oversight

Maritime Administration: Weaknesses Identified in Management of the Title XI Loan Guarantee Program

Published by the Government Accountability Office on 2003-06-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to the Chairman, Committee
             on Commerce, Science, and
             Transportation, U.S. Senate


June 2003
             MARITIME
             ADMINISTRATION
             Weaknesses Identified
             in Management of the
             Title XI Loan
             Guarantee Program




GAO-03-657
                                                June 2003


                                                MARITIME ADMINISTRATION
                                                Weaknesses Identified in Management of
Highlights of GAO-03-657, a report to the       the Title XI Loan Guarantee Program
Chairman, Senate Committee on
Commerce, Science, and Transportation




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

GAO recommends that Congress                    Estimated and Actual Defaults and Recoveries to Date for Loans Originated between
consider providing no new funds
                                                Dollars in millions
for new loan guarantees under the                                  488
                                                500
Title XI program until certain
controls have been instituted and               400
MARAD has updated its default and
recovery assumptions to more                    300
accurately reflect costs. GAO also
recommends that MARAD                           200                                          185
undertake several reforms to help
                                                                                                     95
improve program management.                     100
In written comments, the                                 45

Department of Transportation                      0
disagreed with some report
findings, however, recognized that                            Defaults                        Recoveries

program improvements were
needed.                                                          Estimated
                                                                 Actual
www.gao.gov/cgi-bin/getrpt?GAO-03-657.
                                                Sources: MARAD (data); GAO (presentation).
To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Tom McCool at
(202) 512-8678 or mccoolt@gao.gov.
Contents


Letter                                                                                  1
               Results in Brief                                                         2
               Background                                                               4
               MARAD Has Not Fully Complied with Some Key Title XI Program
                 Requirements                                                           8
               MARAD Techniques to Manage Financial Risk Contrast to
                 Techniques of Selected Private-sector Maritime Lenders               17
               MARAD’s Credit Subsidy Estimates and Reestimates Are
                 Questionable                                                         23
               Conclusions                                                            31
               Matters for Congressional Consideration                                31
               Recommendations for Executive Action                                   32
               Agency Comments                                                        34

Appendix I     Scope and Methodology                                                  41



Appendix II    Comments from the Department of Transportation                         43



Appendix III   Comments from the Office of Management and
               Budget                                                                 49



Appendix IV    GAO Contacts and Staff Acknowledgments                                 51
               GAO Contacts                                                           51
               Staff Acknowledgments                                                  51


Tables
               Table 1: Projects Included in Our Review                                 9
               Table 2: Comparison of Private-sector and MARAD Maritime
                        Lending Practices                                             17
               Table 3: Projects Selected for Our Review                              41


Figures
               Figure 1: MARAD’s Defaulted Projects (1993–2002)                         6


               Page i                                  GAO-03-657 Maritime Administration
Figure 2: Estimated and Actual Defaults of Title XI Loan
         Guarantees (1996–2002)                                                           27
Figure 3: Estimated and Actual Recoveries on Title XI Loan
         Defaults (1996–2002)                                                             28




Abbreviations

AMCV              American Classic Voyages, Co.
DCAA              Defense Contract Audit Agency
DOT               Department of Transportation
FCRA              Federal Credit Reform Act
IG                Department of Transportation Inspector General
MARAD             Maritime Administration
MHI               Massachusetts Heavy Industries, Inc.
OMB               Office of Management and Budget
SEC               Securities and Exchange Commission



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Page ii                                             GAO-03-657 Maritime Administration
United States General Accounting Office
Washington, DC 20548




                                   June 30, 2003

                                   The Honorable John McCain
                                   Chairman
                                   Committee on Commerce, Science, and Transportation
                                   United States Senate

                                   Dear Mr. Chairman:

                                   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.1 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.2 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.




                                   1
                                    Defaulted amounts may include disbursed loan guarantee funds, interest accrued, and
                                   other costs.
                                   2
                                    Loan guarantees are legal obligations to pay off debt if an applicant defaults on a loan.



                                   Page 1                                                GAO-03-657 Maritime Administration
                   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.


                   MARAD has not fully complied with some key Title XI program
Results in Brief   requirements. In approving loan guarantees, MARAD generally complied
                   with requirements to assess an applicant’s economic soundness. MARAD
                   used waivers or modifications, which, although permitted by Title XI
                   regulations, allowed MARAD to approve applications where borrowers did
                   not meet all financial requirements. In monitoring projects it financed,
                   MARAD did not ensure that shipowners and shipyard owners provided
                   required financial statements. Overall, we could not always track financial
                   reporting because of missing or incomplete documentation. Without a
                   systematic analysis of changes in the financial condition of its borrowers,
                   MARAD cannot take the appropriate steps to minimize losses. Further,
                   MARAD disbursed loan funds without sufficient documentation of project
                   progress. MARAD also permitted a shipowner to minimize its investment
                   in a project before receiving guaranteed loan funds. With respect to the
                   disposition of assets, MARAD has guidelines, but no requirements, in place
                   to ensure that it maximizes recoveries.



                   Page 2                                     GAO-03-657 Maritime Administration
Selected private-sector maritime lenders told us that they manage financial
risk by (1) establishing a clear separation of duties for key lending
functions; (2) permitting few, if any, exceptions to key underwriting
standards; (3) using a more systematic approach to monitoring the
progress of projects; and (4) employing independent parties to survey and
appraise defaulted assets. Private-sector representatives we interviewed
stated that they were very selective when originating loans for the
shipping industry. While MARAD cites its mission as an explanation as to
why it does not employ these practices, these controls would actually help
it to accomplish its mission while managing financial risk.

MARAD’s credit subsidy estimates and reestimates are questionable.
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. While the nature and
characteristics of the Title XI program make it difficult to estimate subsidy
costs and may affect MARAD’s ability to produce reliable cost estimates,
MARAD has not performed the basic analyses necessary to assess and
improve its estimates, which differ significantly from recent actual
experience. Specifically, we found that in comparison with recent actual
experience, MARAD’s default estimates significantly understate defaults,
and its recovery estimates significantly overstate recoveries. If this pattern
of recent experiences 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. However, MARAD has never evaluated the
performance of its loan guarantee projects to determine if its subsidy cost
reestimates were comparable to actual costs. Finally, while the Office of
Management and Budget (OMB) approved each MARAD estimate and
reestimate, its review was not sufficient since it did not identify that
MARAD’s assumptions were outdated and lacked adequate support.

This report makes several recommendations to help MARAD improve its
management of the Title XI loan guarantee program, including its
processes for approving loan guarantees, monitoring and controlling
funds, and managing and disposing of defaulted assets, and better
implementing its responsibilities under the Federal Credit Reform Act
(FCRA). We also recommend that Congress consider legislation to clarify
borrower equity contribution requirements and incorporate concentration
risk in the approval of loan guarantees. Because of the fundamental flaws
we have identified, we question whether MARAD should approve new loan
guarantees without first addressing these program weaknesses.


Page 3                                       GAO-03-657 Maritime Administration
             We provided a draft of this report to the Department of Transportation for
             its review and comment. MARAD noted that it has already begun to take
             steps to improve the operations of the Title XI program, consistent with
             several of our recommendations. MARAD 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. OMB agreed that recent recovery
             expectations should be incorporated into future reestimates, but disagreed
             that it had provided little or no oversight over the program’s subsidy cost
             estimates. However, we believe that 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 its default and recovery
             assumptions.


             Title XI of the Merchant Marine Act of 1936, as amended, authorizes the
Background   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.3 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,



             3
              Vessels eligible for Title XI assistance generally include commercial vessels such as
             passenger, bulk, container, cargo and oceanographic research; also eligible tankers, tugs,
             towboats, barges, dredges, floating power barges, offshore oil rigs and support vessels, and
             floating dry docks. Eligible technology generally includes proven technology, techniques,
             and processes to enhance the productivity and quality of shipyards; novel techniques and
             processes designed to improve shipbuilding; and related industrial production that
             advances U.S. shipbuilding.




             Page 4                                               GAO-03-657 Maritime Administration
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.




Page 5                                      GAO-03-657 Maritime Administration
Figure 1: MARAD’s Defaulted Projects (1993–2002)

    Surf Express



     HAM Marine


         Great
  Independence


Great Pacific NW



 Cape May Light



 Cape Cod Light


 Massachusetts
Heavy Industries


          Searex



Project America



                   0                                          100                              200
                   Defaulted amounts in millions of dollars


                            Non-AMCV-related

                            AMCV-related

Source: GAO.



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



Page 6                                                         GAO-03-657 Maritime Administration
certain projects limited to 75 percent financing. The interest rate of the
guaranteed obligations is determined by the private sector.4 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.5 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.



4
MARAD must determine that the interest rate is reasonable.
5
 Congress recognized that data were limited or unreliable in the early years of credit reform
and that this could impede the ability of agencies to make reliable estimates. Thus,
Congress provided for permanent, indefinite budget authority for upward reestimates of
subsidy costs. Agencies with discretionary credit programs then could reestimate subsidy
costs as required without being limited by the constraints of budgetary spending limits.




Page 7                                               GAO-03-657 Maritime Administration
                       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.


                       MARAD has not fully complied with some key Title XI program
MARAD Has Not Fully    requirements. We found that MARAD generally complied with
Complied with Some     requirements to assess an applicant’s economic soundness before issuing
                       loan guarantees. MARAD used waivers or modifications, which, although
Key Title XI Program   permitted by MARAD regulations, allowed MARAD to approve some
Requirements           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).




                       Page 8                                    GAO-03-657 Maritime Administration
                           Table 1: Projects Included in Our Review

                               Dollars in millions
                                                                    Year loan           Original           Risk
                               Project                             committed            amount         category        Status
                               (AMCV) Project America, Inc.             1999            $1,079.5             2A        Default
                               Searex                                   1996               $77.3             2B        Default
                               Massachusetts Heavy
                               Industries (MHI)                           1997              $55.0               3      Default
                               Hvide Van Ommeran Tankers
                               (HVIDE)                                    1996              $43.2             2C       Active
                               Global Industries                          1996              $20.3             1C       Active
                           Source: MARAD.

                           Note: MARAD places projects into one of seven risk categories that, from lowest to highest, are 1A,
                           1B, 1C, 2A, 2B, 2C, and 3.




MARAD Used Waivers and     MARAD regulations do not permit MARAD to guarantee a loan unless the
Modifications to Approve   project is determined to be economically sound.6 MARAD generally
Loans That Would           complied with requirements to assess an applicant’s economic soundness
                           before approving loan guarantees, and we were able to find
Otherwise Not Be           documentation addressing economic soundness criteria for the projects
Approved                   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.7 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


                           6
                            All projects must be determined to be economically sound, and borrowers must have
                           sufficient operating experience and the ability to operate the vessels or employ the
                           technology on an economically sound basis. Particularly, MARAD regulations contain
                           language stating that (1) long-term demand must exceed supply; (2) documentation must
                           be provided on the projections of supply and demand; (3) outside cash flow should be
                           shown, if in the short-term the borrower is unable to service indebtedness; and (4)
                           operating cash flow ratio must be greater than one (sufficient cash flow to service the
                           debt).
                           7
                            Economic soundness analyses are prepared by the Office of Insurance and Shipping
                           Analysis which is responsible for recommending approval or disapproval of loans from an
                           economic soundness perspective, and the Office of Statistical and Economic Analysis. It
                           should be noted that we did not assess the substance of these economic analyses.




                           Page 9                                                    GAO-03-657 Maritime Administration
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.8 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.9
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.10
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.11 Subsequently, MARAD used cash flow tests for


8
 In another case, Congress statutorily waived economic soundness criteria. Specifically, the
Coast Guard Authorization Act of 1996 contained a provision waiving the economic
soundness requirement for reactivation and modernization of certain closed shipyards in
the United States. Previously, MARAD had questioned the economic soundness of the MHI
proposal and rejected the application.
9
 MARAD may waive or modify financial terms or requirements upon determining that there
is adequate security for the guarantees.
10
  Unterminated passengers are individuals who pay for a cruise, but do not actually take
the cruise, and the payment is not refunded. However, the passenger may take the trip at a
later date.
11
 Cash management is a financial management technique used to accelerate the collection
of debt, control payments to creditors, and efficiently manage cash.




Page 10                                              GAO-03-657 Maritime Administration
                            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.12 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.


MARAD Did Not Follow        MARAD did not fully comply with requirements and its own established
Requirements for            practices pertaining to project monitoring and fund disbursement.
Monitoring the Financial    Program requirements specify periodic financial reporting, controls over
                            the disbursement of loan funds, and documentation of amendments to
Condition of Projects and   loan agreements. MARAD could not always demonstrate that it had
for Controlling the         complied with financial reporting requirements. In addition, MARAD could
Disbursement of Loan        not always demonstrate that it had determined that projects had made
Funds                       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.13 MARAD did so without documenting this change in the loan




                            12
                             U.S. Department of Transportation, Office of Inspector General, Maritime
                            Administration Title XI Loan Guarantee Program (Washington, D.C.: March 27, 2003).
                            13
                             An escrow fund is an account in which the proceeds from sales of MARAD-guaranteed
                            obligations are held until requested by the borrower to pay for activities related to the
                            construction of a vessel or shipyard project or to pay interest on obligations.




                            Page 11                                              GAO-03-657 Maritime Administration
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.14 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.



14
 On June 25, 2001, AMCV restated losses from $6.1 million to $9.1 million for the first
quarter of 1999.




Page 12                                              GAO-03-657 Maritime Administration
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


Page 13                                    GAO-03-657 Maritime Administration
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


Page 14                                       GAO-03-657 Maritime Administration
                           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.


MARAD Does Not Have        MARAD has guidance governing the disposition of defaulted assets.
Requirements in Place to   However, MARAD is not required to follow this guidance, and we found
Govern the Handling of     that MARAD does not always adhere to it. MARAD guidelines state that an
                           independent, competent marine surveyor or MARAD surveyor shall survey
Defaulted Assets           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


                           Page 15                                     GAO-03-657 Maritime Administration
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.15
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.




15
  MARAD has no financial interest in the equipment purchased for Project America II , and
therefore has no right to sale proceeds for this vessel.




Page 16                                             GAO-03-657 Maritime Administration
                                                          Private-sector maritime lenders we interviewed told us that it is imperative
MARAD Techniques                                          for lenders to manage the financial risk of maritime lending portfolios. In
to Manage Financial                                       contrast to MARAD, they indicated that to manage financial risk, among
                                                          other things, they (1) establish a clear separation of duties for carrying out
Risk Contrast to                                          different lending functions; (2) adhere to key lending standards with few,
Techniques of                                             if any, exceptions; (3) use a more systematic approach to monitoring the
                                                          progress of projects; and (4) primarily employ independent parties to
Selected Private-                                         survey and appraise defaulted projects. The lenders try to be very selective
sector Maritime                                           when originating loans for the shipping industry. While realizing that
Lenders                                                   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.

Table 2: Comparison of Private-sector and MARAD Maritime Lending Practices

                                                       Phases of the lending process
 Private-sector practices                                                MARAD practices
 Application
 • Permit few exceptions to key financial underwriting requirements • Permit waivers of key financial requirements
    for maritime loans                                                   • Have no committee oversight regarding the approval of
 • Seek approval of exceptions or waivers from Audit Committee             exceptions or waivers of program requirements
 • Perform an in-depth analysis of a business plan for applications      • Employ little variation in the depth of review of business
    received for start-up businesses or first-in-class shipyard vessels    plans based on type of vessel, size of loan guarantee, or
                                                                           history of borrower
 Monitoring
 • Set an initial risk rating at the time of approval and review rating  • Assign one risk rating during the application phase. No
    annually to determine risk rating of the loan                          subsequent ratings assigned during the life of the loan
 • Use industry expertise for conducting periodic on-site inspections • Use in-house staff to conduct periodic on-site inspections to
    to monitor progress on projects and potential defaults                 monitor progress of projects
 • Perform monitoring that is dependent on financial and technical       • Perform monitoring based on technical risk, familiarity with
    risk, familiarity with the shipyard, and uniqueness of the project     shipyard, uniqueness of project, and availability of travel
 • Analyze the borrower’s financial statements to identify significant     funds
    changes in borrower’s financial condition and to determine           • Have no documentation of analyses of borrowers’ financial
    appropriate level and frequency of continued monitoring at least       statements
    annually
 Default and disposition
 • Contract with an independent appraiser to prepare a valuation of • Permit an interested party or MARAD official to value assets
    a defaulted project                                                  • Permit an interested party or MARAD official to perform
 • Enlist a technical manager to review the ship after default to          technical review of Title XI assets
    assist in determining structural integrity and percentage of
    completion
Sources: GAO analysis of MARAD and private-sector data.




                                                          Page 17                                      GAO-03-657 Maritime Administration
Private-sector Lenders   Private-sector lenders manage financial risk by establishing a separation of
Separate Key Lending     duties to provide a system of checks and balances for important maritime
Functions                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.


                         Page 18                                    GAO-03-657 Maritime Administration
Private-sector Practices   The private-sector lenders we interviewed said they apply rigorous
Employ Less Flexible       financial tests for underwriting maritime loans. They analyze financial
Lending Standards          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.16 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



                           16
                             The IG also recommended that MARAD impose compensating factors for loan guarantees
                           to mitigate risks.




                           Page 19                                         GAO-03-657 Maritime Administration
                             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.


Private-sector Lenders Use   Private-sector lenders minimized financial risk by establishing loan
a More Systematic            monitoring and control mechanisms such as analyzing financial statements
Approach to Loan             and assigning risk ratings. Each private-sector lender we interviewed said
                             that conducting periodic reviews of a borrower’s financial statements
Monitoring                   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


                             Page 20                                     GAO-03-657 Maritime Administration
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.17
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.




17
 Classification society representatives are individuals who inspect the structural and
mechanical fitness of ships and other marine vessels for their intended purpose.




Page 21                                              GAO-03-657 Maritime Administration
Private-sector Lenders Use    Private-sector maritime lenders said they regularly use independent
Industry Expertise to Value   marine surveyors and technical managers to appraise and conduct
Defaulted Assets              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.


MARAD Cites Mission as        According to top-level MARAD officials, the chief reason for the difference
the Difference in             between private-sector and MARAD techniques for approving loans,
Management of Financial       monitoring project progress, and disposing of assets is the public purpose
                              of the Title XI program, which is to promote growth and modernization of
Risk Compared to Private-     the U.S. merchant marine and U.S. shipyards. That is, MARAD’s program
sector Lenders                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.18


                              18
                               U.S. General Accounting Office, Standards for Internal Control in the Federal
                              Government, GAO/AIMD- 00-21.3.1 (Washington, D.C.: November 1999) and Internal
                              Control Management and Evaluation Tool, GAO 01-1008G (Washington, D.C.: August
                              2001).




                              Page 22                                         GAO-03-657 Maritime Administration
                      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.


                      MARAD uses a relatively simplistic cash flow model that is based on
MARAD’s Credit        outdated assumptions, which lack supporting documentation, to prepare
Subsidy Estimates     its estimates of defaults and recoveries. These estimates differ
                      significantly from recent actual experience. Specifically, we found that in
and Reestimates Are   comparison with recent actual experience, MARAD’s default estimates
Questionable          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.




                      Page 23                                     GAO-03-657 Maritime Administration
MARAD’s Credit Subsidy   FCRA was enacted, in part, to require that the federal budget reflect a
Estimates Are            more accurate measurement of the government’s subsidy costs for loan
Questionable             guarantees.19 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.20
                         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.




                         19
                          The Federal Accounting Standards Advisory Board developed the accounting standard for
                         credit programs in Statement of Federal Financial Accounting Standards No. 2,
                         “Accounting for Direct Loans and Loan Guarantees,” which generally mirrors FCRA and
                         which established guidance for estimating the cost of guaranteed loan programs.
                         20
                          MARAD’s recovery assumption assumes a 50 percent recovery rate within 2 years of
                         default. However, 2 years have not yet elapsed for several of the defaults and so we could
                         not yet determine how the estimated timing of recoveries compares to the actual timing of
                         recoveries.




                         Page 24                                             GAO-03-657 Maritime Administration
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


Page 25                                     GAO-03-657 Maritime Administration
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.21 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).




21
 Our analysis focused on loans beginning in 1996 because (1) this was the first year in
which MARAD implemented its risk category system, and (2) MARAD could not provide us
with any supporting data for its default and recovery assumptions for loans originating
before 1996. Further, only one default occurred between 1993–1996, representing less than
1 percent of MARAD’s total defaults between 1993–2002.




Page 26                                            GAO-03-657 Maritime Administration
Figure 2: Estimated and Actual Defaults of Title XI Loan Guarantees (1996–2002)

200 Default dollars in millions                           200 Default dollars in millions
         187


                                                     59
                                                                            Excluding AMCV
150                                                       150

                          124
                                       117

                                                                                   99
100                                                       100



                                                                                                          59

    50                                                     50


                    13            14                                        12          13
           9                                 8                     9                              8
                                                                        0                     0
    0                                                       0

           2A            2B        2C            3                 2A         2B         2C           3
         Risk category

                              a
                 Estimated

                 Actual

Sources: MARAD (data); GAO (presentation).
a
 We excluded estimates for risk categories 1A, 1B, and 1C, because estimated defaults for these
categories totaled only $1.5 million or 3.4 percent of total estimated defaults.


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.


Page 27                                                         GAO-03-657 Maritime Administration
Figure 3: Estimated and Actual Recoveries on Title XI Loan Defaults (1996–2002)
100 Recoveries (dollars in millions)                   100 Recoveries (dollars in millions)
        94


    80                                                  80               Excluding AMCV


                         62
    60                                                  60

                               47                                               47

                                                                         39
    40                                                  40
                                                  32                                               32
                                             30                                               30


    20                                                  20
                                         9
                 7
                                    0                           0    0               0    0
     0                                                   0

            2A            2B        2C        3                 2A         2B        2C        3
         Risk category

                               a
                     Estimated
                          b
                     Actual

Sources: MARAD (data); GAO (presentation).
a
 Estimated recoveries are based on applying MARAD’s 50 percent recovery rate within 2 years to the
actual default amounts. Our analysis of recovery estimates includes estimated recovery amounts for
two of the five defaulted AMCV loans, even though 2 years have not elapsed, because, according to
MARAD officials, no additional recoveries are expected on these two loans. Thus, our recovery
calculation was based on $370.6 of the $487.7 million in defaulted loans, which includes defaults for
which 2 years have elapsed, as well as the two AMCV defaults for which no additional recoveries are
expected. With its 50 percent recovery assumption, MARAD would have estimated that, at this point,
it should have recovered $185.3 million of these defaulted loans.
b
 We calculated the actual recovery rate by comparing the total actual recoveries to the $370.6 million
in relevant actual defaulted amounts. At the time of our review, MARAD had recovered $94.9 out of
this $370.6 million.


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.22



22
 MARAD’s risk category system incorporates ten factors that are set out in Title XI, which
specifies that MARAD is to establish a system of risk categories based on these factors.
How MARAD weighs and interprets these factors is described in program guidance.




Page 28                                                      GAO-03-657 Maritime Administration
                         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.


MARAD’s Credit Subsidy   After the end of each fiscal year, OMB generally requires agencies to
Reestimates Are Also     update or “reestimate” loan program costs for differences among
Questionable             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


                         Page 29                                     GAO-03-657 Maritime Administration
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.


Page 30                                     GAO-03-657 Maritime Administration
OMB Has Provided Little     Based on our analysis, we believe that OMB provided little review and
Oversight of MARAD’s        oversight of MARAD’s estimates and reestimates. OMB has final authority
Estimates and Reestimates   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.


                            MARAD does not operate the Title XI loan guarantee program in a
Conclusions                 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.


                            We recommend that Congress consider discontinuing future
Matters for                 appropriations for new loan guarantees under the Title XI program until
Congressional               adequate internal controls have been instituted to manage risks associated
                            with the program and MARAD has updated its default and recovery
Consideration               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


                            Page 31                                     GAO-03-657 Maritime Administration
                      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.


                      We recommend that the Secretary of Transportation direct the
Recommendations for   Administrator of the Maritime Administration to take immediate action to
Executive Action      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
                      should provide;

                  •   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;




                      Page 32                                     GAO-03-657 Maritime Administration
•   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


    Page 33                                     GAO-03-657 Maritime Administration
                  recommend that the Director of OMB provide greater review and oversight
                  of MARAD’s subsidy cost estimates and reestimates.


                  We provided a draft of this report to DOT for its review and comment. We
Agency Comments   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


                  Page 34                                   GAO-03-657 Maritime Administration
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


Page 35                                     GAO-03-657 Maritime Administration
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


Page 36                                      GAO-03-657 Maritime Administration
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


Page 37                                     GAO-03-657 Maritime Administration
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


Page 38                                     GAO-03-657 Maritime Administration
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


Page 39                                    GAO-03-657 Maritime Administration
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.

Sincerely yours,




Thomas J. McCool
Managing Director, Financial Markets and Community Investment




Page 40                                     GAO-03-657 Maritime Administration
             Appendix I: Scope and Methodology
Appendix I: Scope and Methodology


             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).

             Table 3: Projects Selected for Our Review

              Project                            Year loan committed     Type of project
              (AMCV) Project America, Inc.                     1999      Cruise ships
              Searex                                           1996      Lift boats
              Massachusetts Heavy Industries                   1997      Shipyard
              (MHI)                                                      modernization
              Hvide Van Ommeran Tankers                        1996      Tanker
              (HVIDE)
              Global Industries                                1996      Barge
             Source: GAO.



             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



             Page 41                                       GAO-03-657 Maritime Administration
Appendix I: Scope and Methodology




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.




Page 42                                   GAO-03-657 Maritime Administration
             Appendix II: Comments from the Department of Transportation
Appendix II: Comments from the Department
of Transportation




             Page 43                                          GAO-03-657 Maritime Administration
Appendix II: Comments from the Department of Transportation




Page 44                                          GAO-03-657 Maritime Administration
Appendix II: Comments from the Department of Transportation




Page 45                                          GAO-03-657 Maritime Administration
Appendix II: Comments from the Department of Transportation




Page 46                                          GAO-03-657 Maritime Administration
Appendix II: Comments from the Department of Transportation




Page 47                                          GAO-03-657 Maritime Administration
Appendix II: Comments from the Department of Transportation




Page 48                                          GAO-03-657 Maritime Administration
              Appendix III: Comments from the Office of
Appendix III: Comments from the Office of
              Management and Budget



Management and Budget




              Page 49                                     GAO-03-657 Maritime Administration
Appendix III: Comments from the Office of
Management and Budget




Page 50                                     GAO-03-657 Maritime Administration
                             Appendix IV: GAO Contacts and
Appendix IV: GAO Contacts and Staff
                             Staff Acknowledgments



Acknowledgments

                  Thomas J. McCool (202) 512-8678
GAO Contacts      Mathew J. Scirè (202) 512-6794


                  In addition to those individuals named above, Kord Basnight, Daniel Blair,
Staff             Rachel DeMarcus, Eric Diamant, Donald Fulwider, Grace Haskins,
Acknowledgments   Rachelle Hunt, Carolyn Litsinger, Marc Molino, and Barbara Roesmann
                  made key contributions to this report.




(250087)          Page 51                                    GAO-03-657 Maritime Administration
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