BACKGROUND PAPER

Loan Guarantees:

Current Concerns and

Alternatives for Control

August 1978

Congress of the United States

Congressional Budget Office
LOAN GUARANTEES:

CURRENT CONCERNS AND ALTERNATIVES FOR CONTROL

The Congress of the United States

Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office

Washington, D.C. 20402
PREFACE

At the request of the Senate Budget Committee, CBO has prepared

Loan Guarantees; Current Concerns and Alternatives for Control, a study

of the use and growth of loan guarantee programs, current concerns about

the appropriateness of using them, and alternative methods of Controlling

them. John D. Shillingburg of CBO's Budget Process Unit prepared the

report, with the assistance and supervision of Richard P. Emery, Jr.

W. Donald Campbell of the Senate Budget Committee contributed extensively to the report through his review and suggestions. The author also

wishes to acknowledge the helpful comments of Richard D. Morgenstern,

Helmut Wendell, and Brent G. Shipp of CBO; and John Mitrisin of the

Congressional Research Service. Patricia H. Johnston edited the manuscript, and Kathryn A. Quattrone and Susan L. Bailey typed the many

drafts.

Appendix A provides summary answers to the specific questions

contained in the request from Chairman Muskie and Senator Bellmon. A

number of specialized background reports were prepared in the course of

this study. They will be published shortly in a companion volume.

Alice M. Rivlin

Director

August 1978

m

CONTENTS

PREFACE .

SUMMARY .

CHAPTER I.

CHAPTER II.

CHAPTER III.

CHAPTER IV.

INTRODUCTION

LOAN GUARANTEES: WHAT THEY

ARE AND WHAT THEY DO

Loan Guarantees: How They Work . .

Impact of Guarantee Programs

on the Budget

Recent Growth of Guarantees . . . .

Concerns About Such Growth

CONCERNS ABOUT THE USE OF

LOAN GUARANTEES

Guaranteed Lending in the

Federal Budget

Choosing Between Public and

Private Activities

Allocating Resources Among

Competing Uses

Coordinating Fiscal Policy Effects . ,

CONTROLLING LOAN GUARANTEES,

Guaranteed Loan Principal as

Budget Authority ,

Creating a Credit Section in

the Budget ,

An Informational Credit Analysis . .

Indirect Controls Through

the FFB

Two Supplementary Options ... .

Conclusion: The Preferred

Alternative

Page

iii

xi

3

5

9

13

16

19

19

20

25

26

29

30

32

35

35

37

39
Page

APPENDIX A. RESPONSES TO QUESTIONS IN

ORIGINAL INQUIRY 43

APPENDIX B. FEDERAL CREDIT ACTIVITIES:

AN OVERVIEW 47

APPENDIX C. FORMS OF LOAN GUARANTEES .. . 57

VI
TABLES

TABLE 1. NEW FEDERAL CREDIT EXTENDED, BY TYPE,

FISCAL YEARS 1977 TO 1979: IN MILLIONS

OF DOLLARS 4

TABLE 2. ESTIMATES OF FISCAL YEAR 1979

AGGREGATES, INCLUDING NEW

COMMITMENTS FOR LOAN

GUARANTEES AS BUDGET AUTHORITY:

IN BILLIONS OF DOLLARS 31

APPENDIX TABLES

TABLE B-l. SUMMARY OF DIRECT FEDERAL LENDING,

FISCAL YEAR 1979: IN MILLIONS OF

DOLLARS 49

TABLE B-2. LOAN SALES AS A PERCENT OF LOAN

REPAYMENTS: BY FISCAL YEARS. .. . 51

TABLE B-3. SUMMARY OF GUARANTEED LENDING,

FISCAL YEAR 1979: IN MILLIONS OF

DOLLARS 52

TABLE B-4. ROLE OF THE FEDERAL FINANCING

BANK, FISCAL YEAR 1979: IN MILLIONS

OF DOLLARS 53

TABLE B-5. FFB PURCHASES OF NEW GUARANTEES,

FISCAL YEARS 1974-1978: IN MILLIONS

OF DOLLARS 54

TABLE B-6. SUMMARY OF LENDING BY FEDERALLY

SPONSORED CREDIT INTERMEDIARIES,

FISCAL YEAR 1979: IN MILLIONS OF

DOLLARS 56

Vll

FIGURES

FIGURE 1.

FIGURE 2.

FIGURE 3.

FIGURE 4.

GROWTH OF NEW COMMITMENTS AND

TOTAL OUTSTANDING GUARANTEED

LOANS FOR FISCAL YEARS 1952-1979 . . .

RELATIVE SHARES OF NEW COMMITMENTS

FOR GUARANTEED LOANS, BY AGENCY,

FISCAL YEARS 1950 AND 1979

TOTAL GUARANTEES OUTSTANDING FOR

ACTUARIALLY SOUND PROGRAMS AND

FOR PROGRAMS FOR MARGINAL

BORROWERS

TOTAL LOAN GUARANTEES OUTSTANDING

FOR DISCRETE VENTURES

12

14

32-219 O - 78 - 2

IX

SUMMARY

Loan guarantees have been a useful federal policy tool since the

Depression. Billions of dollars of loans have been guaranteed by the

federal government, enabling countless families to buy their own homes,

farmers to buy their own farms, and even fishermen to buy their own

boats. Recently, the nature of loan guarantee programs and proposals has

changed dramatically, raising questions about how they should be used and

how they can be controlled as part of the federal budget process.

LOAN GUARANTEES; THEIR CHANGING NATURE

Loan guarantees were first used on a large scale during the

Depression to help families purchase their own homes. Essentially

insurance programs, these programs operate on an actuarially sound basis,

charging premiums for insuring the loan. The premiums are set high

enough to pay operating costs and probable losses. The government pools

the risk of a number of small loans; the borrowers as a class bear the risks

through their insurance premiums.

A second group of programs evolved out of the first as the insurance

programs were extended to marginal borrowers—such as students and lowincome families seeking to purchase homes—who posed greater than

ordinary risks, either because of a greater than normal probability of

default or a lack of acceptable collateral. These programs for marginal

borrowers operate much the same as the insurance programs with one

important exception: although the risks of individual loans are pooled

across a large number of loans, the government bears a portion of the risk.

Since the premiums charged are set below the levels required to cover

operating costs and losses, the programs carry an element of subsidy.

Recently, a third class of guarantee programs has emerged.

Characteristically for large loans to a single borrower or to a small group

of borrowers running common risks, these programs represent decisions by

the government to finance discrete ventures or projects by allocating

them credit. These programs have often been proposed in the energy

field, for plants using new technologies not yet proven successful or

profitable. These programs "cannot be operated as insurance programs

since the numbers of loans guaranteed are small and the risks cannot be

pooled across different borrowers. Because the size of each loan is large,

any default can have serious budgetary consequences.
LOAN GUARANTEES; RECENT CONCERNS

The shift in the focus of loan guarantee proposals from actuarially

sound programs to the financing of discrete ventures has raised new

questions about the use and effects of loan guarantees. Proposals to use

loan guarantees as a means of financing have great appeal: the

appearance of low budgetary costs and minimal federal intervention in the

economy. Budgetary costs appear low because guaranteed loans are

excluded (by statute) from the definition of budget authority, and hence,

are not adequately addressed in a budget process designed to control new

budget authority and outlays. Federal intervention in the economy

through loan guarantees appears minimal because loan guarantees are

assumed to leave intact the decisionmaking processes of lenders and

borrowers.

These perceptions of minimal intervention and low cost can be far

from accurate, however, and may cause inappropriate legislative

decisions. For example:

o Misunderstanding the actual effects of guarantees on the

behavior of lenders and borrowers can lead to creation of

programs that presuppose effective screening of project

feasibility by lenders when no such screening will actually

occur.

o The perception of low cost can cause the allocation of

resources to a program that would not be undertaken if a full

evaluation of project benefits in relation to costs had been

made.

o Incomplete knowledge about the credit flow stimulated by

guarantees complicates the coordination of fiscal policy.

In each of the above cases, the result could be failure of the program, high

and unforeseen costs to the government, and costs to the economy as a

whole. The changing nature of proposals for loan guarantee programs and

the problems resulting from inadequate Congressional review and control

have heightened Congressional concern about the use of federal

guarantees.
LOAN GUARANTEES; HOW THEY CAN BE CONTROLLED

Credit programs in general and loan guarantees in particular are on

the boundary between the public and private sectors of the economy. In

the private sector, the marketplace is the mechanism for allocating

resources. The budget process performs that role for the public sector.

While there may be strong elements of private sector involvement in

guaranteed loans, the government supplants critical market calculations,

for example, by assuming default risks, selecting borrowers, and determining interest rates. Thus, loan guarantees should be controlled in the public

sector's principal resource allocation mechanism, the budget process.

Six alternative methods for integrating loan guarantees into the

budgetary process are discussed below.

Redefining Budget Authority to Include Loan Guarantees. Loan

guarantees are excluded from the definition of budget authority and new

spending authority contained in sections 3(a)(2) and 401(c)(2) of the

Congressional Budget Act of 1974. As a result, they are excluded from the

targets and ceilings of the concurrent budget resolutions, as presently

constituted. This approach would delete the exclusion of loan guarantees

from the definitions and would cause the principal of loans being

guaranteed to be counted as budget authority. While this approach would

subject guarantees to the disciplines of the process, it could reduce the

usefulness of budget authority totals by weakening the relationship of

budget authority to expected outlays.

Credit Section in the Federal Budget. A credit section in the budget

could operate as follows: the President would recommend and the

Congress would enact targets and ceilings for the total volume of new

direct loans and new guarantees to be extended by the federal government. Authority to enter into commitments for new direct loans and new

guarantees would be shown in the budget. \J Such a proposal could be

implemented either formally, through legislation enacted by the Congress,

or informally, through the Budget Committees' authority to include in the

budget resolutions "such other matters relating to the budget as may be

appropriate." 2/

I/ In his fiscal year 1979 budget, President Carter stated that the

Administration would be presenting a credit control proposal along

such lines to the Congress later this year.

2/ The Congressional Budget Act of 1974, Public Law 93-344, Section

301(a)(6).

xm
This proposal has several advantages. First, by combining direct and

guaranteed lending, it would be possible to compare credit programs with

direct spending programs, in total and by functional category. Second, it

would also be possible to determine better the federal impact on the

domestic credit markets. Finally, the proposal for a credit section in the

budget is compatible with the present budget process, permitting the

Congress to vote on targets for direct and guaranteed lending each year as

part of the concurrent budget resolutions.

Informational Credit Analysis. This approach would provide to the

Congress essentially the same information that would be used in a credit

section of the budget—roughly the same data now contained in the special

analysis on credit that accompanies the budget each year. Decisionmakers could use the informational analysis to inform themselves about

the extent of current federal activity credit before making decisions

creating new programs or extending older ones. Better Congressional

control could result simply from greater understanding by the Congress of

guarantee programs and their effects.

Indirect Control Through the Federal Financing Bank. The Congress

could require loan guarantees to be financed through the Federal

Financing Bank (FFB). By limiting the amount of annual activity of the

FFB, the Congress could control the level of credit activities. Under this

approach the government would not only guarantee the loans, it would also

supply the funds. Thus, all guaranteed loans would actually become direct

federal loans. Unless the off-budget status of the FFB were changed,

however, none of this activity would be reflected in the budget authority

and outlay totals.

Two other methods of control could be adopted separately from, or

in combination with, one of the above alternatives:

Direct Program Controls. Loan guarantee activities could be

controlled directly by subjecting new commitments to annual appropriations, or by requiring that all programs have default reserves appropriate

to the government's risk and permitting outstanding obligations only in

amounts proportional to the reserves on hand.

Self-policing Elements. Standards of program design could be

refined so that individual guarantee programs would create incentives for

borrowers and private lenders to act in a manner consistent with prudent

federal policy. Guarantee programs could require credit needs tests for

borrowers, coinsurance by lenders, equity participation by private investors, and other elements to prevent program abuse. These instruments are

not so much a means of aggregate control as elements of adequate

program design.

xiv
CONCLUSION

CBO considers the establishment of a credit section in the federal

budget to be the most effective way to improve Congressional control of

the total volume of federal financing guarantees. The credit section

should be used in combination with direct controls on individual program

activity and self-policing elements in the design of the programs. This

combination of aggregate and individual program controls would provide

the Congress a means of effectively planning for and overseeing the

federal government's credit assistance programs.

xv

CHAPTER I. INTRODUCTION

The federal government has a broad array of policy tools available

to accomplish the diverse and complicated objectives of its various

programs. These tools—direct expenditures, grants-in-aid, direct loans,

loan guarantees, regulatory measures, and tax expenditures—each have

their particular strengths and weaknesses. A knowledge of these strengths

and weaknesses permits policymakers to tailor the federal government's

response to a particular situation. Decisionmakers should, however,

understand the likely effects of each tool on the economy and the budget

before using it. Unfortunately, these effects are not as easy to determine

as has often been supposed.

Determining the effects of individual programs is only part of the

problem. Attention must also be given to determining the combined

effects of various policies enacted separately but implemented simultaneously. In the past the accomplishment of federal objectives usually

involved only direct federal expenditures. The budgetary process was

perceived to be an adequate forum for making choices among competing

federal activities and for setting national priorities. The recognition in

recent years that the federal government significantly influences the

economy and the allocation of economic resources by means other than

direct expenditures has uncovered a problem. Coordination of these

activities—loan guarantees, regulations, and the like—with direct federal

activities is not completely possible through the budgetary process. For

example, the budget fully reflects a federal decision to spend $300 million

for education, but federal regulations requiring state and local governments to spend an equal amount or loan guarantees redirecting

$300 million in credit to student loans are not reflected in the budget.

Making federal decisions that allocate private resources, such as these do,

on an ad hoc basis outside of a framework considering all such decisions

may result in less efficient and productive use of the nation's economic

resources. The Congress should continuously review the budgetary process

to assure consideration, when possible, of all allocative activities in which

the federal government plays a role.

This paper considers one type of allocative decision not now fully

encompassed in the budgetary process: federal guarantees of loans and

other credit. The next chapter discusses what loan guarantees are and

how they operate. The third chapter enumerates various problems in the

current operation of many loan guarantee programs. Some of these

problems stem directly from the inability of policymakers to coordinate

loan guarantee and direct spending programs. The final chapter examines

various options for improving Congressional control of federal guarantee

programs.

32-219 O - IS - 3

CHAPTER II. LOAN GUARANTEES:

WHAT THEY DO

WHAT THEY ARE AND

A guaranteed loan may be simply defined as a loan or security on

which the federal government has removed or reduced a lender's risk by

pledging to repay principal and interest in case of default by the

borrower. ]_/ Guaranteed or insured lending has been an important

component of credit advanced by the federal government during the postWorld War II era. As Figure 1 illustrates, the annual growth in new

Figure 1.

Growth of New Commitments and Total Outstanding Guaranteed Loans3

for Fiscal Years 1952-1979b

Billions of Dollars

300

200

100

Total Outstanding

Guaranteed Loans

New Commitments

tor Guaranteed Loans

1952 1955 1959 1963 1967 1971 1975

Fiscal Years

SOURCE: Budget of the United States Government, Special Analysis on Credit, Fiscal Years 1952-1979.

Unadjusted figures

Fiscal year 1978 and 1979 figures are estimates.

1979

\J As used in this paper, guaranteed loans include those designated as

"insured."
guarantees was relatively steady throughout the 1950s and 1960s. This

steady annual annual growth, however, caused the amount of total

guarantees outstanding—that is, the total amount of loan principal the

government has pledged to repay in case of default—to grow rapidly.

Annual growth since 1970 has sharply accelerated; in fiscal year 1979 the

federal government will guarantee an estimated $53.4 billion of loans, an

increase of 19 percent over the previous year. These rapid increases in

annual growth in recent years have caused an even sharper acceleration in

the amounts outstanding. Total guarantees outstanding will increasevby

$23.2 billion during fiscal year 1979, from $200.4 billion at the close of

fiscal year 1978 to $223.6 billion by September 30, 1979. 2/

The steady annual growth of new guarantees has meant that

guaranteed lending continues to be a major share of the federal

government's credit assistance. Throughout the post-World War II era, the

volume of guaranteed lending was roughly twice that of direct federal

lending. This two-to-one proportional mix is indicative of a long-standing

policy to use private credit whenever it can be made available on

reasonable terms, such as through the introduction of a federal guarantee.

As Table 1 illustrates, the two-to-one ratio has remained valid in recent

TABLE 1. NEW FEDERAL CREDIT EXTENDED, BY TYPE, FISCAL

YEARS 1977 TO 1979: IN MILLIONS OF DOLLARS

Type of Credit Assistance 1977 1978 a/ 1979 a/

Direct Loans, On-budget

Direct Loans, Off-budget

Guaranteed Loans b/

Total

21,854

13,558

40,794

76,206

29,361

16,871

44,669

90,901

26,575

17,575

53,354

97,504

SOURCE: Budget of the United States Government, Fiscal Year

1979, Special Analysis F.

a/ Estimates.

b/ Primary guarantees, adjusted.

2_/ Unless otherwise indicated, all estimates in this paper are derived

from the Budget of the United States Government, Fiscal Year 1979,

Special Analysis F. Note that unadjusted data are used in Figure 1;

adjusted data have been available only since 1970.
years for guaranteed loans and direct loans by on-budget agencies. The

rapid growth in lending by off-budget agencies, however, has reduced the

ratio of guaranteed lending to all federal direct lending to something less

than two-to-one. _3/

The year-to-year growth in new guarantees in Table 1 shows that the

rapid growth of guarantees in the early 1970s is continuing. In part this

growth may stem from a perception that loan guarantee programs are a

free good—that they cost the government little or nothing and result in

only negligible government intervention in the private sector. This

perception, however, reflects a lack of understanding of the workings and

effects of loan guarantee programs.

LOAN GUARANTEES: HOW THEY WORK

As noted earlier, the effect of a federal guarantee is to reduce a

lender's risk of nonrepayment in case of default by a borrower. This can

be done explicitly: the federal government, as a third party in a loan

agreement, pledges to repay to the lender all or part of the principal or

interest in the case of a default by the borrower, as in the FHA mortgage

insurance programs. Or it may be done by more subtle arrangements, such

as the federal government entering into long-term contracts or leases

with a borrower, who then assigns part of the proceeds of such contracts

or leases to the lender to pay all or part of the debt service on the loan.

In this case the lender's risk is reduced because the borrower can

demonstrate a long-run, stable income stream from a project, based on

the lease by or contract with the federal government. The federal

government has helped finance office buildings, college dormitories, and

ocean-going vessels by these means, kj

3/ For additional discussion of the various types of federal credit

assistance, their budgetary treatment, and current magnitudes, see

Appendix B of this paper and the forthcoming background paper

Federal Credit Programs; A Statistical Compilation.

kj Although these long-term contracts are not explicit guarantees of

credit, the Office of Management and Budget (OMB) considers them

and several other financing mechanisms to be loan guarantees for

purposes of inclusion in the special analysis on credit programs. (See

OMB, Circular A-ll, Section 42.2, May 25, 1978.) These mechanisms include lease guarantees, contingent direct loan commitments to guarantee private financing, direct loans sold with an

agreement to repurchase them, and callable capital contributions.

These mechanisms are explained in greater detail in Appendix C.
By reducing the risks associated with certain types of lending,

federal loan guarantees are intended to influence lenders to make more

credit available in certain sectors of the economy and to aid borrowers in

obtaining that credit. Borrowers find the lessened risks mean lower

interest costs. Guarantee or insurance programs have two effects:

allocation of credit to specific purposes and the reduction of the costs of

credit.

Allocation of Resources

Loan guarantees act to allocate credit in two ways. For some

projects for which credit is available, the interest costs may be too high

for a borrower to pay. The effect of a guarantee may be to reduce the

interest costs to within the range a borrower can afford. Alternatively,

the risks of some projects are so great that commercial lending

institutions do not consider them credit-financable at any interest

rate. 5j For such projects, a government guarantee may shift a sufficient

portion of the risk from the lender to the government to persuade lenders

to extend the credit needed. In the first case, guarantee programs act to

make a project credit-financable for the borrower; they allow individuals

to purchase homes, small businessmen to expand their operations, and

farmers to secure loans to buy seed, fertilizer, livestock, equipment, or

even the farm itself. In the latter case, guarantee programs make a

project credit-financable from the lender's perspective; lenders are

induced to lend funds to railroads to help them modernize and buy rolling

stock, to manufacturers of electric vehicles, or to utilities producing

synthetic fuels.

Until recently the largest share of the resources allocated through

loan guarantees has been in the housing field. These programs are

designed to allow individual borrowers to finance their own homes with

credit. As Figure 2 illustrates, housing programs in the Veterans

Administration and the agencies now included in the Department of

The risk of default imposes costs—primarily in terms of monitoring

or overseeing a project—that are reflected in the interest rates

lenders charge. If the risk is perceived to be very high, lenders may

refrain from extending credit. Typically, credit is used to finance

only low-risk ventures for which the lender provides funds in return

for a fixed yield. Riskier ventures are ordinarily financed in the

equity or venture capital markets (through sale of stock primarily).

In such cases the investor not only bears the risk of loss but also

stands to share proportionally in the profit of a successful venture

through dividends or capital appreciation.
Figure 2.

Relative Shares of New Commitments for Guaranteed Loans,

by Agency, Fiscal Years 1950 and 1979a: In Millions of Dollars

Fiscal Year 1950

veterans

Administration

Fiscal Year 1979

Health, Education and Welfare

$2,135

Other fc

$3,155

Small Business Administration

$3,530

SOURCE:

Budget of the United States

Government, Fiscal Year 1952,

Special Analysis E; and Budget

of the United States Government, Fiscal Year 1979,

Special Analysis F.

a

 Data for 1979 are estimates.

''Comprised of those agencies

now included in the Department of Housing and Urban

Development.

Veterans

Administration

Housing and

Urban Development

$54,415

50.8%
Housing and Urban Development (HUD)--principally the Federal Housing

Administration (FHA)--accounted for 97 percent of the new commitments

for guarantees in fiscal year 1950. While housing programs have continued

to grow in absolute volume, the lower panel of Figure 2 illustrates that

they have declined in terms of the relative share of credit allocated

through the guarantee mechanism. Numerous new guarantee programs

have allocated guaranteed credit to a wider variety of purposes. Many of

these programs are designed to make credit-financable projects that

lenders otherwise would consider more suitable for equity financing. The

different nature of these new programs is one source of concern about the

proliferation of new guarantee programs in recent years, an issue to be

discussed later in this chapter.

Reduction of the Costs of Credit

Most federal guarantee programs provide credit to private borrowers

on more favorable terms than are available in the private markets. These

more favorable terms take three principal forms:

o Interest rate reductions—that is, rates lower than those

charged nonguaranteed loans;

o Fees or premiums set at rates lower than those required to

cover operating costs and losses; or

o Waivers of such fees or premiums.

Interest rate reductions occur in guaranteed or insured loan

programs in two ways. The reduction may be explicit, in the form of an

interest rate subsidy, as in the HUD College Housing Program, in which

the government contracts to pay annually the difference between the

average annual debt service on loans obtained in the private market and

the average annual debt service that would be required if the loan were

made at a three percent interest rate. 6/ Such subsidies are provided

through contract authority and subsequent liquidating appropriations

included in the budget. Or, the interest rate reduction may be implicit,

resulting from the fact that the government, by assuming risks, lowers the

cost of borrowing below that charged for nonguaranteed borrowing in the

private market. Such implicit interest rate reductions may have no direct

budgetary costs to the government.

6/ Long-term agreements for annual contributions to pay all or a

portion of the debt service of projects are considered guarantees of

the underlying credit. (See OMB Circular A-ll, Section 42.2,

May 25, 1978.)
The value of the interest rate reduction to a borrower in a

guaranteed or insured loan program may be calculated as the difference

between the cost of borrowing under the federal program and the cost of

borrowing at market rates. In practice the calculation of that difference

is very difficult because of the need to estimate the interest rate that the

borrower would have had to pay for a nonguaranteed loan in the private

credit markets. For some loans, particularly those for housing, private

credit market rates are readily available, and can be used in calculating

the subsidy. For other programs—student loans and public housing, for

example—no comparable private loans exist. Therefore, assumptions must

be made about the rates private markets would charge.

In the mid-1970s OMB attempted to calculate the value of the

interest rate reductions occurring in guaranteed or insured loan programs.

It deferred calculation of the value of such reductions in the fiscal year

1979 budget because of significant differences of view among experts on

the way such calculations should be made. OMB has never estimated the

benefits derived under the other favorable credit terms found in many

guarantee programs—reduced or waived fees or premiums. The fact that

the value of these favorable terms has not been calculated does not,

however, mean that they are costless to the government. For example, if

the fees or premiums charged a borrower for a guarantee are set below

the actuarially computed levels necessary to cover operating expenses and

losses, or if such fees or premiums are entirely waived, then the guarantor

agency bears these costs. These must be paid with federal funds—funds

that must be included in the budget totals.

IMPACT OF GUARANTEE PROGRAMS ON THE BUDGET

The foregoing discussions of the allocative and subsidy effects of

guarantee programs tend to suggest that such programs are not alike in

terms of their effects on the federal budget. For example, HUD's

Section 203(b) program of home mortgage insurance is actuarially sound

and costs the government nothing. On the other hand, the student loan

program in HEW is experiencing significant losses, and all loans

guaranteed by the HUD New Communities program are undergoing

difficulties. Three general classes of loan guarantee programs, in terms

of their effects on the budget, can be identified. Tj

7J This classifying structure was used in a Senate Budget Committee

report on federal energy financing and subsequently in a

Congressional Research Service report on the growth of loan

guarantee programs from 1960 to 1976. (See Senate Budget

32-219 O - 78 - 4
The First Class: Actuarially Sound Programs

The first class of guarantees includes relatively small loans to

individuals or households, the risks of which are pooled across a large

number of such loans by the guarantor agency. As a result the borrowers

actually bear such risks as a class. Fees or premiums are based on

actuarial estimates of the receipts required to cover operating costs and

probable losses. Typically such programs require no budgetary resources

and are financed out of revolving funds. The receipts finance future

operations of the fund and are deducted from the outlays, thus leaving

only a net figure to appear in the budget. Some of these programs

actually have negative outlays, receipts of fees and premiums being

greater than costs and expenses. By pooling risks across a large number of

borrowers, these programs may result in lower interest costs to individual

borrowers.

Guarantees in this class were first used in the housing field in the

Depression as a means of correcting perceived imperfections in the

capital markets. The Mutual Mortgage Insurance Program of the Federal

Housing Administration (FHA) in HUD is the prime example. General

acceptance had to be created during the Depression for self-amortizing,

long-term residential mortgages, covering 80 percent or more of a

property's value. Prior to that time, home loans had short maturities and

required large down payments. Bankers were reluctant to offer the new

type of mortgages because they had no experience with which to estimate

default rates.

In 1934, FHA mortgage guarantees were instituted. Federal

policymakers believed that the actual risks of new mortgages of the longterm type were less than private lenders were estimating on the basis of

incomplete information. By pooling the risks of each loan across a large

group of loans, the government was able to reduce the costs of borrowing.

After several years' experience, sufficient information was collected to

provide the private market data on which to estimate defaults. As a

result, the long-term, self-amortizing mortgage gained general

acceptance, and such loans began to be offered even without government

guarantees.

Committee, Federal Energy Financing, Committee Print,

August 30,1976, and CRS, Federal Loan Guarantees and Their Use as

a Mechanism to Correct Market Imperfections, Assist Marginal

Borrowers, and Finance Discrete Ventures, April 27,1977.)

10
Although the number of these actuarially sound guarantee programs

is not large, their volume of activity is substantial. Of the 59 major loan

guarantee programs in the CRS study sample, 8/ only four could be

classified in this group of actuarially sound programs:

o Farmers Home Administration, farm operating loans;

o Federal Housing Administration, property improvement loans;

o Federal Housing Administration, mortgage insurance; and

o Veterans Administration, guaranteed mortgages.

These four programs, however, accounted for $48 billion, or 93 percent, of

the total guarantees outstanding for the 59-program sample in fiscal year

1960 and $116 billion, or 65 percent, of the amount outstanding in fiscal

year 1976.

The Second Class: Programs Requiring Subsidy

The first class of guarantees pools the risks of small loans for

ordinary borrowers, and the borrowers as a class bear the risks. A second

class includes guarantees of small loans to firms or individuals who pose

greater than ordinary risks, either because of a greater than normal

probability of default or a lack of acceptable collateral. Again, risks of

individual loans are pooled across a large number of loans. In this case,

however, the government bears a portion of the risk. Any fees or

premiums charged borrowers are set below the levels required for

actuarially sound operations. The federal government bears the costs of

operation and losses above the receipts, usually by appropriations to the

revolving fund through which the program is financed.

Guarantees were first extended for this purpose for home loans in

urban renewal areas and for replacement housing for people displaced by

urban renewal projects. Other examples include guaranteed loans for

students and small businesses.

8/ The CRS study uses a sample of 59 major loan guarantee programs

for which continuous data could be collected over the 16-year sample

period. While this sample does not include all loan guarantee

programs, it accounts for 97 percent of all guarantees outstanding

reported by the Treasury in fiscal year 1960, 80 percent in fiscal

year 1965, 87 percent in fiscal year 1970, and 86 percent in fiscal

year 1976. (Federal Loan Guarantees and Their Use as a Mechanism

to Correct Market Imperfections, Assist Marginal Borrowers, and

Finance Discrete Ventures, April 27, 1977.)

11
Guarantee programs of this second class are more numerous than the

actuarially sound programs; the 59-program sample of CRS lists 37 of

these guarantee programs. While the dollar volume of subsidized

guarantees is smaller than the volume of actuarially sound guarantees, the

former grew more rapidly and erratically during the 1960-1976 period, as

illustrated in Figure 3. In fiscal year 1960, they accounted for only

$3.4 billion, or 6 percent, of the total guarantees outstanding for the

59 program sample. By 1976 they had grown seventeen fold to

$58.8 billion, or 32 percent of the total guarantees outstanding.

Figure 3.

Total Guarantees Outstanding for Actuarially Sound Programs

and for Programs for Marginal Borrowers

Billions of Dollars

120

Programs for

Marginal Borrowers

1960 1962 1964 1966 1968 1970

Fiscal Years

1972 1974 1976

SOURCE: CRS, "Federal Loan Guarantees and Their Use as a Mechanism to Collect Market Imperfections,

Assist Marginal Borrower's and Finance Discrete Ventures", April 27, 1977.

12
The Third Class; Financing Large Ventures

A third class includes guarantees of large loans to a single borrower

or a few borrowers with commonly shared risks. These guarantee

programs arise out of the government's decision to finance discrete

ventures by allocating them credit. Often these ventures involve new

processes yet to be proven technologically or economically successful,

such as new energy technologies. Or they may be projects the assets of

which are not easily disposed of in the event of a default. Examples of

these latter programs include the Emergency Loan Guarantee Board,

which helped restore the Lockheed Corporation to financial stability, and

guarantees of loans to Amtrak and Conrail.

It is impossible to anticipate the timing and magnitude of losses

associated with these guarantees. The number of such guarantees have

been small, and their circumstances so individual that their default rates

cannot be compared from program to program. Nor can the risks be

pooled across different borrowers. Because the guarantees are for large

amounts, the default of only one or two borrowers can impose large

financial burdens on the government.

This third class of guarantees has been characterized by only a few

large loans made each year. As a result, the amount of such guarantees

outstanding each year has oscillated sharply. In 1960, these guarantees

outstanding totalled $79,000 or less than 1 percent of the outstanding

volume of the 59-program sample. At the end of fiscal year 1976,

$3.1 billion of these guarantees were outstanding, still only 1 percent of

the sample's outstanding volume, but almost a 40 thousand-fold increase

over the period. Figure 4 illustrates the growth of this third class of

guarantees for that period. The growth of this class and the large number

of recent legislative proposals that fall into it are part of the concern

about loan guarantees today.

RECENT GROWTH OF GUARANTEES

Loan guarantees have become increasingly popular in recent years as

a financing mechanism, especially in the energy field. Loan guarantee

programs have been enacted in the last several years to stimulate activity

in all phases of the energy field: research and development, demonstration of untried technologies, new production, and conservation. For

example:

13
Figure 4.

Total Loan Guarantees Outstanding for Discrete Ventures

Billions of Dollars

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0

1960" 1962 1964 1966 1968 1970 1972 1974 1976

Fiscal Years

SOURCE: CRS, "Federal Loan Guarantees and Their Use as a Mechanism to Collect Market Imperfections,

Assist Marginal Borrower's and Finance Discrete Ventures," April 27,1977.

a

 During fiscal years 1960 - 1967, total guarantees outstanding were less than $50 million.

o The Geothermal Energy Research, Development, and Demonstration Act of 1974 (Public Law 93-410), as amended, authorizes

guarantees of up to $100 million per project for research,

development, and construction of demonstration facilities using

geothermal energy.

o The Energy Policy and Conservation Act (Public Law 94-163)

authorizes guarantees of up to $30 million each for the development of new underground coal mines, up to a limit of $750 million

in outstanding indebtedness guaranteed.

14
o The Electric and Hybrid Vehicle Research, Development, and

Demonstration Act of 1976 (Public Law 94-413), as amended,

authorizes guarantees of up to $3 million each for borrowers

seeking to develop prototype electric or hybrid vehicles, up to a

limit of $60 million in outstanding guaranteed loans.

o The Energy Conservation and Production Act of 1976 (Public Law

94-385) authorizes guarantees of up to $5 million each on loans to

states and localities for the purchase and installation of conservation or renewable resource equipment, up to a limit of $2 billion in

outstanding guaranteed loans.

o The Department of Energy Act of 1978—Civilian Applications

(Public Law 95-238) added a new section to the Federal Nonnuclear Energy Research and Development Act of 1974 (Public

Law 73-577), providing the Secretary of Energy generic authority

to guarantee loans for alternative fuel demonstration facilities.

There is no limit on outstanding guaranteed indebtedness for

projects under $50 million. Projects with costs greater than $50

million will require specific authorization by the Congress.

Guarantee programs have also been enacted recently for purposes

other than energy. For example, the Railroad Revitalization and

Regulatory Reform Act of 1976 (Public Law 94-2210) authorizes $1 billion

in total guarantees outstanding for the purpose of rehabilitating the

nationwide rail freight system.

The 95th Congress has considered a number of loan guarantee

proposals. Major elements of the national energy program, as adopted by

the Senate include guarantee provisions. For instance:

o The Senate-passed version of the Natural Gas and Petroleum

Conservation and Coal Utilization Policy Act of 1976 (H.R. 5146)

authorized guarantees of $10 billion of loans for the installation of

pollution control devices attendant upon conversion to coal.

o The Senate-passed version of the Public Utilities Regulatory

Policy Act of 1977 (H.R. 4018) authorized guarantees of

$100 million of loans for the financing of small hydroelectric

projects.

15
In both cases these guarantee provisions were not included in the final

versions of the bills agreed to by the conferees.

Among other energy-related guarantee proposals is S. 419, the

Federal Oil Shale Commercialization Act. As passed by the Senate, this

bill authorizes the Secretary of Energy to guarantee state and local

obligations for the purpose of financing essential community development

stemming from oil shale commercialization projects. Under this impact

authority, the Secretary may guarantee $20 million of state and local

borrowing in both fiscal years 1978 and 1979.

Guarantee programs also figure prominently in the Carter Administration's urban program. The proposed National Development Bank would

have authority to guarantee up to $15 million of long-term debt to finance

the capital costs of a private business investing in new plant and

equipment in distressed urban areas. It is hoped that the guarantees and

associated interest rate subsidies and grants would create jobs and

improve the fiscal and economic base of the distressed areas. The

Administration is proposing a total of $8 billion of loans to be guaranteed

during fiscal years 1979, 1980, and 1981.

CONCERNS ABOUT SUCH GROWTH

In recent years Congressional concern over loan guarantees has

grown because of the increased number of proposals to use this mechanism

and the shift of such proposals from the actuarially sound, small-loan

programs to the more venturesome proposals for financing specific

projects, especially large capital plants. At the end of the 94th Congress,

in an oversight hearing conducted jointly by three House subcommittees,

Chairman William S. Moorhead of the House Banking Subcommittee on

Economic Stabilization noted the following about proposals for loan

guarantee programs:

...In the past, they were small, secured generally by readily

marketable assets, and since individual risks usually were small

and broadly diversified, program portfolios meant that the risk

per program was generally small. Indeed, much of the past

criticism of the guarantee centered on the belief it usually was

conducted in a much too conservative fashion.

16
This would appear no longer to be the case.

First, many of the guarantee proposals introduced in the

94th Congress, particularly those associated with energy

programs, were large relative to the program portfolios.

Second, they tended also to be plagued by substantial technical

uncertainty since it was not known whether the technology to

be supported by the guarantee would succeed. Third, there

was significant uncertainty regarding the costs and the

profitability of the project, even in the event of technical

success. Fourth, assets offered tended to be highly specialized—which was a polite way of stating they tended to

have limited resale value. 9/

The attractiveness of loan guarantees as a financing mechanism is in

part based on a perception of low budgetary cost and negligible

intervention by the federal government, a perception that may be shared

alike by government policymakers and the public. While this perception

may be reasonably valid for the first class of guarantees—the actuarially

sound programs of small loans to individuals—it is less valid for the second

and third classes of guarantees. Of the latter, it may be completely

misleading, as a Senate Budget Committee staff report noted in assessing

energy financing proposals:

In fact, loan guarantees...can be costly policy tools.

They may reallocate capital, and drive up interest rates in

sectors which receive less capital. Some other projects—

possibly worthwhile projects—may be unable to secure

financing. They thus have an overall impact on the economy

that should not be ignored. They also can have a major

impact on budget totals, should a default occur. 10/

9/ Statement of Honorable William S. Moorhead in Loan Guarantees

and Off-Budget Financing, Hearing before the Subcommittee on

Economic Stabilization of the Committee on Banking, Currency, and

Housing; the Subcommittee on Oversight of the Committee on Ways

and Means; and the Tax Expenditure Task Force of the Committee

on the Budget, House of Representatives, 94:2, (November 10, 1979),

p. 2.

K)/ Federal Energy Financing, Staff Report of the Task Force on Energy

of the Senate Committee on the Budget, 94:2, (August 30, 1976),

17
Thus, particular caution is appropriate when designing a guarantee

program that proposes to capitalize on one of the two basic aspects of

loan guarantees: allocation of credit or reduction of borrowing costs. As

the next chapter will show, the consequences of a guarantee may be quite

different from its intended effects, with the result being costs to the

government and the economy as a whole.

18
CHAPTER III. CONCERNS ABOUT THE USE OF LOAN GUARANTEES

Proposals to use loan guarantees as a means of financing new

activities have seductive appeal: their budgetary costs appear low and

they seem to involve only minimal federal intervention in the economy.

These perceptions of low cost and minimal intervention may lead to the

use of loan guarantees when other financing mechanisms are, in fact,

more suitable. Undesirable consequences may result from the employment of loan guarantees without a knowledge of their full costs and

effects—costs resulting from the billions of dollars of contingent

liabilities placed on the government for as long as forty years, and effects

such as the unintended redirection of national resources from some highpriority activities.

This chapter begins by reviewing briefly the current practices of

accounting for loan guarantee programs in the' federal budget and the

reasons why these practices prevent the Congress from fulfilling its

budgetary responsibilities with respect to loan guarantees. It then

explores concerns and problems resulting from policymakers' inability to

make rational decisions about loan guarantee programs within the

framework of the functions of the budget.

GUARANTEED LENDING IN THE FEDERAL BUDGET

The federal budgetary accounting system is designed to control

expenditures in the form of budget authority and outlays. Budget

authority is defined as "authority provided by law to enter into obligations

which will result in immediate or future outlays involving government

funds." _!/ Outlays are the sum of checks issued, interest accrued on most

public debt, and other payments in a given year under budget authority.

Loan guarantees, however, result in obligations of the federal government

that are only contingent, not inevitable; outlays occur only if there is a

default by the borrower. As a result, loan guarantees have been excluded

from the accounting for budget authority. Instead, the budget totals

include only the direct expenditure effects of loan guarantee programs,

such as budget authority for appropriated default reserves, outlays for

I/ The Congressional Budget Act of 1974, Section 3(a)(2), Public Law

93-344, 31 USC 1302.

19
administrative costs, and payments for defaults. Thus, current budgetary

practice reflects changes in the government's financial position. It does

not, however, account for such important fiscal activities as the volume

of the credit being guaranteed or insured by government agencies.

The volume of new loans being guaranteed by the federal government in a given year is not explicitly considered when the Congress

establishes budget totals or allocates resources to competing needs. The

level of new guarantees should be subject to explicit public decision.

Moreover, the budgetary treatment of guarantees should stimulate the

Congress to ask key questions in reviewing program design and operation,

questions that would help coordinate the allocation of resources by loan

guarantees with other federal resource allocations:

o Is guaranteeing or insuring the repayment of a loan the most

appropriate mechanism to allocate resources to the given

purpose? Or would direct spending, direct loans, or a tax

expenditure function more effectively?

o What is the true cost of such a program to the government?

o How do the credit flows stimulated by loan guarantees affect

federal fiscal policy?

These questions are central to the three functions of the budget

process: choosing between public and private means to accomplish a given

purpose, allocating resources among competing uses, and coordinating

fiscal policy. Without knowing the answers to these questions, the

Congress cannot fully understand the implications of using loan guarantees

for a particular purpose. The next three sections consider the problems

resulting from incomplete analysis of these issues for loan guarantee

programs.

CHOOSING BETWEEN PUBLIC AND PRIVATE ACTIVITIES

A basic function of the budget is to set out the choices between

public and private activities to achieve various goals. When the private

sector is unwilling or unable to provide a service deemed necessary by

elected policymakers, the public sector must do it. Loan guarantees, one

of the policy tools available, fall on the boundary between the public and

private sectors. They are a means by which the federal government can

influence private lenders to finance a publicly desired venture. Program

20
advocates often claim that loan guarantees will overcome imperfections

in the credit markets that prevent the flow of credit to such projects.

They further claim that guarantees can redirect private investment

toward public purposes with only minimal government intervention,

leaving intact the decision processes and institutional relationships of the

private credit markets.

Loan guarantees operate by changing the calculations of risks by

lender and borrower. Lenders are attracted to make funds available by

the prospect of a guaranteed investment. Borrowers find the lessened

risks of their borrowing mean lower interest costs. Despite these changed

calculations, lenders and borrowers are still assumed to be motivated to

evaluate the soundness of a financing proposal as if it were being

completely financed privately. That assumption may not be valid.

Knowledge of the full effects of loan guarantees on the behavior of

borrowers and lenders is incomplete. Guarantees do change the

calculations of risks by both lenders and borrowers. These changed

calculations can affect the behavior of lenders and borrowers in ways that

policymakers did not intend or anticipate when programs were designed.

This lack of understanding impairs the ability of the Congress to choose

rationally between public and private activities.

Changed Calculation of Risks by Lenders

Loan guarantees are supposed to change the calculations of risk by

lenders to encourage them to make more credit available for certain types

of borrowing. This can occur several ways:

o By reducing the risk of an unfamiliar form of lending, guarantees

can lower interest costs, as they did in the FHA mortgage

insurance programs of the 1930s.

o By reducing the risks associated with lending to marginal

borrowers, guarantees can influence lenders to make credit

available to borrowers in this class.

o By reducing the risks of uncertainty of success or profitability of

large, discrete ventures, guarantees can make credit available to

these types of projects.

21

32-219 O - 78 - 5
o By making borrowings more uniform as well as insuring the

investment, guarantees can stimulate growth of a secondary

market for various types of borrowing, thus reducing a lender's

risk of tying up his funds for extended periods of time.

Guarantee programs, however, may not always work as intended.

Private participation in a guaranteed loan—either in terms of sharing the

risk or performing servicing and originating functions—has been considered by policymakers to be a strong point of the guarantee mechanism.

Private participation is assumed to cause a lender to evaluate the viability

of an entire financing proposal even though the government's guarantee

limits his personal stake in the project. Private lenders, however, may be

more concerned about evaluating the extent of the government's guarantee commitment than they are about evaluating the viability of a proposed

project in order to eliminate ill-conceived ventures. Consider the

following examples in which guarantees erode the evaluation of risks by

private lenders and distort the choice between public and private

activities.

Unconditional Guarantees. Guarantees in which the government's

liability to repay indebtedness is unconditional are often called full-faithand-credit guarantees. These full-faith-and-credit guarantees are considered by the financial markets to be almost the same as government

securities; more important than the standing of the borrower or the

project being financed is the nature of the government guarantee. This

factor is of such importance that the major banking houses typically

purchase and sell these securities through their government securities

divisions, rather than through their corporate lending divisions, in which

the normal analysis of risk and return of individual ventures takes place.

PartiaH^uarantees—Riskless Investment. Some guarantee programs offer practically riskless investments for lenders, even though they

may have been designed with provisions thought to ensure private

participation. By guaranteeing only 90 percent of a loan, policymakers

may assume that the lender, who bears the risk for the other 10 percent,

will evaluate the riskiness of a project. Often, however, the ability to

write off losses against tax liabilities in effect means that the private

lender bears little or no risk on his portion of the loan. This can lead

investors to enter riskier ventures, with higher probabilities of default

than would prudently be accepted. This happened before 1973 in the HUD

Section 235 Homeownership Assistance Program. This program, designed

to assist marginal borrowers in obtaining access to mortgage credit,

combined a guarantee with interest subsidy provisions. The government's

22
guarantee, while not 100 percent of the loan, often covered more than

90 percent of the loan. The small percentage of private participation, it

was assumed, would encourage lenders to scrutinize the individual

applications. In practice, however, lenders made many loans without

adequate risk assessment, feeling themselves protected against loss by the

guarantee. The Section 235 program experienced a substantial number of

defaults. The federal government still holds a large number of foreclosed

properties, and the program has incurred large losses through default

payments.

Partial Guarantees—Speculative Investments. Partial guarantees

may also encourage speculative investing by lenders. From the lender's

perspective, a partially guaranteed loan has two components: a risk-free

investment (the guaranteed portion) that justifies a yield equal to similar

government securities, and a nonguaranteed loan that should have a higher

yield to compensate the lender for the risk he is bearing. Since only one

interest rate is charged for the entire loan, however, the added risk

premium incurred by the lender on the nonguaranteed portion of the loan

may be concealed.

For example, a secondary market for Small Business Administration

(SBA) Section 7(a) business guaranteed loans has emerged. SBA guarantees 90 percent of loans up to $500,000. Commercial banks originating

these loans charge interest rates in the 10 percent range. Originating

banks have begun selling the 90 percent guaranteed portion of the loan to

other investors through bond brokers. The original borrower continues to

make principal and interest payments on the total loan to the bank. The

bank then forwards to the second investor interest on the 90 percent

guaranteed portion. The interest rate the bank pays to the second

investor on this portion is above the cost of Treasury borrowing, but below

the 10 percent rate it receives overall. As a result, its effective rate of

interest on its 10 percent investment may be 20 percent or more. This

rate would justify far riskier loans than commercial banks would normally

agree to finance for fully private ventures. Thus, the effect of the

guarantee is to reduce sharply the bank's incentive for evaluating the risk

and return of the individual project. Or, if the bank makes only prudent

loans, the high yield provides it with a windfall profit on its investment.

Changed Calculation of Risks by Borrowers

The terms of a guarantee program can also affect the way in which

a borrower calculates his own risks when entering a project. For example,

if his liability is limited by a guarantee to the assets of the particular
project being financed, a borrower may be more willing to attempt a risky

venture than if all his assets were liable, as would probably be required by

lenders in the absence of a guarantee.

Consider the situation of a firm wishing to build a synthetic fuel

plant. It faces great uncertainty about the future market in which its

products are to be sold. If the cost of producing fuel from oil shale, coal,

or urban waste is greater than the price of competing fuel sources, the

project will fail. The financial uncertainty would ordinarily prevent the

plant from receiving major credit financing. To replace the uncertain

future in which the product must be sold at prices set by changing market

forces, the government could guarantee to make up the difference

between the project's cost of production and a lower market price. In so

doing it shifts the risks of changing market prices or production costs

from the producer to the guarantor agency. The guarantees could thus

make it attractive to the firm to finance the synthetic fuel plant with

borrowed capital.

Through such a price guarantee mechanism—an idea that has

surfaced recently in connection with several energy programs—the

government can encourage the private market to develop and operate

risky ventures, such as synthetic fuel plants. Combined with a limitation

of the borrower's loss to his equity in the particular project, price

guarantees may, however, change the calculation of risks by the borrower

in a way unintended by government. Because of his limited liability, a

borrower may undertake a project without adequately evaluating the

probabilities of success, or may undertake riskier projects with an

expectation of windfall profits. Also given the limited liability, both

borrowers and lenders may be more likely to abandon prematurely a

troubled project, instead of investing additional resources and attempting

to salvage the venture. The government stands the major risks and could

be left "holding the bag"—vainly attempting to recover its losses by

disposing of the specialized assets of such a plant.

Summing Up—Choosing Between Public and Private Activities

Guarantee programs are often assumed to leave the private market

relationships between borrower and lender intact, so that private risk and

return analysis continues to be exercised. Often, lenders are more

occupied with evaluating the guarantee commitment itself. The guarantee can change the calculation of risks so that ventures normally

considered too risky for financing are financed, based on the strength of

24
the government's guarantee. While such guarantees reduce the risk of loss

to lender and borrower, they cannot reduce the project's risk of economic

failure. As a result, the government may be saddled with a number of

failing ventures on which it must repay losses.

ALLOCATING RESOURCES AMONG COMPETING USES

A second major function of the budget process is to allocate

resources among competing needs. If loan guarantee programs were fully

subject to the discipline of the budget process, they could more

effectively be coordinated with each other and with other credit and

expenditure programs. On the other hand, if exclusion of guarantees from

the budget should lead the Congress to consider them costless, guarantee

programs might direct national resources into uneconomic and unsound

ventures that could not have survived in real competition with other

national needs.

For example, the Housing and Urban Development Act of 1968

(P.L. 90-448) established the New Communities program by authorizing

the appropriation of $30 million in grants and authorizing federal

guarantees of obligations issued by public and private developers of new

communities in amounts up to $250 million outstanding at any one time.

Subsequent amendments increase that authority to $500 million and then

to $698.5 million. Financing was needed for large scale land assembly,

site preparation, and construction of roadways and water and sewer lines.

Cash returns from such investments in new communities could be

expected only after long delays and even then would be highly uncertain

and irregular. This pattern of cash flows is ill-suited to the need for

regular payment of principal and interest as required by credit financing.

These investments are thus ordinarily financed with federal grants,

private equity, or relatively small increments of municipal borrowing.

The Administration proposed, and the Congress agreed, to terminate the

grant program at the end of fiscal year 1973. HUD was able to proceed

with the new communities program by continuing to finance the projects

with the authorized loan guarantees. As of June 30, 1976, HUD had

guaranteed financing for thirteen very large, highly speculative development projects. At that time, the outstanding guaranteed indebtedness of

the program peaked at $280 million.

The results have been bitter. Not one of the thirteen new

communities has been financially successful. Six have now been

reorganized and are operating with direct federal assistance. The other

25
seven were foreclosed; the government is now acquiring and liquidating

four of them and trying to restart the remaining three projects under new

management. The federal government must retire the outstanding

guaranteed debt by repaying the principle and interest due lenders and

provide additional operating funds where cash resources are exhausted.

The experience demonstrates that guarantees are far from costless to the

government. The fiscal year 1979 budget projects a net loss of

$76.6 million by the end of fiscal year 1979.

Ironically, the use of loan guarantees not only facilitated illconsidered ventures, it also hastened the financial collapse of new

communities by saddling developers with heavy debt burdens. In fact, the

New Communities Guarantee Fund itself had drawn $9.4 million in fees

and premiums from the developers as of September 30,1976, before the

loans got into serious trouble.

COORDINATING FISCAL POLICY EFFECTS

The last principal budgetary function is the coordination of fiscal

policy. If loan guarantees were fully subject to the discipline of the

budget process, the Congress would have a way to coordinate guarantee

programs with other fiscal activities through which the government

intervenes in the economy. This coordination would not be easy, however,

because much remains to be learned about the effects of guaranteed

programs on the capital markets and economic activity. Among major

unanswered questions are the following:

o How do guaranteed loan programs affect the total volume of

credit available in the economy?

o For any given sector of the credit markets, how much of the

lending would have occurred anyway, in the absence of federal

guarantees? How much represents new credit attracted into the

sector by the guarantee?

o How do guarantee programs affect the total national spending for

activities the programs are intended to foster?

The evidence in the economic literature on these questions is mixed.

The failure to coordinate loan guarantees with other federal fiscal policies

could, however, produce some significant problems.

26
One possible problem is the unintended "crowding out" of private

borrowers during periods of tight credit. If guarantees do stimulate

additional credit expansion, then the costs of guarantee programs to the

total economy would be balanced by the benefits of additional growth.

Additional guarantees could increase total gross national product (GNP),

and the increased income effects might filter throughout the economy. If

total credit is relatively fixed, however, as in periods of tight monetary

policy, the effect of guarantee programs may be simply to reallocate

credit from one group of borrowers to another. As guarantee programs

bring strong new demanders of credit into the markets, the price of

unguaranteed credit would rise, as unassisted borrowers are forced to bid

on shares in a smaller pool of unguaranteed credit. In effect, the

unguaranteed borrowers would subsidize guaranteed borrowers and would

pay higher interest costs as a result. Those borrowers who could not

afford to pay the higher costs would be forced out of the market. The

borrowers most likely to be pushed out of the market are small businesses,

homebuyers, and state and local governments.

The effects of loan guarantees may vary across economic sectors.

In a period of tight money and limited credit, guarantee programs may

buffer some sectors and shift the pressure of tight money onto other

sectors. Loan guarantees have, for instance, been used in an effort to

buffer the housing sector from sharp fluctuations in mortgage credit.

Federal guarantees have made possible the development of secondary

mortgage markets that can ease the flow of mortgage funds during periods

of tight credit. Thus the effort to buffer some housing from fluctuations

may build pressure on the whole economy and cause other borrowers,

perhaps other housing, to be forced out of the market.

Guaranteed lending programs may, during periods of high inflation,

bring higher borrowing costs to the federal government. The issuance of

large amounts of federally guaranteed debt produces a large class of

borrowers who are relatively insensitive to market interest rates. The

Federal Reserve may have to force much higher interest rates in order to

accomplish a desired cooling of the economy. Higher federal borrowing

costs would be the result, and all taxpayers would end up paying the cost

of loan guarantee programs.

Although the effects of loan guarantee programs cannot be

completely measured, the preceding discussion suggests that guarantees

should not be used unless their potential effects on the economy are

carefully assessed.

27

CHAPTER IV. CONTROLLING LOAN GUARANTEES

The federal budget does not at present encourage the Congress to

review and control federal credit activities. Increasingly, Members of

Congress are recognizing this to be an urgent problem. When the

President's Commission on Budget Concepts presented the unified budget

concept in 1967, it expressed uneasiness that it was unable to make a

recommendation about the budgetary treatment of loan guarantees. The

commission also recognized that the inclusion of direct loan programs

within the budget totals would intensify incentives to use loan guarantees.

As earlier chapters have shown, subsequent experience has justified the

commission's fears.

In violation of the principles of the President's commission, the

federal budget excludes a rapidly growing class of important fiscal

activities. The commission stated in its 1967 report:

In the private sector of the economy, the efficient

allocation of resources is best performed in a decentralized

fashion by the disciplines of the market place. In the public

sector, however, it is the budget process which performs the

resource allocation function.

To work well, the governmental budget process should

encompass the full scope of programs and transactions that are

within the Federal sector and not subject to the economic

disciplines of the marketplace. \J

Loan guarantees are powerful tools of federal policy. With them federal

agencies can supplant the most basic decisions of the private credit

markets, for example, by removing risks of default and selecting eligible

borrowers. With them the government allocates national resources.

Therefore, guarantees should be fully considered and controlled within the

federal budget process.

!_/ Report of the President's Commission on Budget Concepts (October

1967), p. 2*.

29
This chapter considers the following options for improving

Congressional control of guarantee programs:

o Including guaranteed loan principal in the totals for budget

authority;

o Creating a credit section in the budget;

o An informational credit analysis;

o Institutional control through the Federal Financing Bank (FFB);

o Direct program controls; and

o Self-policing elements in the design of individual programs.

The first two of these options would refine the structure of the federal

budget to make it a better tool for controlling guarantees. The next two

options would seek to control guarantees outside the structure of the

budget. The final two methods of control could be implemented

separately or in conjunction with one of the first four alternatives.

GUARANTEED LOAN PRINCIPAL AS BUDGET AUTHORITY

This option would maintain the structure of the federal budget and

Congressional budget resolutions essentially as they are, but would count

guaranteed lending as budget authority. Administrative costs and default

losses would be counted as outlays, as at present.

Early versions of the Congressional Budget Act of 197^ would have

implemented this option. As enacted, however, the act excludes loan

guarantees from the definitions of budget authority in section 3(a)(2) and

new spending authority in section 401(c)(2). In both of these definitions

the act states, "Such term does not include authority to insure or

guarantee the repayment of indebtedness incurred by another person or

government." 2J Thus, loan guarantees are not effectively subject to the

ceilings and targets of the concurrent budget resolutions, to controls on

backdoor spending, and to the discipline of the budget process.

2/ This exclusion was included in the amendment-in-the-nature-of-asubstitute to S. 1541 reported by the Senate Rules and

Administration Committee (S. Rept. 93-688). It was specifically

added to avoid any confusion about the applicability of the controls

to guarantee programs:

30
Under this option, the Congressional Budget Act would be amended

to delete the specific exemptions of loan guarantees from the definition

of budget authority. The effects of such a change would be to add

$63.1 billion to the budget authority totals for fiscal year 1979, if new

commitments for loan guarantees were used as the measure of required

budget authority. The action of the federal government in making a

commitment to guarantee a loan is much like entering into obligations to

make direct expenditures. Table 2 summarizes the changes to the budget

aggregates resulting from such a proposal.

TABLE 2. ESTIMATES OF FISCAL YEAR 1979 AGGREGATES,

INCLUDING NEW COMMITMENTS FOR LOAN

GUARANTEES AS BUDGET AUTHORITY: IN BILLIONS

OF DOLLARS

Revenues

Budget Authority

Outlays

Budget Deficit

Fiscal- Year

1979

Budget

439.6

568.2

500.2

-60.6

New Commitments as Budget

Authority

63.1 a/

Total

439.6

631.3

500.2

-60.6

SOURCE: Budget of the United States Government, Fiscal Year 1979.

a/ Adjusted basis. On an unadjusted basis $107.0 billion would be added

to budget authority for a total of $675.2 billion.

2/ (Continued)

The Committee substitute clarifies the status of

insured and guaranteed loans. Such loans are not direct

obligations of the United States and a liability is incurred

only in the case of default. Thus, it would not be

appropriate to regard such contingent liabilities as budget

authority for purposes of determining the appropriate

levels in the budget resolution. Nor should loan guarantees be subjected to the new procedures for handling

backdoor spending authority. Of course, if the United

States is required to make any outlays pursuant to its

guarantee of loans, such outlays are included in the

budget, (p. 13)

31
Advantages. This alternative would require only minimal changes

in the budget structure and process. The Congressional budget deliberations would not be burdened with new concepts or a larger number of

decisions. A proposed program would compete for budget resources

against the same set of programs regardless of whether it was financed

with guaranteed loans, direct loans, grants, or other direct spending. This

would remove incentives to use guarantees as a way to avoid budgetary

impact.

Disadvantages. The usefulness of the budget authority totals in

the concurrent budget resolutions would be weakened by the inclusion of

large amounts of authority that would never result in federal outlays.

This might lead the Congress to consider less seriously the budget

authority totals for all programs, thus relaxing restraints on future

outlays.

A second disadvantage of this option would be its treatment of the

extension of guaranteed credit the same as direct federal spending. The

two transactions, however, would likely have sharply different effects on

the economy and on federal outlays.

CREATING A CREDIT SECTION IN THE BUDGET

The structure of the federal budget and Congressional budget

resolutions could be changed by adding a section to control credit

activities separately from budget receipts and expenditures. Such a credit

section could include both direct and guaranteed lending, or, perhaps, just

guaranteed lending. The Congressional budget resolutions could include

targets and ceilings for new authority to make or guarantee loans and for

annual activity under that authority. These targets and ceilings would be

comparable to budget authority and outlay controls on expenditures.

A credit section in the budget could be established either by

amending current law or by using existing authority. The Budget and

Accounting Act of 1921 could be amended to require estimates of new

lending, both direct and guaranteed, to be included in the President's

annual budget. The Congressional Budget Act of 1974 could be amended

to require targets and ceilings for credit activities in the concurrent

resolutions on the budget. Alternatively, the Budget Committees could

include a credit section in the Congressional budget resolutions under the

authority of section 301(a)(6) of the Congressional Budget Act of 1974,

which states that the budget resolutions shall set forth "such other

matters relating to the budget as may be appropriate to carry out the

purposes of this Act."

32
A credit section in the budget could, in general, operate as

follows: 3/

o In his annual budget, the President would provide estimates of the

total prospective capital market resources and flows. He would

then propose a target on the volume of credit to be extended

under federal auspices during the fiscal year.

o The Congress would consider this proposal and include in its

concurrent budget resolutions a target or ceiling for federal credit

activities, perhaps with allocations by functional categories.

o Authority to make or guarantee loans could be limited for each

program annually in appropriation acts, just as the level of new

budget authority is set for expenditure programs.

o The volumes of new credit authority and of annual activity under

available authority would be reflected in CBO Scorekeeping

Reports.

o The direct expenditures of credit programs would continue to be

recorded in the budget authority and outlay totals. These include

such items as administrative expenses, subsidies, default losses, or

loans forgiven.

A separate section in the budget for the control of credit programs

has been advocated for some time because of the different economic

effects of credit programs compared to regular spending programs.

Lending programs involve two types of actions—exchanges of assets and

expenditures—whereas spending programs involve only the latter.

Every credit transaction involves an exchange of financial assets. A

lender provides cash now in exchange for another financial asset—a

promise of future repayment of that cash plus payment of an interest

charge to compensate the lender for the time value of his money, the risk

of default, and the costs of collection on the loan.

An expenditure transaction, on the other hand, involves the payment

of funds for goods or services or a transfer of wealth. Expenditures are

recorded in the federal budget for both direct lending and guarantee

programs for default losses, interest rate subsidies, and administrative

3/ This proposal is consistent with the basic outlines of the credit

control proposal announced by the Administration in the fiscal year

1979 budget.
costs of the programs. To the extent that these three types of costs are

not covered by interest payments on direct loans and fees or premiums on

guaranteed or insured loans, they become expenditures of the federal

government. Budget authority must be provided in a sufficient amount,

and outlays will result when they are paid.

For direct loan programs, net lending—the difference between new

loan disbursals and repayments—is also currently recorded as an expenditure or a receipt because of its effects on the government's cash reserves.

This practice has evolved to balance the federal government's cash

accounting: budget authority and outlays being recorded for any excess

lending, and an offsetting receipt reducing outlays in the amount of any

excess repayments. Proposals for a separate section in the budget for

controlling the volume of federal credit have raised questions, as yet

unanswered, about the treatment of net lending.

Thus, the credit section of the budget would have to be designed to

describe accurately the economic effects of federal lending activities and

to maintain the integrity of the budget as a plan for federal spending.

Advantages. This option could provide the Congress with effective control of aggregate credit activities while respecting important

differences between credit activities and direct expenditures. The option

could involve relatively little change in current budget and accounting

procedures. It would achieve better control over credit activities by

refining and strengthening the federal budget structure and process.

Incorporating credit activities within the annual budget debates, and thus

giving them increased visibility, could stimulate more sophisticated

analyses of the economic impact of federal credit programs.

Disadvantages. This option would increase the number of decisions that the Congress has to make in adopting budget resolutions. It

would also require the Congress to become familiar with new budget

concepts. Under this option, a program would compete for budget

resources against one set of programs if it were financed with credit and

against a different set if it were financed with direct spending. Thus,

budgetary treatment could continue to influence the choice of program

financing.

Current economic knowledge does not permit the levels of aggregate

credit activity to be chosen with the same degree of confidence with

which expenditure and revenue totals are established. It cannot yet be

determined how powerful a set of controls the new credit targets and

ceilings would be.

34
AN INFORMATIONAL CREDIT ANALYSIS

Another option would establish an annual informational credit

analysis that would contain much of the same information as the proposed

credit section in the budget. Rather than serve as a means to control

credit activities, this analysis would provide a comprehensive display of

the volume of such activities. It could help inform the Congress about the

size and profile of federal credit activity as decisions are made to create

new programs or change old ones. As in the previous alternative, an

informational analysis could include both direct and guaranteed lending, or

just guaranteed lending. Hearings could be scheduled or other steps could

be taken to give the analysis high visibility.

Advantages. An informational analysis could provide the Congress

with information about federal credit activities without adding new

burdens to Congressional decisionmaking. Although the Congress would

not exercise the discipline of a budgetary process, it could make its

decisions about new activities with more knowledge about the whole range

of federal activities.

Disadvantages. An informational analysis has for many years been

included in the special analysis on credit programs in the President's

budget. Although this analysis has provided an indispensable tool for

specialists, it has not provided the Congress with an effective mechanism

for understanding or controlling credit activities. A new analysis likely

would not improve Congressional control.

INDIRECT CONTROLS THROUGH THE FFB

A fourth alternative would require all guaranteed loans to be

financed through the Federal Financing Bank (FFB). 4/ Guarantees could

then be controlled by limiting FFB purchases of guarantees in appropriations.

The FFB was established in December 1973 as an off-budget agency

operating under the Treasury Department. Its principal purpose is to

coordinate and assist agency- and government-guaranteed borrowings from the public. Instead of going individually to the securities

markets, agencies now borrow from the FFB, which in turn borrows

35
This alternative has been embodied in several bills introduced in the

House of Representatives during the 95th Congress. 5/ These bills would

(1) put the FFB's operations on budget; (2) limit purchases of obligations

by the FFB in any fiscal year to such amounts as may be provided in

appropriation acts; and (3) require guaranteed obligations that would

otherwise be financed in the securities markets to be financed by the

FFB. 6/

Advantages. Indirect control of guarantees, such as proposed by

H.R. 7416 or its companions, may be politically more acceptable than

direct control through a credit section in the budget. Since some

programs, such as primary mortgage guarantees, would not be affected,

their advocates may find this form of control more palatable.

This option would require no new procedures. Limitations on annual

activities have been used in a variety of programs for a number of years.

Disadvantages. Controlling guarantees through the FFB would

create three problems. First, the FFB activity would convert guaranteed

loans into direct federal loans. The government would not only guarantee

the loan; it would also provide the funds for the loan. 7J This would

prohibit the involvement of private lenders in some programs in which

they may have an important role to perform.

from Treasury or the public. The FFB can obtain funds at or just

above the Treasury's own borrowing rates, thus offering government

agencies lower interest costs than they would have incurred if they

had borrowed directly in the securities markets.

5/ See H.R.s 7*16, 7597, 7918, 10416, 11124, and 11177.

6_/ For a discussion of how the FFB finances guarantee programs see

Appendix B. H.R. 7416 and its companions would exempt guaranteed

obligations not ordinarily bought and sold in the investment

securities markets, presumably primary mortgages, from the requirement of FFB financing.

7J When the FFB buys a federally guaranteed obligation, the flow of

funds is identical to that of a direct loan—from the public through

the Treasury and a federal agency to a nonfederal borrower.
A second disadvantage to this option is that the FFB may be forced

to allocate credit among federal programs if the demand for guaranteed

credit exceeds the level of activity permitted the FFB. The FFB is not

equipped or authorized to make such allocation decisions.

A third problem is that the control of guarantees would not be

comprehensive. Since this option would affect only those guaranteed

obligations that are ordinarily traded in the securities markets, it would

be difficult to coordinate guarantee programs in the aggregate with other

government activities.

TWO SUPPLEMENTARY OPTIONS

The first four general options are alternative ways to improve

Congressional control of federal guarantees. The next two methods of

control are supplementary and could be adopted separately from or in

combination with one of the above options.

Direct Program Controls

Loan guarantee activities could be controlled directly by subjecting

new commitments to annual appropriations, or by requiring that each

program have a default reserve appropriate to the government's risk and

permitting outstanding obligations only in amounts proportional to the

reserves on hand. Such direct controls would involve items that would be

visible and trackable in the budget process. For example:

o Individual program ceilings on new commitments for direct loans

and loan guarantees could be enacted annually in appropriations

acts.

o The maximum amounts of contracts to make future debt service

payments could also be specifically authorized in appropriations

acts.

o Default reserves for all direct and guaranteed loan programs could

be required. Agencies could then be allowed to make commitments under these programs up to a ceiling established as the

mathematical product of some factor times the level of the

reserves. By permitting outstanding obligations only in amounts

proportional to the level of reserves, the Congress could control

program activity by controlling the level of the reserves.

37
Advantages. This option would subject guarantee programs to

many of the same forms of oversight and control that are applied to

expenditure programs. A committee other than the one that authorized a

program would recommend the proper level of annual activity. Used in

conjunction with one of the general options, decisions on individual

program levels could be made consistent with the aggregate targets or

controls.

Disadvantages. This would increase the number of decisions that

the Appropriations Committees would have to make within an already

tight schedule. If this option is not used in conjunction with one of the

general options, it may not provide an effective form of control. A

number of guarantee programs now have limits such as authorized ceilings

on outstanding guarantees or appropriated fractional reserves. Rather

than limiting annual activity, however, authorized ceilings have been

enacted for the entire period of a three- or five-year authorization; they

are not reviewed annually for consistency with current economic

conditions. Also they are routinely increased during reauthorizations.

Self-Policing Elements in Program Design

Standards of program design could be refined so that individual

guarantee programs would create incentives for borrowers and private

lenders to act in conformity with prudent federal policy. The Congress

can protect the public's interest by building into loan guarantee programs

self-policing elements, such as variable interest rates, credit needs tests

for borrowers, coinsurance by lenders, and equity participation by private

investors. 8/ Improperly designed guarantee agreements and programs

can have undesirable results, such as windfall profits to lenders through

unjustifiably high yields, indifference of program participants to imprudent risks, and premature abandonment of troubled ventures by lenders

and borrowers with no stake in the projects.

8/ Coinsurance denotes the practice of requiring the lender to share a

portion of the risk. Partial guarantees, wherein the government

guarantees less than 100 percent of the principal and/or interest of a

loan, are examples of coinsurance.

Equity participation denotes the practice of requiring borrowers to

invest their own capital as a portion of the total financing package.

38
What is suggested here is not a set of program design elements that

could be applied uniformly to all programs. Rather, this option would

required detailed program-by-program analysis of the incentives that are

appropriate for borrowers and lenders in particular market environments.

Then, loan guarantee programs should be tailored to create and maintain

those incentives. The federal government needs to develop in guarantor

agencies banker-like skills so that the agencies' intervention in credit

transactions will protect the interests of the public and will foster

activities that are consistent with public policy.

Developing these standards of program design falls beyond the scope

of this paper. However, it is a promising area of inquiry for the Congress

and the executive branch.

CONCLUSION; THE PREFERRED ALTERNATIVE

Understanding of federal government activity through the budget

process is incomplete to the extent that an estimated $53.4 billion of

guaranteed loans are not included in the fiscal year 1979 budget. The

current budgetary treatment of guaranteed lending hinders the coordination of loan guarantee programs with other important elements of

federal fiscal policy. Each of the general options outlined above could be

implemented under several variations. Thus, the Congress has many ways

to improve its control of loan guarantees. CBO believes that guarantees,

as well as other federal fiscal activities, should be reviewed and

controlled within the Congressional budget process. Efforts to improve

control of guarantees should focus on refining the budget structure and

strengthening the budget process.

Of the alternatives considered in this chapter, CBO finds the

establishment of a credit section in the federal budget to be the most

promising option for further analysis and development. This alternative

would permit the Congress to set aggregate levels of new guaranteed

loans within the current budget process. Enhanced controls over

individual programs could be achieved by adoption of individual program

controls and self-policing elements to supplement the aggregate controls

of the credit section.

A credit section in the budget could be implemented either formally

through legislation enacted by the Congress or informally under the

authority granted the Budget Committees by section 301 of the

Congressional Budget Act. Direct program controls and self-policing

39
elements would be included in the legislation enacting credit programs.

This combination of aggregate and individual program controls would

provide the Congress the means to plan effectively for and oversee the

federal government's credit assistance programs.

40
APPENDIXES

APPENDIX A. RESPONSES TO QUESTIONS IN ORIGINAL INQUIRY

The letter from Chairman Muskie and Senator Bellmon requesting

CBO to undertake a study of federal loan guarantees included five specific

questions. While all of these questions have been addressed in the

preceding paper, the questions are restated here and summary answers

provided.

1. What additional programs would be included in the federal

budget if the "authority to insure or guarantee the repayment of

indebtedness incurred by another person or government" were not

excluded from the definition of "budget authority" in Section 3(a)(2) of the

Budget Act?

Inclusion of loan guarantees in the definition of budget authority

would add over 150 programs, totaling an estimated $53.4 billion of new

guarantees, to the fiscal year 1979 budget. These programs have grown

rapidly in recent years, from $8.5 billion in fiscal year 1950 to over

$50 billion in the last several years. The largest part of the assistance

provided by loan guarantees has been for small borrowers: families buying

homes, small businessman expanding their operations, students financing

their education. In recent years proposals for loan guarantees have

focused more on financing discrete ventures, which are so unique and so

large that private investment is not forthcoming. Recent proposals have

included the development of synthetic fuel plants, pollution control

devices for industries converting to coal as a fuel source, and the

promotion of aquaculture.

2. How have these programs been accounted for to date?

Current practices include only the expenditure aspects of loan

guarantee programs in the budget. The exclusion of loan guarantees from

the definition of budget authority means that only administrative costs

and payments for defaults are counted in the budget totals. The amounts

of the principals of new guaranteed loans are nowhere included in the

budget and thus are largely uncontrolled. The purchase of guaranteed

loans by the Federal Financing Bank (FFB) has the effect of converting

guaranteed loans into direct federal loans, which are not included in the

budget totals but do affect Treasury borrowing requirements.

43
3. What has been the actual default experience under these

programs?

There are no good estimates of the default experience of guarantee

programs. A study prepared for CBO surveyed the experiences of 22

major loan guarantee programs. Its principal conclusion was that

differences in definitions and data collection procedures make it impossible to compile estimates of defaults and claims paid. This study, Loan

Insurance and Guarantee Programs; A Comparison of Current Practices

and Procedures, will be included in the compilation of staff working

papers to be published shortly as a companion to this paper.

4. What options, suggested by this experience, would improve the

treatment of credit and other guarantees in the budget?

Six options for improved treatment of credit programs in the budget

are discussed in Chapter IV of the paper. The options are:

o Inclusion of loan guarantees as budget authority;

o A credit section in the federal budget;

o An informational credit analysis;

o Indirect control through the FFB;

o Direct program controls; and

o Self-policing elements in program design.

5. What other activities (such as project guarantees, price

guarantees, leasing arrangements and other contingent liabilities) involve

significant exposure of future federal budgets?

OMB considers price guarantees, project guarantees, lease guarantees, and the like to be guarantees of the underlying credit. Accordingly,

such programs are included in the special analyses on credit as loan

guarantees. Separate data are not kept on the various types of loan

guarantee mechanisms. Other noncredit activities imposing contingent

liabilities on the federal government include:

44
o Depositor's insurance;

o War risk insurance programs;

o Flood, riot, and crime insurance programs; and

o Unfunded retirement and pension liabilities.

The contingent liabilities of the various insurance programs of the

government stood at $1.6 trillion as of September 30, 1976. J7 These

programs are reflected in the budget only for their administrative

expenses and any fees or premiums collected. The liabilities of the

retirement and pension programs have been variously estimated by OMB

and Treasury as several trillions of dollars. These programs are accounted

for in the current operations of the trust funds through which they

operate.

\J Department of the Treasury, Statement of Liabilities and Other

Financial Commitments of the United States Government as of

September 30, 1976.

45

APPENDIX B. FEDERAL CREDIT ACTIVITIES: AN OVERVIEW

To understand the implications of the use of loan guarantees as a

financing mechanism, it is essential to place loan guarantees in the

context of all federal credit activities. Three federal credit mechanisms

can be identified:

o Direct loans, made by both on- and off-budget agencies;

o Guaranteed loans, again made by on- and off-budget agencies; and

o Loans and secondary market operations by government-sponsored

credit enterprises.

The four sections of this appendix describe these credit mechanisms and

their accounting in the budget, and the operations of the Federal

Financing Bank (FFB) with respect to loan guarantee programs.

Data on federal credit activities have been collected systematically

only since 1952. Since that year, a special analysis of federal credit

programs has been included in the volume of special analyses that

accompanies the Budget of the United States Government for each fiscal

year. The data used in the following discussion of credit activities are

taken from an aggregation of the 25 years of data in these special

analyses. I/

DIRECT LENDING

The federal government makes direct loans to individuals, businesses, nonprofit organizations, and local governments for a variety of

purposes:

o The Commodity Credit Corporation makes loans to producers to

finance next year's crop.

\J A forthcoming CBO background paper, Federal Credit Programs; A

Statistical Compilation, consolidates the 25 years of special analyses

on credit in order to describe the growth of federal credit programs

during this period.

47
o The Veterans Administration makes loans to veterans for home

purchases in rural areas and small towns, where other credit is not

available.

o The Small Business Administration makes loans to small businesses

for expansion.

o The Economic Development Administration makes loans to local

governments for public works and to businesses for commercial

expansion in economically distressed areas.

o The Export-Import Bank makes loans to businesses to assist them

to compete in overseas markets.

New commitments for direct loans have grown from $3.5 billion annually

in 1950 to over $20 billion in the mid-1970s.

Direct loans are also made by the various off-budget agencies.

Loans are made by the U.S. Railway Association to various railroads as

part of the reorganization and consolidation in Conrail. Also direct loans

for Rural Electrification Administration programs are made by the

Rural Electrification and Telephone Revolving Fund. By far the largest

volume of off-budget direct loans are made by the Federal Financing

Bank, discussed later in this appendix.

Table B-l summarizes the estimated direct loan activity of the

federal government for fiscal year 1979. It demonstrates how direct loans

are counted in the federal budget.

o New commitments are agreements by the government to extend

direct loans contingent upon prospective borrowers fulfilling

specified conditions, such as securing financing of the private

share of a project, or completing requirements, such as planning

and impact statements. As such, estimates of new commitments

are a good indicator of future financial flows.

o New loans extended represent actual lending in a given year, that

is, the volume of new credit extended directly by the federal

government. Because project financing is often a complicated

process, new commitments in a given year do not always result in

new loans extended, just as obligations in a given year do not

always result in outlays.

48
o Net lending is derived by deducting repayments on direct loans

previously extended against new loans extended. This net lending

figure is the amount actually included in the budget totals for the

on-budget agencies.

TABLE B-l. SUMMARY OF DIRECT FEDERAL LENDING, FISCAL

YEAR 1979: IN MILLIONS OF DOLLARS

On-Budget Off-Budget

Agencies Agencies

Commitments for New Loans 28,942 22,591

New Loans Extended 26,575 17,575

Less Repayments on Lending -22,246 - 4,618

(Loan Asset Sales) (10,272) (720)

Net Lending 4,329 12,957

SOURCE: Budget of the United States Government, Special Analysis F,

Fiscal Year 1979~

The treatment of direct loans on a net basis in the federal budget

presents a serious problem: it distorts the picture of federal credit

activity by understating the amount of current activity. The fact that

there are repayments on loans made in previous years does not alter the

amount of credit extended in new loans in the current year. Of the

estimated $26.6 billion of new direct loans (on-budget) in fiscal year 1979,

the budget totals reflect only $4.3 billion. That $22.2 billion of

repayments are deducted from the total does not mean that $22.2 billion

in new loans were not extended.

Current practices include in repayments the sales of loans by

originating federal agencies to third parties. Of the $22.2 billion of

estimated repayments in fiscal year 1978, $10.3 billion, or 46 percent, are

sales of loan assets. These do not signify the termination of a borrowing

transaction—the repayment of principal and interest—but only the

transfer of the loan obligation to another owner. While there are valid

49
policy reasons for loan asset sales—the intermediation role performed by

the Farmers Home Administration or the countercyclical role sometimes

performed by GNMA, for example—this practice poses a potential

problem.

As these loan asset sales increase—they have reached as high as

70 percent of repayments in recent years (see Table B-2)«it is possible for

agencies to manipulate their budget totals by selling off their direct loan

portfolios. By selling all its new loans extended in a given year, an agency

could create a net entry of zero in the budget, giving the picture of no

activity. Conceivably, by selling additional holdings from its loan

portfolios, the agency could reduce its net lending to a negative figure and

thus reduce the budget deficit. For instance new loans extended by the

Farmers Home Administration in fiscal year 1979 are estimated to be

$8,421 million. After deducting $9,644 million of repayments and

$41 million of other adjustments, the net lending charge in the budget is a

negative $1,264 million. Of the $9,644 million in repayments,

$7,368 million, or 76 percent, represent loan asset sales. While the

negative outlay figure of $1,264 million is an appropriate picture of the

government's cash flow position, it is not a valid representation of the

level of federal lending activity for the fiscal year.

GUARANTEED LENDING

Table B-3 summarizes federal loan guarantee activity for fiscal

year 1979. Comparable to the accounting for direct loans, commitments

for new guarantees forecast future activity. Current activity, however, is

recorded as total loans guaranteed. This total includes some doublecounting. For example, the GNMA tandem plan pools small guaranteed

loans together and then guarantees the certificates of participation in

those pools sold to third parties. The first adjustment deducts these

guarantees of guarantees, or secondary guarantees as they are known. A

second adjustment is required because some guaranteed loans are bought

by federal agencies, thus converting the guaranteed loans into direct loans

since the federal government provides the funds. Deducting these two

adjustments leaves a total for adjusted total guarantees, the most useful

figure for understanding the volume of new guarantee activity in a fiscal

year. For fiscal year 1979 it is estimated to be $53.4 billion. A final

statistic, net guarantees extended, is derived by deducting the principal of

guaranteed loans that have been repaid.

50
TABLE B-2. LOAN SALES AS A PERCENT OF LOAN REPAYMENTS:

BY FISCAL YEARS

Loan Repayments a/

Fiscal (in millions

Year of dollars)

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

TQ

1977

1978

1979

6,930

6,597

6,188

8,123

7,091

7,227

9,567

9,413

10,035

9,376

13,209

10,325

13,744

18,859 c/

5,019 d

19,300 d/

e/ 21,422d/

e/ 22,246

Loan Sales Loan Sales

On-Budget b/ as Percent

(in millions of Repayof dollars) ments

1,142

1,077

1,564

2,961

4,229

5,300

2,005

2,210

2,548

3,356

6,254

3,911

7,922

13,312

3,634

10,068

9,985

10,272

SOURCE: Budget of the United States Government, Special

16.5

16.3

25.3

36.5

59.6

73.3

21.0

23.5

25.4

35.8

47.4

37.9

57.6

70.6

72.4

52.2

46.6

46.2

Analyses

on Credit, Fiscal Years 1965-1978.

a/

b/

c/

d/

e/

Including adjustments to balances, write-offs, etc.

Including GNMA tandem plans.

Does not include Export-Import Bank, as OMB figures do.

Does not include Housing for the Elderly program, as OMB figures do,

Estimate.

51
TABLE B-3. SUMMARY OF GUARANTEED LENDING, FISCAL YEAR

1979: IN MILLIONS OF DOLLARS

Fiscal Year 1979

Commitments for New Guarantees

Loans Guaranteed 89,788

Less Secondary Guarantees and Guaranteed

Loans Acquired for Government Direct

Loan Portfolios -36,434

Total, Primary Guarantees (Adjusted) 53,354

Less Reductions because of Repayments

of Loans -30,166

Net Guarantees Extended 23,188

SOURCE: Budget of the United States Government, Special Analysis F,

Fiscal Year 1979.

THE ROLE OF THE FFB

By combining Tables B-l and B-3, it is possible to derive a picture of

the role of the FFB in converting guaranteed loans into direct loans.

Table B-4 illustrates this conversion. Of the $36.4 billion deducted from

total guarantees extended for secondary guarantees and purchases of

guarantees for direct loan portfolios, $16.2 billion was for purchases by

the FFB. The figure included for the FFB in the direct lending activities

of off-budget federal agencies is exactly $16.2 billion. The extent of the

FFB's activity in its short existence is illustrated in Table B-5. In its first

year, fiscal year 1974, FFB purchases of guaranteed loans amounted to

less than one percent of the total; two years later the FFB was purchasing

almost one-fifth of all guaranteed loans. While this level of activity

appears to have remained constant, the Congress has not yet made any

efforts to control the level of FFB activity to ensure stability.

52
TABLE B-4. ROLE OF THE FEDERAL FINANCING BANK, FISCAL

YEAR 1979: IN MILLIONS OF DOLLARS

Fiscal Year 1979

Direct Lending

On-budget Loans 26,575

Off-budget Loans 17,575

FFB (16,158)

Other ( 1,417)

Gross Total Direct Lending 4'

Less Repayments -26,864

Total Direct Lending 17,286

Guaranteed Lending

Guarantees Extended 89,788

Less Secondary Guarantees -15,640

Less Guarantees Acquired for Government

Direct Loan Portfolios

FFB -16,158

Others - 4,635

Total Primary Guarantees (Adjusted) 53,354

SOURCE: Budget of the United States Government, Special Analysis F,

Fiscal Year 1979.

53
SECONDARY MARKET OPERATIONS

A third form of federal credit activity arises out of the government's attempts to establish secondary market operations for direct and

guaranteed loans as a means of encouraging private participation in public

credit activities. To that end the government has sponsored various

TABLE B-5. FFB PURCHASES OF NEW GUARANTEES, FISCAL

YEARS 1974-1978: IN MILLIONS OF DOLLARS

Fiscal

Year

1974

1975

1976

TQ

1977

1978 a/

1979 a/

Primary

Guarantees

33,461

41,290

44,278

13,312

56,168 b/

64,829 b/

74,148 b/

FFB

Purchases

102

6,958

8,876

2,859

12,379

15,626

16,158

FFB Purchases

as Percentages

of New Guarantees

0.3

16.8

20.0

21.5

22.0

24.1

21.8

SOURCE: Budget of the United States Government, Special Analysis F,

Fiscal Years 1976-1979.

a/ Estimated.

b/ Primary guarantees are adjusted subtotals of the totals for guaranteed lending. Prior to the fiscal year 1979 budget, the adjustment

for secondary guarantees was deducted from total guarantees

extended to arrive at primary guarantees extended. Beginning with

the fiscal year 1979 budget, OMB began including in the adjustment

for secondary guarantees the purchase by GNMA of guarantees for

its direct loan portfolio. This change was made to distinguish

between the purchase of guarantees for direct loan portfolios by onbudget agencies (only GNMA) and by off-budget agencies and

federally sponsored credit intermediaries. Since this table is

concerned with the relationship of FFB purchases as a part of

primary guarantees before other adjustments have been made, the

data for fiscal years 1977, 1978, and 1979 have been adjusted to

reflect the pre-1979 budget practices.

54
private and mixed-ownership enterprises to function as financial intermediaries. The Farm Credit System, the Federal Home Loan Banks, the

Federal National Mortgage Association, and the Student Loan Marketing

Association (SLMA) fall into this category.

Although they are privately owned, all these enterprises are

chartered by the government, are subject to various kinds of federal

supervision, consult the Treasury in planning their operations, and

frequently include federal officials on their boards of directors. Because

these enterprises are given special tax preferences and can point to their

federal relationship, their securities receive a preferred position in the

capital markets. This enables them to borrow money at rates only

moderately above the Treasury's own borrowing rates.

Some of these agencies began with the purpose of establishing

secondary market operations for housing, such as FNMA, or as facilities

providing advances of reserves to financial institutions. They have a basic

function of providing liquidity to primary lenders in times of tight money

conditions, either by buying loans or making advances. These loans are

then sold back or the advances repaid when capital market conditions

improve. In recent years, however, these institutions have expanded their

roles. In addition to buying and selling loans to facilitate the flow of

mortgage credit in tight and easy money markets, they are also seeking to

draw new funds into the mortgage markets. By borrowing additional funds

themselves, they can provide more funds to the basic lending institutions

in the mortgage markets.

Table B-6 summarizes direct lending by these federally sponsored

credit intermediaries for fiscal year 1979. The accounting treatment is

comparable to that for direct and guaranteed loans, although an additional

adjustment has to be made to deduct from gross lending funds advanced to

the credit intermediaries by federal sources. A prime example of this is

FFB purchases of SLMA obligations.

55
TABLE B-6. SUMMARY OF LENDING BY FEDERALLY SPONSORED

CREDIT INTERMEDIARIES, FISCAL YEAR 1979:

IN MILLIONS OF DOLLARS

Fiscal Year 1979

New Commitments 66,969

Gross Direct Lending 62,004

Less Funds Advanced from

Federal Sources -130

Total, Primary Lending 61,874

Less Repayments -47,029

Total, Net Lending 14,845

Total Outstanding 130,082

SOURCE: Budget of the United States Government, Special Analysis F,

Fiscal Year 1979.

56
APPENDIX C. FORMS OF LOAN GUARANTEES

A recent cataloging of loan guarantee programs identified 164 separate programs, and this listing is not considered to be exhaustive. I/

These programs developed over a number of years in response to specific

problems or needs. As a result of this profusion of ad hoc programs, a

variety of guarantee mechanisms has developed, each tailored to specific

program needs. This wide variety of forms and practices makes it

difficult to understand how individual programs operate and to compare

programs to each other.

Defining distinct types of guarantee mechanisms is complicated by

the combination within a single program of loan guarantees with other

credit mechanisms—interest subsidies, direct loans, etc. Using OMB's

definition for classifying programs as loan guarantees within the special

analysis on credit, one can identify at least six more or less distinct

mechanisms.

Explicit Guarantees of Principal and Interest. This is a formalized

commitment by a guarantor agency to repay indebtedness on behalf of a

borrower, such as FHA home loan guarantees. Typically such a program

charges the borrower a fee or premium, is administered through a

revolving fund, and is designed to operate on an actuarially sound basis.

Explicit Guarantees of Leases or Long-Term Contracts on Behalf of

Private Parties. This mechanism is very similar to the first form, but

the guarantee is applied to a lease or long-term contract made by an

individual. The Small Business Administration's lease guarantee program

is the primary example of this mechanism. It is designed to help small

businesses obtain leases of commercial and industrial space that, because

of insufficient credit standing, they would otherwise be unable to obtain

on reasonable terms.

17 Catalog ~of Federal Loan Guarantee Programs, (Committee Print)

Subcommittee on Economic Stabilization of the House Committee

on Banking, Finance, and Urban Affairs, 95:1 (1977).

57
Long-Term Contracts for Government Purchases, Leases, or Contributions. This category in reality covers a variety of forms. A

guarantor agency may sign a long-term contract to purchase various goods

or services from a private concern. Or, the agency may enter into longterm contracts to lease property toward payment of debt service on

behalf of a private borrower. Examples include price guarantees for

financing energy generating facilities, Department of Defense contracts

to lease oil tankers, and the HUD College Housing Program. In all these

cases there is no formalized guarantee attached to the actual indebtedness incurred by the private borrower. Instead, the operative factor is the

existence of a long-term, stable income stream resulting from the

government contract.

Contingent Direct Loan Commitments to Guarantee Financing. In

some programs for which an agency has the authority to make direct

loans, the agencies will make direct loan commitments to borrowers, who

then pledge those loan commitments as collateral in securing private

financing. Although some programs, such as the temporary loan program

of the Urban Renewal Administration, have specific statutory authorization to make such commitments as a means of guaranteeing credit

obtained in the private markets, it is not clear whether an agency must

have such authority to use its direct loan programs as a guarantee

mechanism.

Direct Loans Sold with an Agreement to Repurchase. In some

cases the federal government can convert a direct loan it has made into a

privately financed, guaranteed loan by selling that loan note to a third

party. It then guarantees the loan by agreeing to repurchase it from the

third-party buyer if the borrower defaults. Because such sales to third

parties are considered loan asset sales, the receipts are counted as

repayments and deducted from new lending. As a result this practice can

be used to reduce recorded budget outlays.

Callable Capital Contributions. The assets of various international financial institutions are composed of capital contributions subscribed by member nations. Only a portion, 7 to 10 percent, of the

subscribed capital is paic! into the international banks, the remainder being

"callable capital"—funds the subscribers stand ready to supply if ever

needed. None of the international banks has ever had to call in these

pledges to date.

58

O