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78–663 2002

SUBSIDY RATE CALCULATION: AN UNFAIR TAX ON

SMALL BUSINESS

HEARING

BEFORE THE

COMMITTEE ON SMALL BUSINESS

HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

WASHINGTON, DC, MARCH 13, 2002

Serial No. 107–47

Printed for the use of the Committee on Small Business

(

(II)

COMMITTEE ON SMALL BUSINESS

DONALD MANZULLO, Illinois, Chairman

LARRY COMBEST, Texas

JOEL HEFLEY, Colorado

ROSCOE G. BARTLETT, Maryland

FRANK A. LOBIONDO, New Jersey

SUE W. KELLY, New York

STEVE CHABOT, Ohio

PATRICK J. TOOMEY, Pennsylvania

JIM DEMINT, South Carolina

JOHN R. THUNE, South Dakota

MICHAEL PENCE, Indiana

MIKE FERGUSON, New Jersey

DARRELL E. ISSA, California

SAM GRAVES, Missouri

EDWARD L. SCHROCK, Virginia

FELIX J. GRUCCI, JR., New York

TODD W. AKIN, Missouri

SHELLEY MOORE CAPITO, West Virginia

BILL SHUSTER, Pennsylvania

NYDIA M. VELAZQUEZ, New York

JUANITA MILLENDER-MCDONALD,

California

DANNY K. DAVIS, Illinois

BILL PASCRELL, JR., New Jersey

DONNA M. CHRISTENSEN, Virgin Islands

ROBERT A. BRADY, Pennsylvania

TOM UDALL, New Mexico

STEPHANIE TUBBS JONES, Ohio

CHARLES A. GONZALEZ, Texas

DAVID D. PHELPS, Illinois

GRACE F. NAPOLITANO, California

BRIAN BAIRD, Washington

MARK UDALL, Colorado

JAMES R. LANGEVIN, Rhode Island

MIKE ROSS, Arkansas

BRAD CARSON, Oklahoma

ANIBAL ACEVEDO-VILA, Puerto Rico

DOUG THOMAS, Staff Director

PHIL ESKELAND, Deputy Staff Director

MICHAEL DAY, Minority Staff Director

(III)

C O N T E N T S

Page

Hearing held on March 13, 2002 ............................................................................ 1

WITNESSES

Dorn, Hon. Nancy, Deputy Director, Office Of Management and Budget .......... 3

Barreto, Hon. Hector, Administrator, U.S. Small Business Administration ...... 5

Crawford, Christopher, Executive Director, National Association of Development Companies ................................................................................................... 8

Wilkinson, Anthony, President & CEO, The National Association of Government Guaranteed Lenders ................................................................................... 9

APPENDIX

Opening statements:

Manzullo, Hon. Donald .................................................................................... 34

Velazquez, Hon. Nydia ..................................................................................... 36

Prepared statements:

Dorn, Hon. Nancy ............................................................................................. 39

Barreto, Hon. Hector ........................................................................................ 44

Crawford, Christopher ..................................................................................... 51

Wilkinson, Anthony .......................................................................................... 61

Additional Information:

Post hearing submission from Small Business Administration ................... 61

(1)

HEARING ON SUBSIDY RATE CALCULATION:

AN UNFAIR TAX ON SMALL BUSINESSES?

WEDNESDAY, MARCH 13, 2002

HOUSE OF REPRESENTATIVES,

COMMITTEE ON SMALL BUSINESS,

Washington, DC.

The Committee met, pursuant to call, at 10:06 a.m. in room

2360, Rayburn House Office Building, Hon. Donald Manzullo

(Chairman of the Committee) presiding.

Chairman MANZULLO. Good morning and welcome to this hearing

of the Committee on Small Business. A special welcome to those

who have come some distance to participate and attend this hearing. A special welcome also to the Administrator. In case he leaves

very, very quickly, which I have noticed, there is a third bambino

on the way and that is where he belongs. If he does not leave

quickly I will usher you out myself, Mr. Barreto, and take you to

the hospital personally to get you there.

We are here today to discuss the subsidy rate calculations for the

7(a) and 504 loan programs. First of all I want to commend the Administration for recognizing the importance of this issue and beginning to correct the problem. We have seen more movement on this

issue over the past eight months than over the past eight years.

Thanks, in large part, to the personal involvement of Dr. Lloyd

Blanchard who left OMB to join SBA as its Chief Operating Officer. Excellent choice and a good move. Good move for the SBA and

for the OMB.

The subsidy rate calculation has weighted loans originated by

the preferred lenders program more heavily than other SBA loans

which dropped the subsidy rate by 20 percent. I appreciate that

change.

The Administration is also committed to developing an econometric model for the next budget cycle which is it hoped will provide a more accurate forecast for the performance of the SBA loan

portfolios.

I also appreciate the willingness of the SBA to examine other alternatives to make sure that access to the 7(a) program is not cut

in half next year.

I look forward to working with the SBA as a constructive partner

to see what we can do together.

I wish we had an accurate subsidy rate calculation now so that

there would be no question about the availability of the 7(a) program in 2003. Fees could also be reduced in the 504 program. Inaccurate subsidy costs results in overpayment of fees and eliminate

flexibility of program delivery. I trust that we will not be in this

predicament next year.

2

Again, I commend the Administration for moving, I believe, very

rapidly on this, staying in constant contact with our office. I look

forward to this issue being resolved.

I now yield for an opening statement by my good friend and colleague, the Ranking Member, Mrs. Velazquez of New York.

[Chairman Manzullo’s statement may be found in the appendix.]

Ms. VELAZQUEZ. Thank you, Mr. Chairman.

It should come as no surprise to anyone on this committee that

access to capital is access to opportunity. It is the one tenet of business development that holds true regardless of time, place or industry. If entrepreneurs can’t tap into credit, the difficult task of

starting a business can become insurmountable. That is where the

SBA loan program comes to the rescue. With competitive interest

rates and a streamlined application process, these programs have

been responsible for lending over $10 billion annually, providing 40

percent of the long term capital mix for small business.

These lending programs bridge the gap between affordability and

accessibility, creating a partnership with the private sector that is

the government’s best bargain investment for its money.

Unfortunately, a disconnect in both Democratic and Republican

Administrations has limited the reach of these programs. We have

the potential to help many more small businesses. This disconnect

has translated into an over-charge for both lenders and borrowers

of more than $1 billion to date. This is a fact, plain and simple,

and it is the most blunt example of the arrogance of our government that I have seen in my service in Congress.

Every year we raise this issue, yet all we hear are excuses. Either the model is not right or more data are needed. There is always an excuse and never a solution. What has been clear is that

the OMB in both Democratic and Republican Administrations have

been cooking the books in an attempt to hide this Stealth Tax from

small businesses, and it taps our nation’s entrepreneurs as a cash

cow for the U.S. Treasury.

Frustration with this complacency and negligence forced a coalition of lawmakers, including myself, to cut the fees for 7(a) lending

in half in order to open up more capital and reduce the cost to

small businesses. This move presented the Administration with a

golden opportunity to do the right thing and finally report an accurate subsidy rate. Unfortunately, the Administration again chose to

play budget games with this year’s budget proposal, jacking up the

subsidy rate for the 7(a) program to almost double the current

level.

The Bush Administration’s excuse for increasing what they

should have lowered this time was our fee reduction. But if the fee

reduction is their excuse, what possible explanation can there be

for the 504 program which also saw its fees increase without any

substantive rate reduction? This is just one example of the inconsistencies that have plagued this debate.

Another example is all the phony numbers that are floating

around. In many cases the figures used to calculate the default rate

so critical to the overall subsidy rates are laughable, and are even

contradicted by the Administration’s own budget. This junk math

will taint almost any proposed solution.

3

The latest excuse we will hear is that SBA has contracted a firm

to help construct an econometric model to help more accurately

predict true program performance. But given all the phony numbers flowing around, no equation will ever actually report the true

cost of the program because if you put garbage in you most certainly will get garbage out.

This is the time of reckoning. Either OMB and SBA report an accurate subsidy rate or we on the Committee working with other

like-minded Members will do it ourselves, even if it means taking

the money from OMB and SBA to make up the shortfall or making

changes to credit reform or even if we have to legislate the subsidy

rate every year.

Yes, these are drastic actions, but this problem has gone on for

too long to be left unresolved any longer. This change is especially

critical at a time when our country is attempting to climb out of

a recession. Small businesses make a crucial contribution to this effort. They hauled us out of the last recession into the greatest

peacetime expansion on record. They will do it again with our help.

So the question for this Committee and the Administration is, do

we fix this problem and provide a $5 billion stimulus to this nation’s small businesses to go out and create jobs? Or do we continue

the draconian practice of taxing small businesses and keep them

from providing the boost this economy so desperately needs?

I know which way I am leaning, Mr. Chairman, and I am pretty

sure about you too.

Thank you very much.

[Ms. Velazquez’s statement may be found in the appendix.]

Chairman MANZULLO. Thank you.

We will start with Nancy Dorn who is the Deputy Director of the

Office of Management and Budget. Normally we would start with

the Director, but this is the preference so that your testimony will

sequence into the next, is that correct?

Ms. DORN. That’s correct.

Chairman MANZULLO. I look forward to your testimony.

All the statements of the witnesses and the Members of Congress

will be made part of the record.

Please.

STATEMENT OF THE HONORABLE NANCY DORN, DEPUTY

DIRECTOR, OFFICE OF MANAGEMENT AND BUDGET

Ms. DORN. Thank you, Mr. Chairman, and good morning.

Chairman Manzullo, Congresswoman Velazquez and Members of

the Committee, I am Nancy Dorn, Deputy Director of the Office of

Management and Budget. I am pleased to be here today to discuss

OMB’s role in implementing the Federal Credit Reform Act of

1990. It is in this capacity that OMB worked with SBA on cost estimations for loan programs.

Before I begin let me say that it is unfortunate that the premature release of preliminary and incomplete estimates for SBA’s

7(a) business loan program may have led to unrealized expectations. I would like to point out that our efforts to improve the accuracy of the subsidy rate calculation, the first such effort in over a

decade, resulted in a 20 percent reduction in cost. The Administrator will explain in further detail the steps that OMB and SBA

4

took to improve the methodology and the progress made in developing an econometric model for use in the fiscal 2004 budget.

While the Administration recognizes the importance of SBA’s

lending programs, we feel that the best way to address the needs

of small business is through sound tax and regulatory policy. Reductions in individual taxes benefit the approximately 20 million

small businesses who pay taxes at individual income rates. In addition this Administration is committed to reducing the financial and

administrative burden on small businesses, complying with tax, environment, health and labor regulations which again benefit the

vast majority of the nation’s 25 million small businesses.

To address the lending needs of small businesses affected by the

September 11th attacks, the Congress passed and the President

signed legislation to temporarily lower fees for SBA lending programs and transfers from the rest of the government. While the fee

reductions may help those businesses and lenders that participate,

it also means that the subsidy rate and the cost of these programs

rises. Given the additional costs, the budget supports a 7(a) loan

volume that’s lower than the 2002 loan volume even with an increase in appropriations for the basic 7(a) program.

With respect to the fiscal 2003 budget, the increase in the subsidy rate for the 7(a) program is not the result of any Administration proposal. However, we believe that there may be opportunities

to leverage additional lending in other SBA programs to offset the

decreased loan volume in the 7(a) program.

I would like to speak for just a minute about the Federal Credit

Reform Act since that is one of the main reasons that OMB is involved in this process.

As you know, the Federal Credit Reform Act became effective in

fiscal year 1992 and it required federal agencies to accurately

measure the true cost of lending programs by budgeting up front

for the expected net loss to the government.

Prior to that time the cost of federal loan programs was very uncertain and in many instances it took years for the costs to become

apparent. Loan defaults and guarantee claim payments were reflected in the budget years after loan disbursements and guarantee

commitments had been made.

The cost of interest subsidies was clear only after several years

of experience with market interest rates. The cost of direct loans

was systematically over-estimated and the cost of loan guarantees

systematically under-estimated. Credit reform, federal budgeting,

and accounting for credit programs on an equal footing by requiring that the cost of loan programs be calculated and recorded up

front in the years that the loan is made or guaranteed. It takes the

best information available at a given point in time to measure the

budget impact of federal loan programs. It uses the actual historical cash transactions of loan programs to compare the net present

value of payments by the government with the net present value

of receipts. This allows policymakers to make more informed decisions about credit programs and to compare more accurately the

budget impact of credit programs with other federal expenditures.

Consistent with the Budget Enforcement Act agencies must also

use the technical assumptions derived at the time of the budget’s

release for budget execution which means that they must use the

5

default and recovery rates, the discount rate, and other relevant

assumptions as provided in the budget for that fiscal year. This

protects the integrity of the analysis and protects the loan volumes

provided by Congress by removing or changing the subsidy rate estimate during or after the appropriations process.

Credit reform also requires that legislative changes to the subsidy rate be scored accordingly. Under credit reform agencies must

update their subsidy estimates each year to reflect the accurate

performance and experience in loan programs. Programs that experience higher costs than projected generate upward cost re-estimates and therefore require an additional mandatory appropriation

from the Treasury to cover those losses.

Programs experiencing lower costs and projections generate

downward cost re-estimates and therefore return excess funds to

the Treasury. These re-estimates do not require further action in

the annual appropriations process.

The Federal Credit Reform Act gives OMB the authority to make

subsidy estimates. We have in most cases delegated that authority

to the agencies but have retained the right to review and approve

all estimates submitted by the agencies as part of their budget formulation and execution. We take this role very seriously at OMB.

The staff works to ensure that estimates have been calculated in

accordance with the requirements of the Federal Credit Reform Act

and the applicable guidance issued by OMB, Treasury, the Financial Accounting Standards Advisory Board and other entities.

A large part of this role is ensuring that consistent standards are

applied. To help agencies meet these requirements OMB’s developed a number of tools to estimate and re-estimate the cost of credit programs as well as spreadsheets to assist in the end-of-year calculations. We have also provided detailed training on credit budgeting concepts and applications.

Chairman MANZULLO. How are you doing on time?

Ms. DORN. I am about out.

Chairman MANZULLO. Can you conclude there, or can you get

to——

Ms. DORN. Yes, sir. Let me just say that from our perspective we

have a good working relationship with SBA. We have worked very

closely historically on these subsidy estimates. We understand that

the Congress is concerned about the current situation and we look

forward to working both with the SBA and with the Congress to

look for ways to alleviate the stress on the system.

I look forward to answering any questions you may have.

[Ms. Dorn’s statement may be found in the appendix.]

Chairman MANZULLO. Thank you.

Mr. Barreto.

Mr. BARRETO. Thank you.

STATEMENT OF THE HONORABLE HECTOR V. BARRETO, JR.,

ADMINISTRATOR, U.S. SMALL BUSINESS ADMINISTRATION

Mr. BARRETO. Good morning, Mr. Chairman, Ranking Member

Velazquez and Members of the Committee. Thank you for this opportunity to discuss the subsidy rates for the SBA’s credit programs. I hope that my testimony and our discussion that will folVerDate 11-MAY-2000 07:29 May 18, 2002 Jkt 078663 PO 00000 Frm 00009 Fmt 6633 Sfmt 6602 E:\HR\OC\A663.XXX pfrm11 PsN: A663
6

low will clear up some of the misconceptions regarding the models

and assumptions we use to calculate these rates.

First of all, please allow me to explain——

Chairman MANZULLO. Administrator, excuse me. We just heard

the call for the vote. My preference would be for us to go vote and

then come back right away. Would that be okay with you?

Mr. BARRETO. That would be fine, sir.

Chairman MANZULLO. We will be back in about ten minutes.

Thank you.

[Off the record for a vote from 10:26 to 10:34 a.m.]

Chairman MANZULLO. Administrator Barreto, do you just want to

start over?

Mr. BARRETO. Whatever you would like, sir.

Chairman MANZULLO. We got your name. Why do you not proceed from there. Thank you.

Mr. BARRETO. Thank you, Mr. Chairman, Ranking Member

Velazquez, and Members of the Committee. Thank you for this opportunity to discuss the subsidy rates for the SBA’s credit programs. I hope that my testimony and our discussion that will follow will clear up some of the misconceptions regarding the models

and assumptions that we use to calculate these rates.

First of all, please allow me to explain what a subsidy rate is.

The subsidy rate represents the amount of appropriations necessary as a percent of total loan volume to cover the projected loan

default for a cohort of loans made in a single fiscal year. It is calculated by finding the net present value of cash flow to and from

government over the life of the loans made in that year.

A simple equation that defines the subsidy rate would set the

subsidy rate equal to cash outflows minus cash inflows. The loan

defaults purchased by SBA represents the cash outflows. The cost

is offset by the cash inflows which include up front fees from the

borrower, ongoing fees from the lender, and whatever we can recover from the purchase default which has amounted to about half

of all defaults.

In general, higher fees and lower defaults reduce the subsidy

rates and lower fees and higher defaults raise the subsidy fees.

I understand your concern why the SBA’s calculation of the subsidy rates for the 7(a) and 504 programs has seemed inconsistent

with actual performance. Nevertheless the subsidy rates reflect

SBA’s average historical performance.

The challenge we face, however, is looking into an uncertain future and predicting the average loan performance for the next cohort of loans for each year of life for that cohort. Doing so is akin

to predicting the average test score performance for the next class

of kindergartners for each year that they are in school all the way

through high school, 12 years into the future.

One approach is to predict the 13 average annual scores by using

the data from the past year’s average scores in grades K–12. This

approach is essentially the same one we have been using to estimate loan performance. We take past performance from the last 16

years to predict how the next cohort of loans going forward for 15

to 20 years will perform.

To focus more on the 7(a) program, Mr. Chairman, I realize that

for nine of the past ten years we have experienced net downward

7

re-estimates in the 7(a) program during what proved to be the most

extraordinary period of economic expansion in our country’s history. Just as the stock market grew faster than the underlying fundamentals warranted, this same phenomenon caused the SBA to

similarly underestimate the performance of its loan portfolio.

The issue in retrospect becomes whether the SBA should have

followed the path of irrational exuberance in forecasting over that

which Chairman Greenspan showed such concern or whether we

should have stayed the course and continued to rely on fundamentals. I believe that the SBA followed the more prudent course by

relying on fundamentals.

From 1993 to the present fiscal year the subsidy rate for the 7(a)

program was successfully reduced from 5.21 percent to 1.07 percent

based on historical experience.

For fiscal year 2003, SBA executed a new interim calculation

method which weights preferred lender loans more favorably than

non-preferred lender loans with improved methodologies based on

SBA’s data to reliably delineate the default experience of the two

programs.

The subsidy rate was consequently lowered by one-fifth, all the

way to .88 percent which at the President’s $85 million request for

7(a) budget authority would have funded $9.7 billion in lending.

The President’s plan was to provide record levels of lending to

small businesses. However, P.L. 107–100 subsequently reduced the

fees paid by borrowers and lenders for a two year period beginning

in October 2002 causing the subsidy rate to double to 1.76 percent.

Since this legislation doubled the cost of providing 7(a) loans the

President’s request of $85 million can only fund half as much in

7(a) lending. Nevertheless the SBA is continuing to create a more

accurate method of calculating the subsidy rate.

We work closely with the General Accounting Office and the Office of Management and Budget to determine the best way to incorporate historical data in calculating subsidy rates. While GAO ultimately disagreed with the interim method chosen by SBA and

OMB, both GAO and OMB agreed with SBA that the econometric

approach is the best method to use.

We all agreed that a sound methodology adequately addresses

economic fluctuations and programmatic changes while remaining

unbiased, producing subsidy estimates that are just as likely to be

revised upward as they are downward over a long term period of

time. An econometric model is a more sophisticated weighting

method than the PLP weighting model as it creates a way for each

relevant factor and estimates the subsidy rate based on the relative

strength of these weights.

I am confident that our implementation of the econometric model

in fiscal year 2004 will resolve many of the concerns you have. It

is a proven model. As I stated, OMB and GAO both agree that it

is the most appropriate method to use and other federal agencies,

including the Federal Housing Administration and the U.S. Department of Education already use it to calculate the subsidy rates

for their credit programs.

To implement the model the SBA has contracted with the Office

of Federal Housing Enterprise Oversight or OFHEO, an agency

8

which uses such a model to monitor the housing credit markets

and the performance of mortgage loans.

Mr. Chairman, Ranking Member and Members of the Committee, thank you for the opportunity to appear here today. I will

be happy to answer any of your questions.

Thank you.

[Mr. Barreto’s statement may be found in the appendix.]

Chairman MANZULLO. Thank you.

Our next witness is Christopher Crawford who is the Executive

Director of the National Association of Development Companies.

We look forward to your testimony, Mr. Crawford.

STATEMENT OF MR. CHRISTOPHER L. CRAWFORD, EXECUTIVE

DIRECTOR, NATIONAL ASSOCIATION OF DEVELOPMENT

COMPANIES

Mr. CRAWFORD. Good morning. I am pleased to again come before

the Committee to comment on the SBA 2003 budget model and

subsidy assumptions. I would like to thank you Chairman Manzullo, Ranking Member Velazquez and the Committee for convening this hearing.

The 2003 budget adds to the injustices of the past budgets by

again forcing our borrowers to pay millions of dollars in fees to the

U.S. Treasury. It appears it will take this Committee’s oversight to

motivate the Administration to stop using these loan programs to

cover deficits.

This budget increases the annual fee charged each 504 small

business borrowers from .410 to .425 percent. The program is supposed to pay for itself through these fees, and it does this and far

more.

Since we went to zero subsidy in 1997 borrowers have paid the

Treasury $400 million in excess fees and interest according to

SBA’s own re-estimates. Even paying fees over and above these inflated cost estimates the Administration demands still more from

small business by increasing the fee for 2003. This is truly an unwarranted tax on our borrowers.

This fee increase is caused by errors we believe SBA and OMB

are making in their assumptions and their forecasts.

First, the estimate of loan defaults is 8.3 percent. Attached to my

statement that you have been provided are charts that show loan

defaults for the past 12 years are nowhere near eight percent.

The President’s own budget supports our estimates, not SBA’s

forecast.

Page 49 of the budget request and performance plan admits the

true defaults are running $60 to $70 million annually, at an annual

volume of $2 billion or more defaults are averaging under five percent.

Second, SBA loan recovery forecasts do not match actual performance through the asset sales or our CDC liquidation program.

They forecast collection of 58 cents of every dollar on defaulted

loans. However, SBA also forecasts they will spend 38 cents to

make that recovery leaving a net recovery of only 20 cents of each

dollar.

Our CDC liquidation program has averaged 55 percent recovery

since it began some three years ago. At the same time SBA states

9

they are recovering 50 percent for loans sold through their assets

sales.

I have to ask you, where did the money go? It did not go into

the recovery expenses for either the liquidation program or the

asset sales since neither program has substantial operating costs.

Third, we believe SBA is using erroneous forecasts of future loan

prepayments. We are funding 504 loans today at a record low market rate, often below six percent. Even with servicing and SBA fees

added on, borrowers will obtain long term rates that they are not

likely to want to pre-pay in future years. I believe pre-payments

will in fact go down, not increase for this cohort.

Finally, even the SBA recognizes that they are not doing a good

job of forecasting our portfolio performance yet their solution is to

change the subsidy models rather than improve their data analysis.

They plan to spend the next five years building and debugging a

new econometric model that was actually created to reflect housing

costs, not commercial lending costs. This process will consume

time, money and resources to get it right and give the Administration further excuses for continued subsidy errors.

Our subsidy problems have led to inflated fees and has made 504

truly a Treasury cash cow as Ms. Velazquez pointed out. Borrowers

are paying hundreds of millions of dollars in excess fees and are

now told that they are going to pay even more for the 2003 cohorts.

We strongly object to this budget proposal and we need your

help. I ask this Committee to get to the bottom of the Administration’s questionable assumptions. Without your intervention I fear

that our small business borrowers will continue to pay excessive

fees for years to come.

Thank you for this opportunity to provide comments.

[Mr. Crawford’s statement may be found in the appendix.]

Chairman MANZULLO. Thank you.

Our last witness is Anthony Wilkinson, President and CEO of

The National Association of Government Guaranteed Lenders.

Mr. Wilkinson.

STATEMENT OF MR. ANTHONY R. WILKINSON, PRESIDENT

AND CHIEF EXECUTIVE OFFICER, THE NATIONAL ASSOCIATION OF GOVERNMENT GUARANTEED LENDERS, INC.

Mr. WILKINSON. Thank you, Mr. Chairman, Ms. Velazquez, and

thank you for holding today’s hearing.

As we all know, users of SBA loan programs have been substantially overcharged the last decade. In the case of the 7(a) program

OMB admits through the budget process that the overcharge or the

downward re-estimate in the 7(a) program totals $1.429 billion. I

have listed these downed re-estimate amounts on page one of my

written testimony.

On page two of my written testimony is another page that discloses that OMB has not been forthcoming in the re-estimate process. This shows that OMB requires the use of rates in the re-estimate process that are higher than what is statistically expected.

Had OMB used the expected default rates in the re-estimate process they would recognize an additional $400 to $600 million in

downward re-estimates in the 7(a) program. This would bring the

total overcharge to approximately $2 billion and it was $2 billion

10

that OMB’s representative admitted to at the Senate Roundtable

discussion that was held last September. That is $2 billion since

the start of credit reform in 1992, or on average a $200 million per

year overcharge.

Now let us take a look at the current year. OMB is estimating

defaults at 12.73 percent, a number that has not been seen over

the last decade. We know from the Senate Roundtable last year

that SBA had recommended using a five year look-back period, a

method that SBA believes would have been more predictive of near

term loan performance. OMB rejected this, and OMB rejected each

of the other six methods that were proposed, deciding to stick with

the method that provided the highest default estimate and hence

the highest costs to 7(a) program users.

In a previous hearing before this Committee SBA testified that

the default rate for the 7(a) program was being managed in the

eight to ten percent range. If OMB were to use a more realistic default assumption for fiscal 2003 we believe the subsidy rate would

fall by approximately 100 basis points or one percent. That would

leave a 7(a) subsidy rate of approximately .76 for fiscal 2003 and

we would need appropriations of about $91 million to meet the anticipated demand for next year.

Now considering the $2 billion that has been overcharged, users

of the 7(a) program have already sent enough money to the Treasury to fund the next 20 years worth of 7(a) loans. That is just not

reasonable.

Mr. Chairman, NAGGL has repeatedly said that we do not care

what model OMB uses in calculating subsidy rates but we do believe the resulting calculation should be fair and reasonable. We

have never demanded that it be totally accurate, just reasonable.

We believe that there should be an equal likelihood that the reestimates could be revised upward as well as downward.

It is obvious that the calculation to date has not been fair or reasonable. OMB has been levying taxes on 7(a) program users. We

start fiscal 2003 with a default estimate of 12.73 and we know we

are going to have a down re-estimate as soon as the year ends. The

same thing is going to happen for this current fiscal year because

they used a default estimate of 13.87, so we will have a downward

re-estimate.

I direct your attention to the subsidy rate re-estimate for loans

that were originated just in fiscal year 2001. OMB says that the

subsidy rate has already fallen by 40 percent, from 1.17 to .71 during the fiscal year. Many of the loans approved in fiscal year 2001

had not even been disbursed by the time they figured out they have

over-estimated the cost of loans made in fiscal 2001.

In Mr. Barreto’s testimony today he cited that all but one of the

years there had been downward re-estimates in the 7(a) program.

The very first re-estimate in 1995 was an upward one. OMB used

this upward re-estimate to pitch the need for higher fees in 1996.

Unfortunately, we had to go along so in 1996 the 7(a) program incurred a huge fee increase, one that we know now was not needed.

As a result of the 1996 fee increases many lenders over time exited

the program. Fortunately Congress saw how OMB was taxing 7(a)

program users and you passed fee reduction legislation last year.

That legislation eliminated only about half of the 1996 fee increase

11

that was not needed. Hopefully we can consider further cost reductions and hopefully get the ratio of downward re-estimates to appropriations down to ten years rather than the current 20.

Lastly I would like to share our concerns over the move to the

so-called econometric model. The current model used by SBA is a

simple net present value cash flow model. It is fairly easy to understand. But the 7(a) subsidy calculation is not driven by the model,

it is driven by the assumptions plugged into the model. OMB could

have easily had a subsidy calculation that was fair and reasonable

simply by adjusting assumptions. They had recommendations from

SBA and GAO and they chose to ignore them.

We believe an econometric model will be much harder to understand, one; and two, will have many more factors that will be driven by OMB assumptions.

To put it in simpler terms, we have cracked the old black box

and figured out what OMB was doing. But now they plan to build

a new black box so they can continue to overcharge users of the

program.

Mr. Chairman, OMB has not been held accountable for the decisions they make in the subsidy calculation process and until they

are we fear the overcharges will continue. OMB had every reason

to adjust its assumption in the fiscal year 2003 budget. There were

mandates from both the Senate and House Small Business Committees, Republicans and Democrats alike. There was report language in the fiscal 2002 Treasury Postal Appropriation Bill and I

can go on and on. Let me just say they chose to ignore it all.

Instead OMB tries to shift the focus of the discussion away from

them and talk about how Congress is to blame for the fiscal year

2003 budget shortfall and how we should all wait another year

while they build their new black box.

Mr. Chairman and Members of the Committee, SBA program

users need your help. It is clear they have been taxed by OMB. It

is clear that OMB has not had any desire to fix this problem. They

have made mockery of the Federal Credit Reform Act and as a result have made the appropriation process very inefficient.

It is time, this fiscal year, right now, for a solution. We believe

OMB accountability has got to be a big part of that solution.

Thank you, Mr. Chairman.

[Mr. Wilkinson’s statement may be found in the appendix.]

Chairman MANZULLO. Thank you all for your testimony.

I have just a couple of questions of Nancy Dorn.

I do not know if I heard this right, but maybe it is reflected on

page two of your statement under, see where it says federal credit

reform about a third of the way down, the heading?

Ms. DORN. Yes, sir.

Chairman MANZULLO. It says the Federal Reform Act—Wait a

second. I’m sorry. I am on the first page.

The first page, second full paragraph. ‘Before I begin’.

Ms. DORN. Right.

Chairman MANZULLO. ‘Before I begin let me say it is unfortunate

that the premature release of preliminary and incomplete estimates for SBA’s 7(a) business loan program may have led to realized expectations.’ Unrealized expectations.

12

Can you explain what you mean by that? I guess first I have to

read it right, but can you explain what you mean by that?

Ms. DORN. Mr. Chairman, I think there was some confusion in

the last year. This was certainly before I came to OMB, but I think

there was some confusion last year about what the calculations

that SBA and OMB were going to lead to in the subsidy rate. I

think there was some thought that we were going to reduce the

subsidy rates but that the reduction would be greater than what

it turned out to be.

Chairman MANZULLO. What caused that? Mr. Blanchard, were

you familiar with what happened there? Did you want to comment

on that?

Mr. BLANCHARD. Yes, sir.

Chairman MANZULLO. That was before Mrs. Dorn’s tenure.

Mr. BLANCHARD. Yes, sir, Mr. Chairman. I am familiar with

what happened.

The staff members of the House and the Senate Small Business

Committees were eager to learn what the subsidy rate would be

using this new model for 2003 before we actually completed the

budget and the estimation of this rate.

At the time, sir, I was at OMB working on this particular issue

and——

Chairman MANZULLO. You briefed us in our office on this, too.

Mr. BLANCHARD. Yes, sir.

I resisted providing a point estimate of what that would be because we simply did not know. We had preliminary analysis. We

had done that to try to see whether this model, this new interim

model would actually perform as well as we think it is performing.

But at the time I was being pushed by staff members to provide

some kind of estimate just so they could have a sense of where it

would be.

In my haste I gave them a range of estimates just to satisfy

them, really trying to be forthcoming with information and to work

closely with our legislative partners in providing that range, sir.

That was then taken as fact. They sort of banked on that, so to

speak. I think that banking led to some preliminary calculations

for the Senate Bill 1196 that——

Chairman MANZULLO. Did that have anything to do with the estimated amount of so-called budget surplus?

Mr. BLANCHARD. I am not sure what you are referring to with

regard to the budget surplus.

Chairman MANZULLO. In other words, when the subsidy rate is

set, or calculated, does that have anything to do with the general

gross revenues that come into the government?

Mr. BLANCHARD. The subsidy rate does indeed have something to

do with that—As Administrator Barreto mentioned earlier in his

testimony, the subsidy rate is essentially a prediction of the appropriations that are necessary to cover defaults. Without knowing

what those defaults would be, we simply make a prediction. As

time goes on we learn more about that default behavior and then

we adjust what is held in the account to cover those defaults. So

it adjusts upwards and downwards. Unfortunately the adjustments

have been such that it has created this surplus that has gone back

to the Treasury over——

13

Chairman MANZULLO. You answered about 80 percent of the

question. Let me follow up and maybe get more particular.

Does the estimated amount of surplus in general revenue of the

government have anything to do with calculating the subsidy rate?

Mr. BLANCHARD. No, sir. Not at all.

Chairman MANZULLO. Totally separate.

Mr. BLANCHARD. Yes, sir.

Chairman MANZULLO. The reference that Ms. Dorn made to the

premature release of preliminary and incomplete estimates for

SBA’s 7(a) business loan programs, that was reference, Dr. Blanchard, to a September 5th Roundtable that you had had with the

Senate?

Mr. BLANCHARD. No, sir. Actually that was subsequent to that

Roundtable.

Chairman MANZULLO. Because at that Roundtable, that is where

you had said the history of this program is one that has had an

unfortunate one. ‘The Administration has worked in its first year

to correct this problem and it is one that we inherited that as you

have all mentioned is a serious problem. WE recognize that over

the past 10 to 12 years there is a cumulative $2 billion that has

gone back to the Treasury.’

The last part of that is correct, is it not? The accumulated——

Mr. BLANCHARD. I actually do not think that is correct. I believe

it is $1.4 billion as Mr. Wilkinson referred to in his testimony.

Chairman MANZULLO. $1.4 as opposed to $2 billion.

Mr. BLANCHARD. Correct.

Chairman MANZULLO. Because you did not have the figures in

front of you at the time and I can understand that. That must have

been the case.

Mr. WILKINSON. I would add on to that, there was a sheet in my

testimony called Unweighted Purchase Rates that goes through the

rate they use in the re-estimate process, yet the rate that they expect in terms of defaults are much lower than they are using in the

re-estimate process.

So while $1.429 billion has been recognized, it is anticipated

there is going to be another $400 to $600 million that will be downward estimated in the future.

Chairman MANZULLO. Thank you.

Let me give you a very simplistic situation here. I am not into

macroeconomics, I am into microeconomics. If you are the one that

loses your job you could care less about whether or not the rest of

the neighborhood is working.

Let us take a look at a loan that goes to A Corporation, and let

us say this loan is $100,000. Figure for me, and you do not have

to give the exact figure, but work through with me how you would

figure the subsidy rate just on this one loan. However you want to

do it. Explain the elements and kind of give me a rough idea.

Mr. BLANCHARD. Okay.

The subsidy rate is calculated before loans are made. What we

are trying to do is estimate for fiscal year 2003, when we make

that $100,000 loan and many more of those loans, what will be the

default rate?

Chairman MANZULLO. You want to set aside a pocket of money

to cover what could be a loss.

14

Mr. BLANCHARD. That is right.

Chairman MANZULLO. That is really what the subsidy rate is.

Okay, go ahead.

Mr. BLANCHARD. That is right.

Based on the historical performance of loans of similar sorts, we

estimate in advance what that default would be. Not only in the

first year of that loan, but in the first, second, third, and throughout the life of the loan.

Chairman MANZULLO. With regard to the 7(a) and the 504 programs, are there different categories of default? Is it based upon

the nature of a business or is everything lumped together in the

7(a) and the 504?

Mr. BLANCHARD. As it has been calculated in the past up to FY

03, all 7(a) loans have been treated the same in that calculation

and all the 504 loans have been treated the same in that calculation.

Chairman MANZULLO. Then on the first element, the default

rate, I am trying to find out where there are areas of agreement

and where there are areas of disagreement, and maybe that is

where we can hone in.

Is there disagreement as to the default rate that occurs with

these loans?

Mr. BLANCHARD. Yes.

Chairman MANZULLO. Not a very good start, is there.

Dr. Blanchard or Administrator Barreto, however you want to do

it. Let us take it element by element and let us see——

Mr. BLANCHARD. We disagree in what the default assumption

should be, sir.

Chairman MANZULLO. Okay. Walk me through that.

Mr. BLANCHARD. Our estimate of the default rate is based on the

average performance of all of the loans that have been made from

1986 to the present date, so data up through 2001.

Chairman MANZULLO. Mr. Wilkinson, what is yours based on?

Mr. WILKINSON. The performance of the program since——

Chairman MANZULLO. What do you think it should be based on,

sorry?

Mr. WILKINSON. Since the start of credit reform, when credit reform started there were substantial programmatic changes. The

program that existed in 1986 is not the program that exists today.

Chairman MANZULLO. Why is that?

Mr. WILKINSON. Lenders have a much greater investment in the

loans today, the guaranteed percentages have declined, the lenders

have to pay an ongoing fee that was not there in 1986. So there

is a much greater financial interest of the lender in the loan program today.

Chairman MANZULLO. Do you agree with that, Dr. Blanchard?

Mr. BLANCHARD. I do agree that the program has changed, which

is precisely why we are weighting the PLP loans differently than

the non-PLP loans for fiscal year 2003.

Mr. WILKINSON. The default rate that they attach to PLP loans

is higher than any default rate we have seen since 1991. They are

using 11 point, it is over 11 percent default for PLP in the

weightings they are using this year and anticipated defaults in the

2000 cohort is 8.1.

15

Chairman MANZULLO. So Dr. Blanchard you are going back to

1986 and you are averaging all the loans since that time to come

up with the——

Mr. BLANCHARD. That is correct.

Chairman MANZULLO. You are saying that about 11 percent of

the loans that default or 11 percent of the amount of money loaned

has been in default?

Mr. BLANCHARD. We are saying 11 percent of the SBA’s portion

of the outstanding——

Chairman MANZULLO. Okay. It is based on money, not the numbers of the loans.

Mr. BLANCHARD. That is correct.

Chairman MANZULLO. Mr. Wilkinson, what is wrong with that

average?

Mr. WILKINSON. First of all they do a simple average. There were

some——

Chairman MANZULLO. I prefer to keep things simple. That is why

I am going through this step by step. But what is wrong with simple average?

Mr. WILKINSON. First of all, it is an arbitrary point in time. They

picked in 1986 because that is where they start with their data.

Chairman MANZULLO. Dr. Blanchard, he said that 1986 is an arbitrary date.

Mr. BLANCHARD. Sir, we have a chart that can help illuminate

it a little more easily.

Chairman MANZULLO. That would be fine.

Mr. BLANCHARD. This takes us down into averaging. Let me set

up the chart.

Chairman MANZULLO. Mr. Barreto, I did not mean to ignore you,

I just left it up to you as to who would answer the question.

Mr. BARRETO. I brought my expert this time.

Chairman MANZULLO. That is fine.

Mr. BLANCHARD. Mr. Chairman, we thought that you might want

to know precisely how this model works, so we built a graphic that

walks you through the cash flow model.

Now it is important to recognize, sir, that the projection of the

default rate is something that we do outside of this model. As our

industry partners mentioned earlier, the main assumption is the

default rate.

Without knowing what the default rate will be in the future, the

best evidence we have is that of the past. What we are going to

do in the future with regard to our calculation method, the econometric model will calculate the default rate. What you do is separate the estimation of the default from the estimation of the subsidy rate. The default is an assumption that drives the subsidy

rate.

Chairman MANZULLO. The reason I went through that is I

thought I would be a nice guy and try to find certain areas where

people agree on getting to this.

Before you do that, Dr. Blanchard, is it the default rate that is

the most contentious of the four items in here?

Mr. BLANCHARD. Yes, sir.

Chairman MANZULLO. Then I guess I started with the right one.

Mr. BLANCHARD. You sure did.

16

Chairman MANZULLO. How do you want to do that?

Mr. BLANCHARD. As you see in front of you there are basically

three components to that. Obviously taxpayers pay taxes into the

Treasury so that is an important component on the back end. But

the outflows, remember that the basic equation here is that the

subsidy rate equals the cash that goes out minus the cash that

comes back in. The cash that goes out, the only cash that goes out

in these loan programs are our purchase of the defaulted loans.

This number says that our expected default rate is 8.2 percent.

This is of all outstanding loans. This number is equivalent to the

12 percent assumption that Tony mentioned that is a proportion of

SBA’s guaranteed portion. I do not want to confuse anybody. But

that sets the outflows.

Then we collect fees from the borrowers, we collect fees from the

lenders, and then we recover some of those defaulted loans. You

see the arrows point to that outflow and inflow. That then tells us

how much money we have to set aside in the form of appropriations to pay for the rest of the program. That is all this model

shows you, sir.

You see that the arrows and the numbers that are attached to

them are also maps to the equation at the bottom of that page.

Chairman MANZULLO. Mr. Wilkinson, do you have a problem

with this chart? Or just with the assumption of the default rate?

Mr. WILKINSON. It is the assumption of the default rate. The arrows are right. That is how the cash flows in and how the cash

flows out.

Chairman MANZULLO. Okay.

Tell me again, why you think that? What Dr. Blanchard is telling

us is that they go back to 1986 and take the average default rate

of the amount of money SBA puts out.

Mr. WILKINSON. It is a simple average going back to 1986. It ignores the program changes that have occurred since 1986.

They have testified that this program is being managed in——

Chairman MANZULLO. What are those program changes since

1986 that you think should do away with simple averaging?

Mr. WILKINSON. Fees have gone up, lenders have seen the guarantee percentage decline. Remember, there was a point in time

there was 90 percent guarantee. The average guarantee since 1986

has gone down.

So again the lender has more at risk in each of these deals.

Chairman MANZULLO. Let me stop you right there.

Dr. Blanchard, those two elements he just put in, why should

they not be figured into the simple averaging?

Mr. BLANCHARD. Before the calculation for the model in 2003

there was no incorporation of the programmatic changes. He is correct in that regard. That is why we have gone to this method of

weighting the PLP loans, which is the programmatic change that

he is referring to, it is different than the way we weigh the nonPLP loans.

Chairman MANZULLO. So are you agreeing on the subsidy rate

for what OMB wants to do for 2004?

Mr. WILKINSON. I do not have a clue what they are doing for

2004. There has been no——

Chairman MANZULLO. 2003, I am sorry.

17

Mr. WILKINSON. Am I agreeing to that subsidy rate? Absolutely

not.

Chairman MANZULLO. Dr. Blanchard just said that before 2003

they did not take into consideration programmatic changes, but

after that date they do take that into consideration.

Mr. WILKINSON. In my opinion the change they made for fiscal

2003 is simple window dressing.

It made a minor change but did not address——

Chairman MANZULLO. Yes, but he said that they take it into consideration in 2003. So there has been apparently a major change

in the manner of the calculations. Would you disagree with that?

Mr. WILKINSON. I disagree. There has not been a major change.

Chairman MANZULLO. Dr. Blanchard, is there a document that

has been generated that shows that those elements that Mr.

Wilkinson says are the program changes? Is there a document that

shows that those have been taken into consideration for 2003?

Mr. BLANCHARD. Yes, sir. That document is the President’s budget.

Chairman MANZULLO. Okay.

Do you agree with that, Mr. Wilkinson?

Mr. WILKINSON. I will agree that they made some changes in

2003 as it was from 2002, but the changes are very minor.

Chairman MANZULLO. Can you show us that section from the

budget? Does anybody have it handy there?

Mr. BLANCHARD. What we did, I do not have it handy, sir, but

I can tell you that in fiscal year 2002 the subsidy rate was 1.07

percent. Our calculation in implementing this new method that

weights the PLP loans differently from the non-PLP, reduced that

subsidy rate to .88 percent. That is a one-fifth reduction in the subsidy rate, sir. That is about a 19 basis point reduction in the subsidy rate. That is how significant this model reduced that subsidy

rate.

Chairman MANZULLO. Do you agree that it is a reduction, Mr.

Wilkinson?

Mr. WILKINSON. First of all, the 1.07 was too high. A 19 basis

point shift when there has been $1.4 billion——

Chairman MANZULLO. He is saying it is going in the right direction.

Mr. WILKINSON. It has been going in the right direction for a decade. Very slowly. And we know that if they start the year with a

12.73 percent default rate we are going to have a downward re- estimate at the end of the year. WE are going to have one this year.

Chairman MANZULLO. So you are saying that even though it is

a reduction, that the reduction still is not——

Mr. WILKINSON. WE would have to have——

Chairman MANZULLO [continuing]. Default range.

Mr. WILKINSON [continuing] A major downward turn in the performance of 7(a) loans to come close to the default estimate in the

model. That to me is the real issue.

Chairman MANZULLO. Would you agree with that, Dr. Blanchard? This is sort of interesting, going back and forth here,

but——

18

Mr. BLANCHARD. A hyperbole of that statement I can accept, but

history has shown that we will not have another year like all of

the extraordinary years that we had in the late 1990s.

Chairman MANZULLO. Okay.

Ms. VELAZQUEZ. And even with all those extraordinary years

that you had in the late 1990s you did not do the right thing in

terms of fixing the subsidy rate.

So Mr. Barreto, I believe we need to get one thing straight, and

that is the notion which the Administration keeps saying that

somehow this mess we are in is due to congressional actions aimed

at giving small businesses some relief from being overcharged by

program fees.

So that we are clear, it is our job, Congress’ job, to legislate.

Based on the past record of the programs that participants were

being grossly overcharged, we legislated a program change.

It is the Administration’s job to implement that change. So you

knew what the subsidy rate will be and you choose to fund the program at half this level.

So if you are looking to place the blame somewhere, look no further than the table where you and Ms. Dorn sit, because it lies

right there.

So my question to you is, you have this legislated change for

three months before the budget was released. Why do you choose

not to go back and fix it?

Mr. BARRETO. Thank you, Mrs. Velazquez for the question. I appreciate it.

At no time are we trying to affix blame or point the finger. I

think one of the things we are trying to do is clarify.

There is this misperception out there that the President and the

Administration chose to cut the 7(a) program in half and as we——

Ms. VELAZQUEZ. But that is exactly what you did.

Mr. BARRETO. But as we indicated before, with the subsidy rate

going down to the .88, which we were very happy about being able

to get down to .88, with the current President’s budget, that would

have been able to provide for a $9.7 billion——

Ms. VELAZQUEZ. Excuse me. We changed the fee. You did not. We

did it.

Mr. BARRETO. Yes.

Ms. VELAZQUEZ. And then you chose.

Mr. BARRETO. The budget had been completed before the time

this legislation actually went into effect. But again, what we are

trying to do is clarify the record to reflect that our intention was

to have $9.7 billion available for 7(a) lending.

Ms. VELAZQUEZ. Mr. Barreto, you could spend the whole morning

here giving me a nice explanation but you do not answer my question.

My question is why you, if you had three months to fix the subsidy rate, you did not.

Ms. Dorn, why did you not?

Ms. DORN. I think the point that we would make is three are sort

of three components to this. One is the establishment of the subsidy rate which is based on criteria. There has been some discussion about the kind of criteria that goes into the calculation. You

look at the history of the program, you look at the actual loans that

19

have been defaulted on, and you, as was pointed out, we have actually taken into account the fact that the preferred lenders’ default

rate has been less. That was cranked into the formulation.

So for over a year we established a subsidy rate, and that is a

separate exercise from either the establishment of the fee, which

you point out Congress changed last year. And then the issue of

the appropriation that we put against the program.

Ms. VELAZQUEZ. Let us move to the next question.

I am sure you have heard the accusations that OMB is using

phony numbers to inflate the loan program subsidy rate. How do

you respond to that?

Ms. DORN. Well Congresswoman, I understand the frustration

that people feel when they see the history of this program, and I

looked at the numbers of the loan subsidy rate and the re-estimates over the last years going back to fiscal year 1992 and I can

say the program is not perfect.

You can see by looking at the re-estimates that over the last several years the margins are falling and they are falling rapidly.

For example in 1992 they missed it by $200 million. In fiscal

year 2000 we missed it by $2 million. So there is some refinement

going on in how we calculate the subsidy rate, and I appreciate the

frustration that people fee.

I think we are making some progress.

Ms. VELAZQUEZ. Let me ask this question. Since the late 1990s

SBA has engaged in the practice of selling defaulted 504 loans

through asset sales. The track record for this has been a net recovery rate of approximately 50 percent. However in the Administration’s recent budget you include in that recovery an assumption of

just 20 percent. Where did the 30 percent go and how do you justify it?

Ms. DORN. I will have to turn to Hector for that.

Mr. BARRETO. On the asset sales that we do, it includes

many——

Ms. VELAZQUEZ. Excuse me, Ms. Dorn. It was not SBA, it was

OMB that established the 20 percent. The 30 percent. It is not

SBA, it is OMB. Is not OMB the one saying it?

Ms. DORN. Well, OMB is indeed the place where the budget

comes from, but we work very closely with——

Ms. VELAZQUEZ. Mr. Crawford, could you please tell me if this

does not sound like a phony number to you?

Mr. CRAWFORD. Yes, ma’am. I would have to agree with you that

the numbers are certainly strange.

If you look at the growth collection rate it is running downward

from 67 to 58 percent. The expense rates are running nearly 40

percent. They are recovering a net of 20 percent.

If you look at the asset sales, there have been five asset sales to

my understanding. They have sold a total of about 1300 loans that

have gone bad. In our entire program since 1986 they sold nearly

900 notes related to those 1300 loans and their own numbers are

a net recovery of 50 percent.

So I do not understand how you get from 50 percent to 20 percent. What happened to the other 30 percent?

20

Ms. VELAZQUEZ. Ms. Dorn, if we were to assume a 50 percent recovery rate, maybe he would be able to answer this question when

she finishes.

If we were to assume a 50 percent recovery rate that has been

the historical trend, what would the subsidy rate be?

Ms. DORN. I am sorry, Congresswoman, I do not know the answer to that question.

Ms. VELAZQUEZ. Do you have the answer to that question?

Mr. BARRETO. What I would like to do is give Dr. Blanchard another opportunity to explain that. It is a very important question

in front of us right now about how that is determined and what

happened to that other 30 percent as you mentioned.

Mr. BLANCHARD. Ms. Velazquez, Mr. Crawford’s point about

asset sales, and incorporating our 50 percent return on asset sales

into recovery for the 504 program, we are comparing apples to oranges.

He is talking about the recovery for one loan program. The asset

sales program engages in sales of products or assets from many of

our loan programs. So that 50 percent recovery rate is a combined

recovery rate from multiple loans of which 504 loans, defaulted 504

loans are only a small percentage.

Ms. VELAZQUEZ. Can you tell me what the rate would be if you

have a recall rate of 50 percent?

Mr. BLANCHARD. No, I cannot tell you that right off the——

Ms. VELAZQUEZ. Mr. Crawford.

Mr. CRAWFORD. It looks to me like it would probably go, it would

probably cut the borrower fee by probably close to 60 percent which

would lead to a borrower fee probably in the .25 down from .42. So

it would be a pretty substantial cut in the actual fee.

I would like to make a statement regarding Lloyd’s comments

about the asset sales.

It is my understanding that each of the asset sales consisted of

a significant number of pools, each of which had homogeneous assets in those pools. In other words they did not want to sell short

term notes and long term notes because Wall Street is not going

to pay a lot of money for that kind of a pool.

Wall Street is going to look for a pool of loans or notes or collateral that is fairly consistent, and it is my understanding that our

real estate notes as well as the real estate notes of 7(a) were put

into similar pools and a fairly discreet number of pools.

Now the number that I use, the 50 percent, I was told by an SBA

manager that that was in fact the recovery rate, the net recovery

rate for 504 specifically, not for 7(a), not for disaster loans but 504.

Ms. VELAZQUEZ. Thank you.

Ms. Dorn, last year when Mr. Blanchard testified before the Senate, he stated that once the President’s budget proposal is submitted to Congress the assumptions contained in the budget cannot

be changed for subsidy rate purposes. Is that your position as well?

Ms. DORN. Congresswoman, the Federal Credit Reform Act specifically directs that that is the case.

Ms. VELAZQUEZ. What is the 7(a) default rate assumption used

in determining the program fiscal year 2003 subsidy rate?

Ms. DORN. Congresswoman, as I think we previously testified, we

used the subsidy rate of .88 for the 2003 budget.

21

Ms. VELAZQUEZ. It wasn’t 12.73?

Mr. BARRETO. For the default rate?

Ms. VELAZQUEZ. The default rate.

What is the subsidy rate?

Ms. DORN. The subsidy rate is .88. I’m sorry, Congresswoman.

Ms. VELAZQUEZ. So the default rate for the——

Ms. DORN. I am sorry, I have been corrected. The subsidy rate

is 1.76 in 2003 I am told.

Ms. VELAZQUEZ. So the default rate is 12.73. Is that correct?

Ms. DORN. That is correct.

Ms. VELAZQUEZ. That is why I am so puzzled. Because when you

look at the default rate assumption for the 7(a) program containing

Table Six of the credit supplement to the President’s fiscal year

2003 budget it is a default rate of 9.38.

So which is it? 12.73 or 9.38?

Mr. BARRETO. Congresswoman, what I have just been told is that

there was a typo in——

Ms. VELAZQUEZ. Oh, a typo.

Mr. BARRETO. There was a typo in that budget.

Ms. VELAZQUEZ. So what is it?

Mr. BARRETO. It is 12.73.

Mr. WILKINSON. I would direct your attention to the chart on the

wall that says 8.19.

Chairman MANZULLO. I have 9.38 on the budget.

Ms. VELAZQUEZ. Tony, would you please explain this type of

phony number here?

Mr. WILKINSON. It is real interesting. The credit supplement does

contain the 9.38 default assumption which we would believe would

be in the correct range of default that this program has been managed to. But it has on occasion been very difficult to get a straight

answer on some of the information.

Again you look at a 9.38 in the credit supplement. They have a

chart up here that says 8.19. The default estimate in the subsidy

models show the 12.73.

Ms. VELAZQUEZ. Ms. Dorn, let us see if we find some more typos.

Let us look at Table Six of the credit supplement. If you look at

the default rate assumptions for 504 it is 8.32 percent. Is that correct?

Ms. DORN. I do not have that table in front of me.

Mr. BARRETO. That is a correct number.

Ms. DORN. 8.32 is correct according to the Administrator.

Ms. VELAZQUEZ. So we do not have a typo there.

Ms. DORN. No.

Ms. VELAZQUEZ. Okay, good.

But if you look at page 49 of SBA’s budget request you state for

the 504 program, and quote, ‘‘Default amounts to about $60 to $70

million annually.’’ With 504 loan volume averaging approximately

$2 billion for the last several years this $60 to $70 million in annual defaults would equate to a default rate of approximately three

to four percent, not 8.32 percent.

That cannot be right.

Ms. Dorn, how does OMB get 8.3 percent for a default forecast

given the $60 to $70 million forecast in the budget?

22

Ms. DORN. Congresswoman, I would refer back to Dr. Blanchard’s testimony about how these loans are calculated using historical data and historical default rates.

Ms. VELAZQUEZ. Mr. Crawford, maybe you will be able to explain

that.

Mr. CRAWFORD. Yes, ma’am.

I do not have a fancy chart like that because I cannot afford it,

but I have a little chart that I put in the back of my testimony that

has the real historical default rates for our program. These numbers are not projections. They are taken from our trustee, the Bank

of New York, so they are real, honest to goodness numbers.

I decided to plot a little curve against those default rates, and

that is that heavy black line. It seems to indicate that the default

rate for the last 12 years has been running anywhere from three,

3.5, four, 4.5 percent.

Ms. VELAZQUEZ. Not eight percent.

Mr. CRAWFORD. Not 8.3 percent. So I have no explanation for

where 8.3 comes from.

Chairman MANZULLO. Can I go to Ms. Napolitano before we——

Ms. VELAZQUEZ. Let me, just one more question.

Chairman MANZULLO. Okay.

Ms. VELAZQUEZ. Ms. Dorn, I guess Mr. Crawford that these again

sound like phony numbers.

But Ms. Dorn, you stated earlier that OMB was not using phony

numbers, but how can you say that when you are using incorrect

recovery, incorrect loss levels, and incorrect defaults?

The last company that kept their books like this was a little company in Texas, Enron. And you know what happened to them.

So how can you sit before this Committee and tell us this garbage with a straight face? Because it does not matter what model

you use. If you put garbage in you will get garbage out, and that

is what we have seen here today.

Thank you, Mr. Chairman.

Chairman MANZULLO. I would like to go to Ms. Napolitano.

Somewhere during the course of this I would like to know if the

SBA ever advised this Committee that there was a typo error in

this budget. Was that ever done?

Mr. BLANCHARD. I am embarrassed to say, Mr. Chairman, that

I just realized it today.

Ms. VELAZQUEZ. Really?

Chairman MANZULLO. Okay.

Ms. Napolitano?

Ms. NAPOLITANO. Thank you, Mr. Chair. I am enjoying the questioning that our Ranking Member is doing. I hate to interrupt her

as she is on a roll.

But I would like to ask one of the questions that has kind of puzzled me, and this is Ms. Dorn’s testimony, on her page, probably

about page four in the OMB’s ruling implementing FCRA. And I

direct you to paragraph two. The second sentence starts off, ‘Staff

worked to ensure the estimates have been calculated in accordance

with the requirements of FCRA and applicable guidance issued by

OMB, Treasury, Financial Accounting Standards Advisory Board

and other entities. A large part of its role is ensuring that consistent standards are applied to similar programs,’ and it goes on.

23

How do you use the same standards for the SBIC program as you

do for the 7(a) and/or the 504? Is that correct? Do you use the same

standards?

Ms. DORN. We use similar inputs, Congresswoman.

I think one of the issues here is how we have gotten to the subsidy rate. We had a long discussion about that. One of the issues

that we talked about is the historical performance of loans and the

historical performance of defaults.

Ms. NAPOLITANO. That is not the information we are getting, is

that you do not use the same standards.

Ms. DORN. Well clearly there are some differences between SBIC

and——

Ms. NAPOLITANO. What differences are there? In other words,

what is it that separates one from the other and why are not the

same standards applied to both? SBIC is what we are getting to,

the small business investment program.

Ms. DORN. Congresswoman, I think we have tailored some criteria to deal with the different kinds of—Clearly 7(a) is a different

kind of program than 504 which is a little different than the program that you cite.

I think in general we try to use historical data. We have tried

to pump in more current, changes in current law, changes in current econometrics——

Ms. NAPOLITANO. You are not using the same standards?

Tony, can you explain this?

Mr. WILKINSON. I do not think they do consistently apply the

standards to similar programs. We are active in with the B&I program over in Department of Ag, it gets a little different treatment.

I am most concerned about the statement that they calculate the

rates in accordance with the requirements of the Federal Credit

Reform Act. There are no requirements in the Federal Credit Reform Act of how they calculate the subsidy rate.

Ms. Dorn says they were required to use all historical cash flows.

Nowhere in the Federal Credit Reform Act does it say they have

to use all historical cash flows. Again, we go back to the Senate

Roundtable where six or seven different types of approaches that

would have been more reflective of the performance of the program

were presented and all of them were rejected, and yet OMB decided

to keep the one that gave the highest default estimates. Even

though they know it is not in a reasonable range.

Ms. NAPOLITANO. Mr. Wilkinson, Tony, would you comment more

about the Ag? You mentioned it and you just skimmed over it. That

is important.

Mr. WILKINSON. We have been working on the Business and Industry loan program and have not has as much luck in learning

all about their subsidy model as we have in the 7(a) program, so

I will not profess to be an expert on their model and should save

that one for another day.

Ms. NAPOLITANO. Okay.

Then Ms. Dorn, given that there is apparently a discrepancy in

how people are looking at how you apply the standards, are you

willing to correct this inequity?

Ms. DORN. Congresswoman, we are working hard on trying to refine the data to go into the econometric model, but——

24

Ms. NAPOLITANO. It is not the refining of the data I am concerned with. It is the application of the data that concerns me.

Ms. DORN. We do this on an annual basis, so clearly every year

we review what we have done in the past and we are trying to refine the data which, as I pointed out before you came in, has resulted in a significant improvement on our estimates. In the early

1990s we were overestimating in the $200 million range; in fiscal

2000 we missed it by $2 million.

So there is improvement in this data. It is not a perfect science,

and we welcome your input and the Committee’s input into the different factors that need to be considered. This is not a static calculation that does not change from year to year. We have continued

to try and refine the model.

Ms. NAPOLITANO. I must say that I have a lot of small business

and Mr. Barreto knows that, who really count on these loan programs, and I am finding out that a lot of them are not qualifying

simply because of the different standards utilized.

So Mr. Chair, I yield back the balance of my time to Ms. Velazquez if Ms. Velazquez wants to finish up.

Chairman MANZULLO. Let me go to Mr. Issa.

Ms. VELAZQUEZ. Okay.

Mr. ISSA. Thank you, Mr. Chairman.

I apologize for not being here for the whole time. Unfortunately

I have an amendment on the Floor which is the usual excuse for

rudeness we have here in this body.

But I am very concerned about this and I guess directing to the

left side of the panel, especially to the Administrator and Ms. Dorn,

I came out of the business world. I was both a CEO and on many

boards. What I hear you saying, and for that matter said very eloquently in writing, is that there is a historic difference between

what you say is going to happen and what happens.

In business we talk about a quarter—maybe, being an anomaly.

Two quarters is a trend. Three quarters is a question of whether

the CEO is still going to be around.

Now maybe we act too quickly in business, but a decade seems

to be too slow even for government.

What I am sharing the sentiments of my colleagues is, why is it

that this year, not next year, not the year after, can we not have

a substantial, based on historic, and you certainly have the evidence, the data now to do it, why can we not have a halving of the

difference? Why is it that while you are calculating we cannot narrow this from eight to seven? Maybe not to four? Maybe not to

what we would like to believe the past performance shows for the

future. But what is it, if there is nothing in the body of law that

we have delivered you that stops you, what stops you from doing

what you can to improve your ability to deliver services? And clearly, based on what I have seen, you have the ability to do it. This

is a decision you are making.

When a CEO makes a decision to continue miscalculating something historically, I have to ask how long do I want to have people

who miscalculate that way?

I will take either of your answers.

Ms. DORN. Well Congressman, we do not intentionally miscalculate. I think there is a process of refining that we have made some

25

significant progress in the last couple of years. I cannot speak very

well to the program over the last ten years in terms of how the program was run, but I think we are making a significant effort to try

and narrow the differences here.

The other thing that I would point out is something that you as

a businessman know very well, and that is that the period of time

between 1992 and 2000 was a period of extraordinary growth and

economic prosperity in this country. We have seen over the last

year that that is not necessarily the template for every year for the

rest of all time. We have to take that into account.

There have been experiences where the federal government has

provided loans in response to outside influences and other things

that turned out not to be a great idea. The S&L situation of the

early 1990s is a great example of where the government overextended itself.

Mr. ISSA. And I am not asking you to change your model for who

you loan to. I am not saying we should change the risk calculation.

What I am saying is you have a past performance, a success if

you will, of having a given default rate and a given cost for it, and

yet we are asked here, with the reluctance of the appropriators, to

over-appropriate if you will based on a historic misjudgment.

I do not agree with you that you have made substantial reforms

because if the facts continue to show this big a disparity, this is

like a four percent loss at the bottom line in your corporation every

year, and I am not even giving you credit for the multiplier effect

to the benefit of your making greater amounts of loans, being able

to do more. Forget about all of that. Forget about what the multiplier is.

The bottom line is you are miscalculating by an amount greater

than we tolerate losses in business for a quarter or two and you

have done it and your predecessors have done it for a decade.

My question succinctly back to you is, why is it that you cannot

make a substantive change this year to reduce that disparity? You

do understand that this body, and we are the people, at least are

part of the body that appropriates if necessary.

If we suddenly see a change it is not a huge amount of dollars,

it is not something that Congress is not going to go okay, for one

year we can do a supplemental to make up for some anomaly. The

fact is, you are not exercising, as I see it, the power you have by

every year miscalculating by this huge amount and then coming

back and saying effectively look how well we did. I do not want you

to do that well. I want you to be accurate, or at least much closer.

Chairman MANZULLO. Okay.

Mr. WILKINSON. Can I add on just one statement?

Mr. ISSA. Please.

Mr. WILKINSON. That is based on the default assumptions that

are plugged into the model we are going to have to go ask for appropriation dollars for fiscal 2003 in an amount double what we are

going to need. And it is exactly right, this makes the appropriation

process very, very inefficient.

Chairman MANZULLO. Before I go on to Congresswoman

Millender-McDonald, let me ask a question, Dr. Blanchard.

26

The typo that appears on page 20 of the budget on Table Six at

9.38, you said that is a typographical error. It should be the 8.1 figure, Doctor?

Mr. BLANCHARD. Mr. Chairman, this is a number that I just saw

this morning before we sat down in front of this committee.

Chairman MANZULLO. You mean the 9.3?

Mr. BLANCHARD. That is right. That number should be 12.73, sir.

Chairman MANZULLO. It should be 12.73?

Mr. BLANCHARD. That is correct.

Chairman MANZULLO. But it is 8.1 on the chart.

Ms. VELAZQUEZ. Mr. Chairman?

Chairman MANZULLO. Just a second.

Mr. BLANCHARD. That number should be 12.73 which is the default rate that SBA has projected for fiscal year 2003.

Chairman MANZULLO. But that is 8.195 up there.

Mr. BLANCHARD. The 8.19 is equivalent to the 12.73 and let me

explain how.

You are dividing the default in this chart by total loan volume.

But as you know, SBA only guarantees 85 percent of that total loan

volume.

In the budget, the way we produce that number in our 12 percent assumption is defaults divided by the proportion of the outstanding loans that SBA guarantees.

In a sense, sir, the denominator is smaller driving that number

up. They are equivalent to each other.

Chairman MANZULLO. So where it says 9.38 it should be 12

point——

Mr. BLANCHARD. Seven-three.

Chairman MANZULLO. The fact that there is a typographical

error that is in this table on Table Six on page 20, does that have

anything to do with the final calculation of the subsidy rate?

Mr. BLANCHARD. No, sir. It does not.

Chairman MANZULLO. Okay.

Ms. Millender-McDonald?

Ms. MILLENDER-MCDONALD. Thank you, Mr. Chairman, and

than, you and the Ranking Member for providing us this opportunity to speak about a very critical issue.

Again, I think the basic question that has been raised here is

whether or not OMB should rely on ten years of data versus more

recent data to produce a default rate that appropriate current reality?

I am sorry that I was not here, but I need to kind of get that

back in front of me, why is it that we are relying on ten years of

data as opposed to something that is more current?

Perhaps you have answered that, but I need to hear it again.

Ms. DORN. No, I am happy to explain our rationale on that front.

Our rationale is simply that for this program and for the other

federal loan programs we rely on the historical data that we have.

In this case it goes back I think to 1986 because economic conditions do play heavily into historical defaults and credits issued. So

we do use the data that we have going back but it is not the only

data that we have plugged into the calculation. And as we have

gone forward we have sought to refine that.

27

As we pointed out in the fiscal 2003 calculation we did use the

information that default rates are lower for those loans that go

through preferred lenders and we did crank that into the data

which did reduce the subsidy rate fairly significantly, by about 40

percent?

Mr. BARRETO. Twenty percent.

Ms. DORN. Twenty percent for fiscal year 2003.

So we are continuing to work to make it more reflective of not

only the historical past but the more recent changes in law and

performance.

Ms. MILLENDER-MCDONALD. Then how many 7(a) loans that

have been made since 1986 are still on the books of the SBA and

what percentage of these loans represent the loans made in those

years and of the loans outstanding today?

Ms. DORN. Can I turn that to SBA? They have a better——

Mr. BARRETO. We have to provide you with an accurate count on

that, Congresswoman, in terms of how many loans are still in the

portfolio. We would be happy to do that. We did not bring that specific number with us today but we can get it to you very quickly.

Ms. MILLENDER-MCDONALD. How soon can we expect that, Mr.

Administrator?

Mr. BARRETO. I think we should have it to you in the next 48

hours.

Ms. MILLENDER-MCDONALD. That would be great because I really

do need to review that. This question is for either Mr. Wilkinson

or Mr. Crawford.

Do you have any confidence small businesses and your members

are going to get a better shake from this econometric model than

they do from the present model?

Mr. WILKINSON. I said in my verbal testimony that——

Ms. MILLENDER-MCDONALD. And I am sorry, I had three other

Committees——

Mr. WILKINSON. That’s fine.

We are concerned about a new model. The model that we have

today is really fairly simple to understand. We have issues with

some of the assumptions that are plugged into the model. The econometric model is going to use many more ‘relevant factors’ all of

which are going to have a weighting that’s going to be determined

by somebody at OMB and we likened it to the fact that we have

broken open the old black box——

Ms. MILLENDER-MCDONALD. Is that to your benefit or what?

Mr. WILKINSON. I doubt it.

Ms. MILLENDER-MCDONALD. I see the gentleman in the blue

shirt shaking his head in an adverse way. Dr. Blanchard.

Dr. Blanchard, why are you disagreeing with Mr. Wilkinson?

Mr. BLANCHARD. I do agree with Mr. Wilkinson that the econometric model will in effect weight multiple factors in accordance

with their impact on the subsidy rates. However, those weights are

not set arbitrarily by OMB or SBA. Those weights are determined

by the data itself. The historical data itself.

Mr. BARRETO. Can I also take a stab at it?

Ms. MILLENDER-MCDONALD. Yes.

Mr. BARRETO. We——

Chairman MANZULLO. What does that mean?

28

Mr. BARRETO. What I would like to comment on is that the econometric model is not going to determine the subsidy rate, but one

of the things the Congresswoman said is that we have to be very

careful of what we are putting in.

We believe the econometric model is going to allow us to come

up with more accurate measurements so that what we are putting

in provides us a much more realistic idea of what is actually occurring.

We did that this last year, and I also want to say that we realized that this was a big issue before we came on board. I got on

board in August and we began working on this situation immediately.

It is difficult for us to be able to look back and say all the factors

that people were considering at the time they were developing subsidy rates in the past. But what we do understand and what we

are very clear on is that we need to do a better job, that we need

to be more accurate.

That is why we felt very gratified that we were able to take the

subsidy rate from 1.07 down to .88. In a very short period of time

we were able to make some progress. We are going in the right direction.

Obviously the fees went down because of P.L. 107–100, that

caused the subsidy rate to go back up. But that was never our intention. That was never something that we had anticipated.

If that subsidy rate would have been held at that .88, we would

be looking at a budget authority right now of $9.7 billion for our

7(a) loan program. That was our intention.

We will continue to work with you, we will continue to work with

the organizations that are here because the work is not done. We

think that the econometric model is going to get us to a place

where we are going to have more accurate reflections and we are

not going to have this continued problem because we are concerned

about it as well.

We have to be competitive. We have to think and act like a small

business just as the Congressman said. If our loans become too expensive, we are going to cease to have the ability to do what our

mission is, which is to touch more small businesses.

At the end of the day we want to do more small business loans.

WE think that our average loan size right now is too large. Inc.

Magazine says that most small businesses are financed with

$50,000. Our average loan size is $239,000.

Ms. MILLENDER-MCDONALD. Mr. Administrator, I want to yield

to the Ranking Member——

Chairman MANZULLO. Ms. Millender-McDonald, the time has expired. Let us let Mrs. Kelly——

Ms. MILLENDER-MCDONALD. Oh, my time has expired? I just

wanted to answer the—I wanted to convey——

Chairman MANZULLO. Let me get a question in because the bell

is going to go off and I want to make sure everybody has the opportunity to ask questions.

Mrs. Kelly?

Ms. KELLY. Thank you very much.

Actually, there are two things.

29

Mr. Barreto, I know you have not been at the SBA for a very

long period of time, but I have been sitting here year after year

after year listening to the SBA come in and say we want to do a

better job, and yet I know there are people in my area who have

come in and asked for 7(a) loans and they are told we do not want

to process those loans, they are too small. They want to process

loans that are larger because they have to do the same amount of

paperwork.

We need some real change. We need some people who are dedicated to coming here in front of this Small Business Committee

and saying we have changed it. We have reduced the paperwork

and we are responsive to the smaller loan needs of these people

who are trying to get into the program.

We cannot grow small business in this nation unless you address

these problems.

I really hope that this coming fall, perhaps, you will come back

to this Committee and you will come back and say here is what we

have actually done, and you will have done something.

The small businesses of this nation I do not think can any longer

wait.

I want to go also to Mr. Wilkinson.

Mr. Wilkinson, I think you had a response to Ms. MillenderMcDonald’s question. I would like to give you time to respond.

Mr. WILKINSON. Yes, I did have one more comment.

At our annual convention last fall in San Francisco our lobbyist

stood up and made a statement that he believed that OMB created

assumptions so that it would force an answer in the model that

was going to achieve a desired result. That they knew what they

wanted the answer to be so they would plug in assumptions to

match it. This was his speech from the statement.

Two former OMB budget examiners came up after his speech and

said you are exactly correct.

Exactly correct.

Hence why we are a little excited about getting this problem

fixed, and why we would have no more confidence in an econometric model that has even more assumptions that are going to be

plugged into the model.

I hope things work out, but hence our concern.

Thank you for allowing me to respond.

Ms. KELLY. Thank you, Mr. Chairman. I yield back.

Chairman MANZULLO. I have a question here.

Two weeks ago we had a hearing with the OMB and the Administrator on why six months had passed and the size standards had

not been changed. What is apparent at this point is that OMB may

be doing its job too well. Their job is to sit there and to make sure

that as little money is spent as possible as they sit there at the

throttle of how the Administration wants to spend money.

But it reaches a point where I think what OMB is doing is not

correct because it is so conservative in the estimates that it is actually doing a disservice to small business people.

What we are going to do is sit down and we are going to examine

the OMB and how they go about this because I think the starting

point of OMB is to say we are going to take the most conservative

position possible. But in all fairness, if you take a look at what

30

happened in 1996, OMB underestimated the loss by $257 million

so they were short almost a quarter of a million dollars and that

will cause anybody to be very conservative coming out of the box

for the next anticipated years.

The next year, for 1997 they were long by $16 million; for 1998

by $279 million; 1999 by $545 million; 2000 by $235 million; 2001

by $528 million; 2002 by $183 million.

I think what is happening is that OMB is still reacting to what

was an incorrect estimate for the loss during 1996.

There were more questions that people wanted to ask. However

you want to divide it, that is okay with me.

Ms. NAPOLITANO. I want to defer to the Ranking Member.

Ms. VELAZQUEZ. Thank you, Mr. Chairman.

Ms. Dorn, is not the outcome of econometric modeling dependent

upon the assumptions used in the model, just as the present model’s results depend on the assumptions used in it?

Ms. DORN. Yes, maam. We are——

Ms. VELAZQUEZ. I just want a yes or no.

Is it a fact, Mr. Barreto you made reference to it, that you are

moving to an econometric model, an admission that the current

system is broken?

Ms. DORN. I think we believe an econometric model would provide more accurate data.

Ms. VELAZQUEZ. So you believe that the present system is broken

is it not? Do you not?

Ms. DORN. Congresswoman, I would——

Ms. VELAZQUEZ. Just say yes or no.

Ms. DORN. I would prefer to use my own words, which is that

this is a process of refinement. I would agree with you that the system is not close to perfect. We are making some changes in it even

as we speak that are going to make it more accurate.

Ms. VELAZQUEZ. Mr. Wilkinson?

Mr. WILKINSON. Can I go back to the Chairman’s comment? You

were reading from some sheet that talked about expected default

rates. From the numbers I have in the budget they showed an expected default rate in 1996 of 17.26 and the expected default rate

of 9.97. They more than doubled the estimate in 1996. The estimate in 1997 was 17.25, they were on pace to do 9.13. I am not

following——

Chairman MANZULLO. This is the actual amount of loss or overcharge. In 1996 OMB underestimated the loss by $257 million.

Then in subsequent years they overestimated.

I just brought that up to show that the numbers that they are

working with, the reason they are perhaps so conservative is because they had in 1995, they underestimated the loss by a quarter

of a billion dollars.

Mr. WILKINSON. In 1996——

Chairman MANZULLO. 1996 rather.

Mr. WILKINSON. In 1996 there was a downward re-estimate of

about $100 million.

Chairman MANZULLO. These are the re-estimates on it from

OMB.

31

Mr. WILKINSON. I guess I would point you to page one of my testimony that lists the re-estimates that have been reflected in the

annual budgets coming forward.

Chairman MANZULLO. I am on page 205 of the budget.

If somebody else has another question here, please go ahead.

Ms. VELAZQUEZ. I have a question, Mr. Chairman.

Ms. Dorn, how is the calculation of the assumptions for the econometric model going to correct the existing inaccuracies of today’s

method of forecasting defaults, prepayments and recoveries?

Ms. DORN. Congresswoman, we are looking to incorporate not

only the historical data which we have used and will continue to

use, but also to factor in more current conditions.

Lloyd, do you want to talk about that in any more detail?

Mr. BLANCHARD. Sure.

Ms. DORN. SBA is the agency that does this. OMB has responsibilities under the Federal Credit Reform Act, but OMB does not,

contrary to popular belief, just make up these numbers.

Mr. BLANCHARD. Ms. Dorn is correct, Ms. Velazquez. The econometric model is simply an estimation tool. It estimates the default

rate.

The assumptions that underlie the econometric model are technical assumptions. They are not the assumptions that Mr.

Wilkinson refers to. That model itself helps us, it takes business

factors, program factors, economic factors and says how do these

factors predict performance of these loans? Performance is the

same thing as the default rate. Then that default rate is plugged

into the cash flow model to predict a subsidy rate.

Ms. VELAZQUEZ. Who is going to decide the assumptions used?

OMB? SBA?

Mr. BLANCHARD. The assumptions used, ma’am, are, those that

come from data. Those come from what the unemployment rate is,

for instance. What the President’s budget publishes as the unemployment rate. If that is a relevant factor, which I believe we all

think it is.

Ms. VELAZQUEZ. Mr. Barreto, you mentioned that you are going

to use OFHEO to implement the model. I have serious concerns

about OFHEO because home loans fit very exact criteria and perform in very predictable manners. All loans are underwritten using

maximum guidelines that are established for total installment of

debt including new home loans versus gross monthly income as a

percentage. How statements of gross monthly income as a percentage will not amount to a price value.

So due to the very precise underwriting criteria that is followed

by every lender granting home loans, they perform in a very predictable fashion and are easily securitized.

It is also very easy to predict loss due to the very large volumes

of loans that are guaranteed on a regular basis, making subsidy

rate models very simple to implement.

These loans all fit in the round hole or square hole, depending

on the market they are serving.

Business loan underwriting is not done using that criteria but

lenders apply different standards as it relates to cash flow coverage, debt to wealth and so forth. Therefore these loans do not fit

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square holes and/or round holes. This makes it much more difficult

to predict how these loans will behave or perform over their life.

At liquidation time, values of equipment will vary greatly due to

present economy and the health or sickness of a certain type of

business.

Based on that, how can an oversight agency who’s primary function is to oversee a very predictable industry now adapt a similar

model to an industry that has no hard and fast underwriting guidelines?

Mr. BARRETO. Great question. Thank you, Congresswoman.

We chose OFHEO for a couple of different reasons. First of all

as we stated earlier, GAO and OMB when we were talking about

what an effective approach would be, believed that the econometric

modeling approach would help us in the short term and would definitely help us in the long term.

One of the reasons that we chose OFHEO is because they have

a lot of expertise in statistical analysis and working with econometric models. I agree with you though, and that is that you cannot take another industry that is dissimilar and try to overlay a

system that works there over here. We are very mindful of that.

Yet they do have the oversight responsibility for Fannie Mae and

Freddie Mac, but also we were very intrigued by the fact that they

hired Dr. Robert Dunsky.

Dr. Robert Dunsky was formerly with PriceWaterhouseCoopers

and he is very very familiar with the SBA asset sales program, and

with our loan programs. We are very excited about is his understanding of the agency, his expertise, the fact that he has this expertise coming from the private sector. And I believe that working

together with him, since he is already familiar with us, we are

going to be able to come up with a system that is customized to

the SBA.

At the end of the day, a lot of larger agencies are able to do this.

They have teams of economists that work for them, et cetera, but

we needed to find a solution that was definitely going to be costeffective and definitely be efficient.

We think that OFHEO offers——

Ms. VELAZQUEZ. Mr. Barreto, do you know why you do not, Congress allow Freddie Mac and Fannie Mae do business loans? This

is like compare day and night. And we sit on the Financial Services

Committee. We know the competence of OFHEO in dealing with

Freddie Mac and Fannie Mae.

Mr. BARRETO. OFHEO is not going to be doing our lending program but they will be helping us to develop an econometric model.

Chairman MANZULLO. Why do we not have these two gentlemen

help you develop the econometric model?

Mr. BARRETO. We share a lot of information already and we are

always open to getting more information and helping.

I know when we worked with NADCO in the past, we actually

developed a pilot program with them, provided them with a lot of

our information because we know that NADCO has said to us in

the past,’’ we think there is a better way of doing this.’’ We are currently working with them and we are hopeful to receive some of that feedback from the discussions that we had on

ways that we can do it better.

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Chairman MANZULLO. We have to wind this up.

A very quick question.

Mr. ISSA. The question can be responded to in writing, if you

don’t mind. Both from OMB and SBA if possible.

Making an assumption that you have a time horizon that of at

least five years for your reserves, not using a single year, not loading in the up or the down market, but using at least five years. If

you were taking, if you will, the budget and multiplying it times

five, would you arrive at a different number? If so, what would that

reserve number be?

Now you can use ten years, I don’t mind, because I personally

believe that if you look at any horizon five years or longer what you

are going to say is our problem is a one year calculation.

Because we are looking at ten years, but then we are always

loading in a higher number for one year because of the things that

might happen.

If you come back to us with a five year or greater, and I prefer

at least five, but you can do give or ten, and give us the number

you believe if you plugged it in without all those hypotheticals for

any one year, but knowing that over the years those hypotheticals

fade, and give us that number, it may empower this Committee to

recommend to the full Congress some additional discretion for you

to make these calculations to narrow what we perceive as an unwarranted delta between reality and predictions.

Thank you.

Mr. WILKINSON. Congressman, attached to my testimony is a

GAO report that did a five year look-back——

Chairman MANZULLO. We are running out of time here. I want

to thank everybody. This has been great.

Will Rogers talked about what the country needs is a one-armed

economist because the economists will say on the one hand you get

this, on the other hand you get the other. Everybody gets an A+

here for sincerity and honesty and workmanship and craftsmanship

and everything. It is interesting because the problem here is that

the members of the Small Business Committee are accusing the

Administration of being too conservative in their estimates. You

might want to think about that. But that is your job as a watchdog.

I look forward to working with you very closely. Mr. Barreto, as

soon as he was confirmed came in my office and he said let’s talk

about this subsidy rate. OMB came in and the first thing out of the

box was that this is very difficult, we want to work with you on

it. And we look forward again to a very close working relationship

because I know your heart is—

I would assure these two gentlemen over here that these men are

very sincere and want to work on this and continue the dialogue

because they are listening and I know I am.

Thank you, and good luck on that new baby.

Mr. BARRETO. Thank you very much, Mr. Chairman and Ranking

Member Velazquez.

Chairman MANZULLO. Thank you.

[Whereupon, at 12:02 p.m. the Committee was adjourned.]

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