Rural Utilities Service: Opportunities to Better Target Assistance to Rural Areas and Avoid Unnecessary Financial Risk
Published: 2004-06-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Agriculture Department's Rural Utilities Service (RUS) makes loans and provides loan guarantees to improve electric service to rural areas. Beyond guaranteeing loans, under a yet-to-be-implemented provision of the 2002 Farm Bill, RUS is also to guarantee the bonds and notes that lenders use to raise funds for making loans for electric and telecommunications services. Fees on these latter guarantees are to be used for funding rural economic development loans and grants. GAO was asked to examine (1) the extent to which RUS' borrowers provide electricity service to nonrural areas and (2) the potential financial risk to taxpayers and amount of loans and grants that the guarantee fees will fund. GAO also identified an alternative for funding rural economic development.
section_title: What GAO Found
paragraphs: While the Rural Electrification Act authorizes RUS' lending only in rural areas, borrowers that receive RUS loans and loan guarantees serve not only rural areas but also highly populated metropolitan areas. This condition stems from RUS' loan approval practices. RUS requires that borrowers serve rural areas when they apply for their first loans, but it approves subsequent loans without applying this criterion. Thus, RUS applies a "once a borrower, always a borrower" standard. Since the 1930s when the program began, substantial population growth has occurred in areas served by many RUS borrowers; 187 of the counties in which RUS borrowers provide service are in metropolitan areas with populations of 1 million or more. For example, three borrowers that received over $400 million in loans in fiscal years 1999 through 2003 distribute electricity in the immediate vicinity of Atlanta, Georgia. In contrast, about 24 percent of the counties served by RUS borrowers are completely rural, while the remainder have a mix of rural and urban populations. RUS estimates, in a worst-case scenario, that the requirement to guarantee lenders' debt could lead to taxpayer losses of $1.5 billion--and GAO estimated that in return for this risk, fees on the guarantees would add about $15 million per year in rural economic development loans and grants. RUS officials believe that while risks are involved, losses are unlikely given the past stability of both the electricity market and the lender that might receive the guarantees. Only one lender is both qualified and interested in obtaining these guarantees. According to financial rating services, that lender is well regarded, but worked through financial concerns in 2002 and 2003, and faces longer-term risks associated with the changes taking place in the electricity and telecommunications markets that it serves. Recognizing the risks of guaranteeing this lender's debt, RUS proposed certain risk mitigation requirements, such as a reserve against losses. However, the lender's officials have stated that RUS' proposed requirements would make the program unattractive. GAO identified an alternative with no additional taxpayer risk to add funds for rural economic development loans and grants. If RUS were authorized to charge borrowers a small loan-origination fee of one-fourth of 1 percent on loans it expects to make and guarantee in fiscal year 2005, $24 million in rural economic development loans and grants might be made available. This amount is almost equal to the level provided by USDA's 2005 budget request for rural economic development loans and grants, and would likely have a minimal cost impact on customers of distribution borrowers. This alternative would not include guarantees of lenders' debt. Furthermore, the lender expected to use the guarantees has indicated that, even without such guarantees, it expects to continue being very successful at accessing capital for lending.

section_title: Letter
paragraphs: The U.S. Department of Agriculture’s (USDA) Rural Utilities Service (RUS)  has rapidly increased its lending for electricity service projects in recent  years. In fiscal year 1999, RUS made loans and provided guarantees on  loans made by other lenders totaling $1.6 billion, while in fiscal year 2003,  RUS made and guaranteed more than twice that amount—about $4 billion.  Overall, during fiscal years 1999 through 2003, RUS made or guaranteed  $14.3 billion in loans for electricity service.
Under the Rural Electrification Act of 1936, as amended (the RE Act), RUS  is authorized to make and guarantee such loans to furnish and improve  electric service in rural areas. For electricity purposes, the act states that  an area is rural if it is not part of areas that the Bureau of the Census  defines as urban—that is, densely populated areas having 2,500 or more  inhabitants. RUS requires borrowers to establish that they serve rural  areas when they apply for their first loan. However, RUS’ regulations and  long-standing practice allow borrowers to receive subsequent loans  without having to meet this test. Thus, RUS applies a “once a borrower,  always a borrower” standard.
Borrowers that receive RUS loans or guarantees on loans for electricity  service projects are primarily nonprofit cooperatives. Most of these  borrowers are “distribution borrowers” that use the loans to construct and  maintain the facilities that provide electricity to users; such borrowers  received $9 billion of the $14.3 billion in loans during the period we  examined. RUS also provides guarantees on loans to “power supply  borrowers,” which received the remainder of the $14.3 billion to finance  the construction of electricity generation and transmission facilities.
The Farm Security and Rural Investment Act of 2002—commonly referred  to as the 2002 Farm Bill—provides RUS with a new program responsibility  that would increase funds for rural economic development loans and  grants. It directs RUS to guarantee payments on bonds or notes issued by  cooperative or other nonprofit lenders, under certain conditions, if the  proceeds of the guaranteed bonds or notes are used to make loans for the  electricity or telecommunications purposes of the RE Act, which can  include refinancing, but not electricity generation. A lender that receives  such a guarantee would pay an annual fee of three-tenths of 1 percent on  the outstanding guaranteed principal. These fees are to be used to fund  rural economic development zero-interest loans and grants that are  available from USDA’s Rural Business-Cooperative Service, as well as to  cover the subsidy costs of the guarantees. The Rural Business-Cooperative  Service provides rural economic development loans and grants for  financing economic development and job creation projects in rural areas,  such as new business start-ups, existing business expansions, and  community improvement projects. RUS has issued proposed regulations  on the program and, as of mid-June 2004, was awaiting the completion of  the Office of Management and Budget’s review of the proposed final  regulations for this program.
As we have previously reported, the federal government has had a long  and successful role in contributing to the development of the utility  infrastructure in the nation’s rural areas. In the mid-1930s, when federal  assistance for rural utilities began, most utilities served high-density areas  and their service lines did not extend to farmers and other rural residents.  This, however, is no longer the case, and we found that RUS lending  practices can often result in loans to borrowers serving heavily populated  areas, and to borrowers capable of using their own resources or of  obtaining private sector loans to fund their utility projects. To address  these conditions, we presented options to Congress for better targeting  RUS’ lending to rural areas and making its loan programs more effective  and less costly.
In this context, you asked us to examine (1) the extent to which RUS  distribution borrowers provide electricity service to nonrural areas and (2)  the potential financial risk to taxpayers of the 2002 Farm Bill requirement  to guarantee lenders’ debts, and the amount of rural economic  development loans and grants that could be funded by fees on the  guarantees. In addition, we reviewed the RE Act to determine whether  there might be an alternative way to provide funds for rural economic  development loans and grants with less risk. In the course of our work, we  reviewed the RE Act and RUS’ implementation policies, financial reports  on RUS loans for fiscal years 1999 through 2003, and data on counties and  metropolitan areas that the borrowers serve. We used counties served by  the distribution borrowers as an indicator of areas being served by those  borrowers that obtain RUS electricity loans. We also reviewed the relevant  portion of the 2002 Farm Bill, the legislative record, and RUS’ proposed  program regulations and economic analysis of guaranteeing lenders’ debt.  We conducted our work from October 2003 to June 2004 in accordance  with generally accepted government auditing standards. Appendix I  describes the scope and methodology of our review in more detail.
subsections: section_title: Background
paragraphs: In 1935, the Rural Electrification Administration was created by executive  order to make loans to electrify rural America. RUS was established by the  Federal Crop Insurance Reform and Department of Agriculture  Reorganization Act of 1994 to replace this agency and now administers the  electricity program. It is located in USDA’s Rural Development mission  area.
RUS’ loans for electricity purposes are made primarily to nonprofit  cooperatives. Cooperatives are organizations owned by their customers  and operated for the benefit of those using their services. The customers  elect boards of directors responsible for policy and operations. Most RUS- financed utility systems have a two-tiered structure covering electricity  distribution and power supply. Retail customers are members of the  distribution cooperative that provides electricity directly to their homes  and businesses. Most distribution cooperatives, in turn, are members of  power supply cooperatives, which generate and transmit electricity to  their members.
Currently, RUS makes three types of direct loans for electricity purposes.  These direct loans are (1) hardship rate loans with a 5 percent interest rate  made to borrowers that have a relatively high cost of providing service, as  indicated by a high average revenue per kilowatt-hour sold, and that serve  customers with below-average income, or at the discretion of RUS’  Administrator; (2) municipal rate loans with an interest rate tied to an  index of municipal borrowing rates, resulting in interest rates ranging from  1.1 percent to 4.6 percent during the first quarter of calendar year 2004;  and (3) Treasury rate loans with an interest rate matching the  government’s cost of money, which ranged from 1.2 percent to 4.4 percent  in mid-March 2004. In addition to making direct loans, RUS places a USDA  100 percent repayment guarantee on loans made by the Treasury’s Federal  Financing Bank, which makes loans at an interest rate equal to the  Treasury’s cost of money plus one-eighth of 1 percent, as well as on loans  made by CFC and by CoBank—a member bank of the Farm Credit System,  which is a government-sponsored enterprise. Most borrowers seeking a  loan guaranteed by RUS choose to have the loan made by the Federal  Financing Bank because of lower interest rates than those available from  the other lenders.
The outstanding principal owed by borrowers with RUS direct and  guaranteed loans totaled $28.3 billion as of September 30, 2003: $9.5 billion  in direct loans, $15.3 billion in guaranteed loans made by the Federal  Financing Bank, $0.4 billion in guaranteed loans made by CFC, $0.2 billion  in guaranteed loans made by CoBank, and $2.9 billion in restructured  loans. During fiscal years 1999 through 2003, RUS made or provided  guarantees on 936 electricity loans, which totaled more than $14.3 billion.  Table 1 shows the level of loans for each type of electricity loan.
As we have reported in the past, RUS has had problems with some  borrowers. During fiscal years 1999 through 2003, RUS wrote off more  than $3.2 billion on loans to three borrowers—$3 billion and $73.2 million  for two borrowers under bankruptcy liquidation and $159.3 million for a  borrower with unsecured debt. Also, it wrote off $7.2 million for another  borrower that had been restructured.
The Rural Business-Cooperative Service, which like RUS, is in USDA’s  Rural Development mission area, operates loan and grant programs that  are intended to assist in the business development of the nation’s rural  areas and the employment of rural residents. Among these programs is the  rural economic development program, which is authorized by section 313  of the RE Act, 7 U.S.C. § 940c. Under the program, the Rural Business- Cooperative Service makes direct loans to entities that have outstanding  RUS electricity or telecommunications loans or to former RUS borrowers  that repaid their electricity loans early at a discount. Rural economic  development loans are not available to former RUS borrowers that repaid  their loans with scheduled payments.
All rural economic development loans are made for relending, and the loan  funds are targeted to specific projects. Rural economic development loan  funds are deposited into a fund that a RUS borrower has established, and  the RUS borrower then relends the money to other borrowers, which may  be any public or private organization or other legal entity, for an economic  development and job creation project. Such projects include new business  creation, existing business expansion, community improvements, and  infrastructure development. Rural economic development loan funds,  however, cannot be used for certain purposes, including the RUS  borrowers’ electricity or telecommunications operations or a community’s  television system or facility, unless tied to an educational or medical  project.
The Rural Business-Cooperative Service also provides rural economic  development grants to RUS utility borrowers to establish revolving loan  funds to promote economic development in rural areas. The revolving loan  funds provide capital to nonprofit entities and municipal organizations to  finance community facilities that promote job creation or education and  training to enhance a marketable job skill or that extend or improve  medical care.
An unusual source of funding is available for rural economic development  loans and grants. The RE Act provides that RUS’ electricity and  telecommunications borrowers can make advance payments on their RUS  loans, referred to as “cushion-of-credit” payments, and earn interest at a  rate of 5 percent on the advance payments. The Rural Business- Cooperative Service is allowed to use the differential between the earnings  on these advance payments and the 5 percent interest to cover the subsidy  costs of rural economic development loans and the cost of rural economic  development grants. During fiscal years 1999 through 2003, the Rural  Business-Cooperative Service made 233 rural economic development  loans, which totaled $82.5 million. Also, 117 rural economic development  grants were made, which totaled $24.6 million. On average, the loan  amounts were about $354,000 and the grant amounts were about $211,000.  The outstanding principal owed by borrowers with rural economic  development loans totaled $155.2 million as of September 30, 2003.
section_title: RUS’ Electricity Loans Are Often Made to Distribution Borrowers Serving Highly Populated Metropolitan Areas
paragraphs: Although the RE Act requires that borrowers serve rural areas, RUS  borrowers serve not only rural areas but also highly populated  metropolitan areas. This situation results from RUS applying its “once a  borrower, always a borrower” standard, which allows borrowers to  continuously receive RUS assistance regardless of the extent of population  increases within their service territories. Since the electricity program  began in the 1930s, substantial population growth has occurred in the  areas served by many RUS borrowers. We analyzed the areas served by the  530 distribution borrowers that received RUS loans or guarantees on loans  between October 1, 1998, and September 30, 2003. These borrowers serve  customers in part or all of 1,988 counties in 46 states, and they received  864 RUS loans or guarantees on loans during this period valued at almost  $9 billion.
Overall, RUS distribution borrowers provide service in more than half the  counties in the country that are classified as metropolitan. In general,  these metropolitan areas contain a substantial core population, together  with adjacent communities having a high degree of social and economic  integration with the core. About 29 percent, or 581 of the 1,988 counties  served partly or completely by RUS borrowers, are in metropolitan areas;  and, in fact, 9.4 percent, or 187 of the 1,988 counties, are in metropolitan  areas with populations of 1 million or more. The following examples  illustrate cooperatives whose service territories include highly populated  areas.
Three cooperatives that received loans during the fiscal year 1999 through  2003 period provide electricity in the immediate vicinity of Atlanta,  Georgia. These three borrowers received a total of more than $400 million  of loans during this period.
A Maryland electric distribution cooperative that serves approximately  115,000 residential customers in four counties in the vicinity of  Washington, D.C., received over $25 million in loans in fiscal years 1999  and 2001. Three of these counties are in a metropolitan area with a  population of more than 1 million people.
A Florida cooperative that serves roughly 150,000 customers in parts of  five counties that are located to the north of Tampa received RUS loans in  fiscal years 2000 and 2002 totaling $66 million. Four of these counties have  a population of more than 100,000 residents, including two with a  population of more than 300,000.
On the other hand, about 24 percent, or 485 of the 1,988 counties served by  RUS borrowers are completely rural or have only nominal urban  populations. The remaining counties are in nonmetropolitan areas, but  with urban populations of 2,500 or more. Table 2 shows the  classifications of the counties being served partly or completely through  RUS electricity loans.
RUS officials pointed out that many metropolitan areas contain rural  sections. In addition, they agreed that its borrowers now provide service  to a mix of areas including rural areas and heavily populated areas, and  that many of its borrowers would not meet the population criterion of the  RE Act if it were applied. RUS officials also told us that they had drafted  legislation consistent with the President’s fiscal year 2005 budget, which  would require borrowers to recertify that they are serving rural areas,  rather than urban or suburban areas.
section_title: Taxpayers Face Risk of Losses in Return for Loans and Grants Estimated at about $15 Million Annually
paragraphs: RUS estimated that guarantees on lenders’ debt under the 2002 Farm Bill  provision could result in losses of up to $1.5 billion on guarantees of $3  billion, although RUS does not expect such losses. RUS officials believe  that while risks are involved, losses are unlikely given the past stability of  both the electricity market and the lender that might receive the  guarantees. In return for taxpayers assuming the risks of guaranteeing  payment on $3 billion of debt, we estimated that the fees paid on the  guarantees would only fund $15 million in rural economic development  loans and grants annually. The one cooperative lender that is currently  qualified and interested in obtaining a guarantee on its debt generally has  had a favorable financial history going back over 30 years. However, the  lender faces risk associated with the electricity and telecommunications  markets. Recognizing risks to taxpayers, RUS proposed to add certain risk  mitigation requirements, but the lender commented that these  requirements would make the guarantees unworkable.
Financial Losses Estimated by RUS. Under the debt guarantee  program, taxpayers would be at risk for the value of guaranteed debts.  RUS estimated this value at $3 billion in an economic analysis of the  program. The estimate was based on the act specification that the full  guarantee level is the amount of principal owed on loans that eligible  lenders had made concurrently with RUS’ electricity and  telecommunications loans. Although taxpayers would be at risk for the full  amount, RUS estimated that in the event of a default, likely maximum  losses could be as much as $1.5 billion. This maximum is based on the  expectation that the government could recover at least one-half of  defaulted amounts. The $3 billion amount is approximately the amount of  concurrent loans that RUS has made in conjunction with CFC, the only  lender currently qualified and interested in participating in the program.  RUS identified CoBank as the only other lender that would be eligible for  the guarantees. However, CoBank is part of a government-sponsored  enterprise, and CoBank does not need the guarantees and does not plan to  participate in the program, according to CoBank officials.
Although RUS does not believe CFC will default on the guaranteed bonds  or notes, there would be a subsidy cost, according to Congressional  Budget Office and RUS officials. However, RUS has not completed a  subsidy cost estimate for the program. In addition, RUS’ economic analysis  did not discuss CFC’s financial history, its current condition, or the risks  in the electricity and telecommunication markets in which CFC operates.
Fees on Guarantees Could Provide about $15 Million Annually in  Rural Economic Development Loans and Grants. We estimated that in  return for the risk to taxpayers, fees on the guarantees could provide  about $15 million annually of additional loans and grants through the Rural  Business-Cooperative Service’s rural economic development program. Our  calculation is based on the $3 billion guarantee level RUS identified, the  details provided in the act about the annual fees that would be paid by a  lender receiving a guarantee, and the use of the funds generated by the fee.  The act provides that a lender receiving a RUS guarantee would pay an  annual fee of 30 basis points (three-tenths of 1 percent) based on the  amount of unpaid principal on the bonds or notes that are guaranteed, and  that at least two-thirds of the funds collected are to be used for rural  economic development loans and grants. The other one-third can be used  for the cost associated with providing guarantees. On the basis of a $3  billion guarantee level, 30 basis points would yield fees of $9 million, of  which $6 million would be available for rural economic development loans  and grants. Of this, we assumed that $4 million would be used for  additional grants, which is equal to the amount of grants in the Rural  Business-Cooperative Service’s fiscal year 2004 budget. We assumed the  remaining $2 million would be used to subsidize additional loans. Based  on the fiscal year 2004 subsidy rate for the rural economic development  program of 18.6 percent, a $2 million level would provide about $11 million  in additional rural economic development loans.
Lender That Likely Would Receive Guarantees Has Successful  History but Faces Some Risks. CFC has had a solid operating record for  over 30 years, a high rating, and CFC officials said that CFC does not  require federal guarantees on debt to raise capital for lending. While  recognizing CFC’s financial strength, in February 2004, its president noted  that CFC had possibly faced some of the most difficult times in its history.  In early 2002, CFC’s long-term debt ratings had been downgraded by three  credit rating services (Moody’s Investors Service, Fitch Ratings, and  Standard & Poor’s) and the services also rated CFC as having a negative  outlook. Subsequently, these services raised CFC’s outlook to stable  because CFC had taken various positive actions including restructuring $1  billion of loans for its largest borrower, which was emerging from  bankruptcy; reducing its exposure to speculative-grade  telecommunications loans; reducing its reliance on short-term debt; and  increasing its loan loss reserves to $565 million.
Even as the rating services raised CFC’s outlook, they cautioned about  certain risks. For example, one rating service stated that half of CFC’s 10  largest borrowers exhibit speculative-grade characteristics. Each also  expressed concern about CFC’s concentration in the electricity and  telecommunications markets. One service cited the probability that  natural gas prices will be volatile, and another stated that cooperatives  operating in service territories adjacent to lower-cost systems might  eventually be forced to compete. While most cooperatives have avoided  competition, CFC has a fund to help defend its member cooperatives  against territorial threats. In addition, one ratings service stated that  competition from wireless carriers is a longer-term threat to rural  telecommunications systems. CFC officials recognized that there are  business risks in CFC’s loan portfolio that they continually address but  said they believe the risks of the loan guarantee program are very low  given CFC’s stable financial history, its access to capital markets, the  restriction preventing lenders from using the proceeds of their guaranteed  debt to fund electricity generation, and the relatively small portion of  CFC’s overall loan portfolio that the guarantee would cover.
In its proposed regulations, RUS included certain risk mitigation measures  including requirements for a bankruptcy trust, pledges of collateral, a 5  percent limit on cash patronage refunds, and the use of certain standards  that apply to depository financial institutions. CFC, the National Rural  Electric Cooperative Association, and others commented that these  proposals would make the program unworkable, and that the only  requirement authorized by the act is that the securities of the lender  receiving a guarantee be investment grade. Also, CFC stated that the  ratings of the nationally recognized financial ratings services should be  sufficient to assure its credit quality, and that if its financial rating  becomes downgraded below investment grade, then that event could  reasonably trigger RUS to partially limit its distribution of patronage  capital. As of mid-June 2004, RUS officials said they were awaiting the  completion of the Office of Management and Budget’s review of the  proposed final regulations for the program.
section_title: Alternative for Funding Loans and Grants without Additional Taxpayer Risk
paragraphs: We developed an alternative approach that could provide funding for rural  economic development loans and grants without added risk to taxpayers.  Specifically, if Congress amended the RE Act to provide for RUS to charge  a loan-origination fee on its direct and guaranteed electricity and  telecommunications loans, and repealed the new lender debt guarantee  requirement, the resulting funds from the loan-origination fee could be  targeted to the rural economic development loan and grant program.  Doing so would accomplish the stated purpose of the debt guarantee  program—that is, to provide an alternative funding source for the Rural  Business-Cooperative Service’s rural economic development loans and  grants—while avoiding additional risk to taxpayers.
RUS’ fiscal year 2005 budget request is for slightly more than $3.1 billion in  electricity and telecommunications loans, and the Rural Business- Cooperative Service’s request is for $25 million in rural economic  development loans and $4 million in grants. At RUS’ 2005 lending level, if  RUS started charging a loan-origination fee of 25 basis points (one-fourth  of 1 percent), the fee could result in an additional $7.8 million in funds to  support rural economic development loans and grants, which, we  estimate, could amount to an additional $20.4 million in loans and $4  million in grants. In effect, such an increase would be more than an 80  percent increase in the level of rural economic development loans and a  doubling in the level of rural economic development grants that the Rural  Business-Cooperative Service proposes making in fiscal year 2005,  recognizing that different electricity and telecommunications loan levels  would result in varying amounts of funds.
The appropriate fee level would, in part, be based on amounts that are  needed to fund rural economic development loans and grants. Since  enactment of the 2002 Farm Bill, millions of dollars have become available  for this purpose through interest earnings on the cushion-of-credit  payments on loans by RUS electricity and telecommunications borrowers.  While the Rural Business-Cooperative Service had $6.9 million at the start  of fiscal year 2002 to cover the subsidy costs of rural economic  development loans and the cost of grants, by the start of fiscal year 2004,  the amount had increased to $40.2 million—roughly six times the  estimated cost for the program in fiscal year 2004.
The impact of a loan-origination fee would likely be relatively minor for  many of the customers of the distribution borrowers that receive RUS’  loans. For example, during fiscal year 1999 through 2003, RUS made or  guaranteed 864 electricity loans to distribution borrowers; 264 borrowers  received one loan and 266 borrowers received more than one loan over  this period. If a 25 basis point fee had been charged on these distribution  loans and fully passed on to the borrowers’ customers, we estimate that  the average one-time cost for the customers would have been  approximately $2.39. Such a fee would be consistent with the fees  charged on some other USDA loans. In comparison, USDA charges a loan- origination fee of 2 percent on guaranteed business and industry loans, 1  percent on guaranteed water and waste disposal loans, and 1 percent on  most guaranteed farm ownership and operating loans.
Although this alternative does not provide for guarantees on CFC’s debt,  CFC’s access to capital for financing projects would not be jeopardized.
CFC’s history and financial reports show that CFC is capable of raising the  capital required for financing projects. In CFC’s 2003 annual report, CFC  reported that it had about $21 billion in loans outstanding, including $16.4  billion in electricity loans and $4.9 billion in telecommunications loans.  CFC stated that despite significant short-term financing risk in energy  trading and power marketing, it has continued to be successful in securing  long-term sources of capital. For example, CFC reported that it had sold  bonds in Australia, which demonstrates its ability to raise capital in major  money centers of the world. CFC also reported that just after the 2003  fiscal year ended, it had access to $3.9 billion through revolving credit  lines.
We discussed the guarantee provision and our alternative option with RUS  officials. RUS’ Administrator and officials commented that they had  originally viewed the provision to guarantee lenders’ debt as unnecessary  because appropriations could be made available for funding the rural  economic development program. Nevertheless, they stated that they are  now engaged in implementing the guarantee provision. They agreed that  the alternative option we raised is consistent with the loan-origination fees  USDA places on some other loans, would be a feasible way to fund rural  economic development loans and grants, and would likely have a very  small effect on the customers of borrowers that receive RUS loans.
section_title: Conclusions
paragraphs: The rural electricity program is no longer operated in a manner fully  consistent with the concept of service to rural areas. RUS policies  allowing loans and guarantees to be provided to borrowers whose  customer base has grown significantly and that provide service in urban  metropolitan areas go beyond the original intent of the program.  Consequently, the program’s focus on service to rural residents has been  blurred, and the federal goals now being served by the program are not  fully transparent. Better targeting of loans to borrowers that provide  service in rural areas would result in more consistent use of RUS’ funds  and reduce the government’s lending costs. Such targeting could be  accomplished by recognizing that there have been population increases in  previously rural areas and applying a population criterion to both initial  and subsequent loans, thereby ensuring that lending remains focused on  rural areas.
We are also concerned about the proposed guarantee of lenders’ debt  because it would unnecessarily increase taxpayer risk. Guarantees on  lenders’ debt are not needed to raise capital for lending to electricity  service providers. In addition, the stated purpose of the debt guarantee  program—raising funds for rural economic development loans and  grants—could be accomplished through a no-risk alternative that we have  identified.
section_title: Matters for Congressional Consideration
paragraphs: We are presenting three matters for congressional consideration. To better  target RUS’ lending to borrowers serving rural areas, Congress may wish  to consider specifying that the program criterion for rural areas applies to  both an initial loan and any subsequent loans that borrowers seek. In  addition, to provide additional funds for rural economic development  loans and grants without risk to taxpayers, Congress may wish to consider  amending the RE Act to authorize a small loan-origination fee on RUS’  electricity and telecommunication loans and direct that fees collected on  such loans be used for rural economic development loans and grants, and  simultaneously repeal the new lender debt guarantee requirement.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to USDA for review and comment. We  received written comments from the Acting Under Secretary for Rural  Development, which are presented in appendix III together with our  detailed responses.
USDA did not express agreement or disagreement with our matters for  congressional consideration. USDA commented that the report challenges  the long-established RUS practice of determining the rural or nonrural  nature of areas at the time RUS made the loan for initial service, but not  doing so for subsequent loans. In this regard, USDA also said that this  issue has been raised with Congress many times before, and that while  Congress has revised the RE Act, it has not accepted previous  recommendations from us and others to address RUS’ lending practices.  However, USDA pointed out that the President’s budget recommends that  the rural status of borrowers be recertified. According to USDA’s budget  summary for fiscal year 2005, RUS’ borrowers would be asked to recertify  that they are serving areas that are rural, rather than urban or suburban  areas. In addition, RUS officials told us that they drafted legislation along  these lines, but that USDA has not sent this proposal to Congress for  consideration. Given this apparent recognition by USDA of the need to  address RUS’ lending practices, there may be an opportunity for improving  the focus of RUS’ program.
USDA also commented that it believes the methodology used in the report  does not accurately portray the extent to which its borrowers serve  consumers who are not in rural areas. USDA referred to the definition of  rural in the RE Act and said it believes that any methodology used to  characterize a borrower’s service territory should be based directly on  Bureau of the Census data as applied to the service territory maps of its  borrowers. USDA also stated that our use of the Economic Research  Service’s county classification system is inappropriate and that the Office  of Management and Budget has said that it is not correct to use statistical  information about metropolitan areas for determining eligibility for federal  programs. The service territory maps of the 530 distribution borrowers  included in our analysis were not available at RUS; collecting these maps  and applying census data to each one would have precluded us from  providing a timely response to our requester. While RUS does not collect  comprehensive data on the areas served by its distribution borrowers, nor  maintain current service territory maps of its borrowers, RUS identified  for us the counties each borrower serves. This information enabled us to  use the Economic Research Service’s rural-urban classification system to  characterize the areas served by RUS borrowers. Also, our report makes  no specific determinations about the eligibility of any RUS borrower to  participate in the program. We disagree with USDA’s objection to the use  of the rural-urban classification method developed by the Economic  Research Service. USDA’s Economic Research Service classification  system is based on Bureau of the Census data, and it classifies areas,  including counties, by degree of rurality. According to the Economic  Research Service, its system captures the diversity of rural America in  ways that are meaningful for developing public policies and programs. We  agree that these classifications are not the criteria of the RE Act. Our  purpose, however, was to describe the characteristics of areas served by  RUS electricity distribution borrowers, and the Economic Research  Service’s classification system is useful for that purpose. We believe our  analyses, taken together, provide insight into the extent of service  provided by borrowers in counties with large urban populations within  metropolitan areas, which we have emphasized in our results.  Furthermore, the population has grown in many areas served by RUS  distribution borrowers that originally qualified for loans under the  requirement that they serve sparsely populated rural areas. During our  review, RUS officials agreed that many of its borrowers would no longer  meet the RE Act population test for service to rural areas if that criterion  were applied.
USDA also discussed the general location of places where rural residents  reside and stated that the majority live in metropolitan counties.  Accordingly, USDA said that the report would classify service to these  consumers as evidence that a distribution borrower was serving nonrural  areas. We did not use our results in this manner and our leading  observation, based on several analyses and our previous reports, is that  RUS distribution borrowers serve not only rural areas but also highly  populated areas. At the same time, we reported that about 24 percent of  the counties served by RUS distribution borrowers are completely rural or  have only nominal urban populations. However, it should be recognized  that, according to USDA’s Economic Research Service, rural areas,  particularly those rich in natural resources, have experienced economic  transformation and rapid population growth, while other areas face  declining job opportunity and population loss. We believe that suggestions  to better target RUS lending could respond to these changed conditions.
Finally, USDA commented that it is important to recognize, and not  criticize, RUS’ efforts to implement the 2002 Farm Bill provision to  guarantee the bonds and notes that lenders could use to raise funds for  making loans for electricity and telecommunications services. USDA  asked that the report be revised to distinguish between criticism of the  legislation and RUS’ efforts to implement it. We believe that our report  properly describes RUS’ efforts to implement the legislation in a factual  manner and supports the purpose rather than criticizes the legislation in  the 2002 Farm Bill calling for the new guarantee program or RUS’ efforts  to implement the legislation. It does, however, provide an alternative for  funding rural economic development that avoids risk. Our report notes  RUS’ view that guaranteeing bonds and notes may not result in losses,  although providing such guarantees would include some risks to taxpayers  and, in a worst-case scenario, could result in potential losses of $1.5  billion. We stated that, recognizing the potential risks, RUS included in its  proposed regulation certain risk-mitigation requirements not specified in  the 2002 Farm Bill. However, we also noted that CFC commented that  these proposals would make the program unworkable. In addition, we  stated that RUS’ economic analyses do not include a discussion of risks  facing CFC in the electricity and telecommunications markets.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 15 days from the  date of this letter. We will then send copies to interested congressional  committees; the Secretary of Agriculture; the Administrator of RUS; the  Director, Office of Management and Budget; officials at CoBank and CFC;  and other interested parties. We will make copies available to others on  request. In addition, this report will be available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please call me at  (202) 512-3841. Key contributors to this report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The Chairman of the Subcommittee on Energy Policy, Natural Resources  and Regulatory Affairs, House Committee on Government Reform asked  that we report to him on (1) the extent to which RUS distribution  borrowers provide electricity service to nonrural areas and (2) the  potential financial risk to taxpayers of the 2002 Farm Bill requirement to  guarantee lenders’ debts, and the amount of rural economic development  loans and grants that could be funded by fees on the guarantees. In  addition, we identified an alternative that could provide funds for rural  economic development loans and grants.
In the overall course of our work, we reviewed the basic statutory  authority for RUS programs—the Rural Electrification Act of 1936, as  amended (RE Act); USDA’s Budget Explanatory Notes for Committee on  Appropriations for fiscal years 1999 through 2005; prior GAO reports; and  RUS reports and publications. To provide relatively current information on  RUS’ electricity program, we focused on the loans RUS made, guaranteed,  and wrote-off in fiscal years 1999 through 2003. We interviewed RUS  officials, including the Administrator and Assistant Administrator for the  electricity program. For the Rural Business-Cooperative Service’s rural  economic development loan and grant program, we used similar sources,  including agency publications and reports, its annual financial report  containing information on loans and grants made from fiscal year 1999  through 2003, the budget explanatory notes, and our prior reports. We also  interviewed USDA’s Deputy Administrator for the business programs. We  did not verify the accuracy of the financial information contained in the  Rural Business-Cooperative Service’s annual financial report.
To address the extent to which RUS distribution borrowers provide  electricity service to rural and nonrural areas, we obtained information  about RUS’ lending policies by reviewing provisions of the RE Act; RUS  regulations; and our prior reports; we also interviewed RUS officials. We  obtained automated financial reports from RUS that covered all direct and  guaranteed electricity loans made between fiscal years 1999 and 2003. We  took steps to verify the accuracy of the information contained in the  automated financial reports, and performed some data reliability testing  and found that the data were reliable enough for our purposes. We also  obtained from RUS a list of the counties served by its active electricity  borrowers, which we compared to the Economic Research Service’s 2003  rural-urban continuum codes. These codes classify all U.S. counties along  a 9-point scale that distinguishes metropolitan counties by the population  size of their metropolitan area and nonmetropolitan counties by the  degree of urbanization and adjacency to a metropolitan area. The  metropolitan and nonmetropolitan classifications are based on the Office  of Management and Budget’s June 2003 groupings. Metropolitan counties  are distinguished by the population size of the metropolitan statistical area  of which they are part. Nonmetropolitan counties are classified according  to the aggregate size of their urban population and by whether they are  adjacent to a metropolitan area. Using this information, we coded the  counties where RUS’ electricity borrowers that received loans between  fiscal years 1999 and 2003 provide service. To avoid overstating the  number of counties served by RUS borrowers, we did not code the same  county twice, in the event that two different borrowers served customers  in the same county. We then analyzed county-level data from the 2000  census. Specifically, we analyzed the number of residents in counties that  the Bureau of the Census classifies as residing in rural and urban areas. In  general, the Bureau of the Census historically defined rural areas as cities,  villages, boroughs, or towns with fewer than 2,500 inhabitants. The Bureau  of the Census revised the definition for the 2000 census to focus on  population density within areas while retaining the 2,500 population  criterion. Thus, for this part of our analysis, we used counties served by  the distribution borrowers as an indicator of areas being served by  borrowers that obtain RUS electricity loans. We also analyzed the service  area maps of selected RUS borrowers.
We also cross-referenced the loan information we obtained from RUS  against data that the distribution borrowers report to the agency annually  on the number of customers that they serve. We then categorized the  borrowers that received loans by various incremental ranges of residential  customers served. These ranges generally correspond with the population  criteria for various USDA rural development programs—for example, a  population of less than 2,500 for electricity loans, 10,000 or less for water  and waste disposal loans and grants, and 20,000 or less for community  facility loans and grants. We used the most recently available customer  data at the time a loan was approved for our analysis. Thus, if a loan was  approved in calendar year 2000, we used customer data as of December  31, 1999. We took this approach because the agency does not collect data  on the number of customers in each county that the borrowers serve. We  recognize that most borrowers serve multiple areas, which could result in  their having a high number of customers. However, we noted that the  residential customer data are counted as individuals responsible for  paying the electricity bills; a household is generally counted as one  customer. Thus, the customer count data would be less than the number of  inhabitants.
To address the potential financial risk to taxpayers of the 2002 Farm Bill  requirement to guarantee lenders’ debts, and the amount of rural  economic development loans and grants that could be funded by fees on  the guarantees, we reviewed the relevant portion of the act and its  legislative record. During the initial portion of our review, RUS had not  issued a proposed or implementing regulation. Because the Rural  Business-Cooperative Service’s Deputy Administrator for the business  programs told us the agency had not yet developed a program-level  estimate of the additional loans and grants that could be funded under the  new program, we made such an estimate using RUS’ estimated level of  guaranteed debt and the resulting available fee proceeds, if that level were  achieved, and the Rural Business-Cooperative Service’s fiscal year 2004  budget figures for rural economic development loans and grants. To obtain  information on RUS’ efforts and plans to implement the new guarantee  program, we interviewed RUS officials, including the Assistant  Administrator for the electricity program. A proposed regulation was  published in the Federal Register on December 30, 2003. We reviewed this  document to determine how the agency was proposing to implement the  new program and the agency’s description of the program’s risk, impact,  and benefits. We interviewed officials of CFC and CoBank to obtain their  views on the proposed new program, and reviewed financial and business  reports on these entities and the electric and telecommunications  industries.
To determine whether an alternative mechanism might be available to  fund the rural economic development program with less risk, we analyzed  RUS’ fiscal year 2005 budget request for electricity and  telecommunications loans and the Rural Business-Cooperative Service’s  request for rural economic development loans and grants to determine  what level of fees would be needed to cover the costs of the Rural  Business-Cooperative Service’s program. For this part of our analysis, we  focused on a fee level that could result in a level of funds to support rural  economic development loans and grants that approximately doubles the  Rural Business-Cooperative Service’s fiscal year 2005 requested program  levels. Moreover, we obtained from the Rural Development mission area’s  finance office information on the level of funds in the cushion-of-credit  account and available to cover the subsidy costs of rural economic  development loans and the cost of rural economic development grants.
We conducted our review from October 2003 to June 2004 in accordance  with generally accepted government auditing standards.
section_title: Appendix II: Customers and Examples of Urban Counties Served by RUS Borrowers
paragraphs: This appendix contains two tables: table 3 provides information about the  numbers of customers served by RUS distribution borrowers included in  our analysis; table 4 provides information about 12 counties with  substantial urban populations that are served entirely or predominately by  RUS electricity borrowers. These counties are located in the vicinity of  Atlanta, Georgia; Charlotte, North Carolina; Tampa, Florida; and  Washington, D.C.
section_title: Appendix III: Comments from the U.S. Department of Agriculture
paragraphs: The following are GAO’s comments on the U.S. Department of  Agriculture’s letter dated May 24, 2004.
subsections: section_title: GAO Comments
paragraphs: 1.  We do not criticize the legislation in the 2002 Farm Bill calling for the  new guarantee program, and offer Congress an alternative for funding  rural economic development loans and grants that does not provide  added risk exposure to the nation’s taxpayers. Our report recognizes  that a key feature of the new program, as specified in the bill report of  the Senate Committee on Agriculture, Nutrition, and Forestry and in  the conference report, is to provide an additional funding mechanism  for rural economic development loans and grants.  2.  The report recognizes that RUS has taken steps to implement the new  guarantee program and does not criticize the agency’s actions.  Moreover, we recognize in the report that RUS proposed steps to  mitigate risk in the new program, including the requirements for a  bankruptcy trust, pledges of collateral, a 5 percent limit on cash  patronage refunds, and the use of certain standards that apply to  depository financial institutions.  3.  We reviewed a January 2004 Bearing Point report prepared for RUS  that lays out credit subsidy rate options, which suggest some risks  with the new guarantee program. This Bearing Point report does not  state or otherwise show that the probability of incurring any loss under  the program is unlikely; it does, however, contain various estimated  subsidy rates assuming defaults. We also reviewed a December 2002  Bearing Point report prepared for RUS on credit subsidies; this report  also has no statement about losses being unlikely. These two Bearing  Point reports are Guarantee Program for Bonds and Notes Issued for  Electrification or Telephone Purposes, Credit Subsidy Input and  Output Sheets for 15-Year Bond Scenarios (January 9, 2004), and  Bond and Note Guarantee Program, Credit Subsidy Research Final  (December 16, 2002). In addition, our report states that RUS estimated,  in the economic analysis section of its proposed program regulations,  maximum potential losses at $1.5 billion, but that RUS does not expect  losses to occur.  4.  Contrary to USDA’s assertion, we do not challenge RUS’ practice of  determining eligibility when a borrower first applies for a loan to  provide electricity service in a rural area. In our opinion, this practice  is called for and meets the provisions of the RE Act. We do question,  however, RUS’ practice of providing subsequent loans for service to  areas that are no longer rural.  5.  We agree with USDA that there has been prior reporting on electricity  loans being made by RUS to borrowers that have experienced  population growth in their service territories and on RUS’ policy of  allowing such lending. However, we have an obligation to report on  the continuation of these conditions because we were specifically  requested to do so. We believe it is important to highlight these  conditions for Congress given the purpose of the RE Act—that is,  providing loans to assist in the electricity infrastructure development  of sparsely populated rural areas.  6.  In discussing the results of our analyses with RUS officials, they told  us that legislation had been drafted that is consistent with the  President’s fiscal year 2005 budget to require borrowers to recertify  that they are serving rural areas. We added this statement to the  report.  7.  We used various methodologies to characterize the areas served by  RUS distribution borrowers because the agency does not collect  comprehensive data on the areas they serve. For example, RUS does  not maintain up-to-date service territory maps or current population  data within those service areas. We recognize that urban-rural  continuum codes of USDA’s Economic Research Service are not the  criteria the RE Act specifies RUS use to determine program eligibility.  We also acknowledge that all the metropolitan counties served by RUS  electricity distribution borrowers have at least some parts that the  2000 census classifies as rural, and that many of these counties are  only partially served by a RUS borrower. Our point, however, is to  generally describe the characteristics of areas served by RUS  electricity distribution borrowers. Moreover, our analysis of the  Economic Research Service’s system was one of various  methodologies we used; the others were our analyses of specific  borrowers serving highly populated areas, counties with substantial  urban populations served by RUS’ distribution borrowers, and the  numbers of customers served by these borrowers. More specifically, as  USDA’s letter acknowledges, the report provides information on five  borrowers that serve highly populated areas. In addition, table 4 in  appendix II lists the total population, urban population, and rural  population based on the 2000 census of 12 counties that are  exclusively or predominantly served by RUS electricity distribution  borrowers. This table shows conclusively that urban populations are  benefiting from RUS electricity loans. Furthermore, table 3 in appendix  II disaggregates RUS electricity borrowers by the number of customers  served.  8.  Neither the draft reviewed by USDA, nor this report, suggests that  metropolitan statistical areas be used as eligibility criteria for  participating in the electricity loan program. Rather, we state in  appendix I of our report that we used counties served by the  distribution borrowers as an indicator of areas being served by  borrowers that obtain RUS electricity loans. Our purpose in providing  information on the metropolitan counties served by RUS borrowers  was to illustrate how some borrowers now provide service to largely  populated areas, rather than providing service solely to sparsely  populated rural areas.  9.  We agree that the electricity loan program involves relatively little  subsidy cost. Our concern with the actual and potential cost of the  program stems from the fact that RUS has experienced a high level of  losses in recent years. Specifically, the background section of this  report notes that RUS wrote off more than $3.2 billion during fiscal  years 1999 through 2003. Our 1998 report noted that RUS wrote off  more than $1.7 billion during fiscal year 1994 through June 30, 1997. In  addition, it is likely RUS will incur additional losses in the near future.  For example, at the end of fiscal year 2003, the assets of two  borrowers that owed a total of more than $22 million were being  liquidated by bankruptcy trustees, and the agency’s officials told us  they anticipate losses.  10.  We disagree. This report contains new information highlighting that  loans are being made to borrowers providing service in highly  populated metropolitan areas; it provides examples of specific  counties in highly populated areas that are served by borrowers; and it  contains a nationwide analysis of counties that are served by  borrowers that obtained loans from RUS in recent years. The report  also contains in appendix II updated information on loans made to  borrowers that have a high number of customers.  11.  We revised the report to recognize that hardship rate loans are made to  borrowers that have a relatively high cost of providing service, as  indicated by a high average revenue per kilowatt-hour sold, and that  serve customers with below-average income, or at the discretion of  RUS’ Administrator. However, we note that in the current period of  low interest rates, the rate charged on hardship rate loans, which is set  at 5 percent, has been higher than the rates charged by RUS on its  municipal rate loans and Treasury rate loans. Specifically, as the report  states, the interest rate on municipal rate loans ranged from 1.1  percent to 4.6 percent during the first quarter of calendar year 2004,  and on Treasury rate loans ranged from 1.2 percent to 4.4 percent in  mid-March 2004.
section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to the individuals named above, Jonathan C. Altshul, Vondalee  R. Hunt, Cynthia C. Norris, Patrick J. Sweeney, and Amy E. Webbink made  key contributions.