oversight

Small Business Administration: Accounting Anomalies and Limited Operational Data Make Results of Loan Sales Uncertain

Published by the Government Accountability Office on 2003-01-03.

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

               United States General Accounting Office

GAO            Report to the Ranking Minority Member,
               Committee on Small Business and
               Entrepreneurship, U. S. Senate


January 2003
               SMALL BUSINESS
               ADMINISTRATION
               Accounting Anomalies
               and Limited
               Operational Data
               Make Results of Loan
               Sales Uncertain




GAO-03-87
               a
                                               January 2003


                                               SMALL BUSINESS ADMINISTRATION

                                               Accounting Anomalies and Limited
Highlights of GAO-03-87, a report to the       Operational Data Make Results of Loan
Ranking Minority Member, Committee on
Small Business and Entrepreneurship,           Sales Uncertain
U.S. Senate




SBA’s loan asset sales are being               From August 1999 through January 2002, SBA held five loan asset sales,
closely watched because similar                disposing of a total of $4.4 billion in disaster assistance home and business
sales are projected for other                  loans (85 percent) and regular business loans (15 percent). SBA created a
government agencies as a means of              sales process that has attracted investors and responded to their concerns.
reducing loan assets and servicing             Lenders who participate in the 7(a) business loan guaranty program were
costs. To assess the progress and
effects of SBA’s loan sales, GAO
                                               also satisfied with the sales as an option for disposing of their defaulted
undertook this study to (1)                    loans. SBA relies on borrower inquiries and complaints to determine
describe the process for selling               whether purchasers of the loans are using prudent loan servicing practices,
loans, (2) identify how lenders and            as required in the loan sale agreements. However, information on
borrowers have reacted to loan                 borrowers’ reactions to loan sales is incomplete, because SBA does not have
sales, (3) determine whether SBA is            a comprehensive process to capture the inquiries and complaints it receives.
properly accounting for its loan
sales and their subsequent impact              SBA incorrectly calculated the accounting losses on the loan sales and
on credit subsidy estimates, and (4)           lacked reliable financial data to determine the overall financial impact of the
assess whether loan sales                      sales. Further, because SBA did not analyze the effect of loan sales on its
generated operational benefits for             remaining portfolio, its reestimates of loan program costs for the budget and
the agency. GAO did not determine
whether SBA maximized proceeds
                                               financial statements may contain significant errors. In addition, SBA could
from the loan sales.                           not explain significant declines in its loss allowance account for disaster
                                               loans. Until SBA corrects these errors and determines the cause of the
                                               precipitous decline in the loss allowance account, SBA’s financial statements
                                               will likely be misstated, and the audit opinion on past financial statements
                                               may be incorrect. Further, the reliability of current and future subsidy cost
We recommend that, before doing                estimates will remain unknown. These errors and the lack of key analyses
more loan asset sales, SBA correct             also mean that congressional decisionmakers are not receiving accurate
the accounting and budgeting                   financial data to make informed decisions about SBA’s budget and the level
errors and misstatements. Also,                of appropriations the agency should receive.
the Inspector General, with SBA’s
independent auditors, should
                                               Our analysis of the operational benefits from loan sales suggests that some
assess the impact of identified
errors in the financial statements             benefits that SBA reported either have not yet materialized or were
and determine whether audit                    overstated. SBA conducted a limited analysis of the impact of loan sales on
opinions for fiscal years 2000 and             its loan servicing centers, showing that loan servicing volume had been
2001 financial statements need to              reduced. However, loan sales had a much greater impact on disaster loan
be revised. We also recommend                  servicing than on business loan servicing. Therefore, how the sales will help
that SBA improve its tracking of               SBA realign its workforce in the small business programs remains unclear.
borrower inquiries and complaints
and analyze the benefits and other             It would be imprudent to continue SBA loan asset sales in the absence of
effects on agency operations of the            reliable and complete information on the accounting and budgetary effects.
sales. SBA generally agreed with               A successful loan sales program is not solely about maximizing proceeds and
our findings and recommendations
                                               attracting investors: it is also a means of improving an agency’s ability to
but did not respond to the
recommendation to analyze the                  achieve its mission and to best serve the American people. Moreover, as
operational effects of loan sales.             OMB continues to encourage loan asset sales, it is important that agencies
                                               embarking on new loan asset sales programs have the capability to properly
www.gao.gov/cgi-bin/getrpt?GAO-03-87.
                                               carry out and account for these activities.
To view the full report, including the scope
and methodology, click on the link above.
For more information, contact Davi M.
D’Agostino or Linda M. Calbom, (202) 512-
8678.
Contents



Letter                                                                                               1
                             Results in Brief                                                        4
                             Background                                                              8
                             SBA’s Sales Process Is Designed to Satisfy Investor Demands            11
                             Lenders Expressed Satisfaction with SBA’s Loan Sales, but SBA’s
                               Data on Borrowers’ Reactions Was Incomplete                          20
                             SBA’s Accounting for Loan Sales and the Remaining Portfolio Was
                               Flawed                                                               25
                             Loan Sales Have Reduced SBA’s Loan Servicing Volume, but Other
                               Operational Benefits May Be Overstated                               33
                             Conclusions                                                            40
                             Recommendations                                                        42
                             Agency Comments                                                        43


Appendixes
              Appendix I:    Scope and Methodology                                                  48
                             SBA Field Locations We Visited                                         51
             Appendix II:    Types of Borrower Inquiries and Complaints Received by
                             SBA                                                                    53
             Appendix III:   Comments from the Small Business Administration                        54
             Appendix IV:    Comments from the Inspector General of the Small Business
                             Administration                                                         58
              Appendix V:    Comments from Cotton and Company                                       60
             Appendix VI:    GAO Contacts and Acknowledgments                                       64
                             Contacts                                                               64
                             Acknowledgments                                                        64


Glossary                                                                                            65


Tables                       Table 1: Key Information on SBA’s Loan Sales One through Five          17
                             Table 2: Loan Receivable Balances of SBA’s Disaster Loan
                                      Program                                                       30


Figures                      Figure 1: Time Line of a Loan Sale                                     13
                             Figure 2: Total Balance of Loans Sold                                  18




                             Page i                                            GAO-03-87 SBA Loan Sales
Contents




Figure 3: Outlets That SBA Borrowers Use for Inquiries and
          Complaints about Loan Sales                                  23
Figure 4: Gain / Loss Calculation on Previously Defaulted Sold
          Guaranteed Loans                                             27
Figure 5: Change in Loan Servicing Volume at the Disaster Home
          Loan and Commercial Loan Servicing Centers                   35
Figure 6: Changes in Number of Employees and Workload per
          Employee at Servicing Centers                                37




Abbreviations

CFO        Chief Financial Officer
OMB        Office of Management and Budget
SBA        Small Business Administration
SFFAS      Statement of Federal Financial Accounting Standards


Page ii                                           GAO-03-87 SBA Loan Sales
A
United States General Accounting Office
Washington, D.C. 20548



                                    January 3, 2003                                                                                 Leter




                                    The Honorable Christopher S. Bond
                                    Ranking Minority Member
                                    Committee on Small Business and Entrepreneurship
                                    United States Senate

                                    Dear Senator Bond:

                                    In 1999, the Small Business Administration (SBA) began a loan asset sales
                                    program, at the direction of Office of Management and Budget (OMB), to
                                    reduce the amount of debt the agency owned and serviced. SBA’s loan asset
                                    sales program is of particular interest because OMB has tentatively planned
                                    loan asset sales at other federal credit agencies. OMB is interested in
                                    increasing loan asset sales in order to improve the management of loan
                                    assets and to transfer loan servicing responsibilities to the private sector.

                                    SBA guarantees business loans through its lending partners in the 7(a)
                                    program and makes direct loans for disaster assistance to individuals and
                                    businesses. Before SBA began its loan asset sales program in 1999, the
                                    agency had never sold large volumes of loans in bulk. More than $9 billion
                                    in disaster assistance and other direct loans and defaulted business loan
                                    guarantees were eligible for sale. As of January 2002, SBA had conducted
                                    five sales, divesting itself of about 110,000 loans with an outstanding
                                    balance of $4.4 billion.1 Approximately 85 percent of the loans SBA sold
                                    were direct disaster assistance loans, most of which have below-market
                                    borrower interest rates. When SBA originally made these loans, it received
                                    appropriations to cover expected default costs as well as financing costs
                                    related to offering below-market interest rates to borrowers. The subsidy
                                    allowance account was established to cover these anticipated losses,
                                    which generally range from $17 to $33 for every $100 that SBA lends. This
                                    allowance indicates that the economic value of the loans is less than the
                                    loan balance at inception. The difference between the outstanding loan
                                    balance and the subsidy allowance is the net book value. When investors
                                    determine the price they are willing to pay for SBA’s loans, they also
                                    consider default risks and the low interest rate on most SBA disaster loans.
                                    As a result, investors bid less than the outstanding balance owed on these
                                    loans.


                                    1
                                     In August 2002, SBA held its sixth sale of about 30,000 loans with an outstanding balance of
                                    $657 million. Additional sales are planned.




                                    Page 1                                                            GAO-03-87 SBA Loan Sales
In determining whether or not to sell these loans, SBA estimated the
current value to the government, also known as the hold value,2 in
accordance with OMB Circular A-11. In essence, the hold value is the
expected net cash flows from the loans, discounted at today’s Treasury
rates. This differs from the net book value recorded on SBA’s books, which
is the expected net cash flows from the loans discounted using Treasury
rates in effect when the loans were disbursed. Therefore, the hold value
takes into account changes in interest rates since the loans were disbursed,
whereas the net book value does not. As a result, changes in interest rates
since the loans were disbursed will not affect the determination of the
benefit of a loan sale to the government based on the hold value.3 In
contrast, the accounting gain or loss on a loan sale—the net book value
compared with the sales proceeds—will be influenced by changes in
interest rates since the loans were disbursed.

SBA received about $2.7 billion in total proceeds and paid about $200
million in selling costs on its first five sales. These net proceeds exceeded
the hold values of the loans to SBA by about $606 million. However, as
discussed above, properly accounting for the sales and their subsequent
impact on loan program costs is more complex and could render a different
outcome regarding the accounting gain or loss. Our assessment of SBA’s
accounting treatment for these sales is discussed later in this report.

Because selling loans in bulk is a new and ongoing activity for SBA, and
OMB plans to expand loan sales in federal credit programs, you asked us to
conduct a broad review of the loan asset sales program. Specifically, you
asked us to (1) describe SBA’s process for selling loans, (2) identify how
lenders and borrowers have reacted to loan sales, (3) determine whether
SBA is properly accounting for its loan sales and their subsequent impact
on credit subsidy estimates, and (4) assess whether the loan sales are
generating operational benefits for the agency.



2
 The hold value of the loans selected for sale represents the estimated value to the
government of continuing to hold the loans until they are repaid, either at or before
maturity. The hold value is calculated on a present value basis, with future payments
discounted at current interest rates. This is a detailed loan-by-loan analysis that specifically
considers the cash flows and characteristics of the loans included in the sales.
3
 The hold value is designed to be a decisional tool used to determine whether or not it is
currently advantageous for SBA to sell loans. The hold value is calculated using current
Treasury interest rates in order to reflect current market conditions in the decisionmaking
process.




Page 2                                                              GAO-03-87 SBA Loan Sales
To respond to these reporting objectives, we reviewed strategic plans,
procedures, and other related documents that SBA used to plan and
manage the loan asset sales program; reviewed the results of the sales in
terms of types of loans sold, and proceeds; interviewed SBA officials,
contractors, investors, and lenders involved in the loan sale process;
reviewed and analyzed inquiries and complaints from borrowers; and
analyzed SBA data related to the impact of the loan sales on loan servicing
workloads and other benefits. We also analyzed relevant budget and
accounting data used to record the results of loan sales for both budgetary
and financial statement purposes, including reestimates of subsidy costs,
the values of loans sold, and proceeds and costs of sales. We compared
these data with the applicable guidance.

To assess SBA’s estimates of hold values for loans sold, we reviewed an
external validation of the hold model used for sales one through three that
was prepared by an SBA contractor, who concluded that the calculations
were accurate and reasonable. Since SBA changed to a more sophisticated
hold model after sale three, we also reviewed the methodology and
assumptions used in SBA's revised model to estimate hold values for loans
sold in sales four and five, and found the approach to be reasonable.4
However, we did not audit the data used to calculate the hold values for
each sale and therefore did not conclude on the reasonableness of the hold
values for any of the sales. We discussed SBA’s budgeting and accounting
procedures for loan sales with the agency, with its independent auditor, and
with OMB officials. We reviewed SBA’s audited financial statements for
fiscal years 1999 through 2001 and related audit workpapers for fiscal years
2000 and 2001.

All of our analyses were based on data from the first five sales, which
occurred between August 1999 and January 2002. The sixth sale, held on
August 6, 2002, was not completed in time for us to include it in our
analyses, because transferring servicing of the loans to the purchasers and
completing accounting adjustments take several weeks after the sale date.
We did not determine whether SBA maximized loan sale proceeds. We
performed our review from January 2002 through October 2002 in
Washington, D.C.; Birmingham, Alabama; Little Rock, Arkansas; Los

4
 SBA’s revised hold model was first used to estimate hold values for sale four. Hold values
from this more sophisticated model were calculated at the loan level rather than being
based on a loan pool approach or averages, and the revised model’s calculations were based
on the actual data from all loans selected for sale rather than on a sample of data from the
loans selected for sale.




Page 3                                                           GAO-03-87 SBA Loan Sales
                   Angeles and Santa Ana, California; Denver, Colorado; and Philadelphia,
                   Pennsylvania, in accordance with generally accepted government auditing
                   standards. Appendix I provides a detailed discussion of our scope and
                   methodology.



Results in Brief   A primary objective of SBA’s loan sales is to maximize proceeds by
                   designing a sales process that attracts and satisfies investors. In order to
                   ensure that investors have all the information they need to make informed
                   bids, SBA has invested resources in developing a carefully structured loan
                   sale process. SBA field offices and servicing centers review loan files to
                   determine which loans can be sold, although lenders must approve the
                   sales of small business loans. A contractor assembles the loan information
                   for investors, and financial advisers create loan pools and advertise the
                   sales. Before a sale goes forward, OMB must approve it. OMB generally
                   approves the sale if the estimate of the value to the government of holding
                   the loans (based on current interest rates) is less than the estimated market
                   value calculated by financial advisers. Beginning with the second sale, SBA
                   has offered primarily performing, secured disaster assistance loans that
                   share many of the characteristics of home mortgages and have attracted
                   mostly large commercial and investment banks. SBA has consulted with
                   investors since the loan sales began in order to structure the sales in
                   accordance with market demands, and it has developed a “lessons learned”
                   process to improve future sales. Most of the investors with whom we spoke
                   or whose survey responses we reviewed responded favorably to the
                   information that SBA provides about the loans for sale and the organization
                   of the loan pools. These investors also reported that they plan to continue
                   participating in SBA’s sales.

                   Lenders with whom we spoke that had participated in the 7(a) business
                   loan guaranty program were satisfied with the loan sales. Most of the
                   lenders with whom we spoke were pleased with the proceeds from the
                   sales and viewed participating in the sales program as a useful way to help
                   manage their portfolios. Some of the lenders also noted that SBA had
                   improved certain aspects of the program since the first sale. However, it
                   was more difficult for us to determine the reaction of borrowers whose
                   business or disaster assistance loans were sold, as SBA does not have a
                   comprehensive process for documenting and tracking borrower inquiries
                   and complaints to ensure that borrower protections are working. Borrower
                   protections included in the loan sale agreements are limited, requiring only
                   that purchasers affirm they were qualified to service the loans and agree to
                   use prudent loan servicing practices. These protections are intended to



                   Page 4                                                GAO-03-87 SBA Loan Sales
ensure that borrowers are not taken advantage of or pressured to change a
loan’s terms or conditions. SBA’s primary mechanism for enforcing these
protections is to follow up on borrower inquiries and complaints, but we
found that the agency did not have a system in place to capture all the
inquiries and complaints received by headquarters or field offices. As a
result, we could not determine how many borrowers had actually
contacted SBA with complaints about the loan sales.

During our review of SBA’s budgeting and accounting for loan sales,5 we
found errors that could significantly affect the reported results in the
budget and financial statements for fiscal years 2000 and 2001. For
example, SBA incorrectly calculated accounting losses on loan sales, which
were then reported in the footnotes to its financial statements. Further,
OMB budget guidance directs agencies to make reestimates of program
costs for all changes in cash flow assumptions in order to adjust the
subsidy estimate for differences between the original estimated cash flows
and the actual cash flows.6 However, SBA did not conduct key analyses of
either the loans sold or its remaining portfolio, in order to determine the
impact of the loan sales on its reestimates of program costs for its
remaining loans. Because of the lack of reliable financial data, we were
unable to determine the actual gain or loss on SBA’s loan sales for the
budget and financial statements. We also found that SBA had significant
unexplained declines in its disaster loan program subsidy allowance
account, to the point of showing that this subsidized program was expected
to generate a profit. Between fiscal years 1998 and 2001, the balance in this
account declined from $1.2 billion to a negative $77 million—that is, by
over 100 percent—while the outstanding loan balance owed by borrowers
declined by only 42 percent. SBA could not provide support for the balance
or explain the reason for this anomaly. Despite these errors and
uncertainties, SBA’s auditor gave unqualified audit opinions on SBA’s fiscal
years 2000 and 2001 financial statements.7 We discussed these issues with
SBA’s auditors, who indicated that they are currently assessing the cause of


5
 The accounting standards for loan programs were established to mirror budget guidance.
This mirroring allows for consistency between loan program cost estimates and the results
for the financial statements and budget.
6
 Cash flow assumptions include known and forecasted information about the
characteristics and performance of a loan or group of loans that are used to estimate future
loan performance and program costs.
7
 An unqualified audit opinion indicates that the balances in the financial statements are free
of significant errors known as material misstatements.




Page 5                                                            GAO-03-87 SBA Loan Sales
the unusual balance in the subsidy allowance account and, if necessary,
plan to reevaluate their audit opinions on the fiscal years 2000 and 2001
financial statements. Until SBA performs further analyses to determine the
full impact of these errors and uncertainties, the financial effect of its loan
sales and the reliability of the current and future subsidy rates will remain
unknown, and congressional decisionmakers will not receive the accurate
financial data they need to make informed decisions about SBA’s budget
and the level of appropriations the agency should receive.

Though SBA has reported that its loan sales will help the agency realign its
workforce and improve the management of its loan portfolio, these
benefits either have not yet materialized or may be overstated. SBA has
said that loan asset sales are beneficial to the agency because it does not
have the capacity to service all of its loans. In addition, the agency noted,
selling loans should allow it to reallocate the personnel who are servicing
loans to functions that are more critical to SBA’s mission, such as lender
oversight and outreach to small businesses. We found that loan sales have
most reduced the servicing workloads for disaster assistance loans; they
have had less of an impact, however, on servicing workloads for 7(a)
business loans, as lenders did not always consent to sell these loans.
Further, because the reductions in loan servicing have involved disaster
assistance loans, it was unclear to what extent loan sales would help the
agency realign its workforce in the district offices that primarily serve
small businesses. We found some support for the other benefits SBA
identified, but other factors may also have contributed to some of these
outcomes. For example, SBA has reported that because of loan asset sales,
more borrowers have paid off their loans. However, the increase in the
number of loans paid off per year began prior to loan asset sales,
suggesting that some of these borrowers might have paid off their loans
regardless of whether a loan sale had occurred.

Although loan asset sales may be beneficial to the government, we were
unable to determine the accounting and budgeting effects of SBA’s loan
asset sales because of problems identified in this report. This report
includes recommendations to SBA and its Inspector General. To provide
accurate and reliable information on the impact of the program and to
address the accounting and budgetary problems, we recommend that (1)
SBA improve the process for tracking borrower inquiries and complaints;
(2) SBA correct the accounting and budgeting errors and misstatements
before conducting additional loan sales; (3) the Inspector General work
with SBA’s financial auditors to assess the impact of the errors in the




Page 6                                                  GAO-03-87 SBA Loan Sales
financial statements; and (4) SBA more thoroughly analyze the benefits and
other effects of the sales on agency operations.

We obtained written comments on a draft of this report from SBA’s Chief
Financial Officer, from the Inspector General, and from Cotton and
Company, SBA’s independent financial statement auditor. In commenting
on a draft of this report, SBA generally agreed with the overall findings and
recommendations, especially the need to better assess the financial impact
of SBA’s loan sales program. SBA noted that it is taking steps to address the
process for documenting and tracking borrower inquiries and complaints.
SBA also stated that it is actively engaging a contractor to help resolve the
accounting and budgetary issues, and that it has worked extensively with
its independent auditor to identify causes and options for resolving the
issues we identified. SBA did not specifically respond to our
recommendation for a more thorough analysis of the impact of loan sales
on agency operations. SBA requested that we delay issuance of the report
until March 2003. By then it hoped to have determined the causes of the
accounting and budgetary problems, and to be able to propose an
appropriate methodology for resolving them. Though we appreciate the
desire to provide a plan of action for addressing these problems in our final
report, it is not our policy to delay issuance of our reports until problems
we have identified are resolved.

The Inspector General also agreed with our recommendations and is
working with Cotton and Company and SBA management to determine the
magnitude of the errors in SBA’s fiscal years 2000 and 2001 financial
statements. The Inspector General also stated that Cotton and Company
informed the IG office that the audit opinion on the fiscal years 2000 and
2001 financial statements should no longer be relied upon, as they may be
materially incorrect because of the errors identified in this report. The
comments also stated that Cotton and Company plans to withdraw its
unqualified audit opinion on those financial statements, and to issue
disclaimers of opinion.

Although Cotton and Company agreed with the findings of our report, it
stated that the report would be more fair and balanced if we further
elaborated on the inherent risks and complexities associated with
accounting estimates and loan sales. Cotton and Company also stated that
it believes there is a lack of comprehensive implementation guidance for
agencies on making credit subsidy and loan sale cost estimates. We agree
that accounting for and auditing credit subsidy estimates and loan sales are
inherently complex, and we describe these complexities in the background



Page 7                                                GAO-03-87 SBA Loan Sales
             section of the report. Further, the errors we identified in the financial
             statements and the related footnotes were primarily concerned with flaws
             in the application of existing guidance rather than with insufficient
             guidance. In addition, the anomalies in the disaster loan subsidy allowance
             account were clearly apparent, and SBA was unable to provide a viable
             explanation for these anomalies.



Background   The President’s fiscal year 1998 budget proposed that SBA begin selling
             disaster and business loans that the agency was servicing and transition
             from the direct servicing of loans to overseeing private-sector servicers.
             Before its loan asset sales program began, SBA was servicing
             approximately 300,000 loans, with a principal balance of over $9 billion.
             About 286,000 of these loans, with a principal balance of $7 billion, were for
             disaster assistance.

             SBA’s loan asset sales program is part of a governmentwide initiative to
             make loan asset sales a potential tool for improving the management of
             federal credit programs. In the conference report accompanying the
             Treasury, Postal, and General Government Appropriations Act, 1996,8
             congressional conferees directed OMB, in coordination with the federal
             agencies involved in credit programs, to evaluate the potential for selling
             loan assets to the private sector. Furthermore, the Debt Collection
             Improvement Act of 1996 encourages federal agencies that provide loans to
             sell delinquent debt when appropriate.9 In June 2002, OMB issued guidance
             requiring agencies to analyze their loan portfolios and loan management
             costs in order to determine whether privatizing functions such as loan
             servicing by selling loan assets or outsourcing would produce greater
             efficiencies. Other federal credit agencies have significantly larger loan
             portfolios than SBA that could be available for loan sales, including the
             Departments of Agriculture and Education, which held $78 billion and $96
             billion, respectively, as of fiscal year 2001.

             SBA’s loan sales include defaulted, formerly guaranteed 7(a) and 504
             (development company) business loans and direct disaster assistance
             loans. SBA provides small businesses with access to credit, primarily by


             8
              H.R. Rep. No. 104-291 at 40–41 (October 25, 1995), to accompany Pub. L. No. 104-52 (Nov.
             19, 1995).
             9
             Pub. L. No. 104-134, Title III, ch. 10, § 31001, 110 Stat.1321-358 (1996).




             Page 8                                                              GAO-03-87 SBA Loan Sales
guaranteeing loans through its 7(a) and 504 programs.10 For the 7(a)
program, SBA guarantees up to 85 percent of the loan amount made by
private lenders to small businesses that are unable to obtain financing
under reasonable terms and conditions through normal business channels.
Under the 504 program, SBA provides its guaranty through certified
development companies—private nonprofit corporations—that sell
debentures that are fully guaranteed by SBA to private investors and lend
the proceeds to qualified small businesses for acquiring real estate,
machinery, and equipment, and for building or improving facilities. When a
7(a) or development company loan defaults, SBA pays the claim and either
relies on the lender to recover as much as it can by liquidating collateral or
takes over the loan servicing and liquidation.11 Because SBA has paid the
guaranty and thus owns the loan, these defaulted business loans—whether
liquidated by the lender or by SBA—may be included in SBA’s loan asset
sales.

SBA also makes loans directly to businesses and individuals trying to
rebuild in the aftermath of a disaster, and it primarily services these loans
directly.12 Most of the disaster assistance loans have low interest rates,
sometimes less than 4 percent, and long repayment terms of up to 30 years.
Interest rates on disaster loans vary, depending on the borrower’s ability to
obtain credit in the private sector. For example, if a borrower cannot obtain
credit elsewhere, the interest rate is typically below the market rate, but a
borrower who can obtain credit elsewhere is likely to receive a higher rate.
Since SBA owns the disaster loans, all disaster loans are eligible to be sold.

The Federal Credit Reform Act of 1990 was enacted to require agencies to
more accurately measure the government’s cost of federal loan programs
and to permit better cost comparisons, both among credit programs and




10
 The 7(a) program is established under section 7(a) of the Small Business Act, 15 U.S.C. §
636 (2000 § Supp. 2002). The 504 program is established under Title V of the Small Business
Investment Act of 1958. See 15 U.S.C. § 696 et seq. (2000 § Supp. 20002).
11
  Liquidation is the act of enforcing collection on a debt that has defaulted by selling
underlying securities that the borrower has pledged as collateral. If collateral proceeds are
insufficient to cover the outstanding balance, lenders may pursue personal guarantees or
obligations provided by business owners or others in support of the loan.
12
 SBA implemented a pilot, as mandated by the Small Business Programs Improvement Act
of 1996, to outsource 30 percent of the servicing of its disaster home loan portfolio.




Page 9                                                            GAO-03-87 SBA Loan Sales
between credit and noncredit programs.13 The act gave OMB responsibility
for coordinating credit program cost estimates required by the act. OMB is
also responsible for approving all loan sales. Authoritative guidance on
preparing cost estimates for the budget and conducting loan sales is
contained in OMB Circular A-11, Preparation, Submission, and Execution
of the Budget. The Federal Accounting Standards Advisory Board
developed the accounting standard for credit programs, including loan
sales.14 This guidance is generally found in Statement of Federal Financial
Accounting Standards No. 2 (Statement 2), Accounting for Direct Loans
and Loan Guarantees, which became effective in fiscal year 1994. This
standard, which generally mirrors the Federal Credit Reform Act and
budget guidance, established accounting guidance for estimating the
subsidy cost of loan programs as well as recording loans and loan sales for
financial reporting purposes.15 The subsidy cost is the present value of
disbursements16—over the life of the loan—by the government (loan
disbursements and other payments) minus estimated payments to the
government (repayments of principal, payments of interest, other
recoveries, and other payments).

For financial statement purposes, loans are reported at both the
outstanding balance and at the present value of their estimated net cash
inflows, known as the net book value, which is reported on the balance
sheet. The difference between these two amounts is the subsidy allowance,
which is reported along with the outstanding loan balance in the footnotes
of the financial statements. The allowance represents the cost of the loan
program that is not expected to be recovered from borrowers, including
default costs and financing costs from subsidizing below-market rate loans.
Statement 2 states that when loans are written off, the unpaid principal of
the loans is removed from the loans receivable balance and the same
amount is charged to the subsidy allowance. Prior to the write-off, the


13
   Federal Credit Reform Act of 1990, Pub. L. No. 101-508 § 13201 (1990), 2 U.S.C. § 661 et seq.
(2000 and Supp. 2002).
14
 The board was created by OMB, Treasury, and GAO to develop accounting standards for
the federal government.
15
 In accordance with the Federal Credit Reform Act of 1990, the subsidy cost of loans does
not include administrative costs of the program.
16
 Present value is the worth of the future stream of returns or costs in terms of money paid
immediately. In calculating present value, prevailing interest rates provide the basis for
converting future amounts into their “money now” equivalents.




Page 10                                                             GAO-03-87 SBA Loan Sales
                         uncollectible amounts should have been fully provided for in the subsidy
                         allowance through the subsidy cost estimate or reestimates.

                         Further, as part of implementing credit reform, agencies are required to
                         estimate the subsidy cost for budgetary purposes. Generally, these
                         estimates are updated or reestimated annually after the end of the fiscal
                         year to reflect any changes in actual loan performance since the estimates
                         were prepared, as well as any expected changes in assumptions related to
                         future loan performance. Changes in subsidy cost that are recognized
                         through reestimates are funded through permanent indefinite budget
                         authority.

                         Before a loan sale, as part of its approval process, OMB reviews the hold
                         value of the loans being sold as compared with their estimated market
                         value. 17 A contractor that assists SBA with the loan sales estimates a
                         market value, which indicates the anticipated proceeds on the loan sale
                         based on current market trends and conditions, and the loans being sold.
                         Comparing the market value with the hold value determines whether it is
                         more beneficial for the government to hold or to sell the loans. However,
                         this determination does not take into account the impact of any changes in
                         administrative costs that results from the loan sales. The glossary at the
                         end of this report provides a list of commonly used terms related to credit
                         program budgeting and accounting.



SBA’s Sales Process Is   SBA officials told us that the loan asset sale process is designed to
                         maximize SBA’s sales proceeds by attracting as many investors as possible
Designed to Satisfy      to the bidding process. The process can take 9 months or longer as
Investor Demands         contractors, SBA field offices, and lending partners work together to
                         prepare loans for sale. For a sale to take place, SBA must have OMB’s
                         approval, which partly depends on an analysis of whether the expected
                         value of the loans to investors is greater than the estimated value to the
                         government. The price obtained for loans sold and investor interest in the
                         first five sales depended in part on the characteristics of the loan pools.


                         17
                          Hold value is the estimated value of loans to the government in the event that the loans
                         were held to maturity or resolution, stated on a present-value basis, discounted with interest
                         rates from the most recent President’s budget at the time the estimate is prepared. This is a
                         more detailed loan value analysis than the credit subsidy estimate, because it specifically
                         considers the cash flows and characteristics of the loans included in the sales and is
                         calculated on a loan-by-loan basis.




                         Page 11                                                           GAO-03-87 SBA Loan Sales
                              Large commercial and investment banks have purchased the performing
                              disaster assistance loans that make up the majority of SBA’s sale portfolio,
                              and primarily small investors have bought the nonperforming business
                              loans.18 Beginning with the first loan sale, SBA instituted a “lessons
                              learned” process to analyze and improve its efficiency and investor
                              satisfaction from sale to sale. Most investors interviewed by us or by SBA
                              contractors stated that SBA has responded to requests for more
                              information and is now providing the information needed to calculate bids.
                              Most investors also said that they plan to continue bidding on future sales.



Loan Sales Require Detailed   SBA’s asset sales team, which manages the loan asset sale program at SBA
Planning and an Investment    headquarters, coordinates the efforts of contractors, SBA field offices, and
                              lending partners to execute a loan sale (fig. 1). Two financial advisers and a
of Resources                  due diligence contractor are involved in each sale.19 The program financial
                              adviser is hired on a multiyear contract to supervise the work of other
                              contractors and consult on strategic planning issues, such as sale design
                              and loan selection. A transaction financial adviser is also hired for each
                              sale, to provide marketing and to manage logistics. All participants in the
                              sales process must work closely together over the approximately 9 months
                              needed to carry out a loan sale and the 2 months required to close it out.




                              18
                               Small investors are organizations, not individuals. SBA used this term in documents and
                              conversations with us to describe the more moderately sized institutions bidding on loan
                              sales.
                              19
                               The goal of due diligence is to provide accurate information about the loans for sale to
                              potential investors so that they may make informed bids.




                              Page 12                                                          GAO-03-87 SBA Loan Sales
Figure 1: Time Line of a Loan Sale
                                                                                               Transaction       Due diligence
                              SBA                SBA field offices      7(a) Lenders        financial adviser     contractor               Investors
       Months
                           Selects
                           loans for sale
               1             List of loans to      Remove                                     Surveys investor
                             be sold goes          nonqualifying                              demands for
                             to field offices      loans from                                 sale process
                                                   sale and add
               2                                   other eligible
                                                   loans
                           Notifies                  Send loan files      Consent to or       Seeks               Performs due
                           borrowers that            to due diligence     reject sale of      lenders'            diligence–
               3           their loan(s)             contractor           loans, and send     consent             verifies that
                           will be sold                                   loan files for      to sell             loan files are
                                                     Continue             sale to due         defaulted           complete,
                                                     servicing            diligence           7(a) loans          orders third-
                                                     loans to             contractor                              party reports
               4                                     be sold                                                      on borrowers
                                                                                                Markets sale      and collateral,
                                                                                                to potential      images loan
                                                                                                investors         documents,
               5                                                                                                  and enters key
                                                                                                                  data into
                           CFO's                                                                                  database
                                                                                                   Stratifies
                           office
                                                                                                   loans
               6           calculates
                                                                                                   into
                           hold
                                                                                                   pools
                           value


               7                                                        Continue                  Prepares
                                                                        servicing                 market-
                                                                        loans to                  value                                    Review
                                                                        be sold                   estimate                                 due
 OMB           8                                                                                                                           diligence
 approval                                                                                                                                  material



               9

 Bid day                                                                                                                                   Bid on loan pools
                                                                                                 Prepares
              10                                                                                 lessons-
                                                                                                 learned
                                                                                                 report
                           Sends share of                                                                                                  Winning bidders
                           proceeds to                                                                                                     send payments
              11           participating                                                                                                   to SBA
                           lenders
                            Notifies borrowers                                                                   Transfers loan files     Winning bidders pick
                            of servicing                                                                         to winning bidders       up loan files from due
              12            transfer                                                                                                      diligence contractor
                                                                                                                                          and notify borrowers
                                                                                                                                          of servicing transfer
 Source: GAO analysis of SBA data.



                                                            SBA and the program financial adviser select the loans for each sale, and
                                                            SBA’s servicing centers and district offices review them, removing any that


                                                            Page 13                                                                 GAO-03-87 SBA Loan Sales
should not be sold, such as loans that are paid in full, are charged off as a
loss in SBA’s accounts, or are in litigation. Before every sale, SBA’s loan
asset sales team sends a detailed procedural notice to field offices to guide
them through every step. The guidance covers loans that should be
removed from the sale, loans that may be added,20 and procedures for
shipping the loan files when the list is finalized. SBA’s 7(a) lending partners
review SBA’s requests to sell defaulted 7(a) loans and provide consent at
their discretion. SBA’s field offices and 7(a) lenders send the final selection
of loan files to the due diligence contractor.

SBA’s due diligence is the most costly and probably the most important
element of the loan sale process. For sales three through five,21 due
diligence averaged 87 percent of total sales costs, which have reached up to
$32.7 million per sale, not including salaries and expenses for SBA
personnel. SBA officials told us, however, that money invested in due
diligence results in higher bids from investors. In part, due diligence is
costly because SBA’s loan information systems do not capture some data
that investors need to make a purchase decision, such as collateral
information. The due diligence contractor must collect this information
from the loan files and create electronic images of documents. Investors
also want reports such as current credit scores, property appraisals, and
broker price opinions, which the due diligence contractor orders before a
sale. The due diligence contractor extracts the key data elements from the
reports and loan files and enters them into a database that investors can
access.

The transaction financial adviser sorts the loans into relatively
homogeneous pools according to characteristics such as the type of loan,
the type of collateral, and the loan’s status (performing or nonperforming).
Loan pools vary in size to appeal to different types of investors. Large
commercial and investment banks have been the primary bidders on blocks
of loans (multiple pools with common characteristics), which have an
aggregate unpaid principal balance of at least $115.8 million. Smaller pools
of loans are also created so that other types of investors can compete in the



20
 For example, if a borrower has multiple SBA loans and one is selected for sale, the field
offices are instructed to add the borrower’s additional loans to the list of loans for sale.
21
 SBA’s loan sale process has evolved, and information provided by SBA indicated that sales
three through five better reflect SBA’s current sale process and selection of loans for sale
than do sales one and two.




Page 14                                                            GAO-03-87 SBA Loan Sales
bidding. Between 14 and 25 investors bid in sales one through five, with a
total average of 4.2 bidders for both large blocks and smaller pools of loans.

Before SBA goes forward with a sale, SBA’s Office of the Chief Financial
Officer estimates the value to SBA of holding these loans to maturity or of
some other resolution, such as a prepayment or default. A “hold” model
was specifically designed to estimate the value to the government of the
loans selected for sale on a present value basis, discounted with current
interest rates. At the same time, the transaction financial adviser prepares a
market value estimate of what SBA would likely receive if it sold the loans
to the private sector. SBA compares these estimates to determine whether
selling the loans would provide a higher expected return than would
holding and servicing them. These estimates are provided to OMB for its
approval to go forward with a sale. For each of the five sales we reviewed,
the market value estimates were greater than SBA’s estimates of the hold
value, or value to government, and thus OMB approved each sale.

SBA officials and contractors explained that market value estimates have
exceeded hold values because investors are more efficient in collecting on
nonperforming loans than is the government, and investors take different
factors into account in valuing performing loans. As a result, investors
often place a higher value on these loans. According to SBA’s program
financial adviser, private-sector lenders service defaulted loans more
productively than the government because they have greater flexibility in
pursuing workouts, including the ability to treat borrowers differently
based on factors such as creditworthiness. SBA officials told us that private
investors value performing loans largely on the basis of what is recoverable
under the loan contract, including collateral. SBA, however, lends to
borrowers based on their ability to repay, and focuses on getting them to
make payments. Furthermore, compared with government agencies,
private-sector lenders have a greater number of portfolio management
strategies at their disposal, such as securitization.22 Securitization generally
yields a higher price than does selling a whole portfolio of loans, because
the seller can split up the portfolio to meet the demands of a wide range of
investors with varying levels of risk tolerance.




22
  Securitization of loans is the process of aggregating similar loan assets and dividing them
into groups of investment instruments for sales that investors will evaluate separately,
according to levels of risk.




Page 15                                                           GAO-03-87 SBA Loan Sales
Sales Results and Investor   For each sale, SBA received proceeds from loans sold that exceeded the
Interest Depended in Part    estimated value to the government of the loans, as calculated by SBA’s hold
                             model. SBA’s proceeds as a percentage of the unpaid balances of the loans
on the Loan Pools’           sold have varied with each sale because, among other factors, the
Characteristics              characteristics of the loans sold differed with each sale. As shown in table
                             1, SBA’s return on the sales, expressed as gross proceeds as a percentage of
                             total unpaid principal balance, ranged from 44.1 percent to 73.6 percent in
                             the first five sales. Although SBA ultimately aimed to maximize proceeds,
                             the agency selected loans for sale according to its own constraints and
                             perceived market interests. In the first sale, SBA sold business loans that
                             SBA had made and serviced directly. According to SBA, most of these loans
                             were performing and secured by collateral. As shown in figure 2, disaster
                             assistance loans made up approximately 92 percent of all loans sold in the
                             other sales. Most disaster assistance loans have low interest rates—around
                             4 percent or lower. Because these loans have below-market interest rates,
                             they offer lower scheduled borrower payments than do similar loans with
                             higher interest rates.23 Therefore, investors price their bids to compensate
                             for the SBA loans’ lower scheduled payments. In sale two, SBA sold
                             disaster assistance loans for the first time, and according to SBA officials,
                             investors also priced their bids to account for the risk they saw in
                             purchasing an unfamiliar loan product. Furthermore, in sale two, SBA
                             focused on selling a large number of loans serviced by its offices in Guam,
                             Puerto Rico, and the Virgin Islands, where servicing was more difficult and
                             costly. In sale four, SBA primarily sold performing, secured disaster
                             assistance loans, in an effort to enable investors to securitize these loans
                             purchased from SBA.




                             23
                               Similar loans refer to loans with comparable maturities, prepayment risks, and default
                             risks.




                             Page 16                                                          GAO-03-87 SBA Loan Sales
Table 1: Key Information on SBA’s Loan Sales One through Five

Dollars in millions
                              Sale 1      Sale 2     Sale 3       Sale 4   Sale 5
Unpaid principal balance     $332.1     $1,200.7   $1,105.1     $1,186.1   $600.6
Gross proceeds               $195.1      $530.0     $662.5       $873.3    $402.8
Gross proceeds/Unpaid          59%         44%        60%          74%       67%
principal balance
Estimated percentage of         n. a.      88%        95%          99%       76%
disaster loans secured
Estimated percentage of         n. a.      78%        82%          89%       88%
disaster loans performing
Estimated percentage of        88%         84%        94%          84%       81%
business loans secured
Estimated percentage of        61%         37%        32%          36%       10%
business loans performing
n. a. = not applicable
Source: SBA.




Page 17                                                  GAO-03-87 SBA Loan Sales
                            Figure 2: Total Balance of Loans Sold
                            1,500     Dollars in millions



                                                             $1,200.7                            $1,186.1
                            1,200
                                                              $162.4             $1,105.1         $52.7
                                                                                  $74.4          $1,133.4
                                                             $1,038.3            $1,030.7
                             900



                                                                                                                    $600.6
                             600
                                                                                                                    $49.8
                                                                                                                    $550.8

                                           $332.1
                             300           $332.1




                                0


                                      Sale 1                Sale 2              Sale 3          Sale 4            Sale 5


                                                Business loans (7a, 504)

                                                Disaster assistance loans (home and business)
                            Source: SBA.



                            SBA officials and investors told us that large investors, including
                            investment banks, have bought the performing disaster home loans, and
                            according to SBA, at least one investor is securitizing and trading them like
                            other mortgage-backed securities. Most of the 7(a) loans sold since sale
                            two have been nonperforming, and many were sold in smaller pools that
                            small investors can bid on, according to SBA officials. Two small investors
                            with whom we spoke have purchased these loans to try to return them to
                            performing status and resell them at a profit.



SBA Used Investor           From the outset of the loan asset sales program, SBA used feedback from
Feedback to Shape and       investors to shape and improve the sales process, with the aim of attracting
                            as many investors as possible and obtaining quality bids on loan pools. As
Improve the Sales Process
                            part of presale marketing, the transaction financial adviser consults with
                            potential investors to determine which loan offerings, loan data, and sale
                            procedures will yield the greatest interest. Investors are also surveyed after



                            Page 18                                                                      GAO-03-87 SBA Loan Sales
the sales to obtain feedback to consider in planning future sales. SBA
officials told us that these surveys are an integral part of the lessons-
learned process that SBA established for the close of each sale, to help the
agency target and address problems. According to SBA officials, analyzing
SBA’s processes and applying lessons learned have made SBA more
efficient in activities such as removing loans that do not meet sale criteria.
According to SBA officials, this process has reduced the number of loans
that investors have sold back to SBA for not meeting the conditions of the
agency’s representations and warranties.24 SBA officials also spoke with
investors to identify common concerns that may have been leading them to
discount their bids. According to SBA, after the early sales, many investors
reported that they wanted SBA to provide additional data, such as
borrower credit scores and lien information. SBA responded by adding
information to its database, including credit scores and lien information, to
reduce investor uncertainty about the quality of loans for sale.

The six investors with whom we spoke and most of the 42 survey responses
for sales four and five positively assessed SBA’s loan sale process. Most
investors stated that the loan pools are well organized and that SBA
provides the data they need to make informed bids. Furthermore, our
review of the information provided to investors found minimal problems
with the completeness of the data. The investors with whom we spoke
indicated that they will continue to bid on sales. Other investors
interviewed by the transaction financial adviser—including those who have
not bid in past sales—reported that they are interested in participating in
future sales. SBA officials believe that the refinement process and
provision of better data to investors has yielded higher bids.




24
  Representations and warranties are a set of legally binding statements by the seller that are
intended to assure buyers that the assets being sold meet certain qualitative expectations.
Representations and warranties are accompanied by obligations to “cure” conditions that
are breaches of the original representations, as well as by remedies available to the investor
if the condition cannot be cured. Such remedies may require a repurchase or substitution of
an obligation.




Page 19                                                            GAO-03-87 SBA Loan Sales
Lenders Expressed         Lenders and borrowers also play a role in the loan sale process. Although
                          many 7(a) lenders that participated in SBA’s loan sales reported satisfaction
Satisfaction with SBA’s   with the way in which the sales were conducted, borrowers’ reactions were
Loan Sales, but SBA’s     difficult to measure. An important factor in the reactions of both groups is
                          that lenders’ involvement is voluntary but borrowers’ is not. Lenders must
Data on Borrowers’        consent before SBA can sell business loans they made, while borrowers
Reactions Was             have no choice. Most of the 7(a) lenders with whom we spoke said they are
Incomplete                satisfied with the loan sale process and the proceeds they are receiving on
                          loans they consented to sell. However, lenders’ participation in sales is
                          limited and driven by a practical decision: whether greater net returns will
                          result from selling the loan or from liquidating it. The reaction of borrowers
                          was difficult to assess because of weaknesses in SBA’s system for
                          collecting and following up on inquiries and complaints—its primary
                          method of ensuring that borrowers whose loans are sold are protected.



Most 7(a) Lenders with    Lenders who participate in SBA’s 7(a) loan guaranty program have an
Whom We Spoke Are         interest in the outcome of the sales, because they still have a stake in the
                          7(a) loans for sale. When a 7(a) loan defaults, SBA honors its loan guaranty,
Satisfied with the Loan
                          paying the lender 75 to 85 percent of the unpaid principal balance.
Sales                     Thereafter, the lender and SBA share any loan payments according to the
                          percentage set out in the guaranty. Therefore, SBA must obtain consent
                          from the lender before selling a defaulted 7(a) loan. We spoke with 12 7(a)
                          lenders who have all participated in more than one SBA loan sale, and 10
                          said that they had used the loan sales as an additional portfolio
                          management tool for nonperforming loans. According to 8 of the lenders
                          whom we interviewed, proceeds from the sales they participated in were
                          satisfactory; 2 lenders stated that SBA is obtaining market value for
                          nonperforming 7(a) loans. One lender stated that SBA sales have tapped a
                          market for nonperforming loans that his company would not otherwise be
                          able to access.

                          According to SBA, following the early sales lenders raised two concerns,
                          which the agency has since addressed. First, in the first four sales, lenders
                          did not know how to estimate the proceeds they would receive by selling
                          loans. And second, when some lenders received their shares of sales
                          proceeds, SBA did not clearly identify the price paid for each loan. These
                          practices resulted in accounting problems for the lenders. Beginning with
                          the fourth sale, SBA sent lenders one check and a list of the earnings from
                          each loan sold. Beginning with the fifth sale, SBA also began providing
                          information on returns from past sales to help lenders decide whether to



                          Page 20                                                GAO-03-87 SBA Loan Sales
                              consent to sell loans. Four lenders we spoke with specifically noted that
                              SBA had made improvements to its loan sale process in areas such as
                              distributing sale proceeds and seeking consent to sell loans.



Expected Returns and          Based on our discussions with 7(a) lenders and SBA district officials, we
Experience with Prior Sales   identified two primary factors that drive lender participation in the sales:
                              whether the net returns from the sale are likely to exceed those from
Drive Lender Participation
                              liquidation, and whether proceeds from a previous sale met expectations.
                              Lenders’ consent to sell 7(a) loans must be given voluntarily, and most
                              lenders sell these loans only after trying to liquidate them. Three SBA
                              district officials and two lenders said that in the early sales, SBA lenders
                              did not have all the information they wanted about expected returns from
                              selling loans and therefore preferred not to sell them. A lack of control over
                              the loan sale process, timing of the sales, and distribution of the proceeds
                              can influence lenders’ expectations of net returns from selling loans rather
                              than liquidating. Lenders have no role in determining in which pools their
                              loans will be sold or whether bids are acceptable. Also, lenders must wait
                              until SBA’s bid day to sell loans, and the value of non–real estate collateral
                              generally declines as time passes. Finally, proceeds from SBA sales do not
                              arrive until almost 2 months after the sale, giving lenders greater incentives
                              to begin loan liquidation in order to try to recover money more quickly.

                              Lenders who have already begun investing resources in liquidation believe
                              they will maximize returns by continuing with their liquidation strategy.
                              Lenders are prepared to sell loans when they believe that their net returns
                              from investing resources in liquidation will no longer provide satisfactory
                              returns in comparison with selling loans. SBA officials confirmed that most
                              7(a) loans that lenders agree to sell have little value left in them.

                              According to SBA district office officials, some lenders have stopped
                              participating in loan sales because the proceeds from a previous sale did
                              not meet their expectations, and we spoke with one lender who confirmed
                              this statement. We also learned that some lenders who had stopped
                              participating in sales had not completed loan collection actions, such as
                              seizing collateral. Another disappointed lender we interviewed decided to
                              return to SBA loan sales, but only to sell loans after completing collection
                              efforts.




                              Page 21                                                GAO-03-87 SBA Loan Sales
SBA Created Borrower          Unlike lenders, SBA’s borrowers have little control over what happens to
Protections Addressing        their loans if SBA decides to sell them. However, SBA has built in some
                              safeguards to protect the integrity of the programs that provided the loans.
Loan Servicing and Disaster   SBA’s loan programs, including loan servicing, are designed to help the
Assistance                    borrower stay in business or recover financially from a disaster. To protect
                              the public policy goals associated with these programs, SBA’s loan sales
                              agreements with purchasers require certification that the investors are
                              qualified to purchase and service the loans and will follow prudent loan
                              servicing practices. The loan sales agreement also prevents purchasers
                              from unilaterally changing the terms and conditions of the loans.

                              SBA made additional policy decisions concerning disaster loans. The
                              agency does not sell some disaster loans, including those issued to
                              borrowers currently residing in a federally declared disaster area and those
                              that are less than 2 years old. SBA decided it would sell disaster loans only
                              if they were more than 2 years old, because disaster loans typically require
                              more servicing in the first 2 years and sometimes must be increased to
                              cover exigencies, such as occurs with revised physical damage estimates.



Information on Borrowers      We were unable to validate the way in which borrowers have reacted to the
Is Incomplete Because         loan sales, because SBA could not provide a reliable estimate or
                              information on the number of borrowers who had contacted them about
SBA’s Process for
                              their sold loans. Complete and reliable information on borrower
Documenting and Tracking      complaints is important, because SBA officials told us that they contacted
Borrower Inquiries and        purchasers when a borrower complained about a servicing action to collect
Complaints Has Weaknesses     additional information and determine whether a purchaser was breaching
                              the borrower protections. For example, in one case in which SBA was
                              receiving many complaints about one particular purchaser, SBA found
                              some evidence to suggest that the purchaser’s servicing employees were
                              overly aggressive or rude with some borrowers. In response, SBA
                              forwarded the specific complaints to the purchaser and requested that the
                              purchaser improve its handling of new loans.

                              One reason why SBA’s tracking system is ineffective is that borrowers with
                              questions or complaints can call or write to several different SBA offices,
                              or to a representative from Congress (fig. 3). Some SBA field office officials
                              told us that SBA does not provide them with clear guidance on how to
                              respond to or document such complaints. Officials from seven district
                              offices, three servicing centers, and two disaster area offices told us that
                              they had received calls and letters from borrowers who had concerns about



                              Page 22                                                GAO-03-87 SBA Loan Sales
loans that had been sold. But the methods of documenting inquiries and
complaints varied across offices, except for congressional letters, which
were consistently forwarded to SBA headquarters.



Figure 3: Outlets That SBA Borrowers Use for Inquiries and Complaints about Loan
Sales


                           Servicing
                            center




  Disaster                                             SBA
    area                                             toll-free
   office                                            number



                       Headquarters



                                                     District
  Congress
                                                     office



                             SBA
                            head-
                           quarters
 Source: GAO.



In August 2001, SBA began providing a toll-free number for borrowers to
call with questions or complaints about loan sales.25 Borrowers were
informed about the toll-free number in a letter telling them how to contact
the new owner of their loan. However, field office staff did not receive any
guidance regarding the purpose and use of the toll-free number. Santa Ana

25
   The Real Estate Settlement Procedures Act (RESPA) requires that loan servicers provide
either a toll-free or collect call number for home loan borrowers to call about servicing
problems before and after the loan is sold. 12 U.S.C. § 2605 (b), (c) (2000 § Supp. 2002). The
act does not specify how long the toll-free number should be operational following the
transfer of servicing.




Page 23                                                           GAO-03-87 SBA Loan Sales
liquidation and loan servicing center staff who answer calls to the toll-free
number told us that initially they thought the number was only provided for
answering borrowers’ questions, and therefore they did not record
inquiries or complaints called in to this number. Therefore, we were unable
to collect a reliable sample of inquiries and complaints from this source.

We also could not validate the number of inquiries and complaints received
at headquarters. SBA officials at headquarters told us that, overall, SBA had
received about 300 inquiries or complaints from borrowers. However, when
we were provided with a database of these inquiries and complaints, there
were only 155. When we asked how SBA came up with the number 300,
officials told us that it was an estimate.

We also reviewed 50 complaints from a servicing center, the only field
office with whom we talked that could provide a record of phone calls and
letters from borrowers whose loans had been sold, to compare them with
the inquiries and complaints at headquarters. Forty-five complaints
involved problems with purchasers during the servicing transfer period—
for instance, some borrowers said that payment had not been posted, and
others had difficulty in modifying the terms of their loans. However, we
found that only 3 of the borrowers listed in 50 complaints from the
servicing center were reflected in the 155 borrower inquiries or complaints
we reviewed at SBA headquarters. An SBA official at headquarters told us
that the office had received some of the complaints from the center, but
acknowledged that they had not included these complaints in the files we
had reviewed.

Though we were unable to determine how many borrowers have contacted
SBA about their sold loans, we reviewed 133 of the 155 written inquiries
and complaints documented at headquarters, along with SBA’s written
responses, to identify the types of questions and problems borrowers may
have when their loans are sold. Our analysis showed that almost half (65)
were inquiries and concerns about their loans being sold, requests to buy
their own loans, or pleas to not have their loans sold. However, 47 of the
borrowers complained about a purchaser’s servicing action. SBA
responded in writing to the written inquiries and complaints we reviewed
at headquarters. More information on our review of these inquiries and
complaints is presented in appendix II.




Page 24                                               GAO-03-87 SBA Loan Sales
SBA’s Accounting for        SBA sold almost 110,000 loans with an unpaid principal balance of about
                            $4.4 billion in five loan sales from August 1999 through January 2002. We
Loan Sales and the          reviewed the budgeting and accounting for these loan sales and found
Remaining Portfolio         errors that could significantly affect the reported results in the budget and
                            financial statements. Specifically, SBA (1) incorrectly calculated loan sales
Was Flawed                  losses reported in the footnotes to its financial statements; (2) did not
                            appropriately consider the effect of loan sales on its estimates of the cost of
                            the remaining portfolio, which could significantly affect its budget and
                            financial statement reporting; and (3) had significant unexplained declines
                            in its subsidy allowance for the disaster loan program. Despite these errors
                            and uncertainties, SBA’s auditor gave unqualified audit opinions on SBA’s
                            fiscal year 2000 and 2001 financial statements. We discussed these issues
                            with SBA’s auditors, who indicated that they are currently assessing the
                            cause of the unusual balance in the subsidy allowance account and, if
                            necessary, plan to reevaluate their audit opinions on the fiscal years 2000
                            and 2001 financial statements. Until SBA performs further analyses to
                            determine the full impact of these errors and uncertainties, the financial
                            effect of its loan sales and the reliability of current and future subsidy rates
                            will remain unknown.



SBA Improperly Calculated   Accounting records related to loan sales indicated that losses exceeded
Losses on Loan Sales        $1.5 billion. However, this amount is overstated because of errors in the
                            way that SBA calculated the losses. Because of the lack of reliable financial
                            data available, we were unable to determine the financial effect of loan
                            sales on SBA’s budget and financial statements. These errors raise serious
                            concerns about the information related to the results of loan sales included
                            in the footnotes to the annual financial statements provided to OMB and
                            the Congress for decisionmaking purposes.

                            For accounting purposes, the gain or loss on a loan sale represents the
                            difference between the net book value (the outstanding loans receivable
                            balance less the subsidy allowance)26 of the loans sold and the net sale




                            26
                              The subsidy allowance account represents the subsidized portion of direct loans and
                            defaulted guaranteed loans assumed by the federal government. It is subtracted from the
                            loans receivable balance on the balance sheet to arrive at the net loan amount expected to
                            be repaid.




                            Page 25                                                         GAO-03-87 SBA Loan Sales
proceeds.27 The accounting gain or loss differs from the hold value
calculation, discussed earlier, which indicates that the sales resulted in a
benefit to the government of about $606 million. This difference exists
because the benefit calculation—the difference between the hold value and
the net sales proceeds—is not designed to take into consideration changes
in interest rates from the time the loans were disbursed to the date of the
sale, while the accounting gain or loss, if properly computed, does take
these changes into account. The footnotes to SBA’s fiscal years 1999 and
2000 financial statements reported accounting losses of $75 million and
$600 million, respectively, on its loan sales. SBA did not separately disclose
in its financial statements the losses calculated on the two loan sales that
took place during fiscal year 2001. According to SBA’s accounting records,
the first five sales have resulted in total losses of more than $1.5 billion.

We reviewed the methodology SBA used to calculate the results of its loan
sales for accounting purposes and found significant errors that caused SBA
to overstate losses. When calculating whether loans are sold at a gain or at
a loss, agencies must estimate the portion of the subsidy allowance to
allocate to each loan sold in order to calculate the net book value for those
loans. Since SBA’s calculation of the net book value of the sold loans
exceeded the net proceeds from the sales, losses were calculated. Our
review of these calculations found that SBA’s estimates did not consider all
the appropriate cash flows when allocating the subsidy allowance to the
sold loans. For example, when calculating the gains or losses for the
disaster loan program, SBA failed to allocate a portion of the subsidy
allowance for financing costs associated with lending to borrowers at
below-market interest rates.

In addition, SBA incorrectly allocated the subsidy allowance for the
previously defaulted 7(a) and 504 loan guarantees. SBA used its estimated
net default cost, which considers first the probability of default and then
the estimated recovery rate after default. For example, if a $10,000
guaranteed loan has an estimated default rate of 10 percent and an
estimated recovery rate of 50 percent, the subsidy allowance allocated by
SBA would be $500 ([$10,000 x .10] x .50). However, since sold guaranteed
loans have already defaulted, SBA should have used only the estimated


27
  OMB Circular A-11 defines net sales proceeds in the context of loan sales as the amounts
paid by purchasers less all seller transaction costs (such as underwriting, rating agency,
legal, financial advisory, and due diligence fees) that are paid out of the gross sales proceeds
rather than paid as direct obligations by the agency.




Page 26                                                             GAO-03-87 SBA Loan Sales
                                         recovery rate for these loans, meaning that the subsidy allowance allocated
                                         would be $5,000 ($10,000 x .50). Figure 4 illustrates the difference in the
                                         calculated gain or loss resulting from this error. The left column, based on
                                         SBA’s methodology, shows that the loan was sold for a $3,000 loss, while
                                         the right column appropriately allocates the allowance based on expected
                                         recoveries and results in a $1,500 gain.



Figure 4: Gain / Loss Calculation on Previously Defaulted Sold Guaranteed Loans
 Dollars

 SBA's method                                                   Correct method
 Previously defaulted loan guarantee                 $10,000    Previously defaulted loan guarantee                    $10,000
 Less allowance based on net defaults                    500    Less allowance based on portion                          5,000
 (defaults less recoveries)                                     not expected to be recovered
 Net book value                                        9,500    Net book value                                           5,000
 Net sale proceeds                                     6,500    Net sale proceeds                                        6,500
 Loss                                                ($3,000)   Gain                                                    $1,500
 Source: GAO analysis.



                                         SBA’s errors in calculating the losses on disaster loans and on previously
                                         defaulted sold guaranteed loans, both resulted in overestimates of the net
                                         book value of the sold loans and the losses that SBA reported in the
                                         footnotes to its fiscal years 1999 and 2000 financial statements. Because of
                                         the way in which the results of loan sales are incorporated into the budget
                                         and the financial statements, the reestimates, if done properly, should have
                                         corrected the effect from these errors. However, as discussed below, we
                                         found that the reestimates were not reliable.



Subsidy Cost Reestimates                 SBA did not conduct key analyses of either the loans sold or its remaining
Are Unreliable                           loan portfolio in order to determine the impact of the sales on its
                                         reestimates of program costs for its remaining loans. OMB’s budget
                                         guidance directs agencies to make reestimates for all changes in cash flow
                                         assumptions in order to adjust the subsidy estimate for differences
                                         between the original estimated cash flows and the actual cash flows. SBA
                                         officials acknowledged that analyses of the impact of loan sales on its
                                         historical averages should be done. However, according to SBA officials,
                                         the agency has lacked the appropriate historical data and resources to do
                                         these necessary analyses. Because SBA did not assess the effect that loan



                                         Page 27                                                      GAO-03-87 SBA Loan Sales
sales would have on its historical averages of loan performance, such as
when loans default or prepay, the agency does not know whether these
averages, which can significantly affect the estimated cost of a loan
program, reasonably predict future loan performance. As a result,
information in both the budget and financial statements related to the
reestimated cost of SBA’s loan programs cannot be relied upon.

SBA is generally required to update or “reestimate” loan program costs
annually. OMB Circular A-11 directs agencies to do reestimates for all
changes in cash flow assumptions. Thus, reestimates should include all
aspects of the original cost estimate, including prepayments, defaults,
delinquencies, and recoveries. These reestimates are done to adjust the
subsidy cost estimate for differences between the original cash flow
projections and the amount and timing of cash flows that are expected
based on actual experience, new forecasts about future economic
conditions, and other events that affect the cash flows.

Even after selling about $4.4 billion of loans, nearly half of its loan
portfolio, SBA has not analyzed the effect of loan sales on the estimated
cost of the remaining loans in its portfolio. SBA officials told us that loans
are selected for sale based on certain criteria, such as where the loan is
located or serviced, the type of collateral, or whether the loan is
performing. Since the loan selection process is not random—that is, all
loans do not have an equal chance of being selected—it is likely that the
loans sold will have different characteristics from those of the portfolio’s
historical averages prior to sales. Consequently, the characteristics of the
remaining loans may also differ substantially from the portfolio historical
averages prior to the sales. For example, during our analysis of the loans
that were sold, we determined that 84 percent of the $3.8 billion of disaster
loans sold were performing—meaning that payments were not more than
30 days delinquent. Selling mostly performing loans could conceivably
leave a disproportionate level of nonperforming loans in SBA’s portfolio.
Because SBA has not analyzed the effect of loan sales on its reestimates of
the remaining portfolio, it does not know if the percentages of remaining
performing and nonperforming loans are different from the historical
averages prior to the sales. A change in these percentages could indicate
that expected defaults in the remaining portfolio could be higher or lower
than current assumptions, based on historical data, suggest.

Another important loan characteristic is the average stated loan term. This
term is the contractual amount of time the borrower has to repay the loan.
SBA’s estimated costs of the disaster loan program are based on historical



Page 28                                                GAO-03-87 SBA Loan Sales
                        average loan term assumptions of 16 years for business disaster loans and
                        17 years for home disaster loans. Based on our review of the disaster loans
                        sold in the first five sales, the average loan term was about 25 years.
                        However, SBA continued to use the average loan term assumptions of 16
                        and 17 years in its reestimates without doing the appropriate analysis to
                        determine whether these assumptions were still valid. Because of the large
                        number of loans sold, it is unlikely that the average loan terms for the
                        remaining loans are still 16 and 17 years, if in fact these are valid estimates
                        of the overall presale averages. Assuming that these assumptions are valid,
                        by selling longer-term loans, the average loan terms for the remaining
                        portfolio would be shorter. As a result, if there are no changes in any other
                        assumptions, the reestimated cost of the disaster loan program would be
                        less, since SBA would be subsidizing below-market rate loans for a shorter
                        period of time.28 Given the significant volume of loans sold since 1999, it is
                        important that SBA assess whether the characteristics of the remaining
                        portfolio are similar to the characteristics of the loans used to calculate the
                        averages used in the credit subsidy estimates. Relatively minor changes in
                        some cash flow assumptions—such as higher or lower default and recovery
                        rates, or changes in loan terms—can significantly affect the estimated cost
                        of the loan program and, therefore, the program’s budget.

                        We attempted to determine the effect of loan sales on the cost estimates of
                        the remaining portfolio. However, SBA could not provide us with timely,
                        basic information about the composition of its loan portfolio before and
                        after each sale, including the amount of loans that were current on
                        payments, delinquent, or in default. According to SBA, this information was
                        not readily available because of systems limitations and reconciliation
                        problems. Shortly before we concluded our work, SBA provided some
                        information about the quality of its portfolio before and after some of the
                        loan sales. However, because a gap of several months occurred between
                        the pre- and post-loan sales analyses, the data could not be reliably used to
                        determine the effect that loan sales were having on the quality of the
                        remaining portfolio.



The Subsidy Allowance   During our review of the accounting for loan sales, we noted that the
Account Was Misstated   subsidy allowance account for the disaster loan program had an unusually


                        28
                          The fact that the average loan term of the loans sold to date, which represents over half the
                        loan portfolio, is 25 years could also mean that the 16- and 17-year assumptions of the
                        average loan term were too short.




                        Page 29                                                            GAO-03-87 SBA Loan Sales
low balance. For a subsidized loan program, the subsidy allowance account
is generally the amount of expected losses on a group of loans related to
estimated defaults and financing costs from making below–market rate
loans. In effect, the subsidy allowance is the cost associated with the loans
that SBA does not expect to recover from borrowers. For financial
reporting purposes, the subsidy allowance reduces the outstanding loans
receivable balance to determine the amount that SBA expects to collect
from borrowers, known as the net loans receivable balance (or net book
value), which is shown on the balance sheet.

Table 2 summarizes the disaster loan program’s reported outstanding loans
receivable balance, the subsidy allowance balance, the net book value, and
the subsidy allowance as a percentage of the loans receivable balance for
fiscal years 1998 through 2001. The subsidy allowance compared with the
loans receivable balance decreased significantly in fiscal years 2000 and
2001, to the point of showing that the remaining portfolio of the disaster
program was expected to generate a profit. SBA could not provide support
for the balance or explain the reason for this anomaly.



Table 2: Loan Receivable Balances of SBA’s Disaster Loan Program

Dollars in millions
                            Fiscal year   Fiscal year   Fiscal year   Fiscal year
Disaster loan program             1998          1999          2000          2001
Loans receivable                $5,634        $5,659        $5,305        $3,293
outstanding
Less / (plus): Subsidy          $1,230          $929          $505          ($77)
allowance balance
Net book value                  $4,404        $4,730        $4,800        $3,370
Subsidy allowance as a           21.8%        16.4%           9.5%        (2.3%)
percentage of loans
receivable balance
Source: SBA.


While Table 2 shows a rapid decrease in the subsidy allowance over the 2-
year period between fiscal years 2000 and 2001, most of the decrease
actually occurred in fiscal year 2000, but was masked by an adjustment
made during the fiscal year 2000 financial statement audit. Before SBA had
made the audit adjustment, discussed below, the subsidy allowance for the
disaster program was about $91 million for fiscal year 2000. This balance
was $838 million, or about 90 percent, less than the $929 million balance for



Page 30                                                 GAO-03-87 SBA Loan Sales
fiscal year 1999, while loans receivable outstanding decreased by only $354
million, or about 6 percent. SBA could not explain why the subsidy
allowance reduction occurred.

In order to restore the subsidy allowance to a more reasonable balance at
the end of fiscal year 2000, in agreement with its auditors, SBA increased
the subsidy allowance balance by recording an audit adjustment that was
essentially meant to reflect the expected impact of loan sales on the
reestimates prepared in fiscal year 2000, which did not factor in the effects
of loan sales.29 This increased the reported cost of the disaster loan
program by $414 million. Since the amount of the adjustment was based on
SBA’s erroneous calculations of loan sales losses, previously discussed, the
amount of the adjustment was incorrect. During fiscal year 2001, SBA
reversed the audit adjustment and revised its reestimates to include cash
flows related to loan sales. Our review of the fiscal year 2001 disaster loan
program reestimates indicated that loan sales increased the reported cost
of the program by about $292 million.30 However, this amount is also likely
misstated because, as previously mentioned, the reestimates did not
consider the specific characteristics of the loans sold or the loans
remaining in the portfolio.

The unexplained decline in the subsidy allowance continued in the fiscal
year 2001 financial statements, where SBA reported a negative balance in
the subsidy allowance for the disaster loan program. As illustrated in table
2, this balance no longer reduced the amount SBA expected borrowers to
repay—it actually increased the expected repayments from borrowers and
indicated that the loan program was profitable. However, because the
program is subsidized, with estimated default and financing costs
exceeding the amount of interest borrowers are expected to pay, it should
not be showing an expected profit. Based on SBA’s most recent
reestimates, the subsidy cost of this program ranges from 17 percent to 33
percent, and thus the balance for the subsidy allowance account appears to
be significantly misstated. As in the prior year, SBA could not explain the


29
 Theoretically, had the reestimates factored in the loan sales, the subsidy allowance
account would have been appropriately adjusted, regardless of any errors made in recording
the calculated accounting losses.
30
  The effects of loan sales on the reestimated cost of a loan program differs from the results
of loan sales based on the hold value because the reestimates, similar to the accounting
gains or losses of a loan sale, are influenced by changes in interest rates from the time the
loans were disbursed to the date of the sale.




Page 31                                                           GAO-03-87 SBA Loan Sales
unusual balance. SBA officials told us they were currently working with
their auditors to determine the cause of these unusual balances.

While neither we nor SBA could determine the specific cause of this
unusual balance, several possibilities exist. As previously mentioned, a
failure to consider the characteristics of the loans sold or of those
remaining in SBA’s portfolio could contribute to the unusual balance.
Another possibility is that SBA could have incorrectly reduced its subsidy
allowance account balance by writing off loan amounts that are still
collectible. This would mean that both the loans receivable outstanding
balance and the subsidy allowance account would be misstated, but not the
net book value. Yet another possibility is that SBA may have
underestimated the cost of its disaster loan program because the cash flow
assumptions used to estimate the subsidy cost did not reflect the true
characteristics or performance of its loan portfolio. If SBA had
underestimated its losses on disaster loans, it would not have put enough
into the subsidy allowance account to cover these losses, and the subsidy
allowance would be depleted as loans were written off against it until there
was a negative balance. This could mean that SBA did not request an
appropriation large enough to cover the cost of the loan program, and that
the difference would be made up through the reestimates, which are
covered by permanent indefinite budget authority. It is also possible that a
combination of these and other errors may have occurred. Regardless of
the reason, because SBA does not currently know why the anomalies are
occurring, the disaster loan program’s subsidy estimates for the budget and
financial statements cannot be relied on.

Despite the significant, unexplained decline in the subsidy allowance and
the errors in calculating the losses on loan sales, SBA received an
unqualified or “clean” audit opinion on its fiscal years 2000 and 2001
financial statements. An unqualified audit opinion indicates that the
balances in the financial statements are free of significant errors, known as
material misstatements. As previously mentioned, SBA’s auditor attempted
to adjust the anomalies in the subsidy allowance during the fiscal year 2000
financial statement audit. However, the adjustment was based on the
previously described erroneous loss calculation. For the fiscal year 2001
audit, SBA’s auditor performed a number of audit procedures related to the
disaster loan program subsidy allowance account. For example, the auditor
evaluated the methodology and formulas used to calculate reestimates,
assessed data used to calculate key cash flow assumptions, and reviewed
various internal controls over the subsidy estimation process. However,
this work did not appear to focus on determining the cause of the unusual



Page 32                                               GAO-03-87 SBA Loan Sales
                        negative balance of the account, which, contrary to the fact that this is a
                        subsidized loan program, would indicate that these loans were expected to
                        generate a profit. The auditor’s workpapers indicated that the auditor had
                        agreed, in discussions with SBA management, that if the “methodology and
                        data were materially correct, we [the auditor] would conclude that the
                        resulting subsidy reserve [allowance] would be materially correct for
                        financial statement reporting purposes.” The workpapers also indicated
                        that, “whatever the results of the reestimates are, as long as the
                        methodology is sound and supportable, we [the auditor] would not
                        consider the balance [of the subsidy allowance] anything other than
                        ‘natural.’”

                        Although SBA’s auditor may have recognized some of the errors we
                        identified, it did not determine the cause of the unusual balance and
                        propose the necessary audit adjustments, nor did it modify its audit report
                        as appropriate. In such situations, when auditors cannot determine
                        whether a balance is fairly stated because sufficient reliable supporting
                        documentation is not available, audit standards call for auditors to qualify
                        their opinion or issue a disclaimer of opinion.31 We discussed these issues
                        with SBA’s auditors and they indicated that they are currently assessing the
                        cause of the unusual balance in the subsidy allowance account and, if
                        necessary, plan to reevaluate their audit opinions on the fiscal years 2000
                        and 2001 financial statements.



Loan Sales Have         SBA reported that loan asset sales had benefited the agency’s operations by
                        reducing loan servicing, and that this reduction in loan servicing volume
Reduced SBA’s Loan      should help allocate resources to other areas necessary to achieving SBA’s
Servicing Volume, but   mission and help the agency to manage its loan portfolio more effectively.
                        Though we found that loan servicing volume had declined for SBA disaster
Other Operational       home loan centers, the effect on regular business loans was less clear.
Benefits May Be         Furthermore, despite these reductions in loans servicing volumes, SBA had
Overstated              not yet redeployed staff to more mission-critical activities, such as lender
                        oversight and business outreach. SBA has also reported that the loan sales
                        have prompted borrowers to pay their loans in full, revealed
                        inconsistencies in the application of the agency’s servicing procedures, and
                        highlighted weaknesses in its information system. We found some support
                        to show that the loan sales had produced portfolio management


                        31
                             Statements on Auditing Standards, AU §508, paragraphs 22 and 23.




                        Page 33                                                           GAO-03-87 SBA Loan Sales
                             efficiencies. But we also found that some of the benefits SBA had reported
                             began before the loan sales program, or could have been caused by other
                             factors.



Reductions in Loan           The loan asset sales have reduced SBA’s servicing and liquidation workload
Servicing Volumes Have       for disaster loans at the disaster home loan servicing centers, but they have
                             had little impact on regular business loans, such as 7(a) loans, at the
Been Greatest for Disaster
                             commercial servicing centers and district offices. SBA had stated that
Loans                        reductions in loan servicing and liquidation workloads would be one of the
                             loan sales program’s most significant benefits, as the growth in loan volume
                             and the continuing decline in staff had compromised its ability to
                             adequately service a growing portfolio. During the 1990s, SBA’s portfolio of
                             7(a) business and disaster loans grew dramatically. For example, from 1990
                             through 1996, SBA’s annual volume of 7(a) loan approvals increased from
                             19,907 to 52,729. Disaster assistance loan approvals varied from year to
                             year, depending on the number and severity of disasters. However, in 1994
                             SBA’s loan approvals for disaster assistance loans increased to over
                             125,000, primarily because of the Northridge earthquake in California—a
                             significant jump from the levels of the previous 4 years, when loan
                             approvals ranged from about 12,000 to 59,000. Servicing and liquidating
                             loans account for large operating expenses for SBA, reaching
                             approximately $85 million a year, according to SBA’s fiscal year 2001
                             Accountability and Performance report. Servicing and liquidating loans
                             currently involve approximately 186 employees at six servicing centers and
                             employees at 70 district offices, who also perform other loan management
                             functions.32

                             SBA’s disaster home loan servicing centers have seen a much greater
                             reduction in the number of loans they service than have the commercial
                             loan servicing centers. According to SBA’s limited analysis, the number of
                             loans serviced at SBA’s disaster home loan servicing centers decreased by
                             17 percent from January 1999 through March 2002 (fig. 5), and SBA’s
                             analysis of the servicing centers shows that if more loans are sold, SBA
                             may be able to reduce and consolidate its loan servicing resources for


                             32
                              SBA has four disaster home loan servicing centers, located in New York City, New York;
                             Birmingham, Alabama; El Paso, Texas; and Santa Ana, California, which service only
                             disaster home loans. SBA also has two commercial loan servicing centers, located in Little
                             Rock, Arkansas, and Fresno, California, which service 7(a) and development company loans
                             as well as disaster business loans.




                             Page 34                                                         GAO-03-87 SBA Loan Sales
                                                      disaster home loans. However, SBA’s analysis also shows that the number
                                                      of loans at SBA’s commercial loan servicing centers fell by less than 0.5
                                                      percent over the same time period. Though the sales have reduced the
                                                      number of disaster business loans, most of the loans in the commercial
                                                      loan servicing centers are from the 7(a) program and are not put up for sale
                                                      until they default. SBA officials told us that lenders do not always consent
                                                      to sell the 7(a) loans that SBA would like to sell. Moreover, one commercial
                                                      loan director explained that servicing performing loans can require as
                                                      much if not more work than can nonperforming loans, as businesses
                                                      frequently seek additional financing and therefore want to modify the
                                                      terms of their loans. For this reason, the growth of the 7(a) program has
                                                      offset the number of loans sold in the commercial loan centers.



Figure 5: Change in Loan Servicing Volume at the Disaster Home Loan and Commercial Loan Servicing Centers
 110 Percent relative to Jan. 1999 (index 1999=100)




                                                                                                                                     99.6
 100




  90



                                                                                                                                    83.1


  80


       Jan.               June        Sept.      Dec. Jan.               June         Sept.   Dec. Jan.   June    Sept.    Dec.     Mar.
       1999               1999        1999       1999 2000               2000         2000    2000 2001   2001    2001     2001     2002


                                                                Commercial loans
                                                                Disaster home loans
 Source: SBA.



                                                      Since the loan sales began, SBA has been able to reduce the number of
                                                      employees at the servicing centers (fig. 6). However, one of the problems
                                                      SBA hoped to address with loan asset sales was to reduce its loan servicing
                                                      volume to a level that matches its staffing capacity. Since the
                                                      implementation of the loan sales, the number of loan servicing staff has



                                                      Page 35                                                    GAO-03-87 SBA Loan Sales
fallen faster than have loan volumes for most of SBA’s loan servicing
centers. According to SBA officials, the reduction in employees at SBA is
driven more by employee departures, retirements, and the hiring freeze
than by reductions in servicing volumes form the loan sales. As a result, the
number of loans serviced per employee increased on average by 14 percent
at the disaster home loan centers and by 23 percent at the commercial
centers (fig. 6). Only one of the disaster home loan servicing centers has
experienced a reduction in the number of loans serviced per employee. The
disparity between staff attrition and loan volumes is especially problematic
at SBA’s commercial loan servicing centers, where the number of loan
servicing employees has fallen by 19 percent and loan volumes have
remained unchanged. The analysis we reviewed did not address how these
employee reductions or any other operational effects may translate into
cost savings.




Page 36                                               GAO-03-87 SBA Loan Sales
Figure 6: Changes in Number of Employees and Workload per Employee at Servicing Centers

         110          Percent relative to Jan. 1999                                                                         Center employees



         100




          90



                                                                                                                                           81.1%
          80


                                                                                                                                           72.9%

          70


               Jan.                June       Sept.   Dec. Jan.              June       Sept.        Dec. Jan.       June   Sept.   Dec.    Mar.
               1999                1999       1999    1999 2000              2000       2000         2000 2001       2001   2001    2001    2002



         125   Percent relative to Jan. 1999                                                                     Workload per center employee

                                                                                                                                            123
         120



         115                                                                                                                                114




         110



         105



         100

               Jan.                June       Sept.   Dec. Jan.              June       Sept.        Dec. Jan.       June   Sept.   Dec.    Mar.
               1999                1999       1999    1999 2000              2000       2000         2000 2001       2001   2001    2001    2002

                                                                  Commercial loan servicing center
                                                                  Disaster home loan servicing center

Source: SBA.




                                                         Page 37                                                               GAO-03-87 SBA Loan Sales
                               Officials from most of the seven district offices that we visited had mixed
                               views about the effect of the loan sales on their own loan servicing
                               portfolios. Some district office officials told us that the first two sales had
                               significantly reduced their portfolios, and that subsequent sales continue to
                               reduce the number of disaster loans they have to liquidate. When a disaster
                               loan is more than 90 to 150 days delinquent, the servicing center can
                               forward it to the appropriate district office for possible liquidation. District
                               offices may also liquidate defaulted 7(a) and development company loans,
                               or may assist lenders in doing so. However, loan sales have had a much
                               smaller effect on the SBA’s 7(a) portfolio at the district offices we visited.
                               District office officials with whom we spoke said that they have had to
                               continue assisting lenders with liquidation or liquidate loans themselves, in
                               addition to reviewing loans for possible sale. The data we reviewed on the
                               district offices’ portfolio of loans in liquidation status for the most part
                               supported what the district officials had told us. For example, the South
                               Florida district office portfolio of disaster assistance loans shrank from 768
                               loans in September 1997 to 92 loans in August 2002. But all of the district
                               offices we included in our review had experienced growth in the number of
                               defaulted 7(a) loans that they were helping lenders to service or liquidate,
                               or that they were monitoring.



The Effects of Loan Sales on   The role of loan asset sales in facilitating SBA’s workforce realignment may
Workforce Realignment          be smaller than was initially expected. SBA had reported that loan asset
                               sales would help the agency move employees out of loan servicing
Have Been Mixed
                               positions to more mission-critical positions, such as lender oversight and
                               outreach to small businesses. But since most of the loans sold have been
                               from the disaster home loan servicing centers, the overall reduction in loan
                               volume has not translated into job reassignments for district office staff.
                               Officials from two district offices wondered how they would benefit from
                               the reduction in workloads at the disaster home loan servicing centers,
                               since the center employees are funded by appropriations for disaster
                               assistance, and most of the district offices are funded by appropriations for
                               business loan programs. Most officials from the district offices and
                               servicing centers told us that they have not been able to reassign servicing
                               and liquidation staff to nonservicing activities such as lender oversight or
                               outreach to small businesses. Moreover, training opportunities to prepare
                               for reassignment have been limited, with only the South Florida district
                               office telling us that they have participated in such training.

                               However, loan sales may facilitate SBA’s long-term efforts to consolidate its
                               loan servicing and liquidation functions into fewer service centers. SBA



                               Page 38                                                  GAO-03-87 SBA Loan Sales
                              recently reported in its draft 5-year workforce transformation plan that it
                              would consolidate its loan servicing and liquidation functions into fewer
                              service centers. This plan also stated that SBA intends to continue its loan
                              asset sales program, to reduce the agency’s overall loan portfolio and
                              workload at some locations.



Loan Sales Have Affected      According to SBA officials, the process of selling loans, particularly the
the Ways in Which SBA         intensive due diligence process and the field office review of loans selected
                              for the sales, makes loan servicing more timely and consistent across the
Manages Its Loan Portfolio,   agency. For example, when defaulted loans are selected for sale, agency
but So Have Other Factors     staff must determine whether anything collectible remains on the loan. If
                              not, the loan is charged off. In these cases, SBA recognizes a loss on the
                              loan and removes it from the receivable accounts. And if SBA is in the
                              process of working out a compromise with a borrower on a loan that is
                              selected for sale, the impending sale prompts agency staff and borrowers
                              to complete the compromise before the sale date. The process of reviewing
                              loans before they are sold undoubtedly provides some benefit to the agency
                              in terms of bringing inconsistencies to light and forcing decisions on some
                              loans. However, we also found that the loan sales alone were probably not
                              responsible for all the benefits SBA reported.

                              In May 2002, SBA testified that of the loans selected for the first four sales,
                              over 9,880 loans totaling about $382 million had been paid in full, 702 loans
                              totaling $107 million had entered into compromise agreements, and 7,549
                              loans totaling about $632 million had been charged off. SBA provided data
                              to us showing that since the loan sales began in 1999, the percentage of
                              loans paid in full ranged from 10.35 to 11.30 percent, and that the
                              percentage of loans written off had ranged from 4.97 to 5.98 percent.
                              However, SBA data also showed that before the loan asset sales—from
                              fiscal year 1997 through fiscal year 1998—the rate of loans paid in full and
                              charged off had already been increasing. For example, the percentage of
                              loans paid in full increased from 8.8 percent in fiscal year 1997 to 10.46
                              percent in fiscal year 1998. Thus, some of the positive effects of the loan
                              sales reported by SBA could have been caused by other factors, including
                              changes in the economy such as lower interest rates, which would prompt
                              people to refinance their mortgages. Officials at SBA’s Birmingham disaster
                              home loan servicing center told us that borrowers who refinanced their
                              mortgages often consolidated their loans and paid off their disaster loans,
                              even though their disaster loans had low interest rates.




                              Page 39                                                 GAO-03-87 SBA Loan Sales
              Other benefits of the sales cited in SBA’s official statements or by SBA
              officials included the highlighting of inconsistencies in the ways that field
              staff applied SBA’s servicing procedures, and the identifying of weaknesses
              in the agency’s information systems. For example, SBA officials at
              headquarters told us that as a result of inconsistencies found in the loan
              files during preparations for the sales, SBA had held a meeting of all the
              servicing center managers to discuss the inconsistencies and to clarify
              policies and procedures for loan servicing. Though field office staff told us
              that they had not substantially changed the ways in which they serviced
              loans because of problems uncovered by the sales, some employees
              provided examples of how they had modified some of their work
              processes. For example, officials at one servicing center told us that they
              had begun to check the accuracy of certain items, such as maturity date,
              when a new loan file arrived.

              Similarly, SBA officials told us that the due diligence process for the loan
              sales had revealed that the agency’s information management system for its
              loan portfolio did not include data that investors value, such as updated
              information on types of collateral and lien positions. These variables were
              being included in plans to upgrade the agency’s information systems.
              However, field office employees at one of the servicing centers told us that
              they had complained about the fact that these items were not included in
              SBA’s information systems long before the loan sales began. Whether the
              loan sales will have an actual impact on improving SBA’s information
              systems is still unclear. At the time of our review, SBA was still having its
              field offices and due diligence contractor compile information on the loans
              from the paper files and had not yet upgraded its information systems to
              capture information such as the current status of collateral and lien
              positions.



Conclusions   SBA had never sold loans in bulk loan sales before undertaking the current
              program. SBA’s loan sales are being closely watched, because OMB plans to
              expand similar sales to other federal credit programs, such as those
              provided by the Departments of Agriculture and Education. The impact of
              SBA’s sales on the agency and the scope of the benefits they provide to the
              government can help OMB in providing guidance on similar sales programs
              in the future. The sales have had some success in attracting investors,
              giving lenders a choice in disposing of defaulted loans, and reducing SBA’s
              servicing workload for disaster assistance loans. But other effects are
              difficult to measure, because SBA lacks a comprehensive system to
              document and track all borrower inquiries and complaints after loans are



              Page 40                                               GAO-03-87 SBA Loan Sales
sold; faulty accounting and reporting methods obscure the actual financial
and budgetary impact of the loan sales; and a thorough analysis of benefits
and other effects on agency operations has not been done.

The lack of a comprehensive process for identifying borrower inquiries and
complaints suggests that SBA may be unable to adequately enforce
borrower protections. From the limited inquiries and complaints we were
able to review, some borrowers had clearly experienced servicing problems
after SBA sold loans to investors. While SBA did track and follow up on
some inquiries and complaints, it did not have a comprehensive process to
collect and document the complaints received at the field offices. As a
result, the agency may not know how many complaints have actually been
registered or whether some private lenders’ actions are in conflict with
SBA’s public policy goals.

Since SBA incorrectly calculated the losses on its loan sales and lacks
reliable financial data, we were unable to determine the financial impact of
SBA’s loan sales on its budget and financial statements. Further, because
SBA did not analyze the effect of loan sales on its remaining portfolio, its
reestimates of loan program costs for the budget and financial statements
may contain significant errors. Until SBA corrects these errors and
determines the cause of the precipitous decline in the subsidy allowance
account, SBA’s financial statements will likely be misstated, and the audit
opinion on past financial statements may be incorrect. Further, the
reliability of the current and future subsidy cost estimates will remain
unknown. These errors and the lack of key analyses also mean that
congressional decisionmakers are not receiving accurate financial data to
make informed decisions about SBA’s budget and the level of
appropriations the agency should receive.

Finally, some of the operational benefits of the loan sales have not yet been
realized, or may be overstated. Most of the reductions in loan servicing
volume have occurred at SBA’s disaster home loan servicing centers. SBA’s
commercial servicing centers and district offices that primarily serve small
businesses are still involved in servicing loans, primarily because SBA has
not been able to sell as many defaulted 7(a) loans, because lenders do not
always consent to sell these loans and SBA employees continue to assist
lenders or take over the servicing from lenders when a loan becomes
delinquent. As a result, SBA has not been able to free up the resources it
had hoped to reallocate to mission-critical areas, such as outreach to small
businesses. Though SBA has conducted limited analysis on the impact of
loan sales on its servicing centers and portfolio activity, a more thorough



Page 41                                               GAO-03-87 SBA Loan Sales
                  evaluation is needed to determine the agencywide effects of the loan sales
                  and the cost savings to the agency.

                  It would be imprudent to continue SBA loan asset sales in the absence of
                  reliable and complete information on the accounting and budgetary effects
                  of the sales. A successful loan sales program is not solely about maximizing
                  proceeds and attracting investors: it is also a means of improving an
                  agency’s ability to achieve its mission and to best serve the American
                  people. Moreover, as OMB continues to encourage loan asset sales, it is
                  important that agencies embarking on new loan asset sales programs have
                  the capability to properly carry out and account for these activities.



Recommendations   We make several recommendations to the Administrator of the Small
                  Business Administration, in order to provide accurate and reliable
                  information about how the sales affect SBA’s borrowers, financial
                  statements, budget, and operations.

                  To ensure that SBA has complete information to enforce borrower
                  protections in its loan sale agreements and has reliable information to
                  report to Congress on how borrowers are reacting to the sales, we
                  recommend that the Administrator develop procedures for documenting
                  and processing inquiries and complaints from borrowers, and provide
                  guidance to the field offices about implementing them.

                  To address the errors and weaknesses in SBA’s accounting and budget
                  reporting, we recommend that the Administrator take the following actions
                  before conducting additional loan asset sales:

                  • Correct the errors in SBA’s loss calculations for loan sales one through
                    five, and adjust the fiscal years 2000 and 2001 financial statements.

                  • Perform the necessary analyses to assess the effect of loan sales on the
                    reestimates, to determine whether the cash flow assumptions in SBA’s
                    model reasonably predict future loan performance.

                  • Perform the necessary analyses to determine and correct the cause of
                    the unexplained decline in the subsidy allowance account, and make the
                    relevant adjustments to the fiscal years 2000 and 2001 financial
                    statements, as appropriate.




                  Page 42                                               GAO-03-87 SBA Loan Sales
                  We also recommend that the Inspector General, in conjunction with SBA’s
                  financial statement auditors, assess the impact of any identified errors in
                  the financial statements and determine whether previously issued audit
                  opinions for the fiscal years 2000 and 2001 financial statements need to be
                  revised.

                  Finally, to provide Congress and SBA with a better understanding of the
                  impact of loan sales on SBA’s operations, we also recommend that the
                  Administrator conduct a more comprehensive evaluation of the loan sales’
                  impact on the agency and the cost savings from the sales.



Agency Comments   We requested comments from SBA, SBA’s Inspector General, and Cotton
                  and Company, SBA’s independent financial statement auditor, on a draft of
                  this report. The Chief Financial Officer for SBA, the Acting Inspector
                  General, and Cotton and Company provided their comments in writing,
                  which are presented in their entirety in appendixes III, IV, and V,
                  respectively.

                  SBA generally agreed in its comments with the overall findings and
                  recommendations in this report. In response to our recommendation on
                  tracking borrower inquiries and complaints, SBA stated that the agency is
                  preparing guidance for distribution to all field offices that will clarify how
                  borrower inquiries and complaints are to be handled. This guidance will
                  include information on SBA’s toll-free number. In addition, SBA stated that
                  it is establishing a designated electronic mail account for use by all SBA
                  employees, to record borrower comments and forward them to
                  headquarters; developing a database to track borrower inquiries and
                  complaints and any other inquiries generated by the sale of loans; and
                  improving the documentation and tracking of inquiries and complaints
                  made through its toll-free number.

                  In its comments regarding our findings and recommendations on the
                  accounting and budgetary anomalies, SBA stated that it is actively engaging
                  a contractor to help resolve these issues and has worked extensively with
                  its independent auditor to identify causes and options for resolving the
                  issues we identified. Additionally, SBA stated that the accounting and
                  budgetary guidance is general in nature and requires interpretation.

                  SBA did not respond specifically to our recommendation to conduct a more
                  thorough analysis of the impact of loan sales on agency operations.




                  Page 43                                                GAO-03-87 SBA Loan Sales
SBA requested that we delay issuance of the report until March 2003. By
then, it hoped to have determined the causes of the accounting and
budgetary problems, and to be able to propose an appropriate methodology
for resolving them. Though we appreciate the desire to provide a plan of
action for addressing these problems in our final report, it is not our policy
to delay issuance of our reports until problems we have identified are
resolved. SBA also stated that the report did not portray the complexity
and unique problems faced in implementing the loan sales program. We
agree that SBA faced a complex and difficult endeavor when it
implemented the loan sales program. In the introduction to the report, we
stated that SBA had never before conducted bulk loan sales. Furthermore,
the first section of our report is intended to reflect the complexity of the
loan sales process and includes a detailed discussion of what is involved in
conducting a sale, including a time line that shows that the process can
take almost a year to complete. This section and the background section
also describe the variety and number of loans sold. SBA also noted that the
report did not reflect the fact that SBA responds in writing to all written
inquiries and complaints from borrowers; therefore, we added a statement
in the report reflecting the fact that SBA had responded in writing to the
written inquiries and complaints we reviewed at headquarters.

The Inspector General also agreed with our recommendations and is
working with Cotton and Company and SBA management to determine the
magnitude of the errors in SBA’s fiscal years 2000 and 2001 financial
statements. The Inspector General stated that Cotton and Company has
informed the IG’s office that the audit opinion on the fiscal years 2000 and
2001 financial statements should no longer be relied upon, as they may be
materially incorrect because of the errors identified in this report. The
comments also stated that Cotton and Company plans to withdraw its
unqualified audit opinion on those financial statements, and to issue
disclaimers of opinion.

Cotton and Company, SBA’s independent financial statement auditor,
agreed with our findings and did not specifically comment on our
recommendations. However, Cotton and Company also stated that the
report would be more fair and balanced if we further elaborated on the
inherent risks and complexities associated with accounting estimates and
loan sales. Cotton and Company also stated that it believes there is a lack
of comprehensive implementation guidance on credit subsidy and loan sale
cost estimates. Additionally, Cotton and Company stated that (1) our prior
reviews of its work did not identify the problems discussed in this report,




Page 44                                                GAO-03-87 SBA Loan Sales
and (2) we did not determine the specific causes of these errors. Further,
Cotton and Company elaborated on some of the audit work it had done.

We agree with Cotton and Company’s and SBA’s statements that accounting
for and auditing estimates of loan program costs and loan sales are
complex, and we describe these complexities in the background section of
this report.

Regarding the adequacy of existing guidance on preparing and auditing
credit subsidy estimates and loan sales, we used guidance that currently
exists in OMB Circular A-11, Preparation, Submission, and Execution of
the Budget; SFFAS No. 2, Accounting for Direct Loans and Loan
Guarantees (effective fiscal year 1994); Technical Release 3, Preparing
and Auditing Direct Loan and Loan Guarantee Subsidies under the
Federal Credit Reform Act (issued July 31, 1999; and Statement of Auditing
Standard 57, Auditing Accounting Estimates (effective January 1989), in
performing our assessment of SBA’s accounting for loan sales and the
credit subsidy estimates. These documents provide considerable guidance
to agencies while still providing the flexibility necessary to be applicable to
a wide variety of credit programs. For example, Appendix B to SFFAS No. 2
contains technical explanations and illustrations related to estimating loan
program costs and loan sales—including guidance for calculating changes
in a loan’s book value, guidance for calculating the gain or loss, and the
impact that loan sales have on various financial statement accounts, such
as the allowance for subsidy. Further, Technical Release 3 provides
guidance on auditing estimates of loan program costs, including assessing
internal controls and inherent risks, as well as suggested audit steps and
analytical review procedures.

While further elaboration may be helpful, the errors we identified in the
financial statements and the related footnotes were primarily related to
fundamental flaws in the application of existing guidance rather than to
insufficient guidance. In addition, the anomalies in the disaster loan
subsidy allowance account were known to Cotton and Company, and SBA
provided no viable explanation for these anomalies.

Regarding prior GAO reviews of Cotton and Company’s related audit work,
these reviews were part of our governmentwide consolidated financial
statement audit and were designed to focus on issues that could be
significant to the consolidated financial statements of the federal
government. Because the materiality of the consolidated financial
statements far exceeds the level of what is material to SBA, these reviews



Page 45                                                 GAO-03-87 SBA Loan Sales
were far less detailed than what was conducted for this report. Further,
loan sales were not significant to the governmentwide financial statements
and, therefore, were excluded from the scope of the prior GAO reviews.
However, it should be noted that prior GAO reviews of Cotton and
Company audit work at SBA going as far back as 1997 raised concerns
about its audit scope and methodology in the credit subsidy area, and
offered suggestions for improvement on both a formal and an informal
basis.

Although we did identify specific errors in the calculation of the loss on
loan sales reported in the financial statements, we agree that we did not
identify the cause of the negative balance in the disaster loan subsidy
allowance account. We were unable to identify the cause because SBA
lacked some of the fundamental information necessary to enable us to do
so. This missing information, which should have been made available for
the financial statement audit, included an aging of the delinquent and
defaulted loans by year of loan commitment, detailed reconciliations of the
allowance for subsidy, and an analysis of the impact that loan sales had on
the estimated performance of the remaining loan portfolio. Because this
type of information was not available at the time of our review or of Cotton
and Company’s audit, it was not possible either for us, Cotton and
Company, or the SBA to determine the cause of the anomalies in the
disaster loan subsidy allowance account. We understand that SBA is now
working on preparing this information.

Regarding the elaboration of audit work that Cotton and Company
provided, we saw this work when we reviewed the auditor’s workpapers,
and we provided a summary of this work in the body of the report.


Unless you publicly announce its contents earlier, we plan no further
distribution until 30 days after the date of this report. At that time, we will
send copies of the report to the Chairman of the Senate Committee on
Small Business and Entrepreneurship, the Chairman and Ranking Minority
Member of the House Committee on Small Business, other interested
congressional committees, the Administrator of the Small Business
Administration, and the Director of the Office of Management and Budget.
We will make copies available to others on request. This report will also be
available at no charge on the GAO Web site at http://www.gao.gov.




Page 46                                                 GAO-03-87 SBA Loan Sales
Please contact us at (202) 512-8678 if you or your staff have any questions.
Additional contacts and staff acknowledgments are listed in appendix VI.

Sincerely yours,




Davi M. D’Agostino, Director
Financial Markets and
  Community Investment




Linda M. Calbom, Director
Financial Management and
  Assurance




Page 47                                               GAO-03-87 SBA Loan Sales
Appendix I

Scope and Methodology                                                                      AA
                                                                                            ppp
                                                                                              ep
                                                                                               ned
                                                                                                 n
                                                                                                 x
                                                                                                 id
                                                                                                  e
                                                                                                  x
                                                                                                  Iis




             In preparing this report, we focused on the first five of SBA’s six loan asset
             sales. The unpaid principal balance of the loans sold in these sales
             represents about 87 percent of all the loans SBA sold from August 1999
             through August 2002. The sixth sale was not completed in time to be
             included in our analysis because purchasers do not begin servicing the
             loans and accounting adjustments are not complete until several weeks
             after the sale date.

             To describe SBA’s loan sale process, we reviewed a variety of documents
             related to planning and conducting a loan sale, including strategic plans,
             guidance, and procedures. We also collected data on the types of loans sold
             and the proceeds that SBA received from the sales, and we interviewed
             SBA officials and contractors. Our interviews with SBA officials took place
             at headquarters and at several SBA field offices that participate in the loan
             sales process, including two disaster home loan servicing centers, one
             commercial loan servicing center, and seven district offices. We selected a
             mix of large and small field offices around the country, based on the size of
             the loan portfolio and the number of loans sold. An additional
             consideration for three of the district offices we selected was their
             proximity to the finance center and the three servicing centers we visited.
             We also interviewed the financial adviser who advises SBA on its overall
             strategy for selling loans; the financial advisers hired to conduct the first,
             third, and fifth sales; and the due diligence contractor for the first four
             sales.

             To confirm that SBA’s loan sale process was working as described, we
             reviewed the loan information in the bidder information packages and
             interviewed investors. To confirm that SBA was providing relatively
             complete data to investors, we evaluated the loan data provided to
             potential investors in the bidder information packages. Specifically, we
             tested the data’s completeness for several key fields, such as interest rate,
             outstanding balance, and maturity date. For investor feedback about the
             loan sale process, we interviewed six investors and reviewed 42 responses
             to surveys conducted by SBA’s Transaction Financial Advisers of investors
             who had participated in sales four and five. We selected a mix of large and
             small investors with a variety of experiences with the sales, including
             investors who had won, lost, or just requested information but declined to
             bid. In our interviews we asked investors to evaluate aspects of SBA loan
             sales, including data they had received about loans for sale,
             communications they had had with SBA and its contractors, the loan sales
             process, and the organization of loan pools. We also asked whether the
             investors planned to participate in future sales. Although we attempted to



             Page 48                                                GAO-03-87 SBA Loan Sales
Appendix I
Scope and Methodology




contact a cross section of investors, the comments we received cannot be
generalized to a larger group.

To determine how SBA loan asset sales affect 7(a) lenders, we reviewed the
lenders’ role in the loan sale process and interviewed officials representing
lenders that had participated in at least one sale. We selected a mix of 12
small and large lenders based on 7(a) lending volume, asset size, and
location. In our interviews we asked lenders to evaluate their experience
with SBA’s loan sale process, describe how they made the decision to
participate in the sales, and discuss their level of satisfaction with the
proceeds. Although we attempted to contact a cross section of lenders,
their comments cannot be generalized to a larger group. We did not
interview any certified development companies that make 504 loans,
because the only 504 loans that were sold did not require consent from the
lender. To obtain additional feedback on SBA’s loan sale process, we spoke
with officials representing the National Association of Government
Guaranteed Lenders and the National Association of Development
Companies, which represent SBA 7(a) lenders and certified development
companies that make 504 loans, respectively.

To determine how borrowers reacted when their loans were sold, we
reviewed borrower inquiries and complaints documented by SBA and the
process for documenting and processing these inquiries and complaints. To
determine the types of inquiries and complaints borrowers have, we
reviewed 133 of 155 borrower inquiry and complaint letters filed at
headquarters since the first loan sale in August 1999. We collected
information that included the date and type of inquiry or complaint (for
example, questions about a loan sale or complaints about a servicing action
by a purchaser) and the name of the purchaser (if available). We prepared a
summary of SBA’s written response. We also interviewed SBA officials at
headquarters and field offices (three servicing centers, seven district
offices, and two disaster area offices) about the types of inquiries and
complaints they receive from borrowers and about SBA’s process for
handling these complaints. In addition, we asked staff at field offices
whether they had forwarded borrower complaints to headquarters or
documented the complaints. We reviewed a nonstatistical sample of
complaints from the third, fourth, and fifth sales drawn for us by staff at
one of the disaster home loan servicing centers to determine whether the
information in borrower complaints received at field offices was accurately
represented in headquarters records. Specifically, we compared the names
on the complaints we received from the disaster home loan servicing
center with the names on the complaints at headquarters. We also reviewed



Page 49                                               GAO-03-87 SBA Loan Sales
Appendix I
Scope and Methodology




the complaints logged through the toll-free number, but these data were
limited because SBA staff did not begin logging the complaints from this
number until April 2002.

To evaluate SBA’s budgeting and accounting for loan sales, we assessed
SBA’s compliance with various budget and accounting guidance, including
OMB Circular A-11, Preparation, Submission, and Execution of the
Budget; Statement of Federal Financial Accounting Standard Statement
No. 2, Accounting for Direct Loans and Loan Guarantees; and U.S.
Government Standard General Ledger, Account Transactions. Specifically,
we analyzed SBA’s cash flow models to reestimate subsidy costs for the
disaster loan program and the 7(a) and 504 loan guarantee programs, in
order to determine the effect of loan sales on the cost of each program for
the budget. We evaluated characteristics of loans sold as compared with
cash flow assumptions used to reestimate the costs of SBA’s loan programs.
To assess SBA’s estimates of hold values for loans sold, we reviewed an
external validation of the hold model used for sales one through three that
was prepared by an SBA contractor, who concluded that the calculations
were accurate and reasonable. Since SBA changed to a more sophisticated
hold model after sale three,33 we also reviewed the methodology and
assumptions in SBA's revised model used to estimate hold values for loans
sold in sales four and five, and we found the approach to be reasonable.
However, we did not audit the data used to calculate the hold values for
each sale, and therefore did not conclude on the reasonableness of the hold
values for any of the sales. We reviewed SBA’s accounting related to the
balances of the loans sold, proceeds and costs of the sales, and calculations
of gains or losses on sales to determine whether SBA considered all
appropriate cash flows in these calculations. We discussed SBA’s budgeting
and accounting procedures for loan sales with SBA and OMB officials,
Federal Accounting Standards Advisory Board staff, and SBA’s independent
auditors. We also reviewed SBA’s audited financial statements for fiscal
years 1999 through 2001 and examined workpapers from SBA’s auditor for
fiscal years 2000 and 2001.

Finally, to assess the ways in which SBA benefited from loan sales, we
reviewed official statements, including testimony, press releases, and other

33
  SBA’s revised hold model was first used to estimate hold values for sale four. Hold values
from this more sophisticated model were calculated at the loan level rather than based on a
loan pool approach or averages. The revised model’s calculations were based on actual data
from all loans selected for sale rather than on a sample of data from the loans selected for
sale.




Page 50                                                          GAO-03-87 SBA Loan Sales
                      Appendix I
                      Scope and Methodology




                      documents that cited benefits related to loan servicing reductions, staff
                      realignment, and loan portfolio management efficiencies. To confirm these
                      benefits, we reviewed and analyzed trend data on SBA’s loan servicing
                      workloads to determine how the loan sales had affected SBA’s loan
                      servicing workloads and staffing. We reviewed and analyzed data on loan
                      activity, including prepayments and charge-offs, before and after the loan
                      asset sales began. We also interviewed SBA officials at headquarters and
                      field offices to obtain their views on how SBA has benefited from the sales.
                      We did not independently verify the accuracy of the loan servicing and loan
                      portfolio data provided by SBA, because we were interested only in the
                      trends before and after the loan sales began.

                      We performed our review from January 2002 through October 2002 in
                      Washington, D.C., and several other locations across the country, listed
                      below, in accordance with generally accepted government auditing
                      standards.



SBA Field Locations   District Offices

We Visited            Birmingham, Alabama
                      Little Rock, Arkansas
                      Santa Ana, California
                      Los Angeles, California
                      Denver, Colorado
                      Miami, Florida (telephone interview)
                      Philadelphia, Pennsylvania

                      Loan Servicing Centers

                      Birmingham, Alabama (disaster home loan servicing)
                      Santa Ana, California (disaster home loan servicing and liquidation)
                      Little Rock, Arkansas (commercial loan servicing)

                      Denver Finance Center

                      Denver, Colorado




                      Page 51                                               GAO-03-87 SBA Loan Sales
Appendix I
Scope and Methodology




Disaster Area Offices

Niagara Falls, New York (telephone interview)
Fort Worth, Texas (telephone interview)




Page 52                                         GAO-03-87 SBA Loan Sales
Appendix II

Types of Borrower Inquiries and Complaints
Received by SBA                                                                                           Appendx
                                                                                                                Ii




              We reviewed 133 of the 155 inquiries or complaints SBA had documented
              from August 1999 through April 2002, to identify the types of concerns and
              problems borrowers faced when their loans were sold.34 From our review,
              we determined that borrowers generally contact SBA about loans that have
              been sold for one of two reasons:

              • they have a question or concern about why SBA is selling their loan, or
                they want to purchase their loan rather than have SBA sell it to the
                private sector; or

              • they want to modify their loan and have a complaint about the
                purchaser’s procedures or treatment.

              Almost half (65) of the 133 letters from borrowers that we reviewed at
              headquarters involved questions about why loans were being sold, requests
              to buy a loan discounted lower than the unpaid principal balance, or pleas
              that the loan not be sold. Forty-seven letters referred to purchasers’
              servicing actions. Twenty-three of these letters involved disagreements or
              frustration with servicing decisions the new purchaser had made, such as
              refusing to subordinate or release collateral,35 or imposing a fee to
              complete a servicing action such as subordination. Another 18 letters came
              from borrowers who wanted to defer payments or change the amount of
              their monthly payment because of financial problems, and felt they were
              not getting appropriate treatment from the purchaser of their loan. Six of
              the letters complained about problems that occurred while SBA was
              transferring the loan to the purchaser. For example, some borrowers found
              that purchasers had not properly applied their loan payments during the
              servicing-transfer period. Nineteen of the remaining 21 letters came from
              borrowers who wanted SBA to subordinate, release collateral, or
              compromise on a loan’s payment or terms, and who were told that SBA had
              sold the loan and thus could no longer service it.



              34
                We tried to review all of the inquiries and complaints documented at headquarters and
              stored in two binders. However, we did not include in our review additional follow-up letters
              from the same borrowers. Furthermore, the database that SBA created after our review
              included inquiries and complaints after April 2002, when we had reviewed the inquiries and
              complaints at headquarters. Therefore, our 133 complaints did not match exactly the 155
              complaints in SBA’s database.
              35
               “Subordination” occurs when a lender allows a new or existing loan to take a superior lien
              to another loan. For example, a borrower with an SBA disaster home loan may want SBA or
              a lender to subordinate the disaster loan to a new or refinanced home mortgage.




              Page 53                                                           GAO-03-87 SBA Loan Sales
Appendix III

Comments from the Small Business
Administration                                            Appendx
                                                                iI




               Page 54             GAO-03-87 SBA Loan Sales
Appendix III
Comments from the Small Business
Administration




Page 55                            GAO-03-87 SBA Loan Sales
Appendix III
Comments from the Small Business
Administration




Page 56                            GAO-03-87 SBA Loan Sales
Appendix III
Comments from the Small Business
Administration




Page 57                            GAO-03-87 SBA Loan Sales
Appendix IV

Comments from the Inspector General of the
Small Business Administration                            Appendx
                                                               iIV




              Page 58             GAO-03-87 SBA Loan Sales
Appendix IV
Comments from the Inspector General of the
Small Business Administration




Page 59                                      GAO-03-87 SBA Loan Sales
Appendix V

Comments from Cotton and Company                      Append
                                                           x
                                                           i
                                                           V




             Page 60           GAO-03-87 SBA Loan Sales
Appendix V
Comments from Cotton and Company




Page 61                            GAO-03-87 SBA Loan Sales
Appendix V
Comments from Cotton and Company




Page 62                            GAO-03-87 SBA Loan Sales
Appendix V
Comments from Cotton and Company




Page 63                            GAO-03-87 SBA Loan Sales
Appendix VI

GAO Contacts and Acknowledgments                                                               Appendx
                                                                                                     iVI




Contacts          For questions regarding this report, please contact Davi D’Agostino at (202)
                  512-8678 or Linda Calbom at (202) 512-9508.



Acknowledgments   Additional staff making major contributions to this report were Dan Blair,
                  Marcia Carlsen, Jay Cherlow, Heather Dunahoo, David Eisenstadt, Edda
                  Emmanuelli-Perez, Katie Harris, DuEwa Kamara, Kay Kuhlman, and Paul
                  Thompson.




                  Page 64                                               GAO-03-87 SBA Loan Sales
Glossary


                        The following is a group of terms commonly used in credit budgeting and
                        accounting. The definitions for many of these terms are equally applicable
                        to direct loans and loan guarantees.



Cash flows              Payments or estimates of payments to or from the government over the life
                        of a loan or group of loans. For direct loans, these may include loan
                        disbursements, repayments of principal, payments of interest,
                        prepayments, fees, penalties, defaults, and recoveries on defaulted loans.



Cash flow assumptions   All known and forecasted information about the characteristics and
                        performance of a loan or group of loans used to estimate future loan
                        performance. Examples include estimates of loan maturity, borrower
                        interest rates, default and delinquency rates, and the timing of cash flow
                        events, such as defaults and collections on defaulted loans.



Credit reform           Refers to the collective requirements as set forth in (1) the Federal Credit
                        Reform Act of 1990, which generally requires that agencies calculate and
                        record the net present value cost of credit programs to the government
                        included in the budget, (2) the Statement of Federal Financial Accounting
                        Standard No. 2, Accounting for Direct Loans and Loan Guarantees, and
                        (3) OMB Circular A-11, Preparation, Submission, and Execution of the
                        Budget.



Gross proceeds          Total amount received from investors as a result of the loan sales.



Hold value              The estimated value of loans to the government if held to maturity or
                        resolution, stated on a net present value basis and discounted with interest
                        rates from the most recent President’s budget at the time the estimate is
                        prepared. The hold value is a more detailed loan value analysis than the
                        credit subsidy estimate, because it specifically considers the cash flows
                        and characteristics of the loans for sale and is calculated on a loan-by-loan
                        basis.




                        Page 65                                               GAO-03-87 SBA Loan Sales
Market value estimate   An estimate of the anticipated proceeds from investors on loans for sale
                        based on current market trends and conditions, and the characteristics of
                        the loans being sold. A contractor who assists SBA with the loan sales
                        prepares the estimate.



Net book value          An amount calculated by subtracting the subsidy allowance from the
                        outstanding loans receivable balance for a loan or group of loans.



Net proceeds            Gross proceeds received from a loan sale less seller transaction costs
                        associated with conducting the sale (such as fees for underwriting, rating
                        agency work, legal advice, financial advice, and due diligence) that are paid
                        out of the gross sales proceeds rather than paid as direct obligations by the
                        agency.



Present value           The worth of the future stream of returns or costs in terms of money paid
                        immediately. In calculating present value, prevailing interest rates provide
                        the basis for converting future amounts into their “money now”
                        equivalents.



Reestimates             Revisions of the subsidy cost estimate based on information about the
                        actual performance of loans or other estimated changes in future cash
                        flows resulting from changes in economic conditions, other events, and
                        improvements in the methods used to estimate future cash flows.



Subsidy allowance       Financial statement reporting account used to recognize the costs of a loan
                        program that are not expected to be recovered from borrowers, including
                        default costs and financing costs arising from subsidizing below-market
                        rate loans.



Subsidy cost            The estimated long-term cost to the government of direct loans or loan
                        guarantees, calculated on a net present value basis, excluding
                        administrative costs. The subsidy cost is the present value of
                        disbursements by the government (loan disbursements and other
                        payments) minus estimated payments to the government (repayments of



                        Page 66                                               GAO-03-87 SBA Loan Sales
                           principal, payments of interest, other recoveries, and other payments) over
                           the life of the loan.



Unpaid principal balance   Amount of outstanding loan principal owed by borrowers (also known as
                           the loans receivable balance).



Unqualified opinion        An auditor’s opinion that states that the financial statements present fairly,
                           in all material respects, the financial position, results of operations, and
                           cash flows of the entity, in conformity with generally accepted accounting
                           principles.




(250059)                   Page 67                                                GAO-03-87 SBA Loan Sales
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