Maritime Administration: Weaknesses Identified in Management of the Title XI Loan Guarantee Program
Published: 2003-06-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Title XI of the Merchant Marine Act of 1936, as amended, is intended to help promote growth and modernization of the U.S. merchant marine and U.S. shipyards by enabling owners of eligible vessels and shipyards to obtain financing at attractive terms. The program has committed to guarantee more than $5.6 billion in ship construction and shipyard modernization costs since 1993, but it has experienced several large-scale defaults over the past few years. Because of concerns about the scale of recent defaults, GAO was asked to (1) determine whether MARAD complied with key program requirements, (2) describe how MARAD's practices for managing financial risk compare to those of selected private-sector maritime lenders, and (3) assess MARAD's implementation of credit reform.
section_title: What GAO Found
paragraphs: The Maritime Administration (MARAD) has not fully complied with some key Title XI program requirements. While MARAD generally complied with requirements to assess an applicant's economic soundness before issuing loan guarantees, MARAD did not ensure that shipowners and shipyard owners provided required financial statements, and it disbursed funds without sufficient documentation of project progress. Overall, MARAD did not employ procedures that would help it adequately manage the financial risk of the program. MARAD could benefit from following the practices of selected private sector maritime lenders. These lenders separate key lending functions, offer less flexibility on key lending standards, use a more systematic approach to loan monitoring, and rely on experts to estimate the value of defaulted assets. With regard to credit reform implementation, MARAD uses a simplistic cash flow model to calculate cost estimates, which have not reflected recent experience. If this pattern of recent experience were to continue, MARAD would have significantly underestimated the cost of the program. MARAD does not operate the program in a businesslike fashion. Consequently, MARAD cannot maximize the use of its limited resources to achieve its mission, and the program is vulnerable to fraud, waste, abuse, and mismanagement. Also, because MARAD's subsidy estimates are questionable, Congress cannot know the true costs of the program.

section_title: Letter
paragraphs: Under the Title XI Loan Guarantee Program, the Maritime Administration  (MARAD) committed to guarantee more than $5.6 billion in shipyard  modernization and ship construction projects over the last 10 years.  During this period, MARAD experienced nine defaults associated with  these loan guarantee commitments totaling over $1.3 billion. The defaulted  amounts associated with these nine loan guarantee commitments totaled  $489 million. Five of these defaults were by subsidiaries of American  Classic Voyages Company (AMCV), a shipowner. AMCV defaults  represented 67 percent of all defaulted amounts experienced by MARAD  during this period, with this borrower having defaulted on guaranteed loan  projects in amounts totaling $330 million. The largest loan guarantee ever  approved by MARAD, for over $1.1 billion, was for Project America, Inc., a  subsidiary of AMCV. Project America, Inc., had entered into a contract in  March 1999 with Northrup Grumman Corporation (formerly Litton Ingalls  Shipbuilding) in Pascagoula, Mississippi, for the construction of two cruise  ships. In October 2001, AMCV filed for bankruptcy, defaulting on $187  million in loan guarantees associated with Project America.
As of December 31, 2002, MARAD’s portfolio included approximately $3.4  billion in executed loan guarantees, representing 103 projects for 818  vessels and four shipyard modernizations. At the end of fiscal year 2002,  MARAD had approximately $20 million in unexpended, unobligated budget  authority that had been appropriated in prior years. In its 2004 budget, the  administration requested no new funds for the Title XI program.
Because of concerns about the scale of recent defaults experienced by  MARAD, particularly those associated with AMCV, you asked us to  conduct a study of the Title XI loan guarantee program. Specifically, you  asked us to (1) determine whether MARAD complied with key Title XI  program requirements in approving initial and subsequent agreements,  monitoring and controlling funds, and handling defaults; (2) describe how  MARAD’s practices for managing financial risk compare to those of  selected private-sector maritime lenders; and (3) assess MARAD’s  implementation of credit reform as it relates to the Title XI program.
To determine whether MARAD complied with key Title XI program  requirements, we identified key program requirements and reviewed how  these were applied to the management of five loan guarantee projects. To  determine how MARAD’s practices for managing financial risk compare to  those of selected private-sector maritime lenders, we interviewed three  maritime lenders to learn about lending practices, and compared these  practices to MARAD’s. To assess MARAD’s implementation of credit  reform, we analyzed MARAD’s subsidy cost estimation and reestimation  processes and examined how the assumptions MARAD uses to calculate  subsidy cost estimates compare to MARAD’s actual program experience.  We conducted our work in Washington, D.C., and New York, N.Y., between  September 2002 and April 2003 in accordance with generally accepted  government auditing standards. Appendix I contains a full description of  our scope and methodology.
subsections: section_title: Background
paragraphs: Title XI of the Merchant Marine Act of 1936, as amended, authorizes the  Secretary of Transportation to guarantee debt issued for the purpose of  financing or refinancing the construction, reconstruction, or  reconditioning of U.S.-flag vessels or eligible export vessels built in U.S.  shipyards and the construction of advanced and modern shipbuilding  technology of general shipyard facilities located in the United States. Title  XI guarantees are backed by the full faith and credit of the United States.  Title XI was created to help promote growth and modernization of the U.S.  merchant marine and U.S. shipyards by enabling owners of eligible vessels  and shipyards to obtain long-term financing on terms and conditions that  might not otherwise be available. Under the program, MARAD guarantees  the payment of principal and interest to purchasers of bonds issued by  vessel and shipyard owners. These owners may obtain guaranteed  financing for up to 87.5 percent of the total cost of constructing a vessel or  modernizing a shipyard. Borrowers obtain funding for guaranteed debt  obligations in the private sector, primarily from banks, pension funds, life  insurance companies, and the general public. MARAD loan guarantees  represent about 10 percent of the U.S.-flagged maritime financing market,  according to MARAD officials. However, MARAD plays a greater role in  certain segments of the maritime finance market. For example, according  to a private-sector maritime lender, MARAD guarantees financing on about  15 percent of the country’s inland barge market.
Over the last 10 years, MARAD experienced defaults in amounts that  totaled $489 million. One borrower, AMCV, defaulted on five loan  guarantee projects in amounts totaling $330 million, 67 percent of the total  defaulted amounts. Figure 1 shows the nine defaults experienced by  MARAD over the past 10 years, five of which were associated with AMCV  and which are shown in gray.
Once an applicant submits a Title XI application to MARAD, and prior to  execution of a guarantee, MARAD must determine the economic  soundness of the project, as well as the applicant’s capability to construct  or operate the ship or shipyard. For example, the shipowner or shipyard  must have sufficient operating experience and the ability to operate the  vessels or employ the technology on an economically sound basis. The  shipowner or shipyard must also meet certain financial requirements with  respect to working capital and net worth.
The amount of the obligations that MARAD may guarantee for a project is  based on the ship or shipyard costs. Title XI permits guarantees not  exceeding 87.5 percent of the actual cost of the ship or shipyard, with  certain projects limited to 75 percent financing. The interest rate of the  guaranteed obligations is determined by the private sector. MARAD also  levies certain fees associated with the Title XI program. For example,  applicants must pay a nonrefundable filing fee of $5,000. In addition, prior  to issuance of the commitment letter, the applicant must pay an  investigation fee against which the filing fee is then credited. Participants  must also pay a guarantee fee, which is calculated by determining the  amount of obligations expected to be outstanding and disbursed to the  shipowner or shipyard during each year of financing.
The Title XI program is also subject to the Federal Credit Reform Act  (FCRA) of 1990, which was enacted to require that agency budgets reflect  a more accurate measurement of the government’s subsidy costs for direct  loans and loan guarantees. FCRA is intended to provide better cost  comparisons both among credit programs and between credit and  noncredit programs. The credit subsidy cost is the government’s estimated  net cost, in present value terms, of direct or guaranteed loans over the  entire period the loans are outstanding. Credit reform was intended to  ensure that the full cost of credit programs would be reflected in the  budget so that the executive branch and Congress might consider these  costs when making budget decisions. Each year, as part of the President’s  Budget, agencies prepare estimates of the expected subsidy costs of new  lending activity for the upcoming year. Unless OMB approves an  alternative proposal, agencies are also required to reestimate this cost  annually. OMB has oversight responsibility for federal loan program  compliance with FCRA requirements and has responsibility for approving  subsidy estimates and reestimates.
All credit programs automatically receive any additional budget authority  that may be needed to fund reestimates. For discretionary programs this  means there is a difference in the budget treatment of the original subsidy  cost estimates and of subsidy cost reestimates. The original estimated  subsidy cost must be appropriated as part of the annual appropriation  process and is counted under any existing discretionary funding caps.
However, any additional appropriation for upward reestimates of subsidy  cost is not constrained by any budget caps. This design could result in a  tendency to underestimate the initial subsidy costs of a discretionary  program. Portraying a loan program as less costly than it really is when  competing for funds means more or larger loans or loan guarantees could  be made with a given appropriation because the program then could rely  on a permanent appropriation for subsequent reestimates to cover any  shortfalls. This built-in incentive is one reason to monitor subsidy  reestimates. Monitoring reestimates is a key control over tendencies to  underestimate costs as well as a barometer of the quality of agencies’  estimation processes.
When credit reform was enacted, it generally was recognized that agencies  did not have the capacity to implement fully the needed changes in their  accounting systems in the short-term and that the transition to budgeting  and accounting on a present-value basis would be difficult. However,  policy makers expected that once agencies established a systematic  approach to subsidy estimation based on auditable assumptions, present  value-based budgeting for credit would provide them with significantly  better information.
section_title: MARAD Has Not Fully Complied with Some Key Title XI Program Requirements
paragraphs: MARAD has not fully complied with some key Title XI program  requirements. We found that MARAD generally complied with  requirements to assess an applicant’s economic soundness before issuing  loan guarantees. MARAD used waivers or modifications, which, although  permitted by MARAD regulations, allowed MARAD to approve some  applications even though borrowers had not met all financial  requirements. MARAD did not fully comply with regulations and  established practices pertaining to project monitoring and fund  disbursement. Finally, while MARAD has guidance governing the  disposition of defaulted assets, adherence to this guidance is not  mandatory, and MARAD did not always follow it in the defaulted cases we  reviewed. We looked at five MARAD-financed projects (see table 1).
subsections: section_title: MARAD Used Waivers and Modifications to Approve Loans That Would Otherwise Not Be Approved
paragraphs: MARAD regulations do not permit MARAD to guarantee a loan unless the  project is determined to be economically sound. MARAD generally  complied with requirements to assess an applicant’s economic soundness  before approving loan guarantees, and we were able to find  documentation addressing economic soundness criteria for the projects  included in our review. Specifically, we were able to find documentation  addressing supply and demand projections and other economic soundness  criteria for the projects included in our review. In 2002, MARAD’s Office  of Statistical and Economic Analysis found a lack of a standardized  approach for conducting market analyses. Because of this concern, in  November 2002, it issued guidance for conducting market research on  marine transportation services. However, adherence to these guidelines is  not required. According to the Department of Transportation (DOT)  Assistant Secretary for Administration, the market research guidelines  developed by the Office of Statistical and Economic Analysis were neither  requested nor approved by Title XI program management. Finally, while  MARAD may not waive economic soundness criteria, officials from the  Office of Statistics and Economic Analysis which is responsible for  providing independent assessment of the market impact on economic  soundness expressed concern that their findings regarding economic  soundness might not always be fully considered when MARAD approved  loan guarantees. They cited a recent instance where they questioned the  economic soundness of a project that was later approved without their  concerns being addressed. According to the Associate Administrator for  Shipbuilding, all concerns, including economic soundness concerns, are  considered by the MARAD Administrator.
Shipowners and shipyard owners are also required to meet certain  financial requirements during the loan approval process. However,  MARAD used waivers or modifications, which, although permitted by Title  XI regulations, allowed MARAD to approve some applications even though  borrowers had not met all financial requirements that pertained to  working capital, long-term debt, net worth, and owner-invested equity.  For example, AMCV’s Project America, Inc., did not meet the qualifying  requirements for working capital, among other things. Although MARAD  typically requires companies to have positive working capital, an excess of  current assets over current liabilities, the accounting requirements for  unterminated passenger payments significantly affect this calculation  because this deferred revenue is treated as a liability until earned.  Because a cruise operator would maintain large balances of current  liabilities, MARAD believed it would be virtually impossible for AMCV to  meet a positive working capital requirement if sound cash management  practices were followed. Subsequently, MARAD used cash flow tests for  Project America, Inc., in lieu of working capital requirements for purposes  of liquidity testing. According to the Assistant Secretary for  Administration, one of the major cruise lines uses cash flow tests as a  measure of its liquidity.
According to MARAD officials, waivers or modifications help them meet  the congressional intent of the Title XI program, which is to promote the  growth and modernization of the U. S. merchant marine industry. Further,  they told us that the uniqueness of the Title XI projects and marine  financing lends itself to the use of waivers and modifications. However, by  waiving or modifying financial requirements, MARAD officials may be  taking on greater risk in the loans they are guaranteeing. Consequently, the  use of waivers or modifications could contribute to the number or severity  of loan guarantee defaults and subsequent federal payouts. In a recent  review, the Department of Transportation Inspector General (IG) noted  that the use of modifications increases the risk of the loan guarantee to the  government and expressed concern about MARAD undertaking such  modifications without taking steps to mitigate those risks. The IG  recommended that MARAD require a rigorous analysis of the risks from  modifying any loan approval criteria and impose compensating  requirements on borrowers to mitigate these risks.
section_title: MARAD Did Not Follow Requirements for Monitoring the Financial Condition of Projects and for Controlling the Disbursement of Loan Funds
paragraphs: MARAD did not fully comply with requirements and its own established  practices pertaining to project monitoring and fund disbursement.  Program requirements specify periodic financial reporting, controls over  the disbursement of loan funds, and documentation of amendments to  loan agreements. MARAD could not always demonstrate that it had  complied with financial reporting requirements. In addition, MARAD could  not always demonstrate that it had determined that projects had made  progress prior to disbursing loan funds. Also, MARAD broke with its own  established practices for determining the amount of equity a shipowner  must invest prior to MARAD making disbursements from the escrow  fund. MARAD did so without documenting this change in the loan  agreement. Ultimately, weaknesses in MARAD’s monitoring practices  could increase the risk of loss to the federal government.
MARAD regulations specify that the financial statements of a company in  receipt of a loan guarantee shall be audited at least annually by an  independent certified public accountant. In addition, MARAD regulations  require companies to provide semiannual financial statements. However,  MARAD could not demonstrate that it had received required annual and  semiannual statements. For example, MARAD could not locate several  annual or semiannual financial statements for the Massachusetts Heavy  Industries (MHI) project. Also, MARAD could not find the 1999 and 2000  semiannual financial reports for AMCV. The AMCV financial statements  were later restated, as a result of a Securities and Exchange Commission  (SEC) finding that AMCV had not complied with generally accepted  accounting principles in preparing its financial statements. In addition,  several financial statements were missing from MARAD records for Hvide  Van Ommeran Tankers (HVIDE) and Global Industries Ltd. When MARAD  could provide records of financial statements, it was unclear how the  information was used. Further, the Department of Transportation  Inspector General (IG) in its review of the Title XI program found that  MARAD had no established procedures or policies incorporating periodic  reviews of a company’s financial well-being once a loan guarantee was  approved.
An analysis of financial statements may have alerted MARAD to financial  problems with companies and possibly given it a better chance to  minimize losses from defaults. For example, between 1993 and 2000,  AMCV had net income in only 3 years and lost a total of $33.3 million. Our  analysis showed a significant decline in financial performance since 1997.  Specifically, AMCV showed a net income of $2.4 million in 1997, with  losses for the next 3 years, and losses reaching $10.1 million in 2000.  Although AMCV’s revenue increased steadily during this period by a total  of 25 percent, or nearly $44 million, expenses far outpaced revenue during  this period. For example, the cost of operations increased 29 percent, or  $32.3 million, while sales and general and administrative costs increased  over 82 percent or $33.7 million. During this same period, AMCV’s debt  also increased over 300 percent. This scenario combined with the decline  in tourism after September 11, 2001, caused AMCV to file for bankruptcy.
On May 22, 2001 Litton Ingalls Shipbuilding notified AMCV that it was in  default of its contract due to nonpayment. Between May 22 and August 23,  2001, MARAD received at least four letters from Ingalls, the shipbuilder,  citing its concern about the shipowner’s ability to pay construction costs.  However, it was not until August 23 that MARAD prepared a financial  analysis to help determine the likelihood of AMCV or its subsidiaries  facing bankruptcy or another catastrophic event.
MARAD could not always demonstrate that it had linked disbursement of  funds to progress in ship construction, as MARAD requires. We were not  always able to determine from available documents the extent of progress  made on the projects included in our review. For example, a number of  Project America, Inc., disbursement requests did not include  documentation that identified the extent of progress made on the project.  Also, while MARAD requires periodic on-site visits to verify the progress  on ship construction or shipyard refurbishment, we did not find evidence  of systematic site visits and inspections. For Project America, Inc.,  MARAD did not have a construction representative committed on-site at  Ingalls Shipyard, Inc. until May 2001, 2 months after the MARAD’s Office  of Ship Design and Engineering Services recommended a MARAD  representative be located on-site. For the Searex Title XI loan guarantee,  site visits were infrequent until MARAD became aware that Ingalls had cut  the vessels into pieces to make room for other projects. For two projects  rated low-risk, Hvide Van Ommeran Tankers and Global Industries, Ltd.,  we found MARAD conducted site visits semiannually and annually,  respectively. We reviewed MHI’s shipyard modernization project, which  was assigned the highest risk rating, and found evidence that construction  representatives conducted monthly site visits. However, in most instances,  we found that a project’s risk was not routinely linked to the extent of  project monitoring. Further, without a systematic approach to on-site  visits, MARAD relied principally on the shipowner’s certification and  documentation of money spent in making decisions to approve  disbursements from the escrow fund.
We also found that, in a break with its own established practice, MARAD  permitted a shipowner to define total costs in a way that permitted earlier  disbursement of loan funds from the escrow fund. MARAD regulations  require that shipowners expend from their own funds at least 12.5 percent  or 25 percent, depending on the type of vessel or technology, of the actual  cost of a vessel or shipyard project prior to receiving MARAD-guaranteed  loan funds. In practice, MARAD has used the estimated total cost of the  project to determine how much equity the shipowner should provide. In  the case of Project America, Inc., the single largest loan guarantee in the  history of the program, we found that MARAD permitted the shipowner to  exclude certain costs in determining the estimated total costs of the ship  at various points in time, thereby deferring owner-provided funding while  receiving MARAD-guaranteed loan funds. This was the first time MARAD  used this method of determining equity payments, and MARAD did not  document this agreement with the shipowner as required by its policy. In  September 2001, MARAD amended the loan commitment for this project,  permitting the owner to further delay the payment of equity. By then,  MARAD had disbursed $179 million in loan funds. Had MARAD followed  its established practice for determining equity payments, the shipowner  would have been required to provide an additional $18 million. Because  MARAD had not documented its agreements with AMCV, the amount of  equity the owner should have provided was not apparent during this  period. Further, MARAD systems do not flag when the shipowner has  provided the required equity payment for any of the projects it finances.
MARAD officials cited several reasons for its limited monitoring of Title XI  projects, including insufficient staff resources, travel budget restrictions  and limited enforcement tools. For example, officials of MARAD’s Office  of Ship Construction, which is responsible for inspection of vessels and  shipyards, told us that they had only two persons available to conduct  inspections, and that the office’s travel budget was limited. The MARAD  official with overall responsibility for the Title XI program told us that, at a  minimum, the Title XI program needs three additional staff. The Office of  Ship Financing needs two additional persons to enable a more thorough  review of company financial statements and more comprehensive  preparation of credit reform materials. Also, the official said that the  Office of the Chief Counsel needs to fill a long-standing vacancy to enable  more timely legal review. With regard to documenting the analysis of  financial statements, MARAD officials said that, while they do require  shipowners and shipyard owners to provide financial statements, they do  not require MARAD staff to prepare a written analysis of the financial  condition of the Title XI borrower. MARAD Assistant Secretary for  Administration noted that if financial documents were not submitted after  a request for missing documents was made, MARAD’s only legal recourse  was to call the loan in default, pay off the Title XI debt and then seek  recovery against the borrower.
He said that MARAD tries to avoid takings these steps. We found no  evidence that MARAD routinely requested missing financial statements or  did any analysis. Also, the IG report on the Title XI program released in  March 2003 noted that MARAD does not closely monitor the financial  health of its borrowers over the term of their loans. We recognize that  MARAD has limited enforcement resources, however, for such publicly  traded companies as AMCV, financial statements filed with the Securities  and Exchange Commission could be used. However, we found no  evidence that MARAD attempted to use SEC filings.
Inconsistent monitoring of a borrower’s financial condition limits  MARAD’s ability to protect the federal government’s financial interests.  For example, MARAD would not know if a borrower’s financial condition  had changed so that it could take needed action to possibly avoid defaults  or minimize losses. Further, MARAD’s practices for assessing project  progress limit its ability to link disbursement of funds to progress made by  shipowners or shipyard owners. This could result in MARAD disbursing  funds without a vessel or shipyard owner making sufficient progress in  completing projects. Likewise, permitting project owners to minimize their  investment in MARAD-financed projects increases the risk of loss to the  federal government.
section_title: MARAD Does Not Have Requirements in Place to Govern the Handling of Defaulted Assets
paragraphs: MARAD has guidance governing the disposition of defaulted assets.  However, MARAD is not required to follow this guidance, and we found  that MARAD does not always adhere to it. MARAD guidelines state that an  independent, competent marine surveyor or MARAD surveyor shall survey  all vessels, except barges, as soon as practicable after the assets are taken  into custody. In the case of filed or expected bankruptcy, an independent  marine surveyor should be used. In the case of Searex, MARAD conducted  on-site inspections after the default. However, these inspections were not  conducted in time to properly assess the condition of the assets. With  funds no longer coming in from the project, Ingalls cut the vessels into  pieces to make it easier to move the vessels from active work-in-process  areas to other storage areas within the property. The Searex lift boat and  hulls were cut before MARAD inspections were made. According to a  MARAD official, the cutting of one Searex vessel and parts of the other  two Searex vessels under construction reduced the value of the defaulted  assets. The IG report on the Title XI program released in March 2003 noted  that site visits were conducted on guaranteed vessels or property only in  response to problems or notices of potential problems from third parties  or from borrowers.
The guidelines also state that sales and custodial activities shall be  conducted in such a fashion as to maximize MARAD’s overall recovery  with respect to the asset and debtor. Market appraisals (valuations) of the  assets shall be performed by an independent appraiser, as deemed  appropriate, to assist in the marketing of the asset. MARAD did not have a  market appraisal for the defaulted Project America assets. Also, MARAD  relied on an interested party to determine the cost of making Project  America I seaworthy. An appraisal of Project America assets immediately  after default would have assisted MARAD in preparing a strategy for  offering the hull of Project America I and the parts of Project America II  for sale. According to MARAD officials, as of March 2003, MARAD had  received $2 million from the sale of the Project America I and II vessels.  Without a market appraisal, it is unclear whether this was the maximum  recovery MARAD could have received.
MARAD hired the Defense Contract Audit Agency (DCAA) to verify the  costs incurred by Northrop Grumman Ship Systems, Inc., since January 1,  2002, for preparing and delivering Project America I in a weather-tight  condition suitable for ocean towing in international waters. A MARAD  official said that the DCAA audit would allow MARAD to identify any  unsupported costs and recover these amounts from the shipyard. The  DCAA review was used to verify costs incurred, but not to make a  judgment as to the reasonableness of the costs. DCAA verified costs of  approximately $17 million.
MARAD officials cite the uniqueness of the vessels and projects as the  reason for using guidelines instead of requirements for handling defaulted  assets. However, certain practices for handling defaulted assets can be  helpful regardless of the uniqueness of a project. Among these are steps to  immediately assess the value of the defaulted asset. Without a definitive  strategy and clear requirements, defaulted assets may not always be  secured, assessed, and disposed of in a manner that maximizes MARAD’s  recoveries—resulting in unnecessary costs and financial losses to the  federal government.
section_title: MARAD Techniques to Manage Financial Risk Contrast to Techniques of Selected Private- sector Maritime Lenders
paragraphs: Private-sector maritime lenders we interviewed told us that it is imperative  for lenders to manage the financial risk of maritime lending portfolios. In  contrast to MARAD, they indicated that to manage financial risk, among  other things, they (1) establish a clear separation of duties for carrying out  different lending functions; (2) adhere to key lending standards with few,  if any, exceptions; (3) use a more systematic approach to monitoring the  progress of projects; and (4) primarily employ independent parties to  survey and appraise defaulted projects. The lenders try to be very selective  when originating loans for the shipping industry. While realizing that  MARAD does not operate for profit, it could benefit from the internal  control practices employed by the private sector to more effectively utilize  its limited resources and to enhance its ability to accomplish its mission.  Table 2 describes the key differences in private-sector and MARAD  maritime lending practices used during the application, monitoring, and  default and disposition phases.
subsections: section_title: Private-sector Lenders Separate Key Lending Functions
paragraphs: Private-sector lenders manage financial risk by establishing a separation of  duties to provide a system of checks and balances for important maritime  lending functions. Two private-sector lenders indicated that there is a  separation of duties for approving loans, monitoring projects financed, and  disposing of assets in the event of default. For example, marketing  executives from two private-sector maritime lending institutions stated  that they do not have lending authority. Also, separate individuals are  responsible for accepting applications and processing transactions for  loan underwriting.
In contrast, we found that the same office that promotes and markets the  MARAD Title XI program also has influence and authority over the office  that approves and monitors Title XI loans. In February 1998, MARAD  created the Office of Statistical and Economic Analysis in an attempt to  obtain independent market analyses and initial recommendations on the  impact of market factors on the economic soundness of projects. Today,  this office reports to the Associate Administrator for Policy and  International Trade rather than the Associate Administrator for  Shipbuilding. However, the Associate Administrator for Shipbuilding is  primarily responsible for overseeing the underwriting and approving of  loan guarantees. Title XI program management is primarily handled by  offices that report to the Associate Administrator for Shipbuilding. In  addition, the same Associate Administrator controls, in collaboration with  the Chief of the Division of Ship Financing Contracts within the Office of  the Chief Counsel, the disposition of assets after a loan has defaulted.  Most recently, MARAD has taken steps to consolidate responsibilities  related to loan disbursements. In August 2002, the Maritime Administrator  gave the Associate Administrator for Shipbuilding sole responsibility for  reviewing and approving the disbursement of escrow funds. According to  a senior official, prior to August 2002 this responsibility was shared with  the Office of Financial and Rate Approvals under the supervision of the  Associate Administrator for Financial Approvals and Cargo Preference. As  a result of the consolidation, the same Associate Administrator who is  responsible for underwriting and approving loan guarantees and disposing  of defaulted assets is also responsible for approval of loan disbursements  and monitoring financial condition. MARAD undertook this consolidation  in an effort to improve performance of analyses related to the calculation  of shipowner’s equity contributions and monitoring of changes in financial  condition. However, as mentioned earlier, MARAD does not have controls  for clearly identifying the shipowner’s required equity contribution. The  consolidation of responsibilities for approval of loan disbursements does  not address these weaknesses and precludes any potential benefit from  separation of duties.
section_title: Private-sector Practices Employ Less Flexible Lending Standards
paragraphs: The private-sector lenders we interviewed said they apply rigorous  financial tests for underwriting maritime loans. They analyze financial  statements such as balance sheets, income statements, and cash flow  statements, and use certain financial ratios such as liquidity and leverage  ratios that indicate the borrower’s ability to repay. Private-sector maritime  lenders told us they rarely grant waivers, or exceptions, to underwriting  requirements or approve applications when borrowers do not meet key  minimum requirements. Each lender we interviewed said any approved  applicants were expected to demonstrate stability in terms of cash on  hand, financial strength, and collateral. One lender told us that on the rare  occasions when exceptions to the underwriting standards were granted,  an audit committee had to approve any exception or waiver to the  standards after reviewing the applicant’s circumstances. However,  according to one MARAD official the waivers are often made without a  deliberative process. Nonetheless, MARAD points to its concurrence  system as a deliberative process for key agency officials to concur on loan  guarantees and major waivers and modifications. However, as mentioned  earlier, the official responsible for performing a macro analysis of the  market is not always included in the concurrence process. We found in the  cases we reviewed that MARAD often permits waivers or modifications of  key financial requirements. Also, a recent IG report found that MARAD  routinely modified financial requirements in order to qualify applicants for  loan guarantees. Further, the IG noted that MARAD reviewed applications  for loan guarantees primarily with in-house staff and recommended that  MARAD formally establish an external review process as a check on  MARAD’s internal loan application review. A MARAD official told us that  MARAD is currently developing the procedures for an external review  process of waivers and modifications.
These private-sector lenders also indicated that preparing an economic  analysis or an independent feasibility study assists in determining whether  or not to approve funding based on review and discussion of the  marketplace, competition, and project costs. Each private-sector lender  we interviewed agreed that performance in the shipping industry was  cyclical and timing of projects was important. In addition, reviewing  historical data provided information on future prospects for a project. For  example, one lender uses these economic analyses to evaluate how  important the project will be to the overall growth of the shipping  industry. Another lender uses the economic analyses and historical data to  facilitate the sale of a financed vessel. In the area of economic soundness  analysis, MARAD requirements appear closer to those of the private-sector  lenders, in that external market studies are also used to help determine the  overall economic soundness of a project. However, assessments of  economic soundness prepared by the Office of Statistical and Economic  Analysis may not be fully considered when MARAD approves loan  guarantees.
section_title: Private-sector Lenders Use a More Systematic Approach to Loan Monitoring
paragraphs: Private-sector lenders minimized financial risk by establishing loan  monitoring and control mechanisms such as analyzing financial statements  and assigning risk ratings. Each private-sector lender we interviewed said  that conducting periodic reviews of a borrower’s financial statements  helped to identify adverse changes in the financial condition of the  borrower. For example, two lenders stated that they annually analyzed  financial statements such as income statements and balance sheets. The  third lender evaluated financial statements quarterly. Based on the results  of these financial statement reviews, private-sector lenders then reviewed  and evaluated the risk ratings that had been assigned at the time of  approval. Two lenders commented that higher risk ratings indicated a  need for closer supervision, and they then might require the borrower to  submit monthly or quarterly financial statements. In addition, a borrower  might be required to increase cash reserves or collateral to mitigate the  risk of a loan. Further, the lender might accelerate the maturity date of the  loan. MARAD notes that in certain cases, such as a loan guarantee to a  subsidiary of Enron, it already uses such requirements. The DOT IG noted  that MARAD should place covenants in its loan guarantees concerning the  required financial performance and condition of its borrowers, as well as  measures to which MARAD is entitled should these provisions be violated.  However, the IG expressed concern that MARAD’s minimum monitoring  approach would not provide financial information in a timely and  sufficient manner. Private-sector lenders use risk ratings in monitoring  overall risk, which in turn helped to maintain a balanced maritime  portfolio.
At MARAD, we found no evidence that staff routinely analyzed or  evaluated financial statements or changed risk categories after a loan was  approved. For example, we found in our review that for at least two  financial statement reporting periods, MARAD was unable to provide  financial statements for the borrower, and, in one case, one financial  statement was submitted after the commitment to guarantee funds. Our  review of the selected Title XI projects indicated that risk categories were  primarily assigned for purposes of estimating credit subsidy costs at the  time of application, not for use in monitoring the project. Further, we  found no evidence that MARAD changed a borrower’s risk category when  its financial condition changed. In addition, neither the support office that  was initially responsible for reviewing and analyzing financial statements  nor the office currently responsible maintained a centralized record of the  financial statements they had received. Further, while one MARAD official  stated that financial analyses were performed by staff and communicated  verbally to top-level agency officials, MARAD did not prepare and maintain  a record of these analyses.
Private-sector lenders also manage financial risk by linking the  disbursement of loan funds to the progress of the project. All the lenders  we interviewed varied project monitoring based on financial and technical  risk, familiarity with the shipyard, and uniqueness of the project. Two  lenders thought that on-site monitoring was very important in determining  the status of projects. Specifically, one lender hires an independent marine  surveyor to visit the shipyard to monitor construction progress. This  lender also requires signatures on loan disbursement requests from the  shipowner, shipbuilder, and loan officer before disbursing any loan funds.  This lender also relies on technical managers and classification society  representatives who frequently visit the shipyard to monitor progress.  Shipping executives of this lender make weekly, and many times daily,  calls to shipowners to further monitor the project based on project size  and complexity. This lender also requires shipowners to provide monthly  progress reports so the progress of the project could be monitored.
MARAD also relied on site visits to verify construction progress. However,  the linkage between the progress of the project and the disbursement of  loan funds was not always clear. MARAD tried to adjust the number of site  visits based on the amount of the loan guarantee, the uniqueness of project  (for example, whether the ship is the first of its kind for the shipowner),  the degree of technical and engineering risk, and familiarity with the  shipyard. However, the frequency of site visits was often dependent upon  the availability of travel funds, according to a MARAD official.
section_title: Private-sector Lenders Use Industry Expertise to Value Defaulted Assets
paragraphs: Private-sector maritime lenders said they regularly use independent  marine surveyors and technical managers to appraise and conduct  technical inspections of defaulted assets. For example, two lenders hire  independent marine surveyors who are knowledgeable about the  shipbuilding industry and have commercial lending expertise to inspect  the visible details of all accessible areas of the vessel, as well as its marine  and electrical systems. In contrast, we found that MARAD did not always  use independent surveyors. For example, we found that for Project  America, the shipbuilder was allowed to survey and oversee the  disposition of the defaulted asset. As mentioned earlier, MARAD hired  DCAA to verify the costs incurred by the shipbuilder to make the defaulted  asset ready for sale; however, MARAD did not verify whether the costs  incurred were reasonable or necessary. For Searex, construction  representatives and officials from the Offices of the Associate  Administrator of Shipbuilding and the Chief of the Division of Ship  Financing Contracts were actively involved in the disposition of the assets.
section_title: MARAD Cites Mission as the Difference in Management of Financial Risk Compared to Private- sector Lenders
paragraphs: According to top-level MARAD officials, the chief reason for the difference  between private-sector and MARAD techniques for approving loans,  monitoring project progress, and disposing of assets is the public purpose  of the Title XI program, which is to promote growth and modernization of  the U.S. merchant marine and U.S. shipyards. That is, MARAD’s program  purposefully provides for greater flexibility in underwriting in order to  meet the financing needs of shipowners and shipyards that otherwise  might not be able to obtain financing. MARAD is also more likely to work  with borrowers that are experiencing financial difficulties once a project is  under way. MARAD officials also cited limited resources in explaining the  limited nature of project monitoring.
While program flexibility in financial and economic soundness standards  may be necessary to help MARAD meet its mission objectives, the strict  use of internal controls and management processes is also important.  Otherwise, resources that could have been used to further the program  might be wasted. To aid agencies in improving internal controls, we have  recommended that agencies identify the risks that could impede their  ability to efficiently and effectively meet agency goals and objectives.
Private-sector lenders employ internal controls such as a systematic  review of waivers during the application phase and risk ratings of projects  during the monitoring phase. However, MARAD does neither. Without a  more systematic review of underwriting waivers, MARAD might not be  giving sufficient consideration to the additional risk such decisions  represent. Likewise, without a systematic process for assessing changes in  payment risk, MARAD cannot use its limited monitoring resources most  efficiently. Further, by relying on interested parties to estimate the value  of defaulted loan assets, MARAD might not maximize the recovery on  those assets. Overall, by not employing the limited internal controls it does  possess, and not taking advantage of basic internal controls such as those  private-sector lenders employ, MARAD cannot ensure it is effectively  utilizing its limited administrative resources or the government’s limited  financial resources.
section_title: MARAD’s Credit Subsidy Estimates and Reestimates Are Questionable
paragraphs: MARAD uses a relatively simplistic cash flow model that is based on  outdated assumptions, which lack supporting documentation, to prepare  its estimates of defaults and recoveries. These estimates differ  significantly from recent actual experience. Specifically, we found that in  comparison with recent actual experience, MARAD’s default estimates  have significantly understated defaults, and its recovery estimates have  significantly overstated recoveries. If the pattern of recent experience  were to continue, MARAD would have significantly underestimated the  costs of the program. Agencies should use sufficient reliable historical  data to estimate credit subsidies and update—reestimate—these estimates  annually based on an analysis of actual program experience. While the  nature and characteristics of the Title XI program make it difficult to  estimate subsidy costs, MARAD has never performed the basic analyses  necessary to determine if its default and recovery assumptions are  reasonable. Finally, OMB has provided little oversight of MARAD’s subsidy  cost estimate and reestimate calculations.
subsections: section_title: MARAD’s Credit Subsidy Estimates Are Questionable
paragraphs: FCRA was enacted, in part, to require that the federal budget reflect a  more accurate measurement of the government’s subsidy costs for loan  guarantees. To determine the expected cost of a credit program, agencies  are required to predict or estimate the future performance of the program.  For loan guarantees, this cost, known as the subsidy cost, is the present  value of estimated cash flows from the government, primarily to pay for  loan defaults, minus estimated loan guarantee fees paid and recoveries to  the government. Agency management is responsible for accumulating  relevant, sufficient, and reliable data on which to base the estimate and for  establishing and using reliable records of historical credit performance. In  addition, agencies are supposed to use a systematic methodology to  project expected cash flows into the future. To accomplish this task,  agencies are instructed to develop a cash flow model, using historical  information and various assumptions including defaults, prepayments,  recoveries, and the timing of these events, to estimate future loan  performance.
MARAD uses a relatively simplistic cash flow model, which contains five  assumptions—default amount, timing of defaults, recovery amount, timing  of recoveries, and fees—to estimate the cost of the Title XI loan guarantee  program. We found that relatively minor changes in these assumptions can  significantly affect the estimated cost of the program and that, thus far,  three of the five assumptions, default and recovery amounts and the timing  of defaults, differed significantly from recent actual historical experience.  According to MARAD officials, these assumptions were developed in 1995  based on actual loan guarantee experience of the previous 10 years and  have not been evaluated or updated. MARAD could not provide us with  supporting documentation to validate its estimates, and we found no  evidence of any basis to support the assumptions used to calculate these  estimates. MARAD also uses separate default and recovery assumptions  for each of seven risk categories to differentiate between levels of risk and  costs for different loan guarantee projects.
We attempted to analyze the reliability of the data supporting MARAD’s  key assumptions, but we were unable to do so because MARAD could not  provide us with any supporting documentation for how the default and  recovery assumptions were developed. Therefore, we believe MARAD’s  subsidy cost estimates to be questionable. Because MARAD has not  evaluated its default and recovery rate assumptions since they were  developed in 1995, the agency does not know whether its cash flow model  is reasonably predicting borrower behavior and whether its estimates of  loan program costs are reasonable.
The nature and characteristics of the Title XI program make it difficult to  estimate subsidy costs. Specifically, MARAD approves a small number of  guarantees each year, leaving it with relatively little experience on which  to base estimates for the future. In addition, each guarantee is for a large  dollar amount, and projects have unique characteristics and cover several  sectors of the market. Further, when defaults occur, they are usually for  large dollar amounts and may not take place during easily predicted time  frames. Recoveries may be equally difficult to predict and may be affected  by the condition of the underlying collateral. This leaves MARAD with  relatively limited information upon which to base its credit subsidy  estimates. Also, MARAD may not have the resources to properly  implement credit reform. MARAD officials expressed frustration that they  do not have and, therefore, cannot devote, the necessary time and  resources to adequately carry out their credit reform responsibilities.
Notwithstanding these challenges, MARAD has not performed the basic  analyses necessary to assess and improve its estimates. According to  MARAD officials, they have not analyzed the default and recovery rates  because most of their loan guarantees are in about year 7 out of the 25- year term of the guarantee, and it is too early to assess the reasonableness  of the estimates. We disagree with this assessment and believe that an  analysis of the past 5 years of actual default and recovery experience is  meaningful and could provide management with valuable insight into how  well its cash flow models are predicting borrower behavior and how well  its estimates are predicting the loan guarantee program’s costs. We further  believe that, while difficult, an analysis of its risk category system is  meaningful for MARAD to ensure that it appropriately classified loan  guarantee projects into risk category subdivisions that are relatively  homogenous in cost.
Of loans originated in the past 10 years, nine have defaulted, totaling  $489.5 million in defaulted amounts. Eight of these nine defaults, totaling  $487.7 million, occurred since MARAD implemented its risk category  system in 1996. Because these eight defaults represent the vast majority  (99.6 percent) of MARAD’s default experience, we compared the  performance of all loans guaranteed between 1996–2002 with MARAD’s  estimates of loan performance for this period. We found that actual loan  performance has differed significantly from agency estimates. For  example, when defaults occurred, they took place much sooner than  estimated. On average, defaults occurred 4 years after loan origination,  while MARAD had estimated that, depending on the risk category, peak  defaults would occur between years 10–18. Also, actual default costs thus  far have been much greater than estimated. We estimated, based on  MARAD data, that MARAD would experience $45.5 million in defaults to  date on loans originated since 1996. However, as illustrated by figure 2,  MARAD has consistently underestimated the amount of defaults the Title  XI program would experience. In total, $487.7 million has actually  defaulted during this period—more than 10 times greater than estimated.  Even when we excluded AMCV, which represents about 68 percent of the  defaulted amounts, from our analysis, we found that the amount of  defaults MARAD experienced greatly exceeded what MARAD estimated it  would experience by $114.6 million (or over 260 percent).
In addition, MARAD’s estimated recovery rate of 50 percent of defaulted  amounts within 2 years of default is greater than the actual recovery rate  experienced since 1996, as can be seen in figure 3. Although actual  recoveries on defaulted amounts since 1996 have taken place within 1–3  years of default, most of these recoveries were substantially less than  estimated, and two defaulted loans have had no recoveries to date. For the  actual defaults that have taken place since 1996, MARAD would have  estimated, using the 50 percent recovery rate assumption, that it would  recover approximately $185.3 million dollars. However, MARAD has only  recovered $94.9 million or about 51 percent of its estimated recovery  amount. When we excluded AMCV, which represents about 68 percent of  the defaulted amounts, from our analysis, we found that MARAD has more  accurately estimated the amount it would recover on defaulted loans, and  in fact, has underestimated the actual amount by about $10 million (or  about 15 percent). If the overall pattern of recent default and recovery  experiences were to continue, MARAD would have significantly  underestimated the costs of the program.
We also attempted to analyze the process MARAD uses to designate risk  categories for projects, but were unable to do so because the agency could  not provide us with any documentation about how the risk categories and  MARAD’s related numerical weighting system originally were developed.
According to OMB guidance, risk categories are subdivisions of a group of  loans that are relatively homogeneous in cost, given the facts known at the  time of designation. Risk categories combine all loan guarantees within  these groups that share characteristics that are statistically predictive of  defaults and other costs. OMB guidance states that agencies should  develop statistical evidence based on historical analysis concerning the  likely costs of expected defaults for loans in a given risk category. MARAD  has not done any analysis of the risk category system since it was  implemented in 1996 to determine whether loans in a given risk category  share characteristics that are predictive of defaults and other costs and  thereby comply with guidance. In addition, according to a MARAD official,  MARAD’s risk category system is partially based on outdated MARAD  regulations and has not been updated to reflect changes to these  regulations.
Further, MARAD’s risk category system is flawed because it does not  consider concentrations of credit risk. To assess the impact of  concentration risk on MARAD’s loss experience, we analyzed the defaults  for loans originated since 1996 and found that five of the eight defaults,  totaling $330 million, or 68 percent of total defaults, involved loan  guarantees that had been made to one particular borrower, AMCV.  Assessing concentration of credit risk is a standard practice in private- sector lending. According to the Federal Reserve Board’s Commercial  Bank Examination Manual, limitations imposed by various state and  federal legal lending limits are intended to prevent an individual or a  relatively small group from borrowing an undue amount of a bank’s  resources and to safeguard the bank’s depositors by spreading loans  among a relatively large number of people engaged in different businesses.  Had MARAD factored concentration of credit into its risk category system,  it would likely have produced higher estimated losses for these loans.
section_title: MARAD’s Credit Subsidy Reestimates Are Also Questionable
paragraphs: After the end of each fiscal year, OMB generally requires agencies to  update or “reestimate” loan program costs for differences among  estimated loan performance and related cost, the actual program costs  recorded in accounting records, and expected changes in future economic  performance. The reestimates are to include all aspects of the original cost  estimate such as prepayments, defaults, delinquencies, recoveries, and  interest. Reestimates allow agency management to compare original  budget estimates with actual costs to identify variances from the original  estimates, assess the reasonableness of the original estimates, and adjust  future program estimates, as appropriate. When significant differences  between estimated and actual costs are identified, the agency should  investigate to determine the reasons behind the differences, and adjust its  assumptions, as necessary, for future estimates and reestimates.
We attempted to analyze MARAD’s reestimate process, but we were  unable to do so because the agency could not provide us with adequate  supporting data on how it determined whether a loan should have an  upward or downward reestimate. According to agency management, each  loan guarantee is reestimated separately based on several factors  including the borrower’s financial condition, a market analysis, and the  remaining balance of the outstanding loans. However, without conducting  our own independent analysis of these and other factors, we were unable  to determine whether any of MARAD’s reestimates were reasonable.  Further, MARAD has reestimated the loans that were disbursed in fiscal  years 1993, 1994, and 1995 downward so that they now have negative  subsidy costs, indicating that MARAD expects these loans to be profitable.  However, according to the default assumptions MARAD uses to calculate  its subsidy cost estimates, these loans have not been through the period of  peak default, which would occur in years 10–18 depending on the risk  category. MARAD officials told us that several of these loans were paid off  early, and the risk of loss in the remaining loans is less than the estimated  fees paid by the borrowers. However, MARAD officials were unable to  provide us with adequate supporting information for its assessment of the  borrowers’ financial condition and how it determined the estimated  default and recovery amounts to assess the reasonableness of these  reestimates. Our analysis of MARAD’s defaults and recoveries  demonstrates that, when defaults occur, they occur sooner and are for far  greater amounts than estimated, and that recoveries are smaller than  estimated. As a result, we question the reasonableness of the negative  subsidies for the loans that were disbursed in fiscal years 1993, 1994, and  1995.
MARAD’s ability to calculate reasonable reestimates is seriously impacted  by the same outdated assumptions it uses to calculate cost estimates as  well as by the fact that it has not compared these estimates with the actual  default and recovery experience. As discussed earlier, our analysis shows  that, since 1996, MARAD has significantly underestimated defaults and  overestimated recoveries to date. Without performing this basic analysis,  MARAD cannot determine whether its reestimates are reasonable, and it is  unable to improve these reestimate calculations over time and provide  Congress with reliable cost information to make key funding decisions. In  addition, and, again, as discussed earlier, MARAD’s inability to devote  sufficient resources to properly implement credit reform appears to limit  its ability to adequately carry out these credit reform responsibilities.
section_title: OMB Has Provided Little Oversight of MARAD’s Estimates and Reestimates
paragraphs: Based on our analysis, we believe that OMB provided little review and  oversight of MARAD’s estimates and reestimates. OMB has final authority  for approving estimates in consultation with agencies; OMB approved  each MARAD estimate and reestimate, explaining to us that it delegates  authority to agencies to calculate estimates and reestimates. However,  MARAD has little expertise in the credit reform area and has not devoted  sufficient resources to developing this expertise. FCRA assigns  responsibility to OMB for coordinating credit subsidy estimates,  developing estimation guidelines and regulations, and improving cost  estimates, including coordinating the development of more accurate  historical data and annually reviewing the performance of loan programs  to improve cost estimates. Had OMB provided greater review and  oversight of MARAD’s estimates and reestimates, it would have realized  that MARAD did not have adequate support for the default and recovery  assumptions it uses to calculate subsidy cost estimates.
section_title: Conclusions
paragraphs: MARAD does not operate the Title XI loan guarantee program in a  businesslike fashion to minimize the federal government’s fiscal exposure.  MARAD does not (1) fully comply with its own requirements and  guidelines, (2) have a clear separation of duties for handling loan approval  and fund disbursement functions, (3) exercise diligence in considering and  approving modifications and waivers, (4) adequately secure and assess the  value of defaulted assets, and (5) know what its program costs. Because of  these shortcomings, MARAD lacks assurance that it is effectively  promoting growth and modernization of the U.S. merchant marine and  U.S. shipyards or minimizing the risk of financial loss to the federal  government. Consequently, the Title XI program could be vulnerable to  waste, fraud, abuse, and mismanagement. Finally, MARAD’s questionable  subsidy cost estimates do not provide Congress a basis for knowing the  true costs of the Title XI program, and Congress cannot make well- informed policy decisions when providing budget authority. If the pattern  of recent experiences were to continue, MARAD would have significantly  underestimated the costs of the program.
section_title: Matters for Congressional Consideration
paragraphs: We recommend that Congress consider discontinuing future  appropriations for new loan guarantees under the Title XI program until  adequate internal controls have been instituted to manage risks associated  with the program and MARAD has updated its default and recovery  assumptions to more accurately reflect the actual costs associated with  the program and that Congress consider rescinding the unobligated  balances in MARAD’s program account. We also recommend that  Congress consider clarifying borrower equity contribution requirements.  Specifically, we recommend that Congress consider legislation requiring  the entire equity down payment, based on the total cost of the project  including total guarantee fees currently expected to be paid over the life of  the project, be paid by the borrower before the proceeds of the guaranteed  obligation are made available. Further, we recommend that Congress  consider legislation that requires MARAD to consider, in its risk category  system, the risk associated with approving projects from a single borrower  that would represent a large percentage of MARAD’s portfolio.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Secretary of Transportation direct the  Administrator of the Maritime Administration to take immediate action to  improve the management of the Title XI loan guarantee program.  Specifically, to better comply with Title XI loan guarantee program  requirements and manage financial risk, MARAD should    establish a clear separation of duties among the loan application, project  monitoring, and default management functions;   establish a systematic process that ensures independent judgments of the  technical, economic, and financial soundness of projects during loan  guarantee approval;   establish a systematic process that ensures the findings of each  contributing office are considered and resolved prior to approval of loan  guarantee applications involving waivers and exceptions made to program  requirements;   systematically monitor and document the financial condition of borrowers  and link the level of monitoring to the level of project risk;   base the borrower’s equity down payment requirement on a reasonable  estimate of the total cost of the project, including total guarantee fees  expected to be incurred over the life of the project;   make apparent the amount of equity funds a shipowner or shipyard owner    establish a system of controls, including automated controls, to ensure  that disbursements of loan funds are not made prior to a shipowner or  shipyard owner meeting the equity fund requirement;    create a transparent, independent, and risk-based process for verifying and  documenting the progress of projects under construction prior to  disbursing guaranteed loan funds; review risk ratings of loan guarantee projects at least annually; and   establish minimum requirements for the management and disposition of  defaulted assets, including a requirement for an independent evaluation of  asset value.
To better implement federal credit reform, MARAD should    establish and implement a process to annually compare estimated to  actual defaults and recoveries by risk category, investigate any material  differences that are identified, and incorporate the results of these  analyses in its estimates and reestimates;   establish and implement a process to document the basis for each key  cash flow assumption—such as defaults, recoveries, and fees—and retain  this documentation in accordance with applicable records retention  requirements;   establish and implement a process to document the basis for each  reestimate, including an analysis of a borrower’s financial condition and a  market analysis; review its risk category system to ensure that it appropriately classifies  projects into subdivisions that are relatively homogenous in cost, given the  facts known at the time of designation, and that risks and changes to risks  are reflected in annual reestimates; and    consider, in its risk category system, the risk associated with approving  projects from a single borrower that would represent a large percentage of  MARAD’s portfolio.
To ensure that the reformed Title XI program is carried out effectively and  in conformity with program and statutory requirements, MARAD should  conduct a comprehensive assessment of its human capital and other  resource needs. Such analysis should also consider the human capital  needs to improve and strengthen credit reform data collection and  analyses.
To assist and ensure that MARAD better implements credit reform, and  given the questionableness of MARAD’s estimates and reestimates, we also  recommend that the Director of OMB provide greater review and oversight  of MARAD’s subsidy cost estimates and reestimates.
section_title: Agency Comments
paragraphs: We provided a draft of this report to DOT for its review and comment. We  received comments from the department’s Assistant Secretary for  Administration, who noted that MARAD has already begun to take steps to  improve the operations of the Title XI program consistent with several of  our recommendations. The department disagreed with the manner in  which we characterized some report findings and provided additional  information and data that we have incorporated into our analyses and  report as appropriate. We also provided a copy of the draft report to OMB  for its review and comment.  We received comments from OMB’s Program  Associate Director for General Government Programs, and its Assistant  Director for Budget, who agreed that recent recovery expectations should  be incorporated into future reestimates, but disagreed that OMB had  provided little or no oversight over the program’s subsidy cost estimates.
The department noted that its Office of Inspector General recently  identified a number of issues raised in our report and that MARAD is  already addressing these issues. MARAD recognized that aspects of the  program’s operation need improvement and said it is working to fine tune  program operations and create additional safeguards. Specifically, MARAD  has agreed to improve procedures for financial review, seek authorization  for outside assistance in cases of unusual complexity, and expand, within  resource constraints, its processes for monitoring company financial  condition and the condition of assets.
The department pointed out that MARAD is permitted, under Title XI  regulations, to modify or waive financial criteria for loan guarantees.  Before issuing waivers in the future, DOT reported that MARAD will  identify any needed compensatory measures to mitigate associated risks.  MARAD also agreed to consider using outside financial advisors to review  uniquely complicated cases. In addition, DOT reported that MARAD is  working to improve its financial monitoring processes by developing  procedures to better document its regular assessments of each company’s  financial health. The department stated that MARAD plans to highlight the  results of these assessments to top agency management for any Title XI  companies experiencing financial difficulties.
The department also reported that MARAD is developing a system that  leverages limited staff resources for providing more extensive monitoring  of Title XI vessel condition. In this regard, DOT said MARAD is  establishing a documentation process for each vessel that would include  improved record keeping of annual certificates from the U.S. Coast Guard,  vessel classification societies, and insurance underwriters. MARAD hopes  to use this system, together with company financial condition  assessments, to determine whether additional inspections are necessary.
In addition, DOT indicated that MARAD has begun an analysis of the  program’s results covering the full 10-year period since FCRA was  implemented to improve the accuracy of subsidy cost estimates. We agree  that MARAD should conduct this analysis as part of its annual reestimate  process to determine if estimated loan performance is reasonably close to  actual performance and are encouraged that MARAD has been able to  obtain the historical data to conduct such an analysis. We had attempted  to perform a similar analysis to assess the basis MARAD used for its  default and recovery assumptions, but MARAD was unable to provide us  with this data.
The department believes that our analysis may provide results that do not  accurately reflect the management of the program as a whole, and that the  results we report are affected by our sample selection. It points out that  the report is based on an analysis of only 5 projects, representing a minute  segment of the Title XI program’s universe, 3 of which are defaulted  projects, even though the program experienced only 9 defaults out of 104  projects financed over the last 10 years. We do not contend that this  sample is representative of all of the projects MARAD finances. However,  we do believe that these case studies uncover policies that permeate the  program and do not provide for adequate controls or for the most effective  methods for protecting the government’s interest. In addition, our  conclusions also draw on the work of a recent IG review, which looked at  42 Title XI projects, as well as a comparison with practices of selected  private sector lenders and our own experience in analyzing loan guarantee  programs throughout the federal government.
The department also believes that as a result of our emphasis on projects  involving construction financing, a significant portion of the report is  directed at issues associated solely with that type of financing, which only  accounts for about 30 percent of Title XI projects since 1993. The  department believes it is important for us to recognize that most projects  (70 percent) have been for mortgage period financing because there are no  disbursements made from an escrow fund for these types of projects, and  there is virtually no need for agency monitoring of the construction  process for these types of projects because the ship owner does not  receive any Title XI funds until the vessel has been delivered and certified  by the regulatory authorities as seaworthy. We believe that projects  involving construction financing are at greater risk of fraud, waste, abuse,  and mismanagement, and therefore require a greater level of oversight  compared to projects involving only mortgage period financing. Again, as  mentioned above, our overall conclusions are based on more than the  cases we reviewed.
DOT asserts that the report’s portrayal of events and the rationale behind  our description of the assessment of defaulted Searex assets and the  verification of the cost for completing Project America I are inaccurate. In  the case of Searex, the department believes that we implied that had the  program officials rigorously adhered to program guidelines, the vessels  would not have been dismantled. We believe that while the use of rigorous  program guidelines may not have prevented Ingalls from dismantling the  vessels, adherence to existing program guidelines would have provided  evidence of the value and condition of the assets at the time of default.  This documentary evidence would be advantageous if legal action  occurred. In the case of Project America, DOT believes that the report  incorrectly asserts that MARAD relied on an interested party, Ingalls  Shipbuilding, Inc., to determine the value of the Project America I assets.  The department believes that MARAD relied on the shipbuilder only to  provide an estimate of the cost of making Project America seaworthy. We  revised the report to reflect that MARAD did not obtain a market appraisal  of the assets, and that it relied on Ingalls to estimate the cost of making the  vessel seaworthy. We believe that in order to market the Project America  assets, MARAD needs to know the costs of the available options including  the cost of making the hull seaworthy.
The department also believes that the report does not convey a clear  understanding of DCCA’s role in the handling of Project America assets  after default. We disagree with this assertion, and believe that the report  appropriately reflects DCCA’s role as outlined in its report entitled the  Application of Agreed-Upon Procedures Incurred on Project America.
DOT believes that the report uses a number of examples to show that  granting waivers or “other occurrences” related to program guidelines  somehow contributed to the three defaults among the cases studied and  expresses concern that the report concludes that weak program oversight  contributed to the defaults examined in the draft. First, the report  correctly notes that MARAD is permitted to approve waivers under certain  circumstances. Nonetheless, waiving financial requirements increases the  risk borne by the federal government. MARAD is now recognizing this by  agreeing to implement the IG recommendations calling for compensating  provisions to mitigate risk when approving waivers. Second, the program’s  vulnerability to fraud, waste, abuse and mismanagement is not only due to  MARAD not complying with program requirements, but also because  MARAD lacks requirements for the management of defaulted assets, does  not utilize basic internal control practices, such as separation of duties,  and cannot reasonably estimate the program’s cost.
With regard to the private sector comparison, DOT does not agree that  MARAD lacks a deliberative process for loan approvals. The department  believes that, in each written loan guarantee analysis, MARAD discusses  the basis for granting major modifications or waivers. Also, DOT believes  MARAD has a deliberative process through its written concurrence system  whereby key agency offices have to concur on actions authorizing waivers  or modifications. We revised the report to reflect the differing opinions of  MARAD officials regarding the process for approving loan guarantees and  waivers or modifications. We believe that it is not clear that MARAD uses a  deliberative process and our review of the project files showed that key  agency offices were not always included in the concurrence process.
DOT believes that the report should acknowledge that MARAD maintains  separation of duties for disbursement. The report correctly notes that the  ultimate decision to disburse funds is made by the same office that  approves and monitors the Title XI loans. We added the name of the office  that it then instructs to disburse funds.
DOT noted that certain lenders consolidate rather than separate approval  and monitoring functions in order to improve efficiencies. The lenders we  spoke to, who are major marine lenders, do not combine these functions.  They also separate approval and monitoring functions from marketing and  disposition functions. Further, we do not believe that efficiencies achieved  through consolidating these functions outweigh the greater vulnerability  to fraud, waste, abuse, and mismanagement associated with consolidation.
The department believes that MARAD’s determination of subsidy costs is  in accordance with OMB guidance. While we did not assess MARAD’s  compliance with OMB guidance, MARAD did not comply with other  applicable, more specific guidance, which states that estimated cash flows  should be compared to actuals, and estimates should be based on the best  available data. The guidance is in the Accounting and Auditing Policy  Committee’s Technical Release 3, Preparing and Auditing Direct Loan  and Loan Guarantee Subsidies Under the Federal Credit Reform Act.  This guidance was developed by an interagency group including members  from OMB, Treasury, GAO, and various credit agencies to provide detailed  implementation guidance on how to prepare reasonable credit subsidies.  Regardless of whether MARAD complied with all applicable guidance,  because MARAD did not conduct this fundamental analysis to assess  whether its cash flow model was reasonably predicting borrower  behavior, it did not know that for the past 5 years, defaults were occurring  at a much higher rate and costing significantly more than estimated, and  recoveries were significantly less than expected. In addition, MARAD did  not appropriately incorporate these higher default rates and lower  recovery rates into its cash flow models.
The department also stated that the report should recognize that, as a  result of its full compliance with FCRA, MARAD set aside adequate funds  for all defaults to date. While MARAD may have complied with some of the  broad requirements of FCRA in preparing estimates and reestimates, these  estimates were based on outdated assumptions and MARAD could not  demonstrate that the estimates were based on historical data or other  meaningful analyses. Further, DOT’s response does not recognize that the  appropriated funds are to cover expected losses over the life of the loan  guarantee program. Because actual losses for the last 5 years have been  significantly more and recoveries significantly less than expected, in the  future actual losses will need to be significantly less and recoveries  significantly more than estimated for MARAD not to require additional  funding.
In addition, DOT believes that our analysis of MARAD’s subsidy estimates  was inaccurate and based on incomplete or incorrect data, and that we  underreported actual recoveries from one of the defaulted projects (MHI).  We disagree and believe our analysis was accurate, based on the  information MARAD had provided. In its comments, the department  provided new information on recoveries for the MHI project. We have now  incorporated this new data, as appropriate, into our analysis. We did not  include data provided on guarantee fees because these are paid upfront  and should not be included in estimates of recoveries.
The department also provided technical comments, which we have  incorporated as appropriate. The department’s comments appear in  appendix II.
OMB agreed that recent recovery expectations on certain defaulted  guarantees cited in our report should be incorporated into future  reestimates, and plans to ensure that these expectations are reflected in  next year’s budget. Further, OMB plans to work with MARAD to review  recovery expectations for other similar loan guarantees. In addition, OMB  has been working with DOT and MARAD staff to implement  recommendations contained in the IG report, and expects that resulting  changes will also address many of the concerns raised in our report.
OMB disagreed with our finding that it provided little review and oversight  of MARAD’s subsidy cost estimates and reestimates and points to the  substantial amount of staff time it devotes to working with agencies on  subsidy cost estimates. OMB claims that the data used in our report does  not seem to support our assertion of a lack of OMB oversight and  disagrees with our implication that the overall subsidy rates would be  higher if it had provided oversight. We clarified our report to convey the  message that if OMB had provided greater oversight, it would have  realized that MARAD did not have adequate support for the default and  recovery assumptions it uses to calculate subsidy cost estimates.  While  OMB asserts that the number of default claims made between 1992 and  1999 is substantially in line with the assumptions underlying the estimated  subsidy costs, we could not verify the magnitude and timing of defaults  prior to the period included in our review (1996–2002) because MARAD  could not provide data on historical default experience. Because MARAD  could not provide adequate support for its default and recovery  assumptions, we question the basis for the estimates and whether OMB  had provided sufficient oversight. We continue to believe that MARAD’s  recent actual experience was significantly different than what MARAD had  estimated and OMB had approved. Even when we exclude all of the AMCV  projects, as well as the MHI project, from our analysis, we found that the  amount of defaults MARAD experienced exceeded what MARAD  estimated it would experience by $63.3 million (or about 177 percent).  Should the program receive new funding in the future, the subsidy rate  estimates should be calculated using updated default and recovery  assumptions to incorporate recent actual experience.
OMB also took issue with our use of data on the eight defaults, particularly  those involving AMCV and MHI, in questioning MARAD’s most recent  reestimates of the costs of loans guaranteed between 1992 and 1995.  However, we continue to question the reasonableness of the negative  subsidies for the loans that were disbursed in fiscal years 1993, 1994, and  1995. First, the loans in these cohorts have not been through what MARAD  considers the period of peak default—years 10–18 depending on the risk  category. Second, MARAD was unable to provide us with adequate  supporting information for how it determined the estimated default and  recovery amounts. OMB agrees that recent experience should be used to  calculate reestimates and states in its comments that it generally requires  agencies to use all historical data as a benchmark for future cost estimates  and agreed that recent recovery experience should be incorporated into  future reestimates.
OMB’s comments appear in appendix III.
We are sending copies of this report to the Secretary of Transportation.  We also will make copies available to others upon request. In addition, the  report will be available at no charge on the GAO web site at  http://www.gao.gov.
If you or your staff have any questions about this report or need additional  information, please contact me, or Mathew Scirè at 202-512-6794. Major  contributors to this report are listed in appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine whether MARAD complied with key Title XI program  requirements, we identified key program requirements and reviewed how  these were applied to the management of five loan guarantee projects. We  judgmentally selected 5 projects from a universe of 83 projects approved  between 1996 and 2002. The selected projects represent active and  defaulted loans and five of the six risk categories assigned during the  1996–2002 period. The projects selected include barges, lift boats, cruise  ships, and tankers. (See table 3.) Two of the selected shipowners had  multiple Title XI loan guarantees during 1996–2002 (HVIDE, five  guarantees; and AMCV, the parent company of Project America, Inc., five).
We interviewed agency officials and reviewed provisions of existing  federal regulations set forth in Title 46, Part 298 of the Code of Federal  Regulations to identify the key program requirements that influence the  approval or denial of a Title XI loan guarantee. We reviewed internal  correspondence and other documentation related to the compliance with  program requirements for the approval of the loan guarantee, ongoing  monitoring of the project, and disposition of assets for loans resulting in  default. We interviewed agency officials and staff members from the Title  XI support offices that contribute to the approval and monitoring of loans  and disposal of a loan resulting in default. Also, we interviewed a retired  MARAD employee involved in one of the projects.
In addition, we interviewed officials that represented AMCV/Project  America, Inc., including the former Vice President and General Counsel  and former outside counsel.
To determine how MARAD’s practices of managing financial risk compare  to those of selected private-sector maritime lenders, we interviewed two  leading worldwide maritime lenders, and one leading maritime lender in  the Gulf Coast region. We interviewed these lenders to become familiar  with private-sector lending policies, procedures, and practices in the  shipping industry. Among the individuals we interviewed were those  responsible for portfolio management and asset disposition. We did not  verify that the lenders followed the practices described to us.
To assess MARAD’s implementation of credit reform, we analyzed  MARAD’s subsidy cost estimation and reestimation processes and  examined how the assumptions MARAD uses to calculate subsidy cost  estimates compare to MARAD’s actual program experience. We first  identified the key cash flow assumptions MARAD uses to calculate its  subsidy cost estimates. Once we identified these assumptions, we  determined whether MARAD had a reliable basis—whether MARAD had  gathered sufficient, relevant, and reliable supporting data—for the  estimates of program cost and for their estimates of loan performance. We  compared estimated program performance to actual program performance  to determine whether variances between the estimates and actual  performance existed. Further, we interviewed those MARAD officials who  are responsible for implementing credit reform and compared the  practices MARAD uses to implement credit reform to the practices  identified in OMB and other applicable credit reform implementation  guidance.
We performed our work in Washington, D.C., and New York, N.Y., between  September 2002 and April 2003 in accordance with generally accepted  government auditing standards.
section_title: Appendix II: Comments from the Department of Transportation
section_title: Appendix III: Comments from the Office of Management and Budget
section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to those individuals named above, Kord Basnight, Daniel Blair,  Rachel DeMarcus, Eric Diamant, Donald Fulwider, Grace Haskins,  Rachelle Hunt, Carolyn Litsinger, Marc Molino, and Barbara Roesmann  made key contributions to this report.