GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

United States General Accounting Office

Washington, DC 20548

August 21, 2001

The Honorable John F. Kerry

Chairman

The Honorable Christopher S. Bond

Ranking Minority Member

Committee on Small Business

United States Senate

The Honorable Donald A. Manzullo

Chairman

The Honorable Nydia M. Velazquez

Ranking Minority Member

Committee on Small Business

House of Representatives

Subject: Small Business Administration: Section 7(a) General Business Loans Credit

Subsidy Estimates

In your May 4, 2001, letter, you expressed concerns about the Small Business

Administration’s (SBA) 7(a) Business Loan Program subsidy rate calculations. As

agreed with the staff of your committees, we reviewed the subsidy rate estimation

process and the data SBA uses in its calculation, with a specific focus on defaults and

recoveries. We identified differences between originally estimated defaults and

recoveries and actual data, and the causes of these differences. Additionally, we

assessed the implications of proposed changes to SBA’s current approach to estimate

defaults. On July 30, 2001, we briefed your staff on the results of our review. This

letter transmits the material from the briefing.

In summary, the process and types of data SBA uses to estimate the subsidy cost of

the 7(a) program are generally reasonable and comply with existing Office of

Management and Budget (OMB) guidance. However, our review of actual and

originally estimated defaults and recoveries showed that, on a cumulative basis since

1992, defaults were overestimated by approximately $2 billion and recoveries were

overestimated by approximately $450 million.1

 During this same period, SBA

overestimated the cost of the 7(a) program by $958 million as evidenced from a trend

 1

Because SBA calculates estimated recoveries as a percent of estimated defaults, most of the

overstated recoveries resulted from the initial overestimate of defaults. When recoveries were

calculated independent of the default overestimate, the cumulative overstatement of recoveries was

less than 1 percent of actual recoveries, or about $3 million.
Page 2 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

of downward reestimates.2 The majority of these downward reestimates can be

attributed to the overestimate of defaults.

For those loan guarantees approved from 1992 through 1997, we were unable to

determine the specific reason for the overestimate of defaults primarily because the

basis SBA used for the estimated default rate for these years was not documented.3

Reestimates during this period account for approximately 84 percent of the total $958

million reestimate. SBA began using its current methodology in 1998. This

methodology uses average historical data since 1986 to estimate defaults. Under this

method, high default rates associated with loan guarantees approved in fiscal years

1986 through 1990 contributed to the difference between estimated and actual

defaults for loan guarantees approved from 1998 through 2000.

SBA has proposed to OMB another methodology that uses the 5 most recent years of

actual loan performance prior to each activity year being estimated—referred to as

the lookback period4

—rather than the current approach that uses all actual loan

performance since 1986, to estimate loan performance for each activity year. OMB is

currently considering this proposal. Either approach has certain benefits and

inherent risks.

Under the current approach, initial estimates of the subsidy rate are fairly stable

because they include more years of historical data that smooth out fluctuations in

economic conditions from year to year. As previously mentioned, the current

approach includes several early years with relatively high default rates. A benefit of

this approach, given SBA's historical experience, is that it provides a cushion in the

event of an unexpected downturn in the economy. However, this cushion ties up

appropriations that could have been available to other discretionary programs. As has

recently been the case for SBA, this approach is more likely to result in continuing

annual downward reestimates when there is a strong economic environment.

The proposed method would be more sensitive to fluctuations in economic

conditions or changes in program delivery or design because it uses a shorter

lookback period. The benefit of this approach is that, in a continuing stable economy,

the original subsidy cost estimate would be expected to more closely match actual

loan performance and reestimates would therefore be smaller. However, the risk of

this approach is that a sudden downturn in the economy would be much more likely

 2

In addition to the differences between actuals and estimates to date, the total downward reestimate

would also be affected by the present value of these differences and changes in the estimates for

expected future loan performance.

3

According to SBA officials, prior to the estimate of the 1998 cohort's subsidy cost in fiscal year 1996,

subsidy cost estimates were prepared based on direct consultation with OMB.

4

For example, under the 5 year lookback period, the 2002 cohort estimate of year one default activity

would be based on the average actual first year defaults that occurred for the 1996 through 2000

cohorts and the second year default activity would be based on actual second year defaults that

occurred for the 1995 through 1999 cohorts. Under the current approach, the lookback for all activity

years includes the average of all cohorts back to 1986.
Page 3 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

to result in actual loan performance being different than estimated and thus would

likely result in larger upward reestimates than under the current approach.

SBA generally agreed with the information presented in this briefing. SBA officials

added, however, that they view the proposed changes in default estimation

methodology to be an interim solution. SBA views the long-term solution as a

sophisticated econometric modeling approach. Econometric modeling considers key

relationships between loan performance and economic and other indicators.

- - - - -

We are sending copies of this letter to the Administrator of the Small Business

Administration and the Director of the Office of Management and Budget. This letter

will also be available on GAO’s homepage at http://www.gao.gov.

If you have any questions, please contact me at (202) 512-9508 or by e-mail at

calboml@gao.gov, or contact Dan Blair, Assistant Director, at (202) 512-9401 or by

email at blaird@gao.gov. Key contributors to this letter were Marcia Carlsen, Ruth

Sessions, and Bill Shear.

Linda M. Calbom

Director

Financial Management and Assurance

Enclosure
Enclosure

Page 4 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

Briefing Before the Staffs of the Senate and House

Committees on Small Business

1

Briefing to Staff of the Senate and House

Committees on Small Business

Small Business Administration

Section 7(a) General Business Loans Credit Subsidy

Estimates

July 30, 2001
Enclosure

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2

Contents

• Objectives

• Scope and Methodology

• Background

• Process and Data Used to Estimate 7(a) Subsidy Costs

• Reestimates of the 7(a) Program Subsidy Costs

• Comparison of Originally Estimated Defaults and Recoveries to Actual

Data

• Effect of Overestimating the 7(a) Program’s Subsidy Cost

• Causes of Differences

• Implications of Proposed Changes

• Agency Comments
Enclosure

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3

Objectives

Our objectives for the Section 7(a) General Business Loans (the 7(a)

program) review were to

• identify the types of data and process used to estimate the subsidy

cost, including the incorporation of program changes,

• compare originally estimated defaults and recoveries from the 1992

through 2000 subsidy cost estimates to actual data recorded in the

accounting system,

• determine the causes of differences between original estimates and

actual defaults and recoveries,

• assess the implications of proposed changes to SBA’s approach to

estimate defaults.
Enclosure

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4

Scope and Methodology

• To achieve our objectives, we

• discussed SBA’s process and types of data used to

prepare subsidy cost estimates with agency staff,

• compared SBA’s current process to prepare subsidy cost

estimates to existing guidance from the Office of

Management and Budget (OMB),

• reconciled actual data used as a basis to estimate

defaults and recoveries with data from the accounting

system,1

• analyzed trends in the actual defaults, recoveries and

guaranteed percentages,

1 We were not able to reconcile to the actual data prior to fiscal year 1992 because the current accounting system was

implemented in 1992 and does not include data prior to that time.
Enclosure

Page 8 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

5

Scope and Methodology

• compared the original estimated default and recovery

amounts for the 1992 through 2000 cohorts2 to actual

loan performance data recorded in the accounting

system,

• discussed the causes of differences and proposed

changes with SBA staff and OMB officials, and

• determined the potential impact of various alternative

approaches on subsidy cost estimates.

• Our audit work was conducted in Washington, D.C., from

May 2001 through July 2001 in accordance with generally

accepted government auditing standards. 2 A cohort includes those direct loans or loan guarantees of a program for which a subsidy appropriation is provided for in

a given fiscal year even if the loans are not disbursed until subsequent years.
Enclosure

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Background

• The 7(a) program guarantees loans made to small

businesses that are unable to obtain financing on similar

terms in the private credit market but can demonstrate the

ability to repay the loan.

• SBA reported that its share of outstanding 7(a) loan

guarantees totaled nearly $22.9 billion as of September

30, 2000. This represents about 65 percent of SBA’s

total loan guarantees outstanding.

• From 1995 to 1996, SBA undertook a significant data

gathering effort to capture historical loan performance for

the 7(a) loan program and began using this data in 1996

to estimate the subsidy cost of the 1998 cohort.
Enclosure

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7

Background

• Since the inception of credit reform, the 7(a) program has

had net downward reestimates of nearly $1 billion.3

• In March 2001, SBA submitted a proposal to OMB,

which is discussed later in more detail, to adjust its

approach to estimating the subsidy cost of the 7(a)

program.

• OMB is in the process of reviewing the recent SBA

proposal.

3 A downward reestimate indicates a cohort of loans or loan guarantees is expected to cost the federal government

less than previously anticipated. This amount does not include the portion of the reestimate attributable to interest.
Enclosure

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8

Background

• Prior to the Federal Credit Reform Act (FCRA) of 1990,

credit programs--like most other federal programs--were

reported in the budget on a cash basis.

• Loan guarantees appeared to be free in the budget year

while direct loans appeared to be as expensive as

grants.

• This cash basis distorted costs and, thus, the

comparison of credit program costs with other programs

and each other.
Enclosure

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Background

• FCRA was, among other reasons, enacted to more

accurately measure the government’s costs of federal loan

programs and to permit better comparisons both among

credit programs and between credit and noncredit

programs.

• Under FCRA, agencies are required to estimate the cost of

extending or guaranteeing credit over the life of the loan,

called the subsidy cost.

• This cost is the estimated long-term cost to the

government of direct loans or loan guarantees calculated

on a net present value4 basis, excluding administrative

costs.

4 The net present value expresses expected future cash inflows and outflows in today's dollars. In calculating the

present value, prevailing interest rates provide the basis for converting future amounts into today's dollar equivalents.
Enclosure

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Background

• In the subsidy cost calculation, agencies estimate the cash

flows for a program, including (but not limited to) estimated

defaults, recoveries, and fees, and the effects of

prepayments, on a cohort basis, for the life of the loans.

• Generally, agencies are required to annually update the

subsidy cost - referred to as reestimates - of each cohort

based on information about the actual performance and/or

estimated changes in future loan performance.

• FCRA recognized that agencies’ ability to make subsidy

cost estimates that mirrored actual loan performance

could be impeded by various factors and provided

permanent indefinite budget authority for reestimates

that reflect increased credit program costs.
Enclosure

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Background

• Section 503 of FCRA states that OMB is responsible for,

among other things,

• coordinating subsidy cost estimates for executive branch

agencies and

• reviewing historical data and developing the best

possible credit subsidy estimates.

• The Accounting and Auditing Policy Committee’s5 (AAPC)

Technical Release 3, Preparing and Auditing Direct Loan

and Loan Guarantee Subsidies under the Federal Credit

Reform Act, identifies specific practices that, if fully

implemented by credit agencies, will enhance their ability to

reasonably estimate loan program costs.

5 The AAPC is sponsored by the Federal Accounting Standards Advisory Board.
Enclosure

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Process and Data Used to Estimate 7(a)

Subsidy Costs

• When calculating the subsidy cost of the 7(a) program, SBA

considers, for the life of the loans guaranteed

(1) fees that will be received,

(2) the percent of total loan amounts guaranteed, which

currently can not exceed 75 or 85 percent depending on

the loan amount,

(3) the volume and mix of loan guarantees,6 and

(4) the amount and timing of defaults and recoveries.

• To estimate defaults and recoveries, SBA averages its

historical loan performance since 1986.7

6 The volume and mix of loan guarantees refers to the total amount of loans SBA expects to guarantee and the

various loan sizes based upon different fee and guaranteed percentages.

7 SBA began using this historical database in 1996 to calculate the subsidy cost of the 1998 cohort.
Enclosure

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Process and Data Used to Estimate 7(a)

Subsidy Costs

• According to SBA staff, when there is a change in the 7(a)

program’s design, SBA staff

• determine if the change affects existing assumptions or

adds a new assumption to the subsidy cost calculation,

• determine if there is any historical data that could be

used to assess the impact of the change on the subsidy

cost estimates, and

• use informed opinion8 to estimate the impact on the

subsidy cost if no applicable historical experience exists.

8 Informed opinion refers to the judgment of agency staff who make subsidy estimates based on their programmatic

knowledge and/or experience. According to Technical Release 3, informed opinion is an acceptable approach in

situations where historical data does not exist.
Enclosure

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Process and Data Used to Estimate 7(a)

Subsidy Costs

• SBA generally uses the same process and types of data as

explained on the prior two slides to calculate reestimates of

subsidy costs. In addition, as part of the reestimate

process,

• as actual loan performance becomes available, it

replaces estimated cash flows and

• expectations of future loan performance are updated

based on information about actual performance and/or

estimated changes in future loan performance.

• In summary, the process and types of data SBA uses to

estimate the subsidy cost of the 7(a) program are generally

reasonable and comply with existing OMB guidance.
Enclosure

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15

Reestimates of the 7(a) Program Subsidy

Costs

• Since the inception of credit reform, SBA has overestimated

the original subsidy cost of the 7(a) program by nearly $1

billion, as evidenced by the net downward reestimate shown

on the following slide.

• Because reestimate data were not separately available for

interest, defaults, fees and other cash flows, we were

unable to determine the net overestimate attributable to

each of these factors.

• However, based on our comparisons of originally estimated

defaults and recoveries to actual loan performance, a

significant portion of the 7(a) program’s total $1 billion net

reestimate is attributed to the overestimate of defaults.
Enclosure

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Reestimates of the 7(a) Program Subsidy

Costs

Reestimate History of the 7(a) Program

(Dollars in millions)

Source: Small Business Administration

Note: For each annual reestimate, net amounts were either received from Treasury (1997

Budget) or returned to Treasury (1998 - 2002 Budget).

Cohort 1997 Budget 1998 Budget 1999 Budget 2000 Budget 2001 Budget 2002 Budget Cummulative

1992 $5 ($55) ($30) ($74) ($5) ($4) ($163)

1993 (14) (77) (50) (80) (21) (16) (259)

1994 53 (14) (63) (60) (12) (4) (100)

1995 11 49 (68) (60) (1) (4) (73)

1996 32 37 (101) (16) (9) (57)

1997 (24) (86) (39) (0) (149)

1998 (52) (39) (39) (130)

1999 (13) (11) (24)

2000 (3) (3)

Totals $54 ($65) ($198) ($513) ($145) ($91) ($958)
Enclosure

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17

Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

• SBA originally overestimated defaults9 for 1992 through

2000 by over $2 billion, or about 87 percent, when

compared to actual loan performance.

• Since estimated recoveries are based on a percent of

estimated defaults, SBA also originally overestimated

recoveries for 1992 through 2000 by nearly $450 million, or

about 62 percent, when compared to actual loan

performance.

• According to SBA staff, overestimating fees also contributed

to the 7(a) program total net reestimate. However, we did

not attempt to quantify the effect of fees.10

9 The amount defaulted is based on the portion SBA guarantees.

10In addition to the differences between actuals and estimates to date, the net reestimate would also be impacted by the

present value of these differences and changes in the estimates for expected future loan performance.
Enclosure

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Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

• The following 4 slides summarize the results of our

comparison of original estimates of defaults and recoveries

to actual defaults and recoveries for the 1992 through 2000

cohorts.

• The original estimates of defaults and recoveries for each

cohort are based on expectations of future loan

performance from the time of origination through fiscal year

2000. Actual defaults and recoveries for each cohort are

based on actual loan performance through fiscal year 2000.
Enclosure

Page 22 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

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Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

Percentage by which Originally Estimated Defaults were more than Actual Defaults for Fiscal

Years 1992 through 2000 (Cumulatively by Cohort)

Source: GAO analysis based on SBA data.

Note: By the end of fiscal year 2000, only the 1992 through 1996 cohorts had reached the typical peak default years,

which historically have been years 3 through 5 after approval.

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

1992 1993 1994 1995 1996 1997 1998 1999 2000 Cohort

Dollars in millions

Estimated Actual

62%

90%

102%

42%

88% 113%

108%

179%

293%

The 1998 cohort was the first to be 

estimated using historical data.
Enclosure

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20

Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

Percentage by which Originally Estimated Recoveries were more (less) than Actual

Recoveries for Fiscal Years 1992 through 2000 (Cumulatively by Cohort)

Source: GAO analysis based on SBA data

Note: N/A indicates that there were no actual recoveries as expected for a cohort in its first year.

$0

$50

$100

$150

$200

$250

$300

1992 1993 1994 1995 1996 1997 1998 1999 2000

Cohort

Dollars in millions

Estimated Actual

22%

(75%) N/A 18%

99% 27%

118%

108%

55%

The 1998 cohort was the first to be 

estimated using historical data.
Enclosure

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21

Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

• In order to assess estimated recoveries independently from

the effect of overestimating defaults, we compared

estimated recoveries based on actual defaults to actual

recoveries.

• This comparison, summarized on the next slide, showed

that adjusting for the effect of originally overestimating

defaults, estimated recoveries have more closely matched

actual loan performance over time.

• The cumulative difference between the adjusted

estimate of recoveries and actual recoveries was about

$3 million, or about 1 percent of actual recoveries.
Enclosure

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Comparison of Originally Estimated

Defaults and Recoveries to Actual Data

Percentage by which Adjusted Estimated Recoveries were more (less) than Actual

Recoveries for Fiscal Years 1992 through 2000 (Cumulatively by Cohort)

Source: GAO analysis based on SBA data.

Note: Estimated recoveries were adjusted to be based upon actual defaults in order to remove the effect of overestimating

defaults. N/A indicates that there were no actual recoveries for the cohort, as expected for a cohort in its first year.

$0

$50

$100

$150

$200

$250

1992 1993 1994 1995 1996 1997 1998 1999 2000

Cohort

Dollars in millions

Estimated Actual

(24%)

(28%) N/A 65%

77%

22%

35%

6%

(22%)

The 1998 cohort was the first to be 

estimated using historical data.
Enclosure

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Effect of Overestimating the 7(a) Program’s

Subsidy Cost

• Because the 7(a) program is a discretionary credit program,

overestimating the cost can affect the number or size of loans

guaranteed, if the program runs out of budget authority.

• However, according to SBA and OMB, the 7(a) program has

typically not depleted its allocated budget authority and has

generally met its demand for loan guarantees.

• According to SBA, the 7(a) program did run out of budget

authority a few days before the end of fiscal year 1995,

preventing SBA from issuing some loan guarantees.

However, SBA issued loan guarantees for those loans the

following fiscal year. Further, for a part of 1997, SBA

established a temporary cap on the size of loans it

guaranteed, which limited the amount of subsidy available per

loan.
Enclosure

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Effect of Overestimating the 7(a) Program’s

Subsidy Cost

• Appropriations for the original 7(a) program subsidy cost,

like other discretionary credit programs, are counted under

the discretionary spending caps and must compete with

other discretionary programs for the funding available under

these limits.

• The cumulative result of the overestimates of the subsidy

cost of the 7(a) program is that $958 million of budget

authority was not available for other discretionary programs

for fiscal years 1992 through 2000.
Enclosure

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Causes of Differences

• For the 1992 through 1997 cohorts,11 the specific reason for the

differences between originally estimated and actual defaults is

unclear because the basis of the estimate is unknown.

• SBA did not begin to use its historical data until 1996, when it

calculated the original subsidy cost estimate for the 1998

cohort.

• According to SBA officials, prior to 1996, subsidy cost

estimates were prepared based on direct consultation with

OMB and the basis used for the default estimates was not

documented.

• However, SBA believes one of the reasons for the differences

was an unexpected good economy.

11 Reestimates of the 1992 through 1997 cohorts have accounted for 84 percent of the 7(a) program’s total downward

reestimate.
Enclosure

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Causes of Differences

• The reason for the differences between originally estimated and actual

defaults for the 1998 through 2000 cohorts is that the historical average

default rate used as the basis for the default estimate was greater than

recent loan performance.

• The historical average default rate was higher because loans

guaranteed in fiscal years 1986 through 1990 defaulted at a

significantly higher rate than those for later years.

• SBA attributes the high default rates in fiscal years 1986 through

1990 generally to differences in (1) economic conditions, (2)

guarantee percentages, and (3) underwriting standards.

• The loans in the 1998 through 2000 cohorts are still relatively new

and have not yet reached the typical peak default years, which

historically have been years 3 through 5 after approval.
Enclosure

Page 30 GAO-01-1095R SBA's 7(a) Credit Subsidy Estimates

Implications of Proposed Changes

• In March 2001, SBA submitted a proposal to OMB12 that

discusses using 5 years or 3 years of the most recent actual

loan performance - referred to as the lookback period13 - as

the basis for the 7(a) program default estimate in order to

more closely track with actual loan performance in the

future. SBA recommends the 5 year lookback period.

• This proposal is based on SBA’s analysis that showed

that the most recent years of actuals are more predictive

of near-term future loan performance, notwithstanding a

sudden shift in the economy.

12 In the past, SBA has proposed other methods to refine its default estimates to OMB. According to OMB, SBA has

not provided acceptable support that the alternatives would provide better estimates.

13 For example, under the 5 year lookback period, the 2002 cohort estimate of year one default activity would be based

on the average actual first year defaults that occurred for the 1996 through 2000 cohorts and the second year default

activity would be based on actual second year defaults that occurred for the 1995 through 1999 cohorts.

27
Enclosure

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Implications of Proposed Changes

• Because the lookback period is shorter, original subsidy

cost estimates, as well as annual reestimates of

outstanding cohorts, would be more sensitive to

fluctuations in economic conditions or changes in

program delivery and design.

• The benefit of this approach is that in a continuing stable

economy, the original subsidy cost estimate would be

expected to more closely match actual loan performance

and reestimates would therefore be smaller.
Enclosure

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Implications of Proposed Changes

• However, the risk of this approach is that a sudden

downturn in the economy would be much more likely to

result in actual loan performance being different than

estimated and thus could result in larger reestimates.

• If SBA were to implement a shorter lookback period

approach, its next reestimate would likely be large

because expectations of future loan performance of

outstanding cohorts would also be impacted by the

change.
Enclosure

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Implications of Proposed Changes

• Under SBA’s current approach, initial estimates of the

subsidy rate are fairly stable because of the longer lookback

period, which smoothes out fluctuations in economic

conditions from year to year.

• This approach is based on the concept that, averaging

“good” and “bad” years is the best way to estimate the

effect of uncertain future economic conditions.

• The benefit of this approach is that it provides a

“cushion” in the event of an unexpected downturn in the

economy.
Enclosure

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Implications of Proposed Changes

• The consequence of this approach is that the “cushion”

ties up appropriations that could have been available to

other discretionary programs.

• This approach is also more likely to result in continuing

annual downward reestimates in a strong economic

environment.

• However, in a less favorable economy, the current

approach may result in original subsidy cost estimates

that are closer to actual loan performance than the

proposed 5 year lookback approach.
Enclosure

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Implications of Proposed Changes

• The following table contrasts the impact of using the current

approach, a 5 year lookback, and a 3 year lookback to

estimate the subsidy cost of the fiscal year 2002 cohort.

Estimation Alternatives’ Effect on Subsidy Rate and Appropriation

for the Fiscal Year 2002 Cohort

Source: GAO analysis based on SBA data.

Note: Estimated appropriation assumes that all other assumptions remain unchanged.

Default Rate Subsidy Rate Appropriation

Current Approach 13.87% 1.07% $114,490,000

5 Year Lookback 9.74% -0.40% -$42,800,000

3 Year Lookback 8.97% -0.61% -$65,270,000
Enclosure

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Implications of Proposed Changes

• For both the 5 year and 3 year lookback approach, we

estimated a negative subsidy, meaning that the program is

estimated to “make money” for the federal government.

• We estimated that the 5 year and 3 year lookback would

project a negative subsidy of $43 million and $65 million,

respectively, versus a subsidy cost of $114 million under

the current approach.
Enclosure

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Agency Comments

• SBA generally agreed with the information presented in this

briefing. SBA officials added that they view the proposed

change in the default estimation methodology to be an

interim solution. SBA views the long-term solution as a

sophisticated econometric modeling approach.

• Econometric modeling is meant to include any estimated

quantitative method of analysis. It defines key

relationships between loan performance and economic

and other indicators.

• SBA has already started work on this type of

methodology.

(190027)