oversight

Small Business Administration: Credit Subsidy Estimates for the Sections 7(a) and 504 Business Loan Programs

Published by the Government Accountability Office on 1997-07-16.

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

                    United States General Accounting Office

GAO                 Testimony
                    Before the Committee on Small Business, House of
                    Representatives




For Release
on Delivery
Expected at
                    SMALL BUSINESS
10 a.m. EDT
Wednesday           ADMINISTRATION
July 16, 1997



                    Credit Subsidy Estimates
                    for the Sections 7(a) and
                    504 Business Loan
                    Programs
                    Statement of Judy A. England-Joseph,
                    Director, Housing and Community
                    Development Issues,
                    Resources, Community, and Economic
                    Development Division




GAO/T-RCED-97-197
    Mr. Chairman and Members of the Committee:

    We are pleased to be here today to discuss our review of the Small
    Business Administration’s (SBA) estimates of credit subsidies for the
    agency’s guaranteed business loan and certified development company
    programs—more commonly called the “7(a)” and “504” programs,
    respectively. As you know, the credit subsidy for these programs is the
    estimated net cost (excluding administrative costs) to SBA in today’s
    dollars of guaranteeing these loans over the entire time period in which
    the loans are outstanding, which can range up to about 25 years. The
    Federal Credit Reform Act of 1990 requires that SBA estimate these costs
    for loans guaranteed after fiscal year 1991 so that they can be included in
    the federal budget in the year in which the loan commitments are made.
    These estimates, and any subsequent re-estimates, identify for the
    Congress the amount of appropriations needed to cover the government’s
    expected costs over the lives of the loans. In the President’s budget for
    fiscal year 1997, SBA estimated that the costs of 7(a) and 504 program loans
    to be made in fiscal year 1997 would be significantly higher than the costs
    of loans made in fiscal year 1996, despite legislated program changes
    designed to keep costs down.

    Our statement today is based on our review of SBA’s estimates of credit
    subsidies for the 7(a) and 504 programs that you requested in April of this
    year as well as our ongoing work on such estimates in the major credit
    agencies throughout the federal government. As requested, this statement
    focuses on three questions: (1) How does SBA calculate the estimates of
    credit subsidies for the 7(a) and 504 programs? (2) What factors accounted
    for the increases in the estimated costs of the loans to be guaranteed by
    these programs in fiscal year 1997? (3) What additional changes, if any, did
    SBA make during the 1998 budget process when estimating the costs of its
    loans? As agreed with your office, we did not assess the reliability of the
    automated data on individual loans that SBA uses to generate its credit
    subsidy estimates.

    In summary, we found the following:

•   SBA bases its estimate of the credit subsidy for each program on
    projections of cash flows—that is, the amounts of cash that SBA expects to
    take in and pay out during each year that the loans are outstanding. Cash
    outflows occur when borrowers default on their loans and SBA pays claims
    filed by lenders. Cash inflows occur when the collateral for defaulted
    loans is liquidated and when borrowers and lenders pay mandatory fees to



    Page 1                                                     GAO/T-RCED-97-197
                 SBA. These cash flow projections are based largely on the historical
                 performance of the programs’ loans; however, SBA adjusts the projections
                 to reflect the estimated influence of changes in the programs’ provisions
                 and other factors. The cash flows are discounted to determine their net
                 present value using a computer model established and maintained by the
                 Office of Management and Budget (OMB).1
             •   The factors contributing to the increases in the estimated credit subsidy
                 rates for fiscal years 1997 differed somewhat between the two programs.
                 For the 7(a) program, SBA projected fewer recoveries (the amounts
                 realized when defaulted loans are liquidated) and less revenue from fees
                 than it had assumed in previous years. These changes, which accounted
                 for about 60 percent of the increase, resulted primarily from SBA’s use of a
                 new database on historical loan performance that expanded and improved
                 on existing data, according to SBA and OMB officials. In addition, an error in
                 applying SBA’s cash flow projections to OMB’s discounting model caused the
                 estimated credit subsidy rate for the 7(a) program to be even larger. This
                 error accounts for the remainder of the increase. On the basis of its
                 appropriated budget authority of $198.5 million, SBA announced that it
                 could guarantee an additional $2.47 billion in 7(a) loans because the credit
                 subsidy rate estimate should have been lower. For the 504 program, SBA
                 projected both more claims and fewer recoveries for defaulted loans than
                 it had assumed previously. As in the 7(a) program, these changes—which
                 account for all of the increase—resulted from SBA’s use of a more
                 extensive historical database.
             •   For the fiscal year 1998 budget request, SBA further revised its projections
                 of cash inflows and outflows for the two programs. For 7(a) loans, SBA
                 decreased its estimate of expected fee revenue, on the basis of data on
                 loans that are paid off prior to maturity, or “prepaid.” Because SBA would
                 have to cover more of the cost of loan defaults if revenues from fees are
                 less than originally expected, this change had an upward effect on the
                 subsidy rate estimate for the 7(a) program. For the 504 program, SBA
                 increased the estimated prepayments and slightly reduced expected claim
                 payments and recoveries. With these changes and a fee increase, SBA
                 estimated a credit subsidy rate of zero for new 504 loans.


                 The 7(a) and 504 programs are two of SBA’s primary programs for
Background       enhancing small businesses’ access to credit. Under the 7(a) program, SBA
                 guarantees up to 80 percent of the amounts of loans made by private
                 lenders to small businesses that are unable to obtain financing under

                 1
                  Present value is the value today of a stream of payments in the future. In calculating the present value
                 of loan subsidy costs, prevailing interest rates for U.S. Treasury securities provide the basis for
                 converting future amounts into current dollar equivalents.



                 Page 2                                                                            GAO/T-RCED-97-197
reasonable terms and conditions through normal business channels. In
fiscal year 1996, SBA guaranteed about $7.3 billion in small business loans
through the 7(a) program. SBA’s guarantee transfers the major risk of
default from the lenders to SBA. When a loan guaranteed through the 7(a)
program defaults, SBA pays the lender’s claim by purchasing the
guaranteed portion of the unpaid balance of the loan.2 SBA then recovers as
much of the claim amount as it can through the liquidation of the small
business’ collateral.3 In return for its guarantee, SBA collects fees from 7(a)
lenders. SBA collects three types of fees for 7(a) loans: (1) an upfront fee
which lenders may collect from borrowers, (2) an annual fee charged to
lenders, and (3) a fee charged to lenders for certain 7(a) loans they sell
through the secondary market.4 According to SBA, about half of the 7(a)
loans made each year are sold through the secondary market.

Like the 7(a) program, the 504 program uses SBA guarantees to assist small
businesses. Under this program, SBA provides its guarantee through
certified development companies (CDC)—private, nonprofit corporations.
CDCs may 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.5 These debentures funded about $2.4 billion in loans during fiscal
year 1996. If a small business defaults on its loan from the CDC, SBA pays a
claim filed through a central servicing agent, thereby ensuring that
investors receive full and timely payments. SBA recovers some of the claim
amount through the liquidation of the small business’ collateral. However,
projects financed with 504 loans typically involve a supplemental
mortgage from a private-sector lender who has a first lien on the collateral.
In return for guaranteeing 504 program debentures, SBA charges both
upfront and annual fees.

To help lower the federal cost of these programs, in October 1995 the
Congress enacted the Small Business Lending Enhancement Act of 1995
(P.L. 104-36). Among other things, the act (1) lowered the maximum
guaranteed portion of most 7(a) loans from 90 to 80 percent, (2) created
the annual fee charged to lenders and increased the upfront fee for 7(a)
loans, and (3) created the annual fee for the 504 program. The latter fee


2
 The lender’s claim can include up to 120 days of accrued interest.
3
 Collateral may be liquidated by either SBA or lenders. Liquidation is the process of converting assets
to cash.
4
 Lenders may sell the guaranteed portion of 7(a) loans to investors. These investors are referred to as
the “secondary market” for the loans.
5
 A debenture is an investment typically backed by the integrity of the borrower (but in this case, by
SBA) and documented by an agreement called an indenture.
Page 3                                                                           GAO/T-RCED-97-197
                              was increased on September 30, 1996 by the Small Business Programs
                              Improvement Act (P.L. 104-208).

                              We obtained information on how SBA’s credit subsidy estimates are
                              prepared primarily by interviewing officials from SBA and OMB. We
                              identified the factors accounting for the changes in the estimates primarily
                              by reviewing the automated cash flow spreadsheets underlying these
                              estimates. However, we did not verify the accuracy of the loan
                              performance data used in the spreadsheets. We also obtained information
                              through interviews with officials from the Congressional Budget Office
                              and the two major industry associations for the 7(a) and 504 programs.


                              For the 7(a) and 504 programs, SBA bases the estimates of credit subsidies
How Credit Subsidy            for the loans guaranteed during a given year on projections of the cash
Estimates Are                 inflows and outflows likely to result from the loans.6 To project future
Currently Calculated          cash flows, SBA first reviews available data on the cash flows it has
                              experienced with loans made in the past. SBA then estimates cash flows for
                              future “outyears”—the later years of the loans’ lives for which there are
                              not yet any historical data—and adjusts for recent program changes that
                              are expected to affect the cash flows. As part of the annual budget
                              process, SBA prepares these cash flow projections for loans to be made
                              during the budget year. An automated discounting model developed and
                              maintained by OMB and distributed to federal agencies converts the cash
                              flows prepared for all federal credit programs into the credit subsidy rate
                              estimates and budget authority requests that are presented in the
                              President’s budget. The estimated credit subsidy rates for SBA’s 7(a) and
                              504 programs are expressed as a percentage of the total amount of loans
                              or debentures to be disbursed.


Performance of Loans          For each program, SBA bases the projected claim payments and recoveries
Made in the Past Is a Key     for defaulted loans largely on the performance of the loans made in the
Factor in Projecting Future   past. According to SBA and OMB officials, SBA uses data on the performance
                              of the loans made through the 7(a) and 504 programs since 1986.
Claims and Recoveries
                              SBA analyzes data on the portion of the loans made in each past year that
                              has defaulted and the amounts it has recovered since the loans were made.
                              SBA uses these data to compute an average claim rate and recovery rate for
                              each year in a loan’s life. For example, the average claim rate for 504 loans
                              in their first year is the average of the actual rates observed in the first

                              6
                               Neither program includes an interest rate subsidy.



                              Page 4                                                     GAO/T-RCED-97-197
years of past loans; the average claim rate for 504 loans in their second
year is the average of the actual rates observed in the second years of past
loans; and so on. Unless SBA expects recent program changes to affect
future defaults, these cash flows of average historical data are SBA’s
estimates of claims and recoveries for new loans. In this way, SBA’s method
of projecting claims and recoveries for new loans gives equal weight to the
performance of loans made in the past, regardless of differences in the
volume of loans made during each year or their ages.

In addition, for 7(a) loans, SBA considers differentials in loan performance
by the type of the loan. Specifically, SBA calculates average claims and
recoveries, on the basis of actual historical data, for the various categories
of (1) the maturity of the loan, (2) the size of the loan, (3) the type of
lender,7 and (4) the percentage of the loan guaranteed by SBA. SBA then
uses these data to calculate an overall average claim rate and recovery rate
for the new loans. SBA does not conduct an analysis of loan type for the 504
program because the program is smaller and because there is less
variation in types of loans than in the 7(a) program.

SBA uses the actual historical averages as a basis for the expected claims
and recoveries during the first 11 years of the new loans’ lives.8 For the
later years of the new loans’ lives—the “outyears”—SBA projects claims
and recoveries through several methods. For 7(a) loans, SBA projects
claims through the 16th year after the loans are made and projects
recoveries through the 18th year. For the 12th and 13th years of the loans’
lives, SBA projects claims and recoveries by assuming a continuation of the
trend demonstrated by the historical data for the first 11 years and by
considering data on the performance during the 12th and 13th years of
loans made prior to 1986. For later years, SBA roughly estimates additional
claims and recoveries by considering the trend in the data for the first 13
years and by assuming that there will be at least some claims and
recoveries during each of these later years. SBA does not project claims and
recoveries beyond the 18th year because of the uncertainty of these
estimates and because the figures are likely to be very small, according to



7
 SBA’s analysis by type of lender considers whether loans are made by preferred lenders, certified
lenders, or other lenders. Preferred and certified lenders receive full or partial delegation of authority
to approve loans.
8
 SBA may also add outyear estimates to the historical data for each past year of loans before the data
are averaged. This procedure ensures that there are 11 years of performance data linked directly to
actual data for each past year of loans, even for loans made less than 11 years ago. SBA adds these
outyear estimates by assuming the same trends in claims and recoveries demonstrated by data for
older loans.



Page 5                                                                             GAO/T-RCED-97-197
                               SBA officials. Although the maximum maturity for 7(a) loans is 25 years,
                               the average maturity is about 12 years, according to OMB officials.

                               For 504 loans, SBA projects claims through the 16th year and recoveries
                               through the 22nd year. For years after the 11th, SBA roughly estimates
                               additional claims and recoveries by considering the trend in the historical
                               data for the first 11 years and by assuming that there will be at least some
                               claims and recoveries during each of these later years. Although the
                               maximum maturity for a 504 loan is 20 years, the average maturity is 19
                               years, according to OMB officials. SBA estimates cash flows for outyears so
                               that the estimated credit subsidy rate represents the expected federal cost
                               of all of the loans made during a year over their entire lives, not just the
                               years for which historical data are available.


Current Rates and              For both the 7(a) and 504 programs, SBA bases its projections of revenues
Historical Data Are Used       from fees primarily on the fee rates in effect at the time that program loans
to Project Future Fee          are made and on the estimates, based on historical data, of annual
                               outstanding loan balances.
Revenues
                               For the 7(a) program, SBA projects revenues for each of the three types of
                               fees, as follows:

                           •   The upfront fee is based on the original dollar amount of the guaranteed
                               portion of the loan. Because the fees vary according to the size of the
                               guaranteed portion, SBA calculates an average rate for upfront fees by
                               estimating the percentage of the new loans in each category of loan size.9
                               SBA’s projection of the cash flow from upfront fees is also based on the
                               collection of the upfront fee over the first two years of the loans’ lives,
                               rather than the entire amount in the first year, because not all loans are
                               disbursed during the first year.
                           •   Annual fee revenue is based on estimated outstanding loan balances at the
                               end of each year of the life of the loans. SBA bases its estimates of
                               outstanding balances on historical data on the portion of balances
                               amortized each year and then subtracts the amount that it expects to pay
                               in claims and the amount of loans that it estimates will be prepaid. SBA
                               does not maintain data showing when 7(a) loans are prepaid. Instead, the
                               agency estimates prepayment rates and trends on the basis of the
                               historical prepayment data that it obtains for those 7(a) loans that are sold


                               9
                                This average also reflects the small number of 7(a) loans with maturities of less than one year. These
                               loans are charged a fee rate that does not vary with the size of the guaranteed portion. SBA estimates
                               that about one percent of all loans made each year have maturities of less than one year.



                               Page 6                                                                           GAO/T-RCED-97-197
                                through the secondary market.10 In this way, the actual data on
                                prepayments and claims for prior year loans helps SBA estimate how much
                                the outstanding principal balance on new loans will decline over the life of
                                the loans and thus how much it is likely to collect in revenues from the
                                annual fee.
                            •   Similarly, SBA estimates the amount of secondary market fee revenues it
                                will collect by looking at historical data on loans sold through the
                                secondary market.

                                For the 504 program, projecting the cash flows from fees is slightly less
                                complicated because the upfront fee does not vary with the size of the
                                loan and there is no secondary market fee. SBA’s projection of upfront fees
                                is based on the rate in effect when the loans are made and the collection of
                                the fee during the first few years of the loans’ lives because not all loans
                                are disbursed during the first year. Like the 7(a) program, annual fee
                                revenues are based on the estimates of outstanding loan balances at the
                                end of each year during the life of the new loans. SBA bases its estimates of
                                outstanding balances on historical data on the portion of balances
                                amortized each year and then subtracts the amount of loans it expects to
                                default and the amount of loans that it estimates will be prepaid. SBA
                                maintains its own data on prepayments in the 504 program because of the
                                program’s prepayment penalty.


SBA Adjusts Cash Flows to       Before converting the projected cash flows into an estimated credit
Reflect Changes in the          subsidy rate, SBA may adjust them to reflect any recent program changes
Programs                        that are expected to reduce or increase future claim payments or
                                recoveries. For example, SBA adjusted its projected recoveries for loans
                                made through the 504 program in 1998 to reflect the impact of the agency’s
                                Liquidation Improvement Project—an effort designed to increase the
                                portion of SBA’s claim payments for defaulted loans that it recovers
                                through the liquidation of collateral.

                                Officials from SBA, OMB, and the two primary industry associations for the
                                7(a) and 504 programs have suggested several alternative methods SBA
                                could use to estimate future claims and recoveries. For example, SBA could
                                develop an econometric model which uses regression analyses to predict
                                future claims and recoveries based on factors such as forecasted interest
                                rates, economic growth, lender type, and loan size. According to a
                                government-wide task force, econometric modeling is the best way to use

                                10
                                  According to SBA, the guaranteed portion of about half of the loans made through the 7(a) program
                                each year are sold through the secondary market. We did not determine whether these loans are
                                representative of all 7(a) loans made each year.



                                Page 7                                                                        GAO/T-RCED-97-197
                          historical data to estimate credit subsidies.11 Similarly, we have used
                          econometric models to forecast future loan performance in programs
                          operated by the Department of Veterans Affairs and the Department of
                          Housing and Urban Development due to their superior predictive
                          capabilities.12 While we believe that, over time, such analysis of loan
                          performance data may yield better estimates, we have not reviewed the
                          merits of any particular approach for SBA’s programs.


OMB’s Model Generates     To generate an estimate of the credit subsidy rate, SBA’s cash flow
Estimates of the Credit   projections for claims, recoveries, and fees assuming a certain amount of
Subsidy Rate              business are run through OMB’s automated discounting model. This model
                          produces an estimate of the credit subsidy rate representing the net
                          present value of the federal costs expected per dollar loaned through the
                          program. This estimate is used to determine the amount of appropriations
                          necessary to cover the long-term costs of a given amount of loans.

                          During the preparation of each year’s budget submission, OMB examiners
                          typically work with SBA to refine its cash flow projections and subsidy
                          estimates. OMB may question the basis for SBA’s projected cash flows
                          and/or request an alternative set of cash flows based on different
                          assumptions. For example, during the past few years, SBA has expressed
                          interest in limiting the historical data used as a basis for projected cash
                          flows to loans made since 1989. According to SBA officials, recently
                          guaranteed loans are better predictors of future loan performance because
                          they reflect the changes made to strengthen SBA’s programs during the
                          1990s. On the other hand, OMB officials stated that the performance of
                          loans in the 1980s should be considered because these years include an
                          economic downturn, which could occur during the life of new loans. For
                          this reason, the older loans have been retained in the averages SBA uses to
                          estimate the subsidy costs of new loans. According to both OMB and SBA
                          officials, there may be a number of iterations leading up to the final
                          estimate of the credit subsidy rate and the associated request for budget
                          authority that are shown in the President’s budget.

                          In addition to estimating the credit subsidy rate for SBA-guaranteed loans,
                          the OMB model uses the cash flows prepared by SBA to report three
                          components of the estimate: (1) net defaults (claim payments minus


                          11
                           See Issue Paper 96-CR-7, May 1, 1996 of the Government-Wide Audited Financial Statements Task
                          Force.
                          12
                           See Homeownership: Appropriations Made to Finance VA’s Housing Program May be Overestimated,
                          GAO/RCED-93-173, Sept. 1993 and Mortgage Financing: FHA Has Achieved Its Home Mortgage Capital
                          Reserve Target, GAO/RCED-96-50, Apr. 1996.


                          Page 8                                                                     GAO/T-RCED-97-197
                       recoveries), (2) fees received, and (3) any other cash flows associated with
                       the program. By splitting the estimate into components, the model
                       indicates how each of the cash flows affects the overall credit subsidy rate
                       estimate.

                       In addition to requiring agencies to estimate the credit subsidies
                       associated with new government-backed loans, credit reform requirements
                       provide for subsequent re-estimates and modifications of credit subsidy
                       estimates. To calculate re-estimates, SBA uses a process very similar to the
                       one described above to project the cash flows associated with existing
                       loans. Re-estimates are calculated after the end of the fiscal year in which
                       the loans are guaranteed. However, the estimated credit subsidy rate may
                       be modified during that year to reflect enacted legislation and certain
                       administrative actions that alter the subsidy cost. A modification does not
                       include government actions permitted within the terms of existing
                       contracts or through other existing authorities. Furthermore, credit
                       subsidy estimates may not be revised mid-year due only to changes in
                       “forecast technical” assumptions, such as expected claims.


                       According to the President’s budget for fiscal year 1997, the estimated
Why the Estimated      credit subsidy rate for the 7(a) program increased from 1.06 percent for
Credit Subsidy Rates   loans made in 1996 to 2.68 percent for loans made in 1997. For the 504
Increased in 1997      program, the estimated rate increased from zero to 6.85 percent, assuming
                       no future program changes.13 The estimates for the 1997 loans were higher
                       largely because SBA modified the cash flow projections that it had used for
                       the fiscal year 1996 and earlier estimates. According to SBA and OMB
                       officials, SBA modified the cash flows to incorporate the results of an
                       intensive analysis of data on the performance of loans made in the past. In
                       addition, the fiscal year 1997 estimate for the 7(a) program was affected by
                       a spreadsheet error unnoticed by either SBA or OMB; without this error, the
                       estimated credit subsidy rate in SBA’s budget submission would have been
                       about 2.03 percent. Appendix III summarizes the factors responsible for
                       these changes in SBA’s estimates.


SBA Developed a New    As part of its planned efforts to meet credit reform requirements, SBA
Loan Performance       developed a loan performance database in 1995. The objectives of this
Database in 1995       effort were to (1) provide access to the data on historical loan



                       13
                        These are the “current services” credit subsidy estimates, according to the 1997 budget. The current
                       services estimate assumes no future changes to the programs.



                       Page 9                                                                         GAO/T-RCED-97-197
                           performance on a cohort basis14, (2) update the subsidy estimates on the
                           basis of the historical data, (3) allow SBA to analyze loan performance on
                           the basis of multiple-risk indicators, and (4) annually validate past subsidy
                           estimates. SBA officials used the database for the first time while preparing
                           the estimates of credit subsidy rates for the 1997 budget.

                           All estimates of credit subsidy rates for loans guaranteed prior to 1997 had
                           been based on the limited loan performance data resulting from a review
                           of the loan portfolio undertaken in 1991. According to SBA and OMB
                           officials, this 1991 review had several weaknesses. Most importantly, it did
                           not utilize transaction-based data, but rather relied on the interpretation of
                           changing loan balances over time to estimate loan performance.
                           Furthermore, it was based on data that were not easily identified by cohort
                           (i.e. by a particular year of loan guarantee commitments). In addition, the
                           results of the 1991 review were not updated to reflect the actual
                           performance of loans in fiscal years 1992 through 1995. According to SBA
                           officials, the new loan performance database—which is updated annually
                           to include recent data—corrected these problems. We did not assess the
                           quality of the data in SBA’s new loan performance database.


Revised Cash Flows and     In 1995, when SBA prepared its 1997 budget request, the loan performance
Spreadsheet Error          database confirmed earlier estimates that, during the life of each year’s
Contributed to Change in   loans, SBA makes claim payments for defaulted loans equal to about
                           13 percent of the original loan disbursements.15 However, the database
7(a) Program Estimate      also indicated that SBA recovers less of the claim amount through the
                           liquidation of loan collateral—about 50 percent rather than the 56 percent
                           indicated by the 1991 review. In addition, the analysis of the database
                           indicated that the timing of defaults was different than estimated in the
                           1991 review; specifically, a greater percentage of the defaults would occur
                           earlier. Incorporating this change slightly increased the estimates of credit
                           subsidy rates because the earlier a cash outflow occurs for SBA, the higher
                           the present value of the cost to SBA. These changes to the estimates of
                           claims and recoveries accounted for about 45 percent of the increase in
                           the fiscal year 1997 credit subsidy estimate.

                           A second factor, accounting for about 15 percent of the increase, was SBA’s
                           lowered forecast of revenues from fees. When preparing the fiscal year

                           14
                            In the case of SBA’s 7(a) and 504 programs, a “cohort” of loans consists of all of the loan guarantees
                           committed through each program during a given fiscal year.
                           15
                             Although we refer to claims throughout this statement as a percentage of the total dollar amount of
                           the loans disbursed, SBA typically defines the claim rate as a percentage of the SBA-guaranteed portion
                           of disbursements.



                           Page 10                                                                          GAO/T-RCED-97-197
1996 credit subsidy estimate, SBA had not accounted for the loss in annual
fee revenue that occurs when borrowers prepay their loans. (Because
annual fees are charged on outstanding loan balances, and prepayments
cause those balances to be lower than they would otherwise be,
prepayments effectively reduce SBA’s revenues from fees.) For the fiscal
year 1997 estimate, SBA added an estimate of prepayments. Furthermore,
SBA reduced its estimate of the amount of revenues it would receive
through the secondary-market fee, based on lower-than-expected revenue
from the first year of experience with the new fee.

Finally, an error in applying SBA’s cash flow projections to OMB’s
discounting model accounted for about 40 percent of the increase in the
credit subsidy estimate in 1997. This error caused the estimated credit
subsidy for the 7(a) program to be expressed as a percentage of the
guaranteed portion of the loans, rather than of their total face amount. SBA
projected that it would guarantee on average about 76 percent of the fiscal
year 1997 loan cohort. Because critical cells in SBA’s cash flow spreadsheet
were based on the number of dollars guaranteed instead of the number of
dollars disbursed (that is, the total face amount of the loans), SBA’s
estimated credit subsidy rate was higher by about 32 percent (1 divided by
0.76, the average guaranteed portion).

This error went unnoticed by both SBA and OMB officials responsible for
reviewing the 7(a) credit subsidy rate estimate. If SBA or OMB officials had
compared the component data generated by OMB’s discounting model for
the erroneous 1997 estimate with the components of the 1996 estimate,
they would have seen an unexplainable increase in the fee revenue
component (there was no increase in the fee rates charged). According to
standards developed by the Federal Accounting Standards Advisory
Board, subsidy estimate component data should be used to monitor and
make decisions about the federal government’s credit programs.16

On the basis of its appropriated budget authority of $198.5 million,17 SBA
announced that it could guarantee an additional $2.47 billion in 7(a) loans
because the credit subsidy rate estimate should have been lower. We are
currently reviewing the changes in estimates over time for selected
programs at five agencies as part of an assessment of the implementation

16
 See Statement of Federal Financial Accounting Standards Number 2, Accounting for Direct Loans
and Loan Guarantees, August 23, 1993. These standards were developed by the Federal Accounting
Standards Advisory Board which is composed of representatives of the Department of the Treasury,
OMB, GAO, the Congressional Budget Office, several other federal agencies, and from the private
sector.
17
  This figure includes an appropriation of $158 million and carryover budget authority of $40 million.



Page 11                                                                          GAO/T-RCED-97-197
                           of the Credit Reform Act. We are also preparing a report on OMB’s
                           automated discounting model. We expect to report on these efforts later
                           this year.


Revised Estimates of       The analysis of the loan performance database of loans made through the
Claims and Recoveries      504 program in prior years showed more dramatic changes than for the
Caused Higher Subsidy      7(a) program. According to SBA officials, the 1991 review substantially
                           underestimated claim rates and overestimated recovery rates because it
Estimate for 504 Program   did not consider a substantial portion of the 504 loan transactions. This
                           occurred because the 1991 review inaccurately assumed that the
                           accounting structure for the 7(a) and 504 programs was the same.
                           However, unlike the 7(a) program, 504 transactions may be recorded
                           under different identification numbers in SBA’s accounting system than the
                           original debenture. Because the 1991 review included only transactions
                           recorded under the original debenture’s identification number, it
                           erroneously omitted relevant data on claims and recoveries. According to
                           SBA officials, the new loan performance database corrects this error by
                           recognizing all transactions associated with the debentures made during
                           each year.

                           In the fall of 1995, SBA used the expanded historical data on the 504
                           program made available through the loan performance database in
                           preparing the fiscal year 1997 cash flow projections. SBA forecast that it
                           would (1) make claim payments during the life of a year’s loans equal to
                           about 19 percent of the face value of the loans, more than twice the
                           7 percent estimate indicated by the 1991 review, and (2) recover about
                           40 percent of the claim amount through the liquidation of loan collateral,
                           or about half of the 80 percent estimate indicated by the 1991 review. The
                           estimate of the total recovery rate in the 1997 cash flows should have been
                           even lower (33 percent), according to OMB and SBA officials.18 The
                           40-percent estimate was based on an error in accumulating the historical
                           data that was corrected when SBA prepared its 1998 estimates, according
                           to SBA officials.




                           18
                             Using a lower total recovery rate would have increased the credit subsidy rate estimate above the
                           6.85 percent rate estimated by SBA.



                           Page 12                                                                         GAO/T-RCED-97-197
                       Since the 1997 estimates were prepared, SBA has made additional revisions
Estimates for 1998     to its cash flow projections. For the 7(a) program, these changes resulted
Budget Reflect         in an estimated subsidy rate of 2.32 percent, assuming no future program
Updates to Cash Flow   changes, for loans to be made in 1998 and a re-estimate of the rate for
                       loans made in 1996 of 2.4 percent.19 In preparing these estimates, SBA did
Projections            not repeat the spreadsheet error that had inflated the 1997 estimate.
                       Nevertheless, the estimates prepared during the 1998 budget process are
                       higher than the corrected budget request estimate (2.03 percent) for the
                       1997 loans because SBA reduced the expected fee revenues from these
                       loans. Specifically, SBA increased its estimate of prepayments—even
                       further than during preparation of the 1997 estimates.

                       SBA increased its estimate of prepayments because it obtained for the first
                       time historical data maintained by Bloomberg Financial Services on the
                       percentage of loans each year that were prepaid. These data are based
                       exclusively on 7(a) loans sold through the secondary market. When
                       preparing the 1997 estimates, SBA assumed that up to about 2.5 percent of
                       the amount of the loans outstanding each year would be prepaid.20
                       However, the historical data obtained from Bloomberg Financial Services
                       showed that in some years of their lives as many as 10 percent of the
                       amount of the loans could be expected to be prepaid.

                       In addition to changes in expected revenues from fees, SBA made small
                       changes to its claim payment and recovery forecasts. Specifically, SBA
                       (1) decreased its expected claim payments over the life of the loans from
                       about 13 percent of the loans’ face value to about 12 percent, on the basis
                       of additional historical data on loan performance in fiscal year 1996, and
                       (2) increased the total recovery rate from about 50 percent of expected
                       claim payments to about 51 percent over the life of the loans, on the basis
                       of recent successes in the Liquidation Improvement Project.

                       For the 504 program, SBA (1) increased estimated prepayments;
                       (2) lowered its expected claim payments for defaulted loans from about
                       19 percent of the loans’ face value to about 16 percent over the life of the
                       loans; and (3) lowered expected recoveries from 40 percent to 34 percent
                       of claims. When calculating the 34-percent recovery rate estimate, SBA
                       corrected the accumulation error discussed earlier and adjusted the


                       19
                         The previous estimate of the credit subsidy rate for loans made through the 7(a) program in 1996 was
                       1.06 percent.
                       20
                        Although we refer to prepayments as a percentage of the total dollar amount of the loans disbursed,
                       SBA typically defines prepayment rates as a percentage of the SBA-guaranteed portion of
                       disbursements.



                       Page 13                                                                        GAO/T-RCED-97-197
estimate upward to reflect the improvements in recoveries expected to
result from the Liquidation Improvement Project, according to SBA
officials. With these changes in expected revenue from fees, claims, and
recoveries, SBA re-estimated the credit subsidy rate for the loans made
through the 504 program in 1996 at 7.54 percent. The estimate for the 1998
loans is zero because the annual fees charged to borrowers and lenders
were increased dramatically after SBA prepared its budget request estimate
for the 1997 loans.21 With recoveries, these fees are expected to cover all
of the costs incurred by SBA for defaulted loans.


Mr. Chairman, this concludes my prepared remarks. We will be pleased to
respond to any questions that you or other Members of the Committee
might have.




21
  This increase in the fee rate also prompted a lowering of the credit subsidy rate estimate for 504
loans made in 1997 from 6.85 percent (budget request) to zero (budget execution).



Page 14                                                                           GAO/T-RCED-97-197
Page 15   GAO/T-RCED-97-197
Appendix I

How Credit Subsidy Rate Estimates Are
Prepared



 Claims and recoveries                                 Fees
    (-)          (+)                                    (+)
                                                Estimate outstanding
  Compute historical averages
                                                balances



                                                 Compute initial
       Add outyear estimates
                                                 revenue estimates




                         Adjust to reflect recent
                           program changes


                       Combine and discount by
                        applying OMB's model




                                Estimate of
                               credit subsidy
                                    rate




                                Page 16                                GAO/T-RCED-97-197
Appendix II

Primary Reasons for Changes in Credit
Subsidy Rate Estimates



                                                                       7(a)              504




                                                                       98
                                                              97




                                                                                 97


                                                                                           98
                                                                     19
                                                            19




                                                                               19


                                                                                         19
                                                                  97
                                                        96




                                                                            96


                                                                                        97
                                                                19
                                                      19




                                                                          19


                                                                                      19
     Lower estimated fees
     based on data on prepayments
     and/or secondary market fees

     Lower estimated recoveries
     based on expanded data

     Higher estimated claims
     based on expanded data

     Higher annual fee rate

     Spreadsheet error




 Note: Based on the 1996 budget execution estimates and the 1997 and 1998 budget request (current
 services) estimates.




                                                  Page 17                                           GAO/T-RCED-97-197
Appendix III

Changes in Cash Flow Projections


Table 3.1: Changes in Projections
Underlying SBA’s Estimates of the 7(a)                               1996                      1997                  1998
Credit Subsidy                                                       (percent)                 (percent)             (percent)
                                         Fees
                                         Prepaymentsa                0                         Up to 2.5 in peak     Up to 10 in peak
                                                                                               year                  year
                                         Secondary-market            0.14                      0.02                  0.03
                                         feesb
                                         Claimsc                     13                        13                    12
                                                        d
                                         Recoveries                  56                        50                    51
                                         Other                                                 Spreadsheet error
                                                                                               inflated credit
                                                                                               subsidy estimate by
                                                                                               32 percent.
                                         Credit subsidy              1.06f                     2.68 (2.03)g          2.32
                                         estimatee
                                         a
                                           Prepayments are shown as an annual percentage of the loans outstanding in the first 10 years.
                                         (SBA typically shows prepayments differently—as a percentage of SBA’s share of outstanding
                                         loans.)
                                         b
                                             Secondary market fees are shown as a percentage of the original disbursements.
                                         c
                                           Claims are shown as a percentage of the original disbursements. (SBA typically shows claims
                                         differently—as a percentage of SBA’s share of disbursements.)
                                         d
                                             Recoveries are shown as a percentage of claims.
                                         e
                                           Estimates shown are the 1996 budget execution estimate and the 1997 and 1998 budget
                                         request (current services) estimates.
                                         f
                                         Re-estimated at 2.40 percent in the 1998 budget.
                                         g
                                          Without the spreadsheet error, the 1997 budget request estimate would have been about
                                         2.03 percent.



                                         Source: GAO’s analysis of SBA’s and OMB’s data.




                                         Page 18                                                                      GAO/T-RCED-97-197
                                        Appendix III
                                        Changes in Cash Flow Projections




Table 3.2: Changes in Projections
Underlying SBA’s Estimates of the 504                                1996                     1997                     1998
Credit Subsidy                                                       (percent)                (percent)                (percent)
                                        Fees
                                        Prepaymentsa                 0                        0                        Up to 4 in peak year
                                                            b
                                        Annual fee rate              0.125                    0.125                    1.084
                                        Claimsc                      7                        19                       16
                                                        d
                                        Recoveries                   80                       40                       34
                                        Credit subsidy               0.00f                    6.85                     0.00
                                        estimatee
                                        a
                                         Prepayments are shown as an annual percentage of the loans outstanding in the first 10 years.
                                        (SBA typically shows prepayments differently—as a percentage of SBA’s share of outstanding
                                        loans.)
                                        b
                                            The annual fee rate is shown as a percentage of the loans outstanding annually.
                                        c
                                         Claims are shown as a percentage of the original disbursements. (SBA typically shows claims
                                        differently—as a percentage of SBA’s share of disbursements.)
                                        d
                                            Recoveries are shown as a percentage of claims.
                                        e
                                          Estimates shown are the 1996 budget execution estimate and the 1997 and 1998 budget
                                        request (current services) estimates. Although the 1996 and 1997 estimates are based on all
                                        loans made through the 504 program, the 1998 estimate shown here excludes loans made
                                        through the Defense Loan and Technical Assistance program.
                                        f
                                        Re-estimated at 7.54 percent in the 1998 budget.



                                        Source: GAO’s analysis of SBA’s and OMB’s data.




(385675)                                Page 19                                                                         GAO/T-RCED-97-197
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