Farmers Home Administration: The Guaranteed Farm Loan Program Could Be Managed More Effectively
Released: 1994-11-16T00:00:00

Letter

Introduction

The Farmers Home Administration (FmHA), a lending agency within the U.S. Department of Agriculture (USDA), provides assistance to financially troubled farmers through direct government-funded loans and guarantees on loans made by other agricultural lenders. Until the early 1970s, FmHA provided direct loans only. The Rural Development Act of 1972 (P.L. 92-419, Aug. 30, 1972) provided FmHA with discretionary authority to guarantee farm loans made by other agricultural lenders, such as commercial banks and the Farm Credit System. In guaranteeing a farm loan, FmHA agrees, in the event that a borrower defaults, to reimburse a commercial lender for up to 90 percent of lost principal plus accrued interest and liquidation costs.

Hierarchy of Farm Credit

American farmers have a hierarchy of credit available. Farmers who need to borrow funds to finance their operations or purchase farm property have three basic sources of credit. First, farmers in the best financial position can obtain credit from lenders such as commercial banks, the Farm Credit System, life insurance companies, or individuals. Second, if farmers’ security or ability to meet repayment terms is somewhat marginal, they can obtain credit from commercial lenders through FmHA’s guaranteed farm loan program. Third, if farmers are unable to obtain financing elsewhere, they can obtain a direct loan from FmHA. Table 1.1 shows that FmHA was responsible for about 12.5 percent of the total farm debt on December 31, 1992—guaranteed loans (3.4 percent) plus direct loans (9.1 percent). Data from December 31, 1992, were the latest available.

Overview of FmHA’s Farm Loan Programs

FmHA’s mission is to be a temporary lender of last resort. For farmers who are unable to obtain credit elsewhere, FmHA can provide financing through either a direct or a guaranteed loan. To be eligible for a direct loan, a borrower must be unable to obtain commercial credit at reasonable rates and terms. To obtain a guaranteed loan, a lender must certify that it is unwilling to make the loan without a government-backed guarantee. Direct loans are made at lower interest rates and for longer repayment periods than guaranteed loans. When direct loan borrowers demonstrate financial progress, they are to graduate to commercial credit. If properly implemented, this process enforces FmHA’s mission to supply temporary credit and makes direct loan funds available for other high-risk farmers needing financial assistance.

Although FmHA has traditionally provided more direct loans than guaranteed loans, it began to use more guaranteed loans in the mid-1980s. The Congress has since supported this changed emphasis with increased authorizations for guaranteed loans.

FmHA provides loan services through a highly decentralized organization consisting of a national program office in Washington, D.C.; a finance office in St. Louis, Missouri; and a field office structure comprising 47 state offices, about 250 district offices, and about 1,700 county offices located throughout the nation. FmHA’s county supervisors, who manage the county offices, have extensive responsibility and authority for administering the agency’s farm loan programs, including approving and servicing loans. FmHA’s district directors are to provide guidance and supervision to county supervisors within designated geographic areas in the making and servicing of farm loans, and state directors are to administer and oversee operations within one or more states. Also, district and state directors have approval authority for certain loans. During 1993, the Secretary of Agriculture proposed to the Congress a plan to restructure USDA. In early October 1994, the Congress approved a restructuring plan for USDA. This action could change the way that farm loans are administered by the Department.

Direct and Guaranteed Loans Have Specific Authorized Uses

FmHA provides direct and guaranteed loans for both farm operating and farm ownership purposes. Farm operating loans are authorized for purposes such as buying equipment items, livestock, and poultry; paying annual operating and/or family living expenses; and refinancing debts. Direct operating loans may not exceed $200,000, including any outstanding principal on other direct farm operating loans. Guaranteed operating loans may not exceed $400,000 in total outstanding loan principal. When a farm operating loan is made, collateral must be provided as security.

Farm ownership loans, whether direct or guaranteed, are authorized for purposes such as buying real estate, refinancing existing debt, and making improvements to the farm. Direct and guaranteed farm ownership loans may not exceed $200,000 and $300,000, respectively, including any outstanding principal on other farm ownership loans, soil and water loans, and recreation loans. When a farm ownership loan is made, real estate or a combination of real estate and chattel property must be provided as security.

Terms for repaying FmHA’s loans vary according to the loan’s type, the loan’s purpose, and the nature of the security. The payment period for farm operating loans may range from 1 to 7 years, while the payment period for farm ownership loans can be as long as 40 years.

FmHA also makes other types of direct farm loans not evaluated in this report, such as emergency disaster loans that are made to farmers whose operations have been substantially damaged by adverse weather or by other natural disasters. These loans are intended to assist farmers in covering actual losses incurred so that they can return to normal farming operations.

Emphasis Has Been Changing to Guaranteed Loans

In the 1980s, FmHA began using more guaranteed loans and fewer direct loans in order to encourage farm lending by commercial lenders, reduce budget outlays on direct loans, and devote more effort to servicing its growing number of direct loans and increasingly delinquent direct accounts. Under the Food Security Act of 1985 (P.L. 99-198, Dec. 23, 1985)—referred to as the 1985 Farm Bill—and again in the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508, Nov. 5, 1990), the Congress supported this shift in emphasis by decreasing authorizations for direct loans and increasing authorizations for guaranteed loans. In each year since fiscal year 1987, FmHA’s new guaranteed loans have exceeded new direct loans. (See fig. 1.1.)

However, the Agricultural Credit Improvement Act of 1992 (P.L. 102-554, Oct. 28, 1992) could change some of this emphasis back to direct loans. Under the act, FmHA must transfer 75 percent of its unobligated guaranteed operating loan authority at the end of the third quarter of a fiscal year to a new agency program that uses direct ownership loans to fund beginning farmers. In fiscal year 1993, FmHA transferred about $650 million under this authority but obligated very little of these transferred funds.

Profile of Borrowers Who Obtained Guaranteed Farm Loans During Fiscal Year 1992

During fiscal year 1992, FmHA guaranteed almost $1.6 billion on slightly less than 14,000 farm ownership and operating loans. On the basis of our random sample of these loans, we estimate that 91 percent of the loans went to borrowers who already had farm loans (whether commercial or FmHA credit) when they obtained an FmHA guaranteed loan and that 9 percent went to first-time farm loan borrowers. In addition, as shown in table 1.2, about 68 percent of the loans went to borrowers who had more than 10 years’ farm experience, 64 percent went to feed grain producers, 69 percent went to borrowers who had sales of between $100,000 and $500,000 annually, and the loans were made to borrowers whose farms averaged over 800 acres.

Furthermore, we estimate that about 54 percent of the loan funds were used for paying operating expenses, various purchases, or other expenses. Another 6 percent was used for farm real estate purchases, as shown in table 1.3, and the remaining 40 percent was used for refinancing existing debt. Also, commercial banks provided the majority of the loans.

Objectives, Scope, and Methodology

Our work was part of a special GAO governmentwide audit effort to help ensure that areas potentially vulnerable to fraud, waste, mismanagement, and abuse are identified and that appropriate corrective actions are taken. Concerned about FmHA’s high losses in its direct loan program and the potential for similar losses in its guaranteed loan program, we reviewed the guaranteed loan program to determine (1) the extent of losses under the guaranteed farm loan program compared with those under the direct loan program, (2) the extent to which the guaranteed farm loan program has graduated FmHA’s direct loan borrowers to commercial credit, and (3) ways to make the guaranteed farm loan program more of a source for funding direct loan borrowers.

In addressing these objectives, we conducted work at 6 FmHA state offices, 12 FmHA county offices, FmHA’s St. Louis Finance Office, and FmHA headquarters. Figure 1.2 shows the location of the state and county offices that we reviewed.

Additionally, we reviewed and analyzed our reports issued since the 1985 Farm Bill was passed, reports issued by USDA’s Office of Inspector General since fiscal year 1988, the results of FmHA’s internal control reviews, and the annual reports from the Secretary of Agriculture to the President required by the Federal Managers’ Financial Integrity Act of 1982 (P.L. 97-255, Sept. 8, 1982). Appendix I provides more detail on our scope and methodology.

To obtain information on the characteristics of FmHA’s guaranteed loan borrowers and the planned use of loan funds, we sent two questionnaires—one on farm ownership loans and another on farm operating loans—to county office officials requesting information about a randomly selected sample of loans that were made to borrowers who obtained loans in fiscal year 1992. Appendix II discusses our survey methodology and contains our estimates and sampling errors. Appendixes III and IV contain copies of the questionnaires used. Additionally, to evaluate the quality of the guaranteed loan portfolio, we sent another questionnaire to county office officials requesting information about the payment record of a randomly selected sample of borrowers who had outstanding loans as of June 30, 1993. Appendix V discusses our survey methodology for this aspect of our work and contains our estimates and sampling errors, and appendix VI contains a copy of the questionnaire.

To determine whether the guaranteed loan program is a viable funding source for more of FmHA’s direct loan borrowers, we conducted a structured interview with 53 commercial lenders in eight states—34 of these lenders had outstanding guaranteed loans, and 19 did not. Also, we interviewed representatives of the American Bankers Association and the Independent Bankers Association of America.

We started our work in February 1993 and used September 30, 1993, as a cut-off date for most of the financial information about FmHA’s farm loan portfolio. This date allowed us to have relatively recent and comparable data on the financial status of FmHA’s direct and guaranteed farm loan portfolios. In addition, we conducted detailed field work through October 1993, updating selected information through July 1994. We performed our work in accordance with generally accepted government auditing standards. FmHA’s written comments on the results of our work appear in appendix VIII.

Guaranteed Loans Have Resulted in Less Losses Than Direct Loans, but FmHA’s Actions Increase Potential for Loss

FmHA’s guaranteed loan program has been more successful than the direct loan program from a financial standpoint. From 1976 through 1993, FmHA guaranteed $12 billion of lenders’ loans and made $55.6 billion in direct loans. Overall losses—actual losses through 1993 plus estimates of future losses—on FmHA’s guaranteed loans are expected to be about 9 percent compared with direct loan losses of about 40 percent. A key reason for the differences in losses is that guaranteed loan borrowers are lower credit risks than direct loan borrowers are; that is, to obtain a direct loan, a borrower must show that a commercial lender would not make the loan at reasonable interest rates. Another contributing factor is that a greater proportion of the direct loans was made just prior to the farm financial crisis in the mid-1980s, when farm lenders experienced higher-than-normal loss rates.

Although more successful than the direct loan program, the guaranteed loan program is experiencing programmatic problems that contribute to increased financial risk to the government. Specifically, FmHA allows guaranteed or direct loan borrowers who have defaulted on previous loans to obtain new guaranteed loans. Also, FmHA’s internal control reviews have reported that field office officials have not always followed the agency’s standards for servicing guaranteed loans.

The Guaranteed Loan Program Is Not as Financially Stressed as the Direct Loan Program

Borrowers who receive FmHA’s guaranteed loans are more creditworthy than FmHA’s direct loan borrowers. As a result, FmHA has experienced and estimates it will experience lower losses from guaranteed loans. Also, as of September 30, 1993, about 5 percent of the outstanding guaranteed loan debt was held by delinquent borrowers compared with about 38 percent that was held by direct loan borrowers.

Actual and Potential Losses From Guaranteed Loans Are Less Than Those From Direct Loans

FmHA’s actual and estimated losses from guaranteed loans are substantially less than those from its direct loans. From 1976 through 1993, FmHA guaranteed about $12 billion in lenders’ loans—almost 135,000 farm loans to approximately 86,000 borrowers—and expects to incur losses of about $1.1 billion, or 9.2 percent. These losses are much lower than those expected for the direct loan program, which total about $22.3 billion on $56 billion of loans for the same period, or about 40 percent. (See table 2.1.)

Guaranteed loan losses would be expected to be less because guaranteed loan borrowers are less of a credit risk than direct loan borrowers are. Another contributing factor to the lower guaranteed loan losses is that a greater proportion of the direct loans was made in the late 1970s and early 1980s, just prior to the start of a period when farm lenders, overall, experienced higher-than-normal losses. Prior to 1987, the majority of FmHA’s farm loans were direct loans. However, beginning with 1987 and through 1993, the majority of FmHA’s farm loans were guaranteed loans.

Guaranteed Loan Portfolio Is Not as Vulnerable to Future Losses as the Direct Loan Portfolio

Consistent with FmHA’s estimate of future losses, two other measures of future performance each indicate that the outstanding guaranteed loans are less vulnerable to future losses than direct loans. These indicators consist of our assessment of the outstanding guaranteed loans and recent delinquencies.

According to our estimates, 13.4 percent of the 1993 guaranteed loan portfolio is at risk: 7.5 percent is held by delinquent borrowers, and 5.9 percent is held by borrowers whose loans have been rescheduled to keep their accounts current. (See table 2.2.) In comparison, as shown in our prior report, we estimated that 70 percent of the direct loans that were outstanding in 1990 were similarly at risk.

Another indicator of the extent that guaranteed loans are less risky than direct loans is the difference in delinquencies. FmHA reports show that as of September 30, 1993, delinquent borrowers held 4.8 percent of the outstanding guaranteed loan debt compared with 37.6 percent of the direct loan debt.

Current Lending Policies and Practices Expose FmHA to Increased Financial Risk

Despite the fact that the guaranteed farm loan program is in better financial condition than the direct loan program, FmHA has hundreds of millions of dollars in guaranteed loans that are at risk, in part, because some of its policies and practices do not protect the government’s interest. Specifically, FmHA does not prohibit borrowers with poor repayment histories from obtaining new loans. Furthermore, FmHA’s field office officials have not always properly implemented loan-servicing standards, which are designed to protect the federal government’s financial interest.

Guaranteed Loan-Making Policies Add to FmHA’s Risk

FmHA’s loan-making policies do not prohibit borrowers who defaulted on a guaranteed or direct loan from obtaining new guaranteed loans. As we reported in February 1994, 408 borrowers who received new guaranteed loans totaling almost $60 million during fiscal years 1991-93 had cost FmHA $67 million in losses on their previous loans. (See table 2.3.)

Although the loans are relatively new—from 1 to 3-years old—16 borrowers, or about 4 percent of the 408, were delinquent on their new loans as of September 30, 1993. For example, one borrower received a guaranteed loan for $80,000 in 1991 after receiving about $317,000 in direct loan debt relief in 1989; by 1993, this borrower was delinquent on the guaranteed loan. Similarly, FmHA guaranteed a $400,000 loan in 1991 for a borrower who had defaulted on an earlier guaranteed loan, thereby causing FmHA to pay a loss claim of $254,000; by 1993, this borrower was delinquent on the new guaranteed loan.

In our April 1992 report, we recommended that to strengthen FmHA’s loan-making standards, the Congress amend the Con Act to prohibit loan guarantees for borrowers (1) whose defaulting on previous guaranteed loans caused FmHA to pay commercial lenders’ loan loss claims and (2) whose defaulting on previous direct loans resulted in debt being written off or written down. The Congress has not implemented these recommendations.

FmHA’s Field Offices’ Noncompliance With Loan-Servicing Standards Adds to FmHA’s Financial Risk

In recent years, FmHA’s field offices have improved their compliance with the agency’s standards for making guaranteed loans but, through fiscal year 1993, had not improved in complying with the standards for servicing such loans. FmHA requires its field offices to follow specific credit standards in approving guaranteed loans. These standards include determining an applicant’s eligibility and repayment ability and the adequacy of collateral. FmHA also requires its field offices to follow specific loan-servicing standards in overseeing the lender’s servicing of loans. This servicing includes (1) inspecting collateral to ensure that the borrower possesses and is maintaining security property, (2) providing the same servicing for FmHA guaranteed loans as for other loans, and (3) ensuring that loan funds are used properly.

To evaluate the extent that FmHA’s field offices comply with the agency’s policies, procedures, and standards, FmHA established the Coordinated Assessment Review (CAR) as a part of its internal control review. The CAR consists of examining a random sample of direct and guaranteed loans each year in selected states. Generally, loans made in about 15 states are sampled and reviewed each year so that each state is reviewed every 3 years. FmHA’s target for an acceptable compliance rate is 85 percent—or no more than a 15-percent noncompliance rate.

According to the CARs, FmHA’s field offices improved their oversight of lenders’ guaranteed loan-making process. Since our April 1992 report, recent CARs have shown that the field offices had less than a 15-percent noncompliance rate for all standards that put the government at risk.

Conversely, through fiscal year 1993, the CARs showed that FmHA’s field offices had not improved their oversight of lenders’ servicing. In our April 1992 report, for example, we reported that in 25 percent of the cases reviewed, field office officials had not, as required, effectively monitored lenders’ compliance with standards for inspecting collateral and for ensuring the proper use of loan funds. The CARs for fiscal year 1993 showed that the field offices continue to have a high rate of noncompliance in several areas. Of the 15 loan-servicing standards, the field offices exceeded a noncompliance rate of 15 percent for 12 of the standards. For example, the following three cases relate to potential loss claims and demonstrate the noncompliance areas found:

There was a 36.8-percent noncompliance rate for the standard that FmHA officials concur with the lender that a delinquency was beyond a borrower’s control before allowing the lender to reschedule or reamortize a loan. The failure to follow this standard can lead to the increased risk of paying higher loss claims because of accrued interest and deteriorated collateral.

There was a 36.2-percent noncompliance rate for the standard that FmHA officials review lenders’ loan files within 90 days of closing a loan. Not following this standard can lead to the increased risk of paying higher loss claims because of errors in the value of collateral and the position of the lien.

There was a 21-percent noncompliance rate for the standard that FmHA officials approve cash flow values prior to advances for the 2nd and 3rd years on line-of-credit operating loans. Such deficiencies can lead to the increased risk of paying higher loss claims because of credit advances to borrowers (1) whose operations had changed to the point where the advances were not in accordance with the terms of the loan or (2) whose financial conditions had deteriorated to the point where repayment would be questionable.

In our April 1992 report, we recommended that FmHA develop and implement a system that ensures that its field office officials adhere to its standards for making and servicing guaranteed loans. In response, FmHA informed us about various actions it had developed for ensuring compliance, such as monitoring through its internal reviews and using the results of reviews to evaluate lending officials’ performance. However, as discussed above, while FmHA’s compliance with loan-making standards has improved, compliance with loan-servicing standards, through fiscal year 1993, had not.

Conclusions

Although the guaranteed loan program has incurred much less losses than the direct loan program, some of FmHA’s lending policies and practices continue to place the government at a higher-than-necessary financial risk. These risks exist because (1) certain loan-making policies allow FmHA to guarantee loans whose potential for loss is high and (2) FmHA’s field office officials have not always followed the agency’s credit standards for servicing guaranteed loans. This risk could be reduced if, for example, the Congress implemented recommendations that we made in our April 1992 report.

Agency Comments and Our Evaluation

In commenting on a draft of this report (see app. VIII), FmHA agreed that a borrower’s past record of debt repayment often reflects a willingness to repay debt. However, FmHA stated that our statistics do not support the position that losses caused by events beyond the control of borrowers should prevent them from receiving additional credit. FmHA also stated that there is no correlation between past failures and a probability of future losses. We share FmHA’s concerns and recognize that there are cases in which borrowers may default for reasons that are beyond their control. Nonetheless, we are concerned that past failures are a strong indicator of not only the willingness but the priority of debt repayment by borrowers—i.e., the forgiveness of debt followed by the making of additional loans sends a signal (1) that could encourage borrowers to default and (2) that there will be little if any impact on obtaining additional loans.

As a beginning of a renewed emphasis on monitoring lenders, FmHA cited several actions that it has initiated and planned. FmHA added that its emphasis has resulted in improved monitoring, as evidenced by a significant improvement in the rate of compliance with the three key standards for servicing guaranteed loans discussed in this chapter. We are encouraged by the results of FmHA’s fiscal year 1994 CAR reviews, which were not complete at the time of our review, and hope that the pattern of compliance with the servicing standards continues to follow the path of compliance with the agency’s loan-making standards.

Furthermore, FmHA stated that its loss rate on guaranteed loans, which it calculated by comparing the total amount of losses incurred with the total amount of loans made over the life of the program, is 4 percent. We disagree with FmHA’s methodology for making this calculation because it fails to take into account the losses estimated on outstanding loans. A more accurate presentation is to compare total loans made with the total of losses already incurred and those estimated to occur on loans that are outstanding. As shown in table 2.1, this results in a 9.2-percent loss rate.

Guaranteed Loans Have Not Been Systematically Used as an Interim Step to Graduate Direct Loan Borrowers to Commercial Credit

Few direct loan borrowers have moved to guaranteed loans as a step toward graduating to commercial—nongovernment supported—credit. A contributing factor has been the lack of an FmHA policy that would encourage the use of the guaranteed loan program as an interim step in graduating direct loan borrowers to commercial credit. At the direction of the Congress, FmHA initiated action in late 1993 to include moving to guaranteed loans as an interim step in the graduation process. Furthermore, FmHA field office staff often fail to follow through on the required processes for identifying direct loan borrowers with the potential for graduation and graduating those who have shown sufficient financial progress to qualify for commercial credit. As a result, some borrowers may remain in the direct loan program longer than justified, taking advantage of the agency’s subsidized interest rates and long repayment terms. Although FmHA officials and commercial lenders believe that few direct loan borrowers can meet the requirements for a guaranteed loan, FmHA does not know how many can qualify.

FmHA Has Not Routinely Used the Guaranteed Loan Program to Help Viable Direct Loan Borrowers Progress to Commercial Credit

A logical step in graduating borrowers from direct loans to commercial credit would be to promptly replace their direct loans with guaranteed loans when a borrower qualifies. However, most direct loan borrowers are not getting guaranteed loans. Furthermore, FmHA has not had a policy to use the guaranteed loan program as a means of encouraging direct loan borrowers to graduate to commercial credit.

Few Direct Loan Borrowers Obtain Guaranteed Loans

According to FmHA’s data on borrowers who have outstanding loans and who receive new loan obligations, most direct loan borrowers do not obtain guaranteed loans. As table 3.1 shows, only about 7,300 FmHA direct loan borrowers, or 4 percent of the total number during fiscal years 1991-93, obtained guaranteed loans. These borrowers held direct loans for varying lengths of time—some for more than 20 years.

FmHA Is Developing a Policy to Use Guaranteed Loans as a Transition From Direct Government Assistance

FmHA has not historically used the guaranteed loan program as a stepping stone in helping direct loan borrowers progress to commercial credit. According to its own policies, FmHA, as a temporary source of credit, should graduate a borrower from direct loans to commercial credit at the earliest possible time. Because qualifying for commercial credit without a government guarantee is more stringent than qualifying with a guarantee, moving from a direct loan to a guaranteed loan is a logical progression for borrowers whose financial condition has improved but not sufficiently to qualify for commercial credit.

FmHA has not used the guaranteed program in this way because its criteria for graduation from direct loans to commercial credit have not included any interim steps. FmHA considers a direct loan borrower to graduate from government support when that borrower (1) pays in full, before the expiration of the loan, all farm program loans or all of one type of farm program loan by refinancing with other credit sources and (2) continues farming. FmHA does not consider graduation to cover a borrower who pays off the debt under normal terms, and the agency specifically excludes borrowers who move from direct to guaranteed loans.

However, FmHA recently initiated action to include moving to guaranteed loans as an interim step in the graduation process. In December 1993, 14 months after enactment of the Agricultural Credit Improvement Act of 1992, which required such action, FmHA published a proposed regulation in the Federal Register to incorporate the use of guaranteed loans as an interim step in graduating direct loan borrowers to commercial credit without a guarantee. In late October 1994, FmHA officials told us that the agency anticipates publishing the revised regulations to graduate direct loan borrowers to guaranteed loans in November 1994.

FmHA Has Not Effectively Administered Its Established Processes for Graduating Direct Loan Borrowers

FmHA requires that its field offices annually review direct loan borrowers for graduation to commercial credit. However, the field office lending officials often do not adhere to the process. As a result, some borrowers with graduation potential are not identified as likely candidates, and other borrowers who are identified are not made to graduate. In addition, its classification of borrowers according to their repayment ability is not reliable. Thus, FmHA does not know how many direct loan borrowers qualify for guaranteed loans. Nonetheless, FmHA officials and commercial lenders believe that few FmHA direct loan borrowers can meet the requirements for a guaranteed loan.

FmHA’s Field Office Officials Often Do Not Comply With Requirements to Identify and Graduate Qualified Direct Loan Borrowers

FmHA’s primary tool for identifying and graduating qualified direct loan borrowers is its annual graduation review process. This process is intended to target borrowers who have displayed sufficient financial progress to graduate from the direct loan program to commercial credit. Annually, FmHA’s St. Louis Finance Office provides each county office with a list of borrowers who have had outstanding loans for 3 years or more. County office officials initially review and remove borrowers from the list who are clearly unable to graduate by using available knowledge of local lenders’ criteria or other information that the officials may have on borrowers’ financial status. County office officials may also add to the list borrowers whose financial condition has substantially improved since obtaining their loans. Borrowers who are not initially removed or who are added to the list are considered potential candidates for graduation. County office officials are to thoroughly evaluate these borrowers’ financial position by considering their financial strengths, income capabilities, and other characteristics that relate to meeting local lenders’ criteria. For those identified as candidates for commercial credit through this process, FmHA requires that they be requested to graduate or to provide information documenting why they cannot graduate.

However, FmHA’s field office officials do not always conduct the reviews to identify which borrowers are potential candidates for graduation. Almost 200 borrowers, or about 17 percent, of the approximately 1,160 borrowers who FmHA should have reviewed for graduation potential during fiscal years 1991 and 1992 at the 12 county offices we visited were not reviewed. County office supervisors said they did not review the borrowers because they believed other pressing work was more important, such as servicing delinquent borrowers. In addition, another 310 borrowers, or about 27 percent, at these 12 offices were removed from consideration without any reasons annotated in the county offices’ records for their removal. County office supervisors could not explain why the borrowers were removed from consideration.

Of 115 direct loan borrowers identified for graduation to commercial credit at these county offices, the FmHA supervisors did not take the additional steps required to graduate 54 borrowers or to conclude that they could not graduate. For 32 borrowers, the county office supervisors said they did not try to graduate them because they believed the borrowers could not meet local lenders’ credit standards. For the remaining 22 borrowers, the county office loan files showed that the borrowers had not responded to the county offices’ request to graduate and that the county office supervisors had not taken any further action. If a borrower fails to respond, the county office supervisor may consider the borrower to be in default as provided for in the loan agreement. A county office supervisor may then initiate action to accelerate repayment of the loan or legal action to foreclose on the loan. In taking such actions, the county office supervisor must obtain the concurrence of the FmHA district and state office officials and, if legal action is involved, USDA’s Office of General Counsel. However, some county office supervisors said they did not pursue more forceful action with borrowers who did not provide the requested financial information because they did not believe that higher-level officials would support their efforts.

Our review indicates that some of the borrowers who did not graduate to commercial credit had financial circumstances indicating that they could have moved from the direct loan program if the county office supervisors would have followed through as required. For example, a borrower obtained a $28,000, 40-year soil and water loan in 1987 and paid off $1,300 by June 1993. According to June 1989 financial information in his FmHA loan file, the borrower had a net worth of over $400,000 and liabilities of about $116,000. The borrower did not comply with the county office’s request for financial information during the 1991 graduation review. In early 1993, the borrower was again asked to provide updated financial information, but no response had been received as of August 1993. The county office’s supervisor acknowledged that FmHA should have taken further action to force this borrower to graduate. Other examples are described in appendix VII.

FmHA’s Field Offices Have Not Accurately Classified Borrowers’ Repayment Ability

Another tool, which the Congress has directed FmHA to use in identifying direct loan borrowers for graduation, is FmHA’s loan classification system. The loan classification system is designed to record FmHA’s current judgment of all borrowers’ ability to repay their loans. The objectives of the system are to assess the overall quality of FmHA’s loan portfolio, estimate loan losses to the government, assess the need for any special loan servicing, and improve the management of the loan program. Classifications are to be assigned when loans are made and updated whenever a borrower’s financial condition changes significantly. As shown in table 3.2, borrowers are classified on a 1-to 5-scale, with the highest-quality loans described as “commercial” (category 1) and the lowest quality described as a “loss” (category 5).

However, in many cases, FmHA’s county offices did not assign a correct classification, and in other cases they did not keep the classifications current, as required. As of September 30, 1993, FmHA’s records showed that about 27,000, or about 20 percent, of FmHA’s approximately 140,000 direct loan borrowers were classified in the two highest loan categories, indicating that they should be candidates for graduation. Of these, 4,856 were classified as commercial, and 22,331 were classified as standard. In reviewing 171 borrowers who were classified as commercial quality borrowers at the 12 county offices we reviewed, county office officials told us that 112 borrowers, or about 66 percent, were improperly classified because they had insufficient income or inadequate loan security to meet minimum commercial credit standards.

County office supervisors explained that many borrowers were simply categorized incorrectly when originally classified. They stated that when the system was implemented in 1988, they had only a limited time to classify all borrowers. In their haste to meet the deadline to classify each borrower, county office supervisors relied on personal knowledge in lieu of supporting financial documents. Moreover, they said that in some cases, they did not update the borrowers’ classifications because they do not view the information as useful to them.

In accordance with congressional requirements, FmHA is developing a plan to improve its graduation process. In December 1993, 8 months after the date established in the Agricultural Credit Improvement Act of 1992 for implementing such action, FmHA published a proposal in the Federal Register to improve the graduation process and plans to implement it in November 1994. The principal change in the proposed regulations strengthens the process by identifying potential graduation candidates on the basis of their financial condition as recorded in FmHA’s loan classification system. Specifically, borrowers classified in the top two categories—i.e., commercial and standard quality—are to be reviewed each year for graduation. However, FmHA’s proposed plan does not contain any new initiative to ensure that FmHA staff accurately assign and update the loan classifications of their borrowers—an overriding weakness in the existing program.

FmHA Officials and Lenders Believe That Few Direct Loan Borrowers Qualify for Guaranteed Loans

FmHA’s headquarters and field office officials believe that few direct loan borrowers can meet the credit standards required by commercial lenders to qualify for guaranteed loans. For example, all 6 FmHA state officials and 9 of the 12 county office supervisors we interviewed said that many direct loan borrowers will never be able to qualify for guaranteed loans unless there is a major turnaround in their production and finances, which they believed would not occur. These officials’ beliefs are based upon perceptions that some direct loan borrowers either (1) do not have sufficient farm management skills or financial education or (2) have farm operations or financial needs that are too small to be of interest to commercial lenders.

Furthermore, some lenders in the eight states we reviewed also believed that FmHA’s guaranteed loan program—as currently designed and operated—is not a viable funding source for some direct loan borrowers. These lenders stated that most direct loan borrowers simply cannot qualify for guaranteed loans. On the other hand, they also told us that it is viable for those individuals who have made progress in overcoming the financial difficulties that led to their becoming direct loan borrowers.

Conclusions

Most direct loan borrowers do not receive guaranteed loans even though obtaining such loans would seem to be a natural progression in improving their creditworthiness and ultimately qualifying them for commercial credit without a guarantee. While FmHA officials and lenders contend that few direct loan borrowers can qualify for a guaranteed loan, FmHA cannot verify this because its county offices have often failed to identify and graduate direct loan borrowers who qualify for commercial credit. As a result, some borrowers remain in the direct loan program and receive government assistance from the program longer than justified.

Congress’s required changes to the graduation process, directed in 1992 legislation, have the potential to bring improvement when FmHA implements them—which are planned for November 1994. Requiring that FmHA’s guaranteed loan program be routinely used as an interim step for direct loan borrowers in their progression to commercial credit without a guarantee and using the loan classification system as the basis for identifying candidates for graduation can bring improvement. However, given the past failure of FmHA field offices to comply with existing graduation and loan classification requirements, FmHA needs to address county supervisors’ views that graduation is not a high priority and their skepticism about whether superiors will support them in graduating borrowers.

Recommendations to the Secretary of Agriculture

To ensure that FmHA effectively implements the congressionally directed plan for using guaranteed loans as an interim step in moving direct loan borrowers to commercial credit without a guarantee, we recommend that the Secretary of Agriculture direct the FmHA Administrator to develop and implement a plan to ensure that county office supervisors assign accurate loan classifications to all new direct loan borrowers, promptly update loan classifications as borrowers’ financial conditions adequately evaluate each direct loan borrower listed annually for graduation potential to identify and graduate those borrowers who qualify for guaranteed loans or commercial credit.

Agency Comments and Our Evaluation

In commenting on a draft of this report (see app. VIII), FmHA agreed that it has not emphasized the graduation of direct loan borrowers to commercial credit through the use of the guaranteed loan program. FmHA stated that it will soon implement various changes to its loan programs, some of which are designed to assist borrowers in graduating from direct loans. For example, FmHA plans to issue regulations requiring that borrowers’ loan classifications be updated at least every 2 years and that borrowers who are classified as commercial or standard grade borrowers be referred to commercial lenders every 2 years. However, FmHA did not provide specifics on how it plans to ensure that county office officials perform the required review of borrowers’ loan classifications and their potential for graduation or graduating those borrowers who qualify. In the past, county office officials have not fully complied with FmHA’s requirements in these areas. “These are FmHA’s highest quality Farmer Program accounts. The financial condition of the borrowers is strong enough to enable them to absorb the normal adversities of agricultural production and marketing. There is ample security for all loans, there is sufficient cash flow to meet the expenses of the agricultural enterprise and the financial needs of the family, and to service debts. The account is of such quality that commercial lenders would view the loans as a profitable investment.” (Underscoring added.)

Therefore, our point remains unchanged—i.e., according to the county supervisors we spoke with, many borrowers (66 percent of the 171 direct loan borrowers reviewed who were classified as commercial) were misclassified using FmHA’s own definition and were not candidates for graduation because of problems with cash flow, high debt, or a marginal repayment record.

Lenders’ and FmHA’s Suggestions for Making the Guaranteed Program a More Viable Funding Source for Direct Loan Borrowers

Commercial lenders and FmHA officials believe that to get lenders to take on a greater portion of FmHA’s approximately 140,000 direct loan borrowers as their own clients, changes would be required in (1) direct loan provisions to more effectively encourage borrowers to move from such loans and (2) the guaranteed loan program to make it more attractive to lenders. Moving borrowers from direct loans would reduce FmHA’s outstanding direct loan debt and the government’s risk exposure that exists with such loans, allow the agency’s field staff to more effectively administer the direct loan program, and reinforce the agency’s role as a temporary credit source. However, even if the suggested changes are made, many borrowers would still not be able to obtain guaranteed loans because they could not meet commercial lenders’ credit standards.

Suggestions Have Been Made to Increase the Use of Guaranteed Loans

Commercial lenders and FmHA field office lending officials that we interviewed suggested changes to FmHA’s direct loan program that they believe would cause existing direct loan borrowers to seek commercial credit with a guarantee as soon as they qualify. These suggestions involve gradually increasing the interest rate charged on direct loans until it equals the rate charged on commercial loans, making direct ownership loans for the purchase of farm land for 10 to 15 years with a balloon payment at the end of the term instead of payments over 40 years, and writing off the amount of the outstanding direct loan debt that exceeds the market value of the security property for the loan (collateral).

Regarding gradually increasing the interest rate charged on direct loans, some commercial lenders we interviewed and a 1991 American Bankers Association (ABA) Task Force report said that interest rates on direct loans, which are lower than commercial rates, should be periodically increased. Specifically, eight commercial lenders suggested that the interest rate that FmHA charges should be increased over time so that the rates eventually match commercial rates. Such increases could cause borrowers to start looking elsewhere for financing as the advantage of below-market rates is eliminated. According to 64 percent of the 53 lenders that we interviewed, borrowers do not have an incentive to move from direct to guaranteed loans because of the low interest rates on direct loans.

The ABA Task Force recommended that all of FmHA’s direct loans have a graduated interest rate clause so that borrowers understand that interest rates will change on specific dates. According to the ABA, because there is no interest rate adjustment mechanism in place for FmHA’s direct loans, borrowers are encouraged to remain in the program, particularly when the rates remain low in relation to commercial rates. For example, while interest rates on guaranteed operating loans made in 1992 averaged 9.8 percent, FmHA’s direct loans were often made at 7 percent.

On the other hand, implementing a proposal that routinely causes interest rates to increase without considering the borrowers’ financial condition could adversely affect some borrowers’ abilities to repay their loans on schedule and thus result in defaults.

With respect to the suggestion for shortening FmHA’s farm ownership loan terms, which typically run 40 years, some of the commercial lenders we interviewed and the ABA Task Force agreed with the need for shorter terms. The ABA emphasized that having a maturity date preceding the amortization date of the loan would enforce FmHA’s purpose of being a temporary lender. Likewise, 10 of the lenders we interviewed told us that longer repayment terms act as a disincentive to get borrowers to move from the direct loan program. As an alternative, one commercial lender suggested that in lieu of making loans with a 40-year repayment, FmHA should make shorter-term loans—e.g., loans with a 15-year maximum term—and require a balloon payment at the end of the term.

On the other hand, implementing a proposal that causes a loan’s maturity date to be shortened and that increases payments could result in repayment difficulties for those borrowers who acquire additional farm real estate to expand their operations or who made capital improvements to their existing operations.

Concerning the third suggestion—that FmHA reduce direct loan debt to the value of the loan security—many lenders believe that some FmHA borrowers have outstanding direct loan debt that exceeds the value of their security. Some of the commercial lenders we interviewed told us that they would not make a loan to repay a borrower’s outstanding direct loan debt if the loan could not be adequately secured by collateral property. Specifically, most of the 53 lenders we interviewed said that FmHA would need to reduce the debt to at least the value of the security if the borrowers could not pay the debt down to that value. Implementing such a suggestion could provide lenders with a greater incentive to provide credit to direct loan borrowers.

On the other hand, implementing a proposal that causes FmHA to reduce outstanding debt would result in the agency’s incurring losses on loans to borrowers who have remained current on their agreed-upon loan payments.

Suggestions Have Been Made to Make the Guaranteed Loan Program More Attractive to Commercial Lenders

Many of the commercial lenders that we interviewed told us about problems they have had in participating in the guaranteed farm loan program and suggested changes. For example, many of the lenders stated that FmHA’s paperwork requirements are excessive. Some also said that FmHA has been slow in processing their guaranteed loan applications. Even though the lenders have had problems, many of them are still interested in participating in the guaranteed loan program. They, as well as the FmHA field office officials we interviewed, provided us with suggested changes that they said could increase the willingness of lenders to take on more direct loan borrowers as clients. These suggestions cover both administrative and programmatic aspects of making guaranteed farm loans.

Problems That Lenders Have Had With the Guaranteed Loan Program

Of the 34 lenders with guaranteed farm loans that we interviewed, 28 told us that FmHA’s paperwork requirements are excessive. Seventy-five percent of these 28 lenders said it was the most significant problem they have had in participating in the guaranteed program. Another problem area frequently cited by the 34 lenders was that FmHA’s field offices have been slow in processing applications. Table 4.1 shows the major problems that lenders identified.

Generally, lenders with guaranteed loans told us that FmHA’s paperwork requirements increase a bank’s workload and the time spent in processing a loan application. This occurs because FmHA requires more information in a guaranteed loan application than a bank requires in an application for a loan not involving a guarantee.

Administrative Changes That May Make the Guaranteed Loan Program More Viable

The commercial lending officials we interviewed suggested changes to administrative aspects of the guaranteed loan program as a means of increasing their participation. These suggestions include reducing the paperwork required for guaranteed loans, eliminating the requirement that lenders submit financial and production history data on existing direct loan borrowers who seek guaranteed loans to repay outstanding direct loan debt, and allowing lenders to certify borrowers’ eligibility to participate in the guaranteed loan program.

As discussed earlier, problems with FmHA’s paperwork requirements were cited by lenders as a significant issue affecting their participation in the guaranteed loan program. Among other things, they told us that because FmHA’s paperwork requirements differ from those normally used in the banking industry, they had to prepare two sets of loan application documents—one for reviews by their internal credit committee and a second containing the same information but in a different format on FmHA’s forms. Also, according to ABA officials, lenders have to submit paperwork in the application package that does not directly relate to the loan, such as a certification that loan funds will not be used for lobbying activities.

According to the lenders, requirements such as these add to their cost of doing business and make them reluctant to participate—particularly, in regard to funding low-valued loans because of their low-profit potential.

In response to previous reports that have criticized FmHA’s paperwork requirements and as required by the Agricultural Credit Improvement Act of 1992, on June 24, 1993, FmHA published interim regulations in the Federal Register revising FmHA’s loan application paperwork requirements for loans of $50,000 or less and for lenders who participate in FmHA’s certified lender program. While these revisions should result in a lessening of the paperwork required for some lenders, many of the lenders that we interviewed did not know that FmHA was attempting to streamline the loan application process.

On the related suggestion that FmHA should stop requiring lenders to obtain and submit financial and production history data for borrowers when applying for guaranteed loans to repay existing direct loan debts, ABA officials and some of the lenders we interviewed questioned the need to submit such data, which the county offices should already have. Also, the lenders said that while FmHA requires 5 years of historical data, some lenders usually consider only the past 3 years in deciding on an application. ABA officials further recommended that if a commercial lender was willing to repay a borrower’s outstanding direct loan debt with a guaranteed loan, then FmHA should simply “pass through” the person’s outstanding debt to the bank without the need to submit any new or additional paperwork. In such cases, the ABA officials said that there is no need for an entire application package as with a new applicant/borrower. Fifty-eight percent of the 53 lenders we interviewed told us that eliminating this requirement could result in an increase in the use of the guaranteed farm loan program to repay applicants’ outstanding direct loan debts.

The third change suggested by lenders was that they, rather than FmHA’s county committees, should be allowed to certify applicants’ eligibility to receive guaranteed loans. Specifically, county committees, which consist of two members elected by local farmers and one designated by FmHA, decide on the eligibility of applicants to participate in FmHA’s farm loan programs. Among other things, two of the lenders who had guaranteed loans said they have encountered personal bias by some county committee members against their loan applicants, and six others said that county committees have been slow in making decisions on guaranteed loan applications. One lender illustrated the situation as follows: The bank makes lending decisions on a daily basis, but it is delayed in making guaranteed loans if the applications do not arrive in time for a county committee meeting or if the committee requests additional information. Nineteen of the 53 lenders we interviewed stated that participation in the guaranteed loan program could increase if lenders were permitted to certify applicants’ eligibility.

Suggested Programmatic Changes to the Guaranteed Loan Program

The commercial lenders and the FmHA field office officials we interviewed also cited various changes to the program that could result in increased use of guaranteed loans. These include increasing the guarantee percentage above 90 percent when the loan is being used to refinance outstanding direct loan debt, removing the guaranteed loan fee for borrowers whose direct loan debts are being refinanced with guaranteed loans, and increasing the authority for making subsidized loans under the Interest Assistance Program.

The first proposal applies to increasing the guarantee percentage above 90 percent when the loan is being used to refinance outstanding direct loan debt owed to FmHA. The Con Act currently limits the guarantee to 90 percent for all loan-use purposes. Forty of the 53 lenders we interviewed said that such a change would increase their use of the guaranteed loan program to repay an applicant’s outstanding direct loan debt. Twenty-seven of these lenders suggested a 100-percent guarantee, and 12 others suggested a 95-percent guarantee (one did not suggest a specific percentage above 90 percent). Furthermore, one lender said that FmHA’s guarantee percentage should be reduced over time, after a borrower demonstrates a record of loan repayment. FmHA has a 100-percent exposure with direct loans. If a 95-percent guarantee was provided on a loan for repaying outstanding direct loan debt, then the government’s risk exposure would be reduced by 5 percent. If a 100-percent guarantee was provided on a loan for that purpose, then FmHA would only have the additional risk for any accrued interest and liquidation costs over what those costs would be to the agency.

Another proposed change was for FmHA to remove the guaranteed loan fee for borrowers whose direct loan debts were being refinanced with guaranteed loans. FmHA charges lenders a 1-percent loan origination fee for the federal guarantee, which lenders usually pass on to borrowers. For example, if a loan is for $200,000 and the guarantee is for 90 percent, then the guaranteed amount is $180,000, and the fee is $1,800. Removing this fee when any part of a guaranteed loan is being used to repay direct loan debt could be an added inducement for borrowers to seek guaranteed loans. Five lenders suggested removing the fee on loans involving the repayment of direct loan debt in order to make the guaranteed program more viable. For example, one lender said that the fee adds to a borrower’s cost, and another said that borrowers can use the added cost as an excuse for not seeking to move from their direct loans. Although FmHA requires county supervisors to waive this fee when more than half of the guaranteed loan funds are being used for refinancing direct loan debt, two county office supervisors we interviewed said they do not waive the fee on any guaranteed loan.

The third change that some commercial lenders and county supervisors suggested was that FmHA’s authority for making subsidized loans under the Interest Assistance Program should be increased. Under this program, which is an interest subsidy program, a lender is reimbursed by FmHA for charging a borrower an interest rate that is less than the lender’s regular rate. Some lenders and county supervisors told us that this program has helped some direct loan borrowers obtain guaranteed farm operating loans. However, the agency has not been authorized to use the program for farm ownership loans. Four commercial lenders and five state and county office officials said that if FmHA’s interest assist authority was expanded, they believe that some direct loan borrowers could move their outstanding farm ownership debt to guaranteed loans.

Many Borrowers May Have No Alternative to FmHA’s Direct Loans

In order for borrowers to obtain commercial loans, they must be able to meet the credit standards of the lenders who make the loans. Because direct loan borrowers may not be able to fully meet standards in areas such as cash flow, security, and equity, lenders may need to lower their standards. However, even if the lenders relaxed their standards, there are, in the opinion of some lenders and banking industry representatives we interviewed, direct loan borrowers who would not be able to obtain commercial credit even with guarantees because of their inability to qualify for such credit. For example, the 30,806 borrowers who were delinquent on $5.2 billion in direct loans, as of September 30, 1993, would not be candidates for commercial credit.

Ten lenders with guaranteed loans told us that the guaranteed program cannot replace the direct loan program for some borrowers. Four lenders without guaranteed loans said that some direct loan borrowers simply are unable to qualify for commercial credit. Furthermore, some lenders, notably those without guaranteed loans, said that (1) they are not looking for risky customers, which FmHA’s direct loan borrowers are by definition, or for clients who cannot meet their minimum credit standards and (2) they will not make a loan that is not financially sound. Three lenders, who did not have outstanding FmHA guaranteed loans, specifically said that they perceived borrowers who needed a guaranteed loan to be financially weak and that they would not lower their lending standards in order to fund an applicant with a guaranteed loan.

Likewise, officials from ABA and from the Independent Bankers Association of America said that even if changes are made to FmHA’s farm loan programs, the guaranteed program would not be a viable funding source for some direct loan borrowers. For example, ABA officials said that commercial banks would be unwilling to fund some direct loan borrowers because their financial histories reflect a long-term pattern of failing to meet their debt obligations.

Conclusions

To stimulate the movement of borrowers from direct loans, lenders have made a variety of suggestions. If some or all of the proposals are implemented, some existing FmHA direct loan borrowers would likely move to guaranteed loans, which could lessen the agency’s risk exposure, reinforce its role as a temporary source of credit, and reduce its workload. The exact number, while unknown, probably would not be a high percentage of FmHA’s approximately 140,000 direct loan borrowers because many have marginal production and financial histories. Nonetheless, moving any portion of the outstanding direct loan borrowers to the commercial sector is desirable if the government’s risk exposure can be adequately protected. Therefore, deciding whether suggested changes should be made ultimately requires balancing FmHA’s risk exposure against the concessions that would have to be made to lenders.

Implementing some of the suggestions in this chapter may not have much impact on FmHA’s risk exposure. For example, there would be no cost impact if FmHA stopped requiring lenders to submit financial and production data for guaranteed loans to refinance existing direct loan borrowers’ debt owed to FmHA. Also, since FmHA has a 100-percent risk exposure with direct loans, allowing a greater-than-90-percent guarantee for loans to repay outstanding direct loan debt may actually lessen FmHA’s risk if the rate was, for example, 95 percent, and may add only slightly to its risk if the rate was 100 percent. To ensure that lenders had some stake in the loan, a guarantee of something less than 100 percent would be needed. However, some proposals, such as reducing outstanding direct loan debt to the value of security would result in immediate losses to FmHA—i.e., forgiveness of some portion of existing debts—although some of the losses may ultimately occur anyway.

We realize that commercial lenders’ support for many of these suggestions is influenced largely by their desire to expand their clientele and generate profit. Even so, we believe that the overall implications of the suggestions presented in this chapter are worthy of further discussion and consideration. For example, if FmHA offered to write off the part of borrowers’ direct loan debts that exceeded the market value of their loan security property, what impact would that have on the agency’s overall losses and on borrowers’ receiving commercial credit, with or without a guarantee? Likewise, if the guarantee percentage for loans to pay off existing direct loans was increased above 90 percent, what impact would the lender’s lessened exposure have on its incentive to properly service the loan and what would be the implications for other government guaranteed loan programs?

Agency Comments and Our Evaluation

In commenting on a draft of this report (see app. VIII), FmHA agreed that additional changes can be made to the guaranteed loan program to assist in moving direct loan borrowers to commercial credit. FmHA cited various actions it has initiated or plans to take to make the guaranteed loan program more attractive to commercial lenders, such as reducing the paperwork required for a guaranteed loan of less than $50,000 and having county office officials assist lenders in completing a guaranteed loan application. FmHA also said that it will consider the other suggestions in this chapter and that it shares our concern about making the guaranteed program vulnerable to the large losses that have been experienced by the direct loan program.