category: Special mention; 
Definition: A special mention asset has potential weaknesses that 
deserve management's close attention. If left uncorrected, these 
potential weaknesses may result in deterioration of repayment prospects 
for the asset or in the institution's credit position at some future 
date. Special mention assets are not adversely classified and do not 
expose an institution to sufficient risk to warrant adverse 
classification.

Risk category: Substandard; 
Definition: A substandard asset is inadequately protected by the 
current sound worth and paying capacity of the obligor or of the 
collateral pledged, if any. Assets so classified must have a well-
efined weakness, or weaknesses, that jeopardize the liquidation of the 
debt. They are characterized by the distinct possibility that the bank 
will sustain some loss if the deficiencies are not corrected.

Risk category: Doubtful; 
Definition: An asset classified doubtful has all the weaknesses 
inherent in one classified substandard with the added characteristic 
that the weaknesses make collection or liquidation in full, on the 
basis of currently existing facts, conditions, and values, highly 
questionable and improbable.

Risk category: Loss; 
Definition: Assets classified loss are considered uncollectible and of 
such little value that their continuance as bankable assets is not 
warranted. This classification does not mean that the asset has 
absolutely no recovery or salvage value, but rather that it is not 
practical or desirable to defer writing off this basically worthless 
asset even though partial recovery may be effected in the future.

Source: OCC guidance.

[End of table]

Bank regulatory guidance states that a bank's rating system should 
reflect the complexity of its lending activities and the overall level 
of risk involved; the guidance also states that no single credit risk 
rating system is ideal for every bank. Large banks typically require 
sophisticated rating systems with multiple rating grades within the 
above broad risk classifications. One bank regulator stated that some 
banks might have a 10-point rating system based on the risk 
classifications, whereas other banks may have up to 25 different 
ratings.

Regulatory Agencies and Accounting Organizations Have Been Reviewing 
Loan Loss Allowance Guidance:

For the past several years, financial regulatory agencies and 
accounting organizations have updated and continued reviewing U.S. 
private sector accounting standards and regulatory guidance governing 
the loan loss allowance.

Regulatory Agencies Supplement Existing Guidance:

In the late-1990s, Securities and Exchange Commission staff noted in 
their normal reviews of filings by financial institutions, including 
banks, that there were inconsistencies between the disclosures about 
the credit quality of registrant's loan portfolios and the changes in 
the loan loss allowances reported in the financial statements. The 
Securities and Exchange Commission staff's review was aimed at 
determining whether the institutions were complying with GAAP for loan 
loss allowances. Securities and Exchange Commission staff was 
concerned, as were some of the bank regulators, that financial 
institutions were (1) not using procedural discipline in developing 
loan loss allowance estimates; (2) not documenting their evaluation of 
loan credit quality or their measurement of loan impairment; or (3) not 
providing clear disclosure, in the financial statements and 
management's discussion and analysis, about the provisioning process 
and allowance analysis.

As a result of the Securities and Exchange Commission staff's review of 
filings, one bank restated its financial results to reflect a reduction 
in its loan loss allowance. According to a bank regulator, although the 
credit quality of the bank's loan portfolio was increasing, its loan 
loss allowance was not decreasing.

Financial regulatory agencies issued additional guidance on the loan 
loss allowance. In March 1999, the FDIC, FRB, OCC, Office of Thrift 
Supervision, and Securities and Exchange Commission issued a joint 
letter to financial institutions on the loan loss allowance, in which 
they agreed to establish a joint working group to study the loan loss 
allowance and provide improved guidance focusing on appropriate 
methodologies and supporting documentation and enhanced disclosures. In 
2001, the Federal Financial Institutions Examination Council finalized 
and issued its Policy Statement on Allowance for Loan and Lease Losses 
Methodology and Documentation, which supplements existing regulatory 
guidance. The Policy Statement was intended to provide further guidance 
on the design and implementation of loan loss allowance methodologies 
and supporting documentation practices. Securities and Exchange 
Commission staff issued parallel guidance on this topic for public 
companies in Staff Accounting Bulletin No. 102.

Accounting Guidance for the Loan Loss Allowance is Under Review:

FASB is charged with establishing authoritative private sector 
accounting principles for financial reporting.[Footnote 110] These 
accounting principles (GAAP) are promulgated primarily through the SFAS 
issued by FASB. In the past, the American Institute of Certified Public 
Accountants (the "Institute") has issued industry and auditing guides 
to provide accounting implementation guidance, subject to clearance by 
FASB.[Footnote 111]

The Institute organized a loan loss task force with observers from the 
OCC, Securities and Exchange Commission and FASB on accounting for loan 
losses to "narrow the boundaries" of what is acceptable under GAAP. The 
Institute's exposure draft of a proposed Statement of Position, 
"Allowance for Credit Losses," was released for public comment in June 
2003 and discussed the following: the distinction between current and 
future losses; how to reconcile acceptable methods for measuring loss 
incurred for specific loans versus pools of loans that are collectively 
evaluated; disclosure requirements; and the appropriate use of 
observable data in the loan loss allowance calculation. As discussed in 
the March 2004 Update on Accounting for Loan and Lease Losses, the 
proposed Statement of Position raised concerns among the banking 
regulators and other members of the financial community who commented 
on the draft. In January 2004, after review of these comment letters, 
the Institute decided to proceed only with guidance to improve 
disclosures.[Footnote 112]

Reviewed Banks Follow Basic Concepts in Accounting and Regulatory 
Guidance but Vary in Allowance Methodologies:

We spoke with three U.S. commercial banks with large lending portfolios 
totaling approximately $800 billion, including large international 
exposures.[Footnote 113] The three banks we spoke with follow the basic 
accounting and regulatory concepts outlined earlier but vary in 
specific loan loss allowance methodologies, including the sources of 
and amount of observable data on which their allowance calculations are 
based. FRB, which is conducting a study to establish "core reserving 
practices" among banks, confirmed that loan loss allowance practices 
among banks are not universal. The loan loss allowance varies depending 
on the type of lending done by the bank and its associated levels of 
risk. In addition, each bank has a unique historical loan loss 
experience on which their reserve calculation is based.

Despite specific differences in loan loss allowance methodologies, 
banks follow the same basic steps in determining their loan loss 
allowance levels for both domestic and international loan portfolios. 
These steps are illustrated in figure 7.

Figure 7: Example of a Commercial Bank's Loan Loss Allowance Process 
for Corporate Loans:

[See PDF for image]

[End of figure]

Assignment of Risk Ratings:

All three banks stated that their loan portfolios are divided between 
their commercial and consumer businesses. We focused on the commercial 
side of the loan loss allowance process of these banks, as it was most 
relevant to the business of the Export-Import Bank. Within their 
commercial loan portfolios (including both domestic and international 
lending), regulatory guidance allows banks to segment their loans 
according to various factors but risk classification is a primary 
factor. The banks assign loans different risk classifications, as 
defined by the bank regulators (see table 2), based on the 
creditworthiness of the loan.

The calculation of the loan loss reserve is dependent on the risk 
ratings assigned to loans. The assignment of risk ratings is based on 
an assessment that includes evaluating an obligor's credit risk based 
on the company or project and also on external factors, such as country 
risk for international lending.

The three banks' approaches to the risk rating assignment and review 
process are multilayered and performed by multiple units within the 
banks. The banks we spoke with have risk management groups that are 
divided into specific risk units. The groups charged with evaluating 
credit risk are involved in assigning risk ratings. Ongoing analysis of 
the loan portfolio is performed to ensure that risk ratings continue to 
be accurate. Units within the risk management groups conduct reviews of 
selected loans in their portfolios throughout the year, sometimes 
focusing on credits in certain risk ratings ranges.

Factors that banks and bank examiners take into consideration when 
analyzing risk in a credit exposure include industry risk; financial 
indicators such as quality of cash flow, balance sheet, debt capacity, 
and financial flexibility; and management. Officials at one bank told 
us that they use agency ratings as benchmarks to test the 
reasonableness of their internal credit risk grading system; however, 
the agency ratings are considered but not specifically weighted into 
their rating decision.

All three banks we spoke with have committees that evaluate the country 
risk levels of their lending portfolios and establish country risk 
ratings and sometimes geographic exposure limits. Officials at one bank 
stated that they have a formal model that assigns risk ratings to 
countries. The model is based on economic, financial, social, and other 
factors. The three banks incorporate information from external sources-
-for example, private companies and ratings agency data--into these 
ratings. However, two banks told us that, although they use external 
sources for data and qualitative information, all of their analysis is 
internal.

Officials at one bank told us that their committee holds bimonthly 
meetings and adjusts ratings monthly. Countries are placed on watch 
lists when economic conditions are unstable. The watch list is based on 
triggers, which include economic factors such as the pricing of debt, 
exchange rates, and other political and social factors.

For international lending, the three banks factor their country risk 
rating, determined internally, into the rating that they assign a loan. 
A loan to a foreign obligor is first rated based on the obligor's 
creditworthiness, according to the banks we interviewed, then the 
country risk rating is incorporated to produce an overall rating for 
that loan. Both the banks and the bank regulators stated that, for 
international loans, the rating assigned to a loan generally will be no 
better than the country risk rating for the country in which the debtor 
is located. However, if a loan is collateralized or guaranteed by a 
third party, the loan may receive a rating better than the country risk 
rating.

FRB officials stated that Interagency Country Exposure Review 
Committee's (the "Committee") country risk ratings and the allocated 
transfer risk reserve requirements often lag behind the ratings of the 
ratings agencies and changes already made by the banks in their reserve 
levels. The three banks stated that they make their own internal 
judgments regarding the allocated transfer risk reserve and can decide 
to have a higher allowance than the allocated transfer risk reserve 
requirement, although they cannot have a lower allowance. The banks, as 
did FRB officials, also stated that the allocated transfer risk reserve 
is a lagging indicator and that many specific losses have already been 
incurred by the time the allocated transfer risk reserve is issued by 
the Committee.

Calculation of Loan Loss Allowance:

Based on direction from regulatory and accounting guidance, the three 
banks calculate loan loss allowances by grouping loans with similar 
characteristics into pools and calculating an allowance for each pool 
(which will be referred to as the "general allowance"). In other cases, 
banks calculate the loan loss allowance for certain loans on an 
individual basis (which will be referred to as the "specific 
allowance"). (Examples of general and specific allowance calculations 
are illustrated in figure 7, Step B.) In calculating the loan loss 
allowance, banks also consider and adjust for various factors including 
imprecision in the financial models used and changing economic 
conditions that may affect forecasted loan losses.[Footnote 114] As 
with all aspects of a bank's loan loss allowance methodology, 
regulatory and accounting guidance require that support for these 
adjustments be well documented.

Calculation of the General Allowance:

In calculating the general allowance, loans are grouped into pools 
based on similar characteristics--risk classification being a primary 
factor--and collectively evaluated for impairment. The three banks we 
spoke with generate expected loss factors for each loan pool by 
estimating such factors as the probability of default, loss given 
default, and expected exposure at default. The three banks use internal 
and external data to estimate the probability of default and loss given 
default components. FRB officials told us that banks tend to use 
external data to calculate the probability of default and internal data 
to calculate the loss given default. The practices of the three banks 
in our study for the most part conformed to this view. The three banks 
primarily used internal data to calculate the loss given default, 
sometimes validated by looking at external data or supplemented with 
external data, and they primarily used external data sources to 
calculate the probability of default.

With respect to the probability of default component, the banks 
weighted external sources differently and used different time periods 
of analysis. Officials at the three banks told us that they relied on 
external sources; however, officials at one bank told us that they also 
internally adjusted the data in their calculation.

The length of the historical loss experience under analysis for the 
banks we interviewed varied among the loss given default components of 
the loan loss allowance calculation. The three banks we spoke with used 
an average of 16 years worth of data for the loss given default 
component.

Calculation of the Specific Allowance:

In their specific allowance calculation, the three banks told us that 
they calculate loan loss allowance for impaired loans that are larger 
than a specific dollar amount on an individual basis. Among the banks 
with whom we spoke, this amount ranged from hundreds of thousands of 
dollars to millions of dollars. This calculation follows the guidance 
in SFAS 114. For individual impaired loans, banks typically use the 
present value of discounted cash flows. One bank told us that expected 
loss factors based on an assessment of the loans' loss potential are 
determined by consultation between loan officers and members of the 
risk management group. The discounted expected future cash flows are 
generated using expected loss factors, the remaining number of months 
that the loan is estimated to be nonperforming, the monthly interest 
rate when the obligation became nonperforming, and the gross principal 
balance when the loan became nonperforming. The three banks 
periodically update their analysis of expected loss factors. A bank 
regulator told us that in the SFAS 114 calculation, banks may develop 
best-, base-, and worst-case scenarios in order to make their best 
estimate.

The three banks pool loans that are for less than the aforementioned 
dollar amount threshold and estimate losses for the loan pools. The 
calculation follows guidance in SFAS 5. Two of the banks we spoke with 
estimate the loss factors used in this calculation based on internal 
statistical studies of historical loss experience.

Review of the Loan Loss Allowance:

The three banks we spoke with review their loan loss allowance at least 
quarterly, as part of the quarterly financial disclosure statements 
required by the Securities and Exchange Commission. However, the banks 
told us that they review large impaired loans monthly but make 
allowance decisions quarterly. The risk management groups within the 
three banks have the responsibility for estimating and formulating the 
allowance parameters and establishing the loan loss allowance. The 
recommendations and the basis of their formulation are reviewed by 
senior management, whose conclusions as to the appropriateness of the 
loan loss allowance, as well as the supporting analysis, are then 
reviewed quarterly by the bank's board of directors.

[End of section]

Appendix IV: Interagency Country Risk Assessment System:

Following enactment of the Federal Credit Reform Act in 1990, the 
Interagency Country Risk Assessment System (ICRAS)--a working group of 
executive branch agencies engaged in international credit activities--
was formed to provide uniformity to the process for evaluating country 
risk and estimating the program costs. The Export-Import Bank (Ex-Im 
Bank) uses ICRAS ratings in determining the program costs of its 
sovereign financing and as a factor in its own rating process for its 
nonsovereign, or private, financing. The determination of expected loss 
rates under the ICRAS system has two components: (1) the assignment of 
risk ratings for particular borrowers or transactions and (2) the 
determination of loss rates for each risk category. Both Ex-Im Bank and 
the Office of Management and Budget (OMB) play key roles in the ICRAS 
process--OMB chairs ICRAS, and Ex-Im Bank provides country risk 
assessments and risk rating recommendations, which are then distributed 
to, and agreed on, by all the ICRAS agencies. OMB is then responsible 
for determining the expected loss rates associated with each ICRAS risk 
rating and maturity level.

Overview of the ICRAS Framework:

ICRAS was formed to satisfy the requirement of the Federal Credit 
Reform Act of 1990 that common standards for country risk assessments 
be established for all U.S. government agencies and programs providing 
cross-border loans, guarantees, or insurance. OMB chairs 
ICRAS,[Footnote 115] Ex-Im Bank serves as the secretariat, and several 
other agencies that undertake foreign lending serve as contributing 
members. Economists with Ex-Im Bank draft country papers that examine 
economic, political, and institutional variables. These papers present 
preliminary ratings on the creditworthiness of sovereign and 
nonsovereign borrowers in a country. These papers are sent to OMB, 
which distributes them to other ICRAS agencies for comment. 
Occasionally, agencies make major written comments indicating 
disagreement with an Ex-Im Bank-recommended rating. If the agency and 
Ex-Im Bank continue to disagree after discussion, OMB schedules a 
meeting of all ICRAS representatives to debate the unresolved issue(s). 
If there is no disagreement on its contents, or when agreement has been 
reached, the recommendations of a country paper become binding when OMB 
puts into effect the recommendations of a "group" of country papers. 
This occurs twice each year.

Based on the results of this interagency process, OMB publishes two 
risk ratings for each country--a sovereign rating and a nonsovereign, 
or private, rating. Each sovereign borrower or guarantor is rated on an 
11-category scale, ranging from A through F- - (or their numerical 
counterparts, categories 1-11). Category 1 (or A) is the most 
creditworthy and category 11 (or F--) is the least creditworthy. 
According to Ex-Im Bank, four categories, A through C-, are considered 
to be roughly equivalent to creditworthy private bond ratings. The 
bottom three categories, F through F--, are used for countries that are 
insolvent or unwilling to make payments. Categories in-between 
represent various degrees of repayment difficulties. These ratings must 
be used in calculating the risk subsidy charged to each agency's budget 
when it undertakes a foreign transaction. Each agency is free to set 
its own policies with respect to fees for different risk categories and 
cover policy (which specifies the risk levels at which it will 
undertake new business).

Under credit reform, OMB is responsible for determining the expected 
loss rates associated with each ICRAS risk rating and maturity level. 
OMB provides updated expected loss rates to the ICRAS agencies for them 
to use each year in preparing budget submissions, calculating 
reestimates, and allocating subsidy costs during the fiscal year.

Country Risk Assessments:

In terms of extending export credits, country risks represent risks 
that threaten the repayment of obligations, apart from the financial 
viability of the transaction. In general terms, the degree of risk is 
measured as the product of the probability of payment delays and the 
probability of subsequent nonrecovery. A payment delay is any failure 
to make payments of principal or interest on original contract terms. 
Nonrecovery occurs in the event of default or debt forgiveness or when 
there are recurring or extended arrears.

Sovereign transactions are those that carry the full faith and credit 
of the central government receiving the export credit. These would 
typically include transactions guaranteed by the Central Bank, 
Treasury, or Ministry of Finance. On a country-by-country basis, other 
institutions may also be designated as sovereign institutions, acting 
on behalf of the state. According to ICRAS documents, the ability of a 
country to service its foreign debt depends on the following major 
factors: foreign debt service burden, the government's ability to 
acquire foreign exchange to repay foreign obligations, macroeconomic 
environment, and political or social constraints. In addition to 
indicators reflecting those factors, ICRAS sovereign ratings are also 
based on ratings of private rating agencies and a group of Organization 
for Economic Cooperation and Development member countries, as well as 
information on a country's payment arrears history with the United 
States and other foreign creditors.

ICRAS ratings for private transactions in a country are based on 
qualitative and quantitative assessments of the depth of private sector 
business activity in a country and the strength of private sector 
institutions. In addition to factors related to vulnerability to 
foreign exchange crises, the ratings focus on a country's banking 
system, legal system, foreign exchange availability, business climate, 
and political stability. They can be either higher or lower than ICRAS 
sovereign ratings.

[End of section]

Appendix V: Credit Reform Budgeting:

The Federal Credit Reform Act of 1990 required that budget authority to 
cover the cost to the government of new loans and loan guarantees (or 
modifications to existing credits) be provided before the credits are 
made. Credit reform requirements specified a net present value cost 
approach using estimates for future loan repayments and defaults as 
elements of the cost to be recorded in the budget. This permits policy 
makers to compare the costs of credit programs with each other and with 
noncredit programs in making budget decisions.

The credit reform act defines the subsidy cost of direct loans as the 
present value of disbursements--over the loan's life--by the government 
(loan disbursements and other payments) minus estimated payments to the 
government (repayments of principal, payments of interest, other 
recoveries, and other payments). It defines the subsidy cost of loan 
guarantees as the present value of cash flows from estimated payments 
by the government (for defaults and delinquencies, interest rate 
subsidies, and other payments) minus estimated payments to the 
government (for loan origination and other fees, penalties, and 
recoveries).

Credit programs have a positive subsidy--that is, they lose money--when 
the present value of estimated payments by the government exceeds the 
present value of estimated receipts. Conversely, negative subsidy 
programs are those in which the present value of estimated collections 
is expected to exceed the present value of estimated payments; in other 
words, the programs make money (aside from administrative expenses.)

The Federal Credit Reform Act of 1990 set up a special budget 
accounting system to record the budget information necessary to 
implement credit reform. It provides for three types of accounts to 
handle credit transactions. The program and financing accounts are used 
by credit obligations made since 1991. The program account receives 
appropriations for adminstrative and subsidy costs of a credit activity 
and is included in budget totals. When a direct loan or a loan 
guarantee is disbursed, the program account pays the associated subsidy 
cost for that loan to the financing account. The financing account, 
which is nonbudgetary, is used to record the cash flow associated with 
loans or loan guarantees over their lives.[Footnote 116] It finances 
loan disbursements and the payments for loan guarantee defaults with 
(1) the subsidy cost payment from the program account, (2) loans from 
the Treasury, and (3) collections received by the government. Figure 8 
diagrams this cash flow.

Figure 8: Program and Finance Account Budgeting for Ex-Im Bank under 
Credit Reform:

[See PDF for image]

[End of figure]

Each year, as part of the President's budget, agencies prepare 
estimates of the expected subsidy costs of new lending activity for the 
coming year. Agencies are also required to reestimate this cost 
annually. The Office of Management and Budget (OMB) has oversight 
responsibility for federal credit program compliance with credit reform 
act requirements and also has responsibility for approving subsidy 
estimates and reestimates. In addition, for international credits 
extended by U.S. agencies, OMB provides agencies with specific 
guidance, including estimated defaults and recoveries by risk rating 
category, to be used in determining expected losses for financing 
activities.

All credit programs automatically receive any additional budget 
authority that may be needed to fund reestimates. Thus, for 
discretionary programs, original subsidy cost estimates receive 
different budget treatment than subsidy cost reestimates.[Footnote 117] 
The original estimated subsidy cost must be appropriated as part of the 
annual appropriation process. However, upward reestimates of subsidy 
costs are financed from permanent indefinite budget authority and do 
not have to be appropriated in the annual appropriations 
process.[Footnote 118]

[End of section]

Appendix VI: Technical Description of OMB Model for Estimating Expected 
Loss of U.S. International Credit Activities:

The Office of Management and Budget (OMB) determines expected losses 
for international credit activities[Footnote 119] through (1) a complex 
model that includes two estimates of default probabilities by ratings 
category and a rule for combining them and (2) an assumption about how 
much of the value of defaulted credits will be recovered. The default 
rate estimates use a statistical concept from finance literature that 
OMB terms "distance to default." The first estimated relationship--the 
spread-default relationship--is between interest rate spreads on 
international bonds and historical default rates of corporate debt. The 
second estimated relationship--the ratings-default relationship--is 
between ratings on corporate debt and the historical default rates of 
that debt. Historical corporate default data are used in estimating 
both relationships. The model is structured so that the overall 
estimates of default for different ratings and maturities would be 
expected to be close to the underlying corporate default rates used. 
They will differ from the underlying historical default rates when 
interest rate spreads are higher or lower than their average over the 
historical period of the data used in the analysis. In addition, 
available information on the model suggests that there may be certain 
technical biases in the model's forecasts.

Distance to Default:

OMB's modeling approach uses a mathematical concept called "distance to 
default," a concept used in some finance models, which is a statistical 
representation of the safety of a credit. The statistical variable has 
an inverse relationship with default probability--the larger the 
distance to default, the smaller the probability of default. OMB's 
model, in common with many models in academic finance journals, assumes 
that changes in this variable follow a normal statistical distribution, 
with a mean of zero, and that changes occur randomly with each time 
period. Using the assumption of a normal distribution, and given an 
estimated standard deviation, each distance to default implies a time 
pattern of annual default rates. Distance to default is estimated by 
finding the default cost implied by each distance to default and 
matching that cost to the prices at which bonds of a given rating are 
trading.

Two forms of distance to default are used in the modeling effort. 
"Actual distance to default" relates to the actual probabilities of 
default. "Risk-neutral distance to default," which is related to 
interest rate spreads, refers to default rates (and recovery rates on 
defaulted credits) that are consistent with observed interest rates, 
assuming that interest rate spreads are attributed only to expected 
default costs. Finance theory attributes the difference between actual 
and risk-neutral distance to default to components of the interest rate 
beyond those that are related purely to default. For example, if 
lenders are risk averse, rather than risk neutral, they may need to be 
compensated with more than $1 of extra interest to bear a risk of loss 
that may, on average, be $1, but that may in some cases be 
substantially more.

Given OMB's estimated standard deviation of 3.79,[Footnote 120] a 
default rate of 25 percent for a 1-year bond implies an actual distance 
to default of 2.57. This can be calculated from a standard normal 
distribution table. Thus, for a given maturity, risk-free rate of 
interest, and standard deviation, knowledge of any of the following 
factors--spread, risk-neutral distance to default, or time pattern of 
default probabilities--allows the calculation of the other two factors.

Spread-Default Relationship:

The spread-default relationship is an estimated relationship between 
interest rate spreads on international bonds and historical default 
rates of corporate debt, by rating and maturity. The relationship is 
structured so that its estimated default rates will be close to the 
historical default rates used when observed spreads are near their 
average levels and higher (or lower) than the historical default rates 
when spreads are higher (or lower) than average.

The spread-default relationship is estimated with a regression that 
uses monthly observations on about 400 sovereign bonds and historical 
default rates on corporate bonds from Moody's Investors Service. The 
dependent variable (the spread-related variable) is the risk-neutral 
distance to default, which is calculated as a function of the monthly 
interest rate spreads on the bonds in the sample. The independent 
variables are (1) the actual distance to default in historical data 
(the default-related variable), which is calculated for each rating and 
maturity as a function of the historical corporate default rates used, 
and (2) the remaining maturity of each bond.

The data used for the spread-related variable in the regression, the 
risk-neutral distance to default, are Bloomberg's monthly observations 
on foreign sovereign bonds, denominated in U.S. dollars and issued in 
1987 or later.[Footnote 121] The spread on each monthly observation was 
calculated and transformed into an implied distance to default to be 
predicted by the regression.

The key independent variable, based on a security's rating, was 
calculated as follows: ratings from Moody's and two other private 
ratings firms, Standard & Poor's and Fitch Ratings, were linked to each 
monthly observation. The average rating[Footnote 122] was calculated 
and used to link each observation to an independent variable, the 
actual distance to default, calculated as a function of historical 
default rates obtained from Moody's. The remaining maturity of each 
bond, the second independent variable, was also taken from the 
Bloomberg data for each monthly observation.

This spread-related variable, risk-neutral distance to default, is 
calculated by taking the spread on a bond of a given maturity and 
converting it to a risk-neutral expected loss. Specifically, the 
calculation determines the difference between the present value of the 
payments of the bond, assuming that the bond does not default, and the 
market price of the bond implied by the bond's yield. The risk-neutral 
expected loss is turned into a risk-neutral expected default by solving 
an equation that relates expected loss to expected default rate. This 
equation calculates the present value of the losses implied by a series 
of default probabilities, where defaults are converted into a series of 
dollar losses by multiplying by a constant loss rate[Footnote 123] and 
the losses are discounted by the prevailing risk-free interest rate. 
Thus, a given standard deviation and a mean "distance to default" will 
generate a time pattern of default rates. This mean is chosen so that 
the present value of the implied dollar losses equals the risk-neutral 
expected loss.

The default-related independent variable, actual distance to default, 
is calculated from Moody's data on corporate defaults. Two Moody's 
tables showing cumulative defaults by risk rating category and maturity 
were used, one for 1920-1999, and another for 1983-1999. The tables 
were combined into one table with a default rate for each combination, 
using the larger of the two default rates for each rating/maturity 
category. Missing table entries, or reversals (such as a higher-rated 
category having a higher default rate than the next lowest category) 
were handled by averaging table entries. A calculation similar to that 
for the dependent variable is made, finding a mean distance to default 
for each Moody's rating category that will generate a time pattern of 
defaults similar to that in the Moody's tables.

Estimation of the regression produces the following parameters:

Risk-neutral distance to default (Spread-related variable)= 
-0.26 - 0.0074 * maturity + 0.73 * actual distance to default (Default-
related variable).

The above relationship is then inverted to produce a forecast of the 
default-related variable, based on the value of the spread-related 
variable, resulting in the following equation:

Actual distance to default = (0.26/0.73) + (0.0074/0.73) * maturity + 
(1/0.73) * risk-neutral distance to default:

An autoregressive parameter is estimated from the residuals of the 
above regression. This parameter is used to estimate a set of weights 
for combining distance to default estimates. For every observed month, 
each bond has a spread and maturity--hence, a predicted actual distance 
to default. The predicted actual distance to default for each bond/
month is averaged to produce an estimated distance to default for that 
bond. The weights, derived from the autoregressive parameter, are used 
to construct the weighted average. The weights are calculated so that 
more recent months have more weight when taking the average.

The actual distance to default predicted by this regression depends on 
the interest spread on each bond relative to the average spread for its 
rating category in the Bloomberg data used in the analysis. If the 
spread on a particular bond is larger than the historical average 
spread in the database, then the predicted actual distance to default 
will be smaller than the historical average.[Footnote 124] This would 
imply that the projected defaults will be larger than the historical 
average, because projected defaults move inversely with distance to 
default. Because this part of the OMB model bases default risk on a 
mixture of both current spreads and past spreads, default risk 
estimates will change more slowly than will the market assessment of 
risk, as reflected in changes in interest rate spreads.

Rating-Default Relationship:

The relationship between ratings on corporate debt and the historical 
default rates of that debt is estimated using the Moody's corporate 
default tables described above. The relationship is structured so that 
it predicts cumulative default rates by ratings category and maturity 
that are almost exactly the same as those in the combined Moody's 
tables. As with the spread-default relationship, it is assumed that 
distance to default is a normally distributed variable whose mean and 
standard deviation corresponds to a pattern of defaults over time. A 
mean for each rating category is estimated, along with a common 
standard deviation for all rating categories, that minimizes the sum of 
squared errors between the cumulative default rates predicted by the 
means and standard deviation and the actual data contained in the 
Moody's corporate default database. A different standard deviation is 
estimated for the first year than for subsequent years. This allows the 
actual distance to default for any given bond in a rating category to 
differ from the average distance to default for all bonds within a 
rating category, in addition to allowing a bond's distance to default 
to change over time.

Aggregating the Estimates:

The estimated actual distances to default for each bond from the 
spread-default relationship are averaged together so that there is one 
estimated distance to default for each rating category. The estimated 
mean distance to default for each rating category obtained from the 
spread data is then combined with the estimated mean distance to 
default from the rating data. A Bayesian (type of statistical) 
weighting scheme is used, giving more weight to the spread-default 
relationship. According to OMB, weights vary by rating category, but 
generally a weight of about two-thirds is given to the spread-default 
relationship and a weight of about one-third is given to the rating-
default relationship.

The result is a single actual distance to default number for each 
rating category. This average value, combined with the common estimated 
standard deviation for all ratings, is used to estimate annual default 
rates for each rating category. An illustration of how spread changes 
can affect OMB's final default estimates is shown in figure 9.

Figure 9: Illustration of How Spread Changes Can Affect the Final 
Expected Default Estimates:

[See PDF for image]

[End of figure]

Recovery Rates:

To derive expected loss rates for each risk and maturity category from 
the expected default rates generated by the model, OMB uses an 
assumption about the percentage of defaulted credits that will be 
recovered. According to OMB, a common recovery rate of 17 percent was 
used for fiscal year 2003, a common recovery rate of 12 percent was 
used for fiscal year 2004, and a common recovery rate of 9 percent was 
used for fiscal year 2005.

Observations on Potential Technical Limitations of the Model:

Available information on the model suggests several potential technical 
limitations, including the following:

* The independent variable in the regression, actual distance to 
default, may be measured with error. The model assumes that a 
particular observation may have a distance to default that is different 
from the average implied by the rating category. Additionally, the 
distance to default implied by the rating category does not change over 
time, while risk may change over time, even within a rating category. 
Measurement error in an independent variable generally results in a 
downward bias in the coefficient for that variable.[Footnote 125] When 
the estimated relationship is reversed so that spreads are used to 
predict default rates, as in the OMB model, this bias will affect the 
projected default rates.

* As noted, the actual distance to default implied by a rating category 
remains constant over time, while the risk neutral distance to default, 
implied by the interest rate spreads on bonds, changes over time. Thus, 
the regression uses the relationship between spreads and defaults 
across rating categories to produce an estimated coefficient. This 
coefficient is then used to estimate default probabilities for a given 
rating category, which change over time. The supporting documentation 
for the model does not demonstrate a correspondence between changes in 
default probability over time within a rating category and changes in 
default probability across rating categories.

* A regression is designed to predict the dependent variable in such a 
way that the squared errors in the prediction of the dependent variable 
are minimized. Using the regression to predict the risk-neutral 
distance to default and then inverting the estimated relationship to 
predict actual distance to default may result in greater errors in the 
projected distances to default than estimating the regression with 
actual distance to default as the dependent variable.

* The relationships between risk-neutral distance to default and the 
two independent variables--actual distance to default and maturity--may 
not be linear. If this is the case, then spreads might provide an 
adequate forecast of default probabilities near the means of the 
Bloomberg data set used in the regression but not for values of spreads 
that depart from the mean spread in the regression data. This issue 
could be important for the reliability of estimates for credits with 
ratings several categories below the average in the Bloomberg data. 
With sufficient data, the potential for quantitatively important 
nonlinearities can be assessed by estimating alternative 
specifications, such as including the squares and cross-products of the 
independent variables.

[End of section]

Appendix VII: 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. This 
methodology is used to estimate loss rates for 8 of the 11 risk-rating 
categories established by the Interagency Country Risk Assessment 
System (ICRAS).

OMB's methodology includes two components that are used to estimate 
default probabilities by ICRAS rating category. One component uses 
default rates for corporate bonds published in 2000 by a nationally 
recognized private rating agency, Moody's Investors Service, to 
calculate the probability that ICRAS agency borrowers will default. It 
estimates default probabilities for each ICRAS rating category by using 
one or more underlying Moody's risk category. The other component uses 
data on interest rate differences, or spreads, to vertically adjust the 
Moody's corporate default rates by rating category when interest rate 
spreads are unusually high or low relative to average spreads in that 
rating category. Once it has determined default probabilities by ICRAS 
rating category, the methodology applies a recovery rate assumption to 
derive expected loss rates by rating category.

We compared the default probabilities underlying OMB's fiscal year 2004 
and 2005 expected loss rates for ICRAS categories 1 through 8 with the 
Moody's corporate default data that OMB used in estimating these rates. 
We determined that the OMB default probabilities were lower for each 
ICRAS rating category in both fiscal years than were the underlying 
Moody's default rates. Figures 10 through 17 compare OMB's default 
probabilities for fiscal years 2004 and 2005 in a given ICRAS rating 
category with the Moody's corporate default rates used in OMB's model 
that correspond to each rating category. The figures show that the OMB 
default rates were generally similar in fiscal years 2004 and 2005, 
with somewhat lower rates in 2005 for certain ICRAS categories.

Figure 10: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 1 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 11: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 2 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 12: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 3 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image]

[End of figure]

Figure 13: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 4 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 14: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 5 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 15: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 6 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 16: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 7 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

Figure 17: Comparison of OMB Default Probabilities for Fiscal Years 
2004 and 2005 for ICRAS Category 8 with Moody's Corporate Default Rates 
Used in OMB Model:

[See PDF for image] 

[End of figure] 

[End of section]

Appendix VIII: Trends in Interagency Country Risk Assessment System 
Expected Loss Rates:

Through the Interagency Country Risk Assessment System (ICRAS), the 
Office of Management and Budget (OMB) annually provides expected loss 
rates to ICRAS agencies to use in preparing their budget submissions 
and subsidy cost estimates. The expected loss rates, issued for each of 
the 11 ICRAS risk categories, have changed in percentage terms over 
time. Figure 18 shows the trends in expected loss rates for ICRAS 
categories 1 through 8 for credits of 8-year maturity, expressed in 
present value terms, for fiscal years 1997 through 2005.[Footnote 126]

Figure 18: Trends in ICRAS Expected Loss Rates for 8-Year Maturity 
Credits, in Present Value Terms, Fiscal Years 1997-2005:

[See PDF for image]

Note: The present values were calculated for credits of 8-year maturity 
using OMB's credit subsidy calculator based on a discount rate of 5 
percent in each fiscal year.

[End of figure]

[End of section]

Appendix IX: Comments from the Office of Management and Budget:

EXECUTIVE OFFICE OF THE PRESIDENT: 
OFFICE OF MANAGEMENT AND BUDGET: 
WASHINGTON, D.C. 20503:

SEP 21 2004:

Mr. Loren Yager: 
Director: 
International Affairs and Trade: 
Government Accountability Office: 
Washington, DC 20548:

Dear Mr. Yager:

Thank you for the opportunity to comment on your draft report 
addressing OMB's method for calculating the expected losses of 
international credits and its impact on the Export-Import Bank.

We appreciate the effort GAO has put into the report and that GAO 
highlights the reasons for our change in method. Our previous method 
reflected the best information and theory available at the time of its 
implementation, but more recent theoretical and empirical evidence 
suggests that the previous method overstated expected losses. Our new 
method represents a substantial advance, though we continue to look for 
theoretical advances and new empirical evidence that may improve the 
methodology. GAO's report will add to the body of information that will 
help us to refine the methodology further.

We are, however, concerned by the draft report's statement that the 
method was not transparent. In this regard, the draft report itself 
notes that GAO could "generally describe and assess key aspects of the 
methodology," and the draft report includes a technical appendix that 
describes our methodology (with calculations of how its estimates 
respond to changes in interest rates). We readily acknowledge that the 
model's estimation process is complex, but this complexity was 
necessary to produce estimates that are as accurate as possible. 
Complexity when necessary for accuracy should not be deemed to reflect 
a lack of transparency. The best way to produce accurate estimates was 
to retain the most compelling feature of our previous method (which was 
its use of private market prices as a measure of risk) while relating 
our default estimates to a long-term historical average benchmark.

OMB will continue to press agencies to collect additional data on the 
performance of their credits. We will also update our corporate default 
data, and re-estimate the model, addressing the comments made in the 
draft report's technical appendix. Further, we will rewrite our 
technical description of the model to include the results of the 
updated estimation and all the information we included in our responses 
to GAO's technical questions during the course of our consultation, and 
provide that description to affected agencies and Congress. We expect 
to update our corporate data and agency data on a regular basis.

While we will continue to solicit feedback from U.S. agencies that use 
or are affected by ICRAS, we also plan to make the description of the 
model available and to seek feedback on the model from a range of 
academics and finance professionals outside of government.

Thank you again for the opportunity to comment on your draft report.

Sincerely,

Signed by: 

J. D. Foster:

Associate Director for Economic Policy: 
Office of Management and Budget: 

[End of section]

Appendix X: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Celia Thomas, 202-512-8987 Shirley Brothwell, 202-512-3865:

Staff Acknowledgments:

In addition to those individuals named above, Allison Abrams, Nathan 
Anderson, Dan Blair, Patrick Dynes, Reid Lowe, Ernie Jackson, Austin 
Kelly, Bruce Kutnick, Berel Spivack, and Roger Stoltz made major 
contributions to this report.

(320161):

FOOTNOTES

[1] This portfolio valuation includes guarantees, loans receivable, 
insurance, receivables from subrogated claims, and undisbursed loans. 
Claims are made to Ex-Im Bank when a loan that it has guaranteed or an 
insurance policy that it has issued becomes overdue or defaults.

[2] Pub. L. No. 101-508.

[3] The Federal Credit Reform Act defines the cost of a direct loan as 
the net present value (at the time of loan disbursement) of loan 
disbursements, principal repayments, and interest payments, adjusted 
for estimated defaults, prepayments, fees, penalties, and other 
recoveries. It defines the cost of a loan guarantee as the net present 
value (at the time the underlying loan is disbursed) of estimated 
payments by the government (for defaults and delinquencies, interest 
rate subsidies, and other payments) minus estimated payments to the 
government (for origination and other fees, penalties, and recoveries). 
When the present value of payments exceeds the present value of 
receipts--that is, when a credit program loses money--a positive 
subsidy exists. When the converse is true, a negative subsidy exists.

[4] The risk ratings assigned to transactions are also an important 
determinant of subsidy costs. Information on how risk ratings are 
determined for Ex-Im Bank is presented in the background section of 
this report, although an assessment of the appropriateness of ratings 
was outside the scope of this review. 

[5] OMB made a small across-the-board downward adjustment to its 
expected loss rates for the fiscal year 2002 budget, but this did not 
entail a change in its basic methodology.

[6] Financial statement loss allowances consist of allowances for 
losses on loans and claims receivable and liabilities for losses on 
insurance and guarantee programs. These allowances are a measurement 
that reflects probable and estimable uncollectible loan balances or 
potential future liabilities, as required under private sector 
accounting standards. They are not tied directly to a funding request. 

[7] Pub. L. No. 107-189, Sec. 14 (12 U.S.C. 635 note).

[8] Ex-Im Bank, which is subject to reauthorization every 4 to 5 years, 
was last reauthorized in June 2002. 

[9] In grouping the countries for which Ex-Im Bank reported exposure in 
its 2003 financial statement, we used World Bank and Organization for 
Economic Cooperation and Development income classifications. 

[10] On a direct loan, default occurs when payments due to Ex-Im Bank 
are not made as scheduled. On a guaranteed loan, default occurs when 
payments due to the private sector lender are not made as scheduled, 
causing the lender to file a claim with Ex-Im Bank. 

[11] Federal agencies that provide credit to the domestic market 
include the Departments of Agriculture, Education, Housing and Urban 
Development, and Veterans Affairs and the Small Business 
Administration. Federal agencies that provide international credit 
include the Departments of Agriculture and Defense and the Agency for 
International Development, Ex-Im Bank, and the Overseas Private 
Investment Corporation.

[12] These expected losses are estimates, based on available 
information, of the mean, or average, level of future losses expected 
from particular credit activities. Actual losses can be higher or lower 
than the expected losses. 

[13] Evaluating the risk rating process or the reasonableness of 
specific ratings was beyond the scope of this engagement.

[14] ICRAS was established in 1991 to create uniformity among the 
federal agencies involved in providing international credit. According 
to OMB, these agencies had previously used separate methodologies for 
estimating their subsidy costs, which often produced different default 
expectations for the same debtor. The ICRAS working group is chaired by 
OMB and includes representatives from the cross-border financing 
agencies, including Ex-Im Bank, the Departments of Agriculture and 
Transportation, the Overseas Private Investment Corporation, the Agency 
for International Development, and the Defense Security Assistance 
Administration. Other interested government organizations, including 
the Departments of Treasury, State, and Commerce; the Federal Reserve; 
the Council of Economic Advisors; and the National Security Council are 
also represented.

[15] The ICRAS ratings for some countries are reviewed yearly, while 
others are reviewed less frequently. Some ratings may be revised more 
frequently depending on circumstances.

[16] These comparisons are made based on a table, or concordance, that 
sets up a cross-walk between ICRAS ratings and the ratings of major 
private rating agencies, such as Moody's Investors Service and Standard 
& Poor's, as well as between ICRAS ratings and OECD ratings.

[17] Ex-Im Bank's Country Limitation Schedule identifies the countries 
for which the bank's support is not available or for which limitations 
on available credit length exist. See http://ww.exim.gov/tools/
country/country_limits.html. 

[18] For medium-term transactions of less than $10 million (which 
represent less than 10 percent of Ex-Im Bank's portfolio), the bank 
uses a portfolio approach to assign rating categories, assigning an 
overall category to a country. According to Ex-Im Bank officials, the 
category assigned to these transactions is generally one risk category 
higher than the private sector ICRAS rating for the country. 

[19] For credit programs, OMB also provides the discount rates that are 
used to calculate subsidy estimates. These rates are built into OMB's 
credit subsidy calculator.

[20] PricewaterhouseCoopers LLP audited the credit subsidy calculator 
in December 1999 to ensure that the calculations it is designed to make 
are done correctly. The calculator was audited because users, as well 
as the accountants and auditors who prepare and audit agency financial 
statements, need to have assurance that it calculates reliable subsidy 
costs in compliance with applicable legislation and accounting 
standards. 

[21] Permanent budget authority is available as the result of 
previously enacted legislation and does not require new legislation for 
the current year. Indefinite budget authority is budget authority of an 
unspecified amount of money. 

[22] The Government Corporation Control Act of 1945 required wholly 
owned government corporations, including Ex-Im Bank, to follow private 
sector principles and procedures. Since 1990, the act has required such 
corporations to undergo annual audits by independent public 
accountants.

[23] In these years, OMB presented its loss rates, for most ICRAS 
categories, in terms of risk premiums, which were estimated average 
differences between the interest rates on traded bonds in a risk 
category and the U.S. Treasury bond rate. The default costs, or 
expected losses, associated with those risk premiums were estimated to 
be the difference between the present value of the loan or loan 
guarantee's expected cash flows discounted at the Treasury interest 
rate and the expected cash flows discounted at the risk-adjusted 
interest rates.

[24] Initially, the spreads were computed relative to the lowest risk, 
or AAA, corporate bonds. Later, OMB computed the spreads relative to 
U.S. Treasury bonds. 

[25] We reported in 1994 that expected losses using this method were 
based on small numbers of spread observations in some ICRAS categories. 
See GAO, Credit Reform: U.S. Needs Better Method for Estimating Cost of 
Foreign Loans and Guarantees, NSIAD/GGD-95-31 (Washington, D.C.: Dec. 
19, 1994). 

[26] Literature cited by OMB included, in part, Jerome S. Fons, "Using 
Default Rates to Model the Term Structure of Credit Risk," Financial 
Analysts Journal 50 (1994): 25-32; and Edwin Elton, Martin J. Gruber, 
Deepak Agrawal, and Chrisotopher Mann, "Explaining the Rate Spread for 
Corporate Bonds," Journal of Finance 56 (2001): 247-277. 

[27] "Portfolio risk" is the risk associated with the variability of 
default rates--the likelihood that losses from defaults will be higher 
in some periods than others. This portfolio risk, although related to 
default costs, is not included in OMB's calculation of expected losses 
because, according to OMB, it is not considered to be a cost to the 
government and, thus, is not a cost for which the U.S. government would 
need to budget. 

[28] Elton et.al., "Explaining the Rate Spread for Corporate Bonds."

[29] Fons, "Using Default Rates to Model the Term Structure of Credit 
Risk." 

[30] This amount of the reduction was based on the amount by which the 
default probability implied by interest rate spreads for ICRAS A-rated 
credits was greater than published default probabilities for AA and 
AAA-rated corporations. 

[31] According to an Ex-Im Bank official, the bank calculates subsidy 
cost reestimates at the end of the fiscal year using an approach that 
is similar but not identical to one of the two approaches specified 
under credit reform. Ex-Im Bank officials said that to reestimate the 
subsidy cost of each cohort, they determine the outstanding principal 
balance at the end of the fiscal year, the weighted average remaining 
term to maturity, and the weighted average risk rating. They apply the 
most current OMB expected loss rate that corresponds to each cohort's 
average risk rating to the cohort's outstanding principal balance to 
determine the cohort's reestimated subsidy cost. They compare that 
amount with the amount already set aside for the cohort. If reestimated 
subsidy costs are less than the amounts set aside the previous fiscal 
year, this would result in a downward reestimate, the amount of which 
is transferred from Ex-Im Bank's financing account to the Treasury.

[32] Information in this report about Ex-Im Bank's reestimates is based 
on information that the bank provided for each year in which it 
calculated reestimates. This information differs slightly in some years 
from information about the bank's reestimates that is reported in the 
Federal Credit Supplement to the budget. These figures reflect only the 
subsidy cost portion of the reestimates cited. Ex-Im Bank also 
calculates interest costs on the subsidy costs, but these costs are not 
included in the figures.

[33] Expected losses for ICRAS categories 9 through 11 are calculated 
differently. They are based on market prices (interest rates) on debt 
issues of countries in these categories. According to OMB, it averaged 
the limited interest rate observations of international debt for 
countries in each category. OMB obtained the data from the 
International Finance Review and WesBruin Capital. OMB changed its 
method for fiscal year 2004 (1) to exclude collateralized instruments; 
(2) for performing bonds, to adjust for the difference between bond 
coupon rates and Treasury rates, excluding issues with unknown coupon 
rates; and (3) to apply a discount to each ratings category (5 percent 
for category 9, 10 percent for category 10, and 25 percent for category 
11) to reflect that countries with high ratios of bilateral debt (debt 
owed to other countries) to private debt are more likely to expect debt 
reduction. 

[34] Moody's ratings are themselves determined by the likelihood of 
default (default rates) and the severity of default (recovery rates), 
according to a Moody's official and agency documents. 

[35] OMB converted the default probabilities in the Moody's tables to 
default probabilities for ICRAS ratings by averaging certain values 
within each table and making some judgmental decisions, which, 
according to OMB, generally resulted in choosing values on the higher 
side of the Moody's ratings when there was not a straight match with 
ICRAS categories. 

[36] We compared the Moody's and OMB's default rates for maturities of 
1-8 years because the combined Moody's series that OMB used had only 8 
years of default rates for ICRAS categories 5 through 8. 

[37] Expected loss is equal to expected default multiplied by one minus 
the recovery rate. Thus, an expected default rate of 15 percent and a 
recovery rate of 20 percent would result in an expected loss rate of 12 
percent. (This is expressed mathematically as 15 (1 - .20) =15 (.80) = 
12.) 

[38] Loss expectations rose slightly between fiscal years 2002 and 2005 
for ICRAS categories 9 and 10 and declined slightly for category 11.

[39] We compared the loss expectations in place for 8-year guarantees 
at ICRAS risk ratings 1-8 using Ex-Im Bank's cash flow worksheets and 
determined their present value using OMB's credit subsidy calculator. 
We selected 8-year credits because this maturity is representative of 
many Ex-Im Bank credits. Specific loss expectations per ICRAS category 
differ depending on the maturity of the credit, but the general trend 
and average reduction over the period were similar for the other 
maturity bands we analyzed. 

[40] The bank's appropriations in a given fiscal year can be carried 
over for up to 3 years if they are not completely obligated. This would 
happen, for example, in years when the actual amount and risk ratings 
of new financing the bank undertook in a fiscal year were lower than 
had been anticipated for that year. 

[41] The figure includes anticipated obligations of $440 million for 
direct and guaranteed loan subsidies and $20 million for direct and 
guaranteed loan modifications.

[42] The carryover resulted in part from Ex-Im Bank obligating 
substantially less budget authority in fiscal year 2003 than it 
expected. In its budget submission, the bank expected to obligate about 
$655 million for new subsidy costs and modifications. However, it 
obligated about $334 million of the $513 million it was authorized for 
subsidy costs in fiscal year 2003.

[43] The bank anticipated obligations of $471 million for direct and 
guaranteed loan subsidies and $20 million for direct and guaranteed 
loan modifications.

[44] In 2002, Ex-Im Bank authorized about $10.1 billion in new 
financing, with an average ICRAS risk weight of 4.9; its obligation of 
subsidy budget authority that year was about $738 million. In fiscal 
year 2003, Ex-Im Bank authorized about $10.5 billion in new financing, 
with an average ICRAS risk weight of 5.0; its obligation of subsidy 
budget authority that year was about $334 million.

[45] When calculating its reestimates, Ex-Im Bank uses the most current 
OMB loss rates available. According to Ex-Im Bank officials, its 
reestimate in fiscal year 2002 was calculated using fiscal year 2004 
loss rates. The officials said that the fiscal year 2003 loss rates 
were not used for any reestimate calculations. 

[46] The total downward reestimate that Ex-Im Bank calculated in fiscal 
year 2002 was about $3.5 billion, of which $2.7 billion was reestimated 
subsidy cost and $0.8 billion was interest cost. At the end of fiscal 
year 2003, Ex-Im Bank calculated a net downward reestimate of about 
$1.9 billion, of which about $1.4 billion was reestimated subsidy costs 
and about $0.5 billion was interest costs.

[47] Percentages on the 2002 reestimates were calculated on subsidy and 
interest costs combined because information on the trends by cohort was 
available only in this format.

[48] Exposure fees are fees that Ex-Im Bank charges borrowers to cover 
the risk that the transaction will not be repaid. These fees vary 
depending on the risk and tenor of the credit being offered. Ex-Im Bank 
also charges other fees, including application processing fees and 
commitment fees.

[49] This agreement was among Participants to the Arrangement on 
Officially Supported Export Credits. Participants to the Arrangement 
are Australia, Canada, the members of the European Community, Japan, 
the Republic of Korea, New Zealand, Norway, Switzerland, and the United 
States. The fee agreement, sometimes called the Knaepen Package after 
the Belgian official instrumental in its formation, was concluded in 
1997 and took effect in 1999. The fees in the agreement result from a 
political agreement, an averaging of fees in place in 1996 across 
certain export credit agencies. 

[50] For corporate borrowers that Ex-Im Bank rates as riskier than the 
OECD sovereign rating for the country where the corporation is located, 
the bank charges fees that are higher than the OECD fee by 10 percent 
increments for each difference in rating level. Thus, if Ex-Im Bank 
rated a corporation in Country A at ICRAS category 5 when Country A is 
rated at ICRAS category 3, the bank would charge that corporation an 
exposure fee 20 percent higher than the OECD fee corresponding to ICRAS 
category 3. However, because that fee would not cover expected loss in 
ICRAS category 5, Ex-Im Bank would incur subsidy costs in this example. 


[51] A foreign government official noted that Ex-Im Bank exhibits a 
greater degree of transparency than other members of the export credit 
group by explicitly disclosing the subsidy cost of its export credit 
activities in its budget documents.

[52] Private sector accounting does not recognize future fee income 
before it is received. In contrast, for budget purposes, the present 
value of future fee income is recognized as an offset to expected 
losses when a loan or guarantee is made.

[53] 2002 was the first year Deloitte & Touche served as Ex-Im Bank's 
external auditor. 

[54] FASB Interpretation Number 45 addresses Guarantors' Accounting and 
Disclosure Requirements for Guarantees, Including Indirect Guarantees 
of Indebtedness of Others, an interpretation of FASB Statements Nos. 5, 
57, and 107 and rescission of FASB interpretation No. 34. 

[55] Ex-Im Bank officials cited Statement of Financial Accounting 
Standard 114, which addresses Accounting by Creditors for Impairment of 
Loan. 

[56] Ex-Im Bank defined as impaired any loans or claims that are 90 
days or more in arrears, that are rated in ICRAS categories 9-11, or 
that have been rescheduled. The bank determined that about 34 percent 
of the loans and about 95 percent of the claims it reported in its 2002 
financial statement were impaired. For fiscal year 2003, about 23 
percent of its loans and 95 percent of its claims were impaired.

[57] Ex-Im Bank discloses detailed information about its loss allowance 
calculation, including the different loss rates it uses, in its Annual 
Portfolio Review, which is compiled by its Portfolio Management and 
Review Division.

[58] Ex-Im Bank also applied different loss rates depending on whether 
the exposures were outstanding or undisbursed. To discount the effect 
of exposure of cancellations and suspension of disbursements, Ex-Im 
Bank set the loss percentage for each ICRAS category of undisbursed 
exposure 15 percent lower than the loss percentage for outstanding 
exposures.

[59] Usually, the loss rates that Ex-Im Bank applies to its financial 
statements are the rates that will be in effect in the coming fiscal 
year. According to an Ex-Im Bank official, fiscal year 2003 expected 
loss rates were not used in the 2002 financial statement because OMB 
made the fiscal year 2004 rates available sooner than expected. 

[60] Ex-Im Bank's financial statement loss allowances have averaged 
about 18 percent of its total exposure since fiscal year 1999. Ex-Im 
Bank did not establish any allowances for credit losses on its loans 
and loan guarantees through fiscal year 1988, suggesting that no 
expected losses were associated with any of these credits. As the 
bank's independent auditor at this time, GAO expressed adverse opinions 
about the bank's financial statements for fiscal years 1983-1988, 
noting that the financial statements were not fairly presented in 
accordance with GAAP. Ex-Im Bank established financial statement loss 
allowances for the first time in 1989, in the amount of $4.8 billion.

[61] Assessing the availability of default data at other ICRAS agencies 
was beyond the scope of this review.

[62] For example, in 1985, Moody's and Standard & Poor's rated a total 
of 15 sovereigns, with 14 of the countries rated in categories 
corresponding to ICRAS category 1 and 1 corresponding to ICRAS category 
5. In 1991, they rated a total of 34 countries, with 21 of the 
countries rated in categories corresponding to ICRAS category 1, 6 
rated in categories corresponding to ICRAS category 2, and 7 rated in 
categories corresponding to ICRAS categories below 2. By 1999, these 
rating agencies rated a total of 91 countries, with 58 rated in 
categories below those corresponding to ICRAS category 2. (These 
figures use an average of the two agencies' ratings, in cases where 
they rated a country differently in a given year.)

In addition to the limited coverage of ratings, experts have noted that 
countries historically have often given preferential treatment to 
payments on their bonds compared with their loans because bonds 
represented a relatively small share of a country's international debt. 


[63] For example, in 1980, a very small percentage of bond issuers 
rated by Moody's were located outside the United States; the non-U.S. 
share grew to about 18 percent by 1990 and 40 percent by 2000. 

[64] The study examined Standard & Poor's data on rated corporations as 
of 1999. See Giovanni Ferri, Li-Gang Liu, and Giovanni Majnoni,"The 
Role of Rating Agency Assessments in Less Developed Countries: Impact 
of the Proposed Basel Guidelines," Journal of Banking and Finance 25 
(2001): 115-148. 

[65] Since credit reform, the value of Ex-Im Bank's annual loans and 
loan guarantees have been the largest among ICRAS agencies, followed by 
the Commodity Credit Corporation and the Overseas Private Investment 
Corporation. On a total exposure basis, at the end of fiscal year 2002, 
Ex-Im Bank represented 40 percent of the U.S. government's credit 
exposure to sovereign and other official foreign borrowers; the Agency 
for International Development and the Departments of Agriculture and 
Defense represented most of the remainder. At that time, Ex-Im Bank 
also represented about 70 percent of the U.S. government's credit 
exposure to private foreign borrowers, with the remainder held 
primarily by the Overseas Investment Protection Corporation and the 
Department of Agriculture. 

[66] OMB initially calculated default probabilities directly for 
different risk categories. Because of the relatively small number of 
observations in the database, the patterns shown were somewhat erratic, 
with higher percentages of defaults in some lower-risk categories than 
in higher-risk categories. OMB then used a statistical model to smooth 
the patterns of historical defaults across ratings categories for ICRAS 
categories 1-6. 

[67] According to Ex-Im Bank officials, in 2000, they provided OMB a 
database of the bank's guarantees and medium-and long-term insurance 
financing activities covering fiscal years 1985-1999, which Ex-Im Bank 
had created to provide information to a private bank with which they 
were considering joint financing. According to Ex-Im Bank officials, 
they did not include loans in the creation of that data set in 1999 
because loans had become less important in the bank's financing. Ex-Im 
Bank officials told us that the reliability of this data is 
considerably greater for transactions initiated in 1996 or later. 
Beginning in 1996, the key component databases were updated to increase 
automatic data entry and verification.

[68] In a written response to our questions, OMB provided information 
indicating that its analysis was based on data from 1993 and later, but 
OMB staff stated subsequently that the analysis had used all 
observations in the data set. Within the data set, credits prior to 
fiscal year 1992 lack ICRAS risk ratings. OMB staff stated that they 
assigned ratings by using risk ratings from private rating agencies. 
However, we determined that very few countries below the highest rating 
categories were rated by private rating agencies before 1992. This is 
discussed in footnote 62. 

[69] We obtained the 1985-1999 data set from Ex-Im Bank and examined 
the distribution of transactions across the period covered. We 
determined that, depending on how one defines the unit of analysis, 
from two-thirds to over three-fourths of the observations in the data 
set for which Moody's Investors Service, Standard & Poor's, or ICRAS 
country ratings were available were from 1994-1999. We also determined 
that, irrespective of which observations had ratings associated with 
them, between slightly more than half and two-thirds of them were from 
1994 or later. Between 85 and 91 percent of all the observations in the 
database were from 1990 or later. 

[70] Footnote 33 provides more information on how OMB uses market 
prices in calculating expected losses for ICRAS categories 9-11. 

[71] We analyzed the Ex-Im Bank data sets primarily at the aggregate 
level. Recovery amounts in this data set represent recoveries received 
directly by Ex-Im Bank and do not include payments to the U.S. 
government through reschedulings of sovereign credits. Ex-Im Bank 
provided us a second data set that updated the 1985-1999 data through 
fiscal year 2001. Our analysis showed that the ratio of aggregate 
recoveries to aggregate claims in the second data set is about 35 
percent. Ex-Im Bank officials said that, when recoveries through 
reschedulings are included, their total recovery rates are higher. Our 
analysis showed that, when recoveries through reschedulings are 
included, total recovery rates were about 26 percent for 1985-1999 
period and about 43 percent for the 1985-2001 period.

[72] For example, in a hypothetical situation where the true default 
probability was known to be 20 percent and the true recovery rate was 
30 percent (corresponding to a loss rate of 70 percent), the true 
expected loss rate would be 14.0 percent (20 x .70=14.0). However, an 
overly low default rate of 15 percent combined with an overly low 
recovery rate of 10 percent (corresponding to a loss rate of 90 
percent) would yield a similar expected loss rate, 13.5 percent (15 x 
.90=13.5). 

[73] Federal Accounting Standards Advisory Board, Federal Financial 
Accounting and Auditing Technical Release 6--Preparing Estimates for 
Direct Loan and Loan Guarantee Subsidies under the Federal Credit 
Reform Act, Amendments to Technical Release 3: Preparing and Auditing 
Direct Loan and Loan Guarantee Subsidies Under the Federal Credit 
Reform Act (Washington, D.C.: January 2004). This guidance was 
developed by the Accounting and Auditing Policy Committee, a permanent 
committee of the Federal Accounting Standards Advisory Board. The 
committee was organized by OMB, GAO, the Department of Treasury, the 
Chief Financial Officers' Council, and the President's Council on 
Integrity and Efficiency as a body to research accounting and auditing 
issues requiring guidance.

[74] Treasury officials determined, for example, that some credits that 
were being used to determine the market value and implicitly the 
riskiness of lower-rated country data were backed with collateral, 
which would be expected to result in lower risk and higher prices. 

[75] When the U.S. government forgives a country's debt, the budgetary 
cost of the debt relief is determined by the estimated value of the 
debt under credit reform terms. Thus, the lower the estimated value of 
the debt, the lower the budgetary cost of debt forgiveness. 

[76] The paper that OMB provided was marked "Draft: For Discussion 
Purposes Only," but OMB representatives told us there were no 
subsequent versions and it should be considered a final paper.

[77] Federal Accounting Standards Advisory Board, Federal Financial 
Accounting and Auditing Technical Release 6--Preparing Estimates for 
Direct Loan and Loan Guarantee Subsidies under the Federal Credit 
Reform Act, Amendments to Technical Release 3: Preparing and Auditing 
Direct Loan and Loan Guarantee Subsidies Under the Federal Credit 
Reform Act (Washington, D.C.: January 2004). This guidance was 
developed by the Accounting and Auditing Policy Committee, a permanent 
committee of the Federal Accounting Standards Advisory Board. The 
committee was organized by OMB, GAO, the Department of the Treasury, 
the Chief Financial Officers' Council, and the President's Council on 
Integrity and Efficiency, to research accounting and auditing issues 
requiring guidance. 

[78] We discussed reserve practices with Export Development Canada, 
Compagnie Française d'Assurance pour le Commerce Extérieur in France, 
Euler Hermes Kreditversicherungs-AG in Germany, the Export Credits 
Guarantee Department in the United Kingdom, and the Office National du 
Ducroire/Nationale Delcrederedienst in Belgium. For ease of reference, 
we do not use these entities' proper names in this appendix. We 
recognize that "reserves" is not a technical term, but we use it in 
this appendix because each ECA used different terminology to refer to 
its practices.

[79] The majority of business the Canadian ECA undertakes annually is 
transacted in what it calls its Corporate Account. 

[80] These are known as Canada Account transactions and are undertaken 
infrequently. The Canadian ECA executes the transaction on behalf of 
the government.

[81] Export and Investment Guarantees Act 1991.

[82] According to U.K. officials, a mandate to break even over the long 
term has been in effect since the ECA's inception, but over time this 
has been translated into quantifiable objectives. This mandate 
currently applies to all business undertaken since 1991 that meets the 
ECA's underwriting criteria. The mandate does not apply to business 
that the ECA is directed to undertake on the basis of national 
interests but that does not meet its underwriting criteria. 

[83] According to U.K. ECA officials, the conversion of their entity to 
a self-sustaining "Trading Fund" is scheduled to take place by 2007.

[84] The U.K. ECA's fiscal year begins on April 1 and ends on March 31. 
The above figure represents the ECA's activity for the fiscal years 
ending March 31, 2002 and 2003. 

[85] This figure reflect allowances on the U.K. ECA's pre-1991 and 
post-1991 activities and includes allowances on paid claims and future 
amounts at risk. 

[86] The U.K. ECA must achieve a "Reserve Coverage Ratio" of at least 
1.5 times the level of future expected losses in its portfolio. Because 
the U.K. ECA is expected to generally break even, including during 
periods when losses are concentrated and thus unusually high, it is 
expected to reserve at a level that is higher than would be needed to 
cover expected losses on average over a long period. The extra reserves 
are to cover what are sometimes called "unexpected losses." With these 
higher reserve levels, reserves should be adequate to cover losses 75 
percent of the time, according to U.K. ECA officials.

[87] According to the Canadian ECA, its overall operations have 
resulted in a profit in every year but one. 

[88] The Canadian ECA is required to follow Canadian Generally Accepted 
Accounting Principles (GAAP), which are similar to U.S. private-sector 
GAAP and include the use of accrual-based accounting. The U.K. ECA 
follows U.K. government accounting standards, which are accrual-based 
standards. This ECA practiced cash flow accounting for many years but 
switched to accrual-based accounting several years ago.

[89] The Canadian ECA examined the Ex-Im Bank loss estimation 
methodology in place at the time of its benchmarking exercise that 
began in 1999, which differed from the loss estimation methodology 
implemented by the Office of Management and Budget for fiscal year 2003 
that is described in this report.

[90] Risk Management Review for HM Treasury and ECGD, KPMG, December 
1999.

[91] For aircraft financing, the U.K. ECA uses data on the recovery or 
second-hand value of aircraft. 

[92] For the Canadian ECA, secured commercial debt has a lower 
probability of loss given default than does sovereign debt.

[93] This group, the Participants to the Arrangement on Officially 
Supported Export Credits, is not an official OECD body, but receives 
support from the OECD Secretariat. Its members include Australia, 
Canada, the European Community, Japan, Korea, New Zealand, Norway, 
Sweden, and the United States. 

[94] The underlying model, CreditMetrics, was introduced by JP Morgan 
in 1997.

[95] The French and German state accounts do not directly finance 
exports. Private financial institutions handle this instead.

[96] According to French and German ECA and government officials, the 
state accounts are operated separately from ECAs' private account. 
Profit on the private account is not used to fund the state account.

[97] A German ECA official told us that the statutory limit has never 
precluded it from undertaking any business that it wanted to undertake 
for the state account.

[98] Different phrases are used interchangeably when discussing credit 
loss reserves, including loan loss reserves, allowance for loan and 
lease losses, and allowance for credit losses. We will use the phrase 
"loan loss allowance."

[99] Loan loss allowance guidance applies to banks and other financial 
institutions. We discuss banks in this appendix because our review 
focuses on lending done by commercial banks for purposes of comparison 
with the Export-Import Bank.

[100] Credit risk is the potential for financial loss resulting from 
the failure of the borrower or counterparty to perform on an 
obligation.

[101] The management of a bank adjusts the level of its loan loss 
allowance through periodic provisioning to offset charge-offs to 
reflect the level of estimated losses in the loan portfolio. Provisions 
are an expense charged against an institution's current earnings and 
represent the amount necessary to adjust the loan loss allowance to 
reflect probable and estimable uncollectible loan balances. 

[102] A loan is impaired when, based on current information and events, 
it is probable that a creditor will be unable to collect all amounts 
due according to the contractual terms of the loan agreement.

[103] SFAS 5 defines a contingency as an existing condition, situation, 
or set of circumstances involving uncertainty as to possible gain or 
loss to an enterprise that will ultimately be resolved when one or more 
future events occur or fail to occur. 

[104] The Federal Financial Institutions Examination Council is an 
interagency body empowered to prescribe uniform principles, standards, 
and report forms for the federal examination of financial institutions 
by the federal banking regulators and to make recommendations to 
promote uniformity in the supervision of financial institutions. 

[105] The Committee is composed of representatives of the OCC, FDIC, 
and FRB.

[106] The allocated transfer risk reserve is a specific allowance that 
is created by a charge to current income. The allocated transfer risk 
reserve is separate from the loan loss allowance and is deducted from 
gross loans and leases. As far as financial statement reporting, FRB 
officials told us that the allocated transfer risk reserve normally 
appears as part of the loan loss allowance, that is, it is not 
identified separate of the allowance.

[107] The Committee meets three times a year to review countries to 
which U.S. banks have had an aggregate exposure of $1 billion or more 
for at least two consecutive quarters. 

[108] Two of the three banks that we spoke with stated that they were 
included in the Committee's process.

[109] The G-10 countries (in addition to the United States) are 
Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the 
Netherlands, Sweden, and the United Kingdom.

[110] Since 1973, FASB has been the designated private sector 
organization responsible for establishing standards of financial 
accounting and reporting, which govern the preparation of private 
sector financial statements. FASB accounting standards are recognized 
as authoritative by the Securities and Exchange Commission and the 
Institute. 

[111] The Securities and Exchange Commission has statutory authority to 
establish accounting principles but, as a matter of policy, it 
generally has relied on FASB to provide leadership in establishing and 
improving accounting principles and standards. The Securities and 
Exchange Commission issued a Policy Statement on April 25, 2003 
recognizing FASB as a designated accounting standard setter. 

[112] The Institute's loan loss task force will evaluate existing loan 
loss allowance disclosure requirements and disclosure recommendations 
received through the comment process and will develop a document on 
list of recommended disclosure enhancements.

[113] See appendix I for a further discussion of our methodology.

[114] The recent exposure draft Statement of Position by the American 
Institute of Certified Public Accountants emphasizes that the loan loss 
allowance consists of only these two components. While the term 
"unallocated reserves" is commonly used in the banking industry, its 
specific meaning may vary. For some, it refers to adjustments to 
historical experience factors, while others believe that those 
adjustments are an element of the allocated allowance for loan losses. 
Others believe that unallocated refers to allowances for credit losses 
that are not attributable to individual loans, referred to as the 
"general allowance" in this appendix. 

[115] The ICRAS working group is chaired by OMB and includes 
representatives from the cross-border financing agencies, including Ex-
Im Bank, the Departments of Agriculture and Transportation, the 
Overseas Private Investment Corporation, the Agency for International 
Development, and the Defense Security Assistance Administration. Other 
interested government organizations, including the Departments of 
Treasury, State, and Commerce; the Federal Reserve; the Council of 
Economic Advisors; and the National Security Council are also 
represented.

[116] Nonbudgetary accounts may appear in the budget document for 
information purposes but are not included in the budget totals for 
budget authority or budget outlay. They do not belong in the budget, 
because they show only how something is financed and do not represent 
the use of resources. 

[117] Discretionary programs are those controlled through the annual 
appropriations process. 

[118] Permanent budget authority is available as the result of 
previously enacted legislation and does not require new legislation for 
the current year. Indefinite budget authority is budget authority of an 
unspecified amount.

[119] This description is based on our analysis of information that OMB 
provided about its current methodology as well as discussions with key 
OMB officials. We did not review any formal documentation of the 
methodology.

[120] This is the standard deviation for the first year of the 
forecast. OMB's methodology for estimating the standard deviation is 
discussed later in this appendix.

[121] These bonds constitute the universe of foreign sovereign bonds 
from Bloomberg from 1987 or later. According to OMB, observations where 
the difference between the price bid and the price asked for the bond 
(the bid-ask spread) of more than 10 basis points (for fiscal year 
2003) or 40 basis points (for fiscal year 2004) were eliminated because 
these observations may have been for illiquid instruments. This 
resulted in removing about half of the observations because of large 
differences between the bid and asked price for the bonds. This left 
2,184 monthly observations. 

[122] Rating categories are those of the nationally recognized 
statistical rating organizations, which are developed by the private 
sector and are widely available in financial reporting. OMB translates 
these ratings organizations' ratings categories into ICRAS categories.

[123] OMB used an "investor loss rate" for this calculation, which OMB 
said differed from the U.S. government loss rates (or recovery rates) 
it used to transform its final estimates of default rates into expected 
loss rates. According to OMB, the investor loss rate it used was based 
on the market prices of F- - (F double minus) credits. 

[124] In regression analysis, when the independent variables are at 
their mean values, the dependent variable will be at its mean value. 
Conversely, if a bond is near the average of the spreads observed in 
the data, then the predicted actual distance to default will be close 
to the average observed in the Moody's data. 

[125] See Peter Kennedy, A Guide to Econometrics, 4TH ed. (Cambridge, 
MA: The MIT Press, 1998), 140-142 and 148. In the case of one 
independent variable, measurement error always leads to a downward 
bias. With more than one independent variable, the analysis more 
complicated. See M. Levi, "Errors in Variables Bias in the Presence of 
Correctly Measured Variables," Econometrica vol. 41, #5 (September 
1973).

[126] During the period analyzed, the format in which OMB presented 
expected loss rates varied. For fiscal years 1997 through 2002, OMB 
presented risk premiums for ICRAS categories 1 through 8, which were 
grouped into several maturity bands. From these premiums, an expected 
loss rate could be derived. Beginning in fiscal year 2003, OMB changed 
its presentation into expected loss rates for ICRAS categories 1 
through 8, across different maturities. To show trends over time, we 
converted the risk premiums into expected loss rates.

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