Direct Loan Borrows money from the treasury Gives it directly to borrowers Government services the loan- collects payments regularly Government forecloses and/or attempts to collect money if it cant be paid
Loan Guarantee • Private lender gives loan to borrower • Ex- Commercial Bank or Mortgage Lender • Private lender originates loan, secures government guarantee and services loan according to government regulations • Government agrees to pay full or partial payment to lender if borrower defaults
Coerciveness • Measures the extent to which a tool RESTRICTS individual or group behavior as opposed to merely encouraging or discouraging it. • There is a dichotomy between the extension of credit and the effort to collect on loans and avoid defaults. • Extension of Credit • Borrower may object to the amount of paperwork and personal disclosure required • Payment of Loan • Direct Loan- keep income tax rebate, suspend a school from eligibility for federal student loan programs • Loan Guarantee- sanctions to lenders who underwrite or service loans improperly, sanctions against direct borrowers
Directness • Measures the extent to which the entity authorizing or inaugurating a program is involved in executing it. • Direct Loan • Allows government to have more information about borrowers because it deals directly with them. • Ex- Dept of Agriculture • Servicing center then local office will attempt to reinstate timely loan payments • local office will attempt to mitigate loss and may foreclose. • Ex- Dept of Education • Uses schools to originate the loans, contractors to service loans and mitigate losses • Loan Guarantees • Private lenders have info on borrowers and don’t always give it to government • Ex- U.S. Small Business Administration • Lender originates ,services and forecloses on the loan • Lender makes a claim to the government for their fraction of the loss on the defaulted loan.
Autonomy • Measures the extent to which a tool utilizes an existing administrative structure to produce its effects rather than having to create its own administrative apparatus. Direct Loans • Give Loans- Not Direct • have to create a delivery system to originate and service loans • Collect Loan- Not Direct Loan Guarantees • Give Loans- Direct • Uses existing private financial services system • Collect Loans- Not Direct
Visibility • Measures the extent to which the resources devoted to the tool show up in the normal budget process Direct Loans • Before 1990 Credit Reform Act- Visible • Year given: Withdrawal of full loan amount • Years paid back: Deposit of repayment amount Loan Guarantees • Before 1990 Credit Reform Act- Not Visible- Clear Budgetary Advantage • Year given: Not on budget • Year defaulted: Withdrawal when lender paid
Subsidy • True cost of a loan is not captured by the cash flow in any one year • Net value over the life of the loan • Subsidy Cost- Net present value of expected cash inflows and outflows over the life of the loan (discounted for each year) • Includes the cost of estimated future loan defaults or claims against a government loan guarantee • Includes preferential interest rates on the loans • Offset by any fees that are charged by the program • Annual budget request includes funds required to cover credit subsidies for new loans or guarantees for the up coming year. • Example: Direct Loan: • Present Value Loan- $100 • Present Value of Inflows- $90 • Subsidy Cost- $10 • Subsidy Rate- 10% • Government will make loans totaling $2,000 • Government will seek appropriations of 10% or $200
A well designed government credit program will balance the tension between doing good and doing well. Doing Good • Serving worthy constituencies Doing Well • Assuring loans are rigorously underwritten • Assuring they are serviced • Assuring they are foreclosed on if need be.
Defining Eligible Borrowers • Most beneficial economically if borrowers are those that are not creditworthy enough for private loans, but still creditworthy enough to handle the loan • FHA- • Was very conservative and didn’t give out much credit • Then switched and gave lots of financially unsound people credit • Took years to determine a balance
Determining the Amount of Subsidy to Provide • Forms of Subsidies • Paying some interest • Grace period before borrower has to start paying interest • Charging lower fees • Tax exemptions of interest receipts • If subsidy rate is over 30% then its like giving a grant but its “justified” because the loan will be repaid • Before the Credit Reform Act of 1990 Congress gave credit to failing companies • Now they would have to figure out a credit subsidy and appropriate funds in the budget
Deciding Whether Loans Will be Backed by CollateralCollateral is a way of reducing financial Risk Secured Loans • For Real Property • Collateral Required (usually the property itself) • FHA, Veterans Administration (VA), Rural Housing Service, SBA • Foreclosing can have unacceptable political costs (ie-a homeowner with a SBA disaster relief loan) Consumer-Type Loans • Student Loans • Collateral Not Required
Risk Sharing Arrangements • With Lenders or private parties (participating schools) • They gain a stake in managing the origination and servicing of the loans • With no financial risk the incentives become distorted • Finding a balance is important • 20 % may not be enough if the return is greater at the beginning (interest paid first) • BUT, 20 % may deter firms from giving credit to are not as creditworthy • Direct Loans • Improve alignment of incentives • State may pay servicers a % of what they collect each month in repayment • Loan Guarantees • Ex-Student Loan Programs • Lenders share 5% of financial risk • Any greater and they may not give disadvantaged students loans
Loan Terms • Include • fees and interest rates • size of loan • Maturities • conditions of default • Most successful federal programs • FHA- 30 year self-amortizing mortgage, allows long term funding • Private mortgage insurance reduces the risks of a level-payment mortgage so private industry has adopted this type of mortgage. • Replaced “balloon mortgages” that required refinancing every few years
Addressing Elements of Financial Risk Borrowers- • Limiting the maximum loan-to-value requirements assures borrowers have a significant equity stake in homes and will then pay mortgage loans on time. Government- • The Credit Reform Act increased the governments financial accountability so they will avoid programs with high default rates
U.S. National Government • The largest programs provide credit for housing, education, agriculture and business purposes • In the last 20-30 years the number of loan guarantees have grown significantly, direct loans have remained constant. • History • WWI: War Finance Corporation (WFC) that became a peace time emergency finance corporation- ended in 1929 • 1932: Reconstruction Finance Corporation (RFC)- gave direct loans and stock subscriptions • Roosevelt Administration- Started FHA, SBA, Export-Import Bank of U.S. • These revived confidence in the markets with the strength of the federal government backing them. • 1973-1984: Farmers Home Administration (FmHA)- bailed out lenders hit by the agricultural downturn. • Reagan Administration- Curtail budget resources. • Push from Direct Loans to Loan Guarantees which continued until the Credit Reform Act
U.S. State and Local Governments • Have less financial capacity than the federal government • Bonds are the most common form of state credit programs • State Bond Banks • Local governments pool together and receive lower costs and more favorable terms. • State Revolving Loan Fund • Credit to businesses or localities to help finance long-term economic development of environmental projects • Begins with a federal grant or long-term loan. • As money is repaid it is put back into the revolving loan fund to be given to new borrowers.
International Experience • Germany- “Landesbanken”- provide real estate, trade, commercial loans • Japan- Government Housing Loan Corporation (GHLC) • Provides 40% of the country’s mortgage credit though heavily subsidized loans • France- Used the “Credit Foncier de France”, a quasi-governmental mortgage bank. • Provides subsidized credit for income-eligible homeowners. • Now use private mortgage credit banks to issue mortgage-backed bonds and fund mortgages • United Kingdom- Student Loan Company Ltd.- non-profit adjunct of U.K Dept. of Education. • Provides income contingent repayment of student loans though the tax department • China- Government has given mass amounts of money to wasteful activities. • Roman Republic- 352 BCE- provided direct loans and loan guarantees to provide relief to poor debtors. • King George III- Loans for infrastructure improvements and relieve economic distress • Germany: Post WWII- Reconstruction Finance Corporation (RFC)- provided support for reconstruction after the war
Start-Up • Develop regulations, contractual agreements, loan documents that reflect the laws that authorize the program. • Develop forms and procedures to screen borrowers for eligibility. • Loan guarantee- procedures to certify/decertify lenders as to edibility to participate in program.
Marketing • Lenders and institutions need to be persuaded to participate. • Ex- Student Loans • At first they were 100% guaranteed by the government, but expensive to service • Large private lenders created specialized student loan businesses to purchase loans from originating banks to lower the costs of servicing them. • Then student loans were more widely given.
Origination • The process of actually extending a loan. • Requires a contractual agreement between lender and borrower stating terms of the loan. • Requires underwriting- determining if the borrower is capable of repaying the loan. • Federal business loans and home loans require using the business or house as collateral. • Federally guaranteed loans require the lender to sign a contract with the government for repayment of a defaulted loan. • Direct Loans- Government originates the loan. • Loan Guarantee- Private lender originates the loan. • MORAL HAZARD: Government guarantee distorts the usual economic behavior of the lender. • Enough fees and interest may make the lender indifferent about the loan defaulting. • Government monitors default rates and lender performance to combat this.
Disbursement • Actual Transfer of funds from the government or lender to the borrower. • Can occur all at once as with a home loan. • Can occur in stages as with a student loan.
Servicing • Arranging to receive timely payments from the borrower • Receiving and accounting for funds as borrowers remit them • Grace period: when repayment isn't necessary right away as with a student loan. • Delinquent: when the borrowers is late making a scheduled payment. • Default: when the borrower has been delinquent for a previously established period of time • Requires either restructuring the loan or foreclosure on the loan. • Direct Loans- serviced by the government • Federal agencies are starting to contract with private firms for this • Loan Guarantees- serviced by the lenders • MORAL HAZARD: • Loan Guarantees-Private lenders are more carful servicing their own unguaranteed loans than they are with their government-guaranteed loans. • Direct Loans- The same can happen if the government contracts out their loans.
Loan Sales and Securitization • It is more economic to bundle up smaller loans and sell them to larger companies that can service them at a lower cost. Ex- Home Mortgages • Ginnie Mae- a secondary market institution that helps lenders to secure government-guaranteed home mortgages. • Lenders originate a large number of mortgages • They bundle them together in a trust structure • They allow investors to buy shares in the cash flow from the mortgage to the trust. • Ginnie Mae guarantees that they will receive timely repayments of both the interest and the principle. • Ex- Student Loans • State Agencies or nonprofit organizations issue tax exempt bonds to fund pools of student loans that they purchase from the originating lenders.
Government Loan Asset Sales • The government uses loan asset sales as a way to receive value from loans that it holds. • Both direct loans and defaulted guaranteed loans • In the 1980s and 90s HUD sold billions of nonperforming loans that they couldn’t collect on. • SBA used this as a way to reduce its workload burdens when the agency downsized. • The government can structure incentives so the private sector can collect on nonperforming loans without treating the borrowers unfairly.
Prepayment, Repayment or Collection • Prepayment- when the borrower pays off the loan ahead of time. • Loan Guarantees- federal government is responsible for some, others it requires the private lenders to be responsible for. • Either foreclose or forced sale of home/business • Lender then collects the federal guarantee from the government. • Some federal programs found that borrowers are current with private obligations, but let federally guaranteed loans default. • Credit Alert Interactive Voice Response System- help screen applicants for federal loans. This finds if they defaulted before and requires that they pay that before getting new credit. • Federal Tax Income Offset- Allows federal credit agencies to use a borrowers income tax credit to offset some of the loss of a defaulted loan.
Write-Off and Recognition of Losses • A loan is written-off when there are no further remedies available to mitigate the loss. • Written-off loans have no value • No incentives for recognizing this financial loss. • Sometimes Disincentives. • Offices may use them as a way to keep more staff • China- Reluctant to close down state-owned enterprises that are in debt. • They use this as an excuse to make large-scale mistakes that will cost the economy for years.
Market Imperfections • Definition: some flaw in the market that deprives creditworthy borrowers access to credit on appropriate terms. • Credit programs are most effective when they overcome a market imperfection. • Provide credit without risk of high levels of default. Examples: • Economy is in disarray- Great Depression • Restrictive Legislation- confining banks to geographic locations • Discrimination- FHA: income and race • Student Loans- given even if there isn't a long history of credit • Market Imperfections are hard to find in good times.
Providing A Subsidy • The government may give out preferential terms even when there isn't a market imperfection. Example- Export-Import Bank of the United States: Give subsidized loans so foreign governments wont give their own loans and deprive U.S. firms of those markets. • Government does not always made wise decisions when giving a subsidy. • Creditworthy people may need credit and not subsidies • Non-creditworthy people may need subsidies or grants and not credit.
Government Credit as a Pioneer • FHA- pioneered the 30 year level payment mortgage that private lenders use today. • By giving disadvantages borrowers credit they can show private lenders that those borrowers are profitable credit risks. • The government has to be willing to turn over large numbers of creditworthy borrowers when their program succeeds.
Developing a Constituency • Credit programs can be hard to start and hard to end. • Start- constituencies may not welcome the change and business disrupt. • End- A successful program will develop a constituency whose well-being will be threatened if the program is terminated.
The Choice between Direct Loans and Loan Guarantees • Involves political considerations • Private firms prefer loan guarantees because they keep government participation low. • Lender can earn the fees and interest • Lender develops a relationship with the borrower which may lead to more loans in the future. • Lenders see direct loans as a competitive threat • Unless they are to the least creditworthy borrowers
Constituencies as a Source of Inertia • Lenders provide a strong base for the program and inertia to maintain the features of the program. • Ex- Dept. of Education • Developed formalistic standards of performance to keep defaults low • Lenders objected- used performance based standards • Now the Dept. is trying to switch to performance based measures • Lenders objected- don’t want the rules to change again
Program Expansion • When constituencies emerge Congress may expand the program to include borrowers not originally helped by the program. Ex-Student Loans • Students that could not show financial need were permitted to take out loans. Ex- FHA- was middle-class and suburbs • Included central cities-low income renters and homebuyers
Credit Budget Politics • Credit Reform Act of 1990- All credit programs are subject to annual budget constraints. • Congress then reduces the amount of subsidy provides so the amount appropriated can serve more people. Ex- Student Loans • Students could take out unsubsidized loans regardless of financial need. • Students make interest payments on these, which the government only makes payments for the subsidized loans. Ex- SBA • Increased the amount of risk sharing with private lenders. • Increased the loan-related fees for borrowers.
Balancing Risks and Mission • Maintain balance between doing “good” and doing “well” • Extend credit to creditworthy borrowers that need it while ensuring the program does not incur unacceptable losses. • Financial problems take years to become apparent which gives them time to accumulate large amount of potential losses. • Political environments Ex- congress will give the SBA funds to help business in need, but not money to cover servicing or foreclosure. • Wholly government owned organizations do this the best. • They are meant to be self-sustaining
Capacity • Availability of staff and systems to maintain program • Hiring freezes and mandatory staff reductions Ex- Ginnie Mae • 1993: 70 staff for hundreds of billions of dollars in mortgage-backed securities • 1999: 56 staff for $540 Billion in securities • Policymakers will allocate more money to the programs with the most defaults • Staff Quality and Training • Less young professionals with new ideas and technology-hiring freezes • More prosperous alternatives in the private market • “Hollow Government” • Government contracts out, but needs staff to assure relationship between government and contractors.
Keeping Third Parties Accountable • Government is devoting increased resources to monitoring performance Ex- Ginney Mae • 1980s- mortgage backed securities defaulted • Agency added an information system to tract loan originators. • Monitor default rates and delinquencies so they can act before there is an unacceptable financial loss. • Effectiveness depends on legal authority given to agency • Ex- Student Loans- Dept. of Education could take action against schools and the number of defaulting loans has dropped. • Accountability- status of defaulted individuals now has to be reported to the credit bureaus.
Adverse Selection • Private lenders want to keep the most profitable loans and send less profitable ones to the government. • Many credit programs will only take people that have been turned down by private firms. • Government credit is at a standard price so private firms want to offer a better price to more creditworthy borrowers. • As they leave government programs the government is left with a higher proportion of less creditworthy borrowers. • FHA mortgages were 1.9 times more likely to default before and are not 4.4 times more likely.
Effectiveness and Manageability • Programs have used the financial strength of the government to experiment with new types of loans and give underserved borrowers credit. • Less effective when they convey a subsidy without proving they will be profitable. • Changes in credit markets make it hard to help those that deserve credit while protecting the programs from high numbers of defaults. • New technologies allow more flexible data management, real-time biases, better customer service.
Efficiency • After Great Depression- improved efficiency of markets. • Do so now when helping borrowers that are neglected by private markets. • Increases in efficiency within private markets have made some programs obsolete. • Government credit encourages indebtedness. • Federal school loans have helped facilitate the dept of many of today's students.
Equity • Credit is an inequitable tool. • Most creditworthy are most attractive to private firms. • The government may be left with people that are unsuitable for large amount of credit.