Backgrounder Update #52
September 14, 1987
(Archived document, may contain errors)
A WARM WELCOME TO FEDERAL LOAN SALES
(Updating Backgrounder No. 541, "Cashing in on the Federal Quarter-Trillion Dollar Loan Portfolio," October 28, 1986.) The federal government has just launched its program of loan asset sales. This is an important step in its privatization campaign, following the March sale to the private sector of Conrail, the frei lit railroad. On September 3rd, the government sold, via a private trust, 1111.8 billion of its Community Program Loans from the Rural Development Insurance Fund, administered by the Farmers Home Administration (FmHA), to bond investors. The original loans were made primarily to public bodies and certain not-for-profit organizations to finance water and sewer facilities in rural areas. The sale represents the first public offering of federal agency loans authorized by the Omnibus Budget Reconciliation Act of 1986. Despite a relatively weak bond market, the offering was received enthusiastically, indicating that loan sales represent an effective way to help meet the federal government's Gramm-Rudman-Hollings budget deficit targ@ts. Congress should build upon this initial success and consider a more comprehensive credit reform program as part of the FY 1988 budget.
Improving Collection Rate. Selling the Community Loan portfolio involved a series of necessary hurdles. First, the financial advisors for the sale, Manufacturers Hanover Trust Company, had to assemble extensive information on the programs 12,000 borrowers to convince potential investors of the loans' quality. Second, the Office of Management and Budget (OMB) issued guidelines stating that the loans had to be sold without recourse to the federal government in the event of default. The reason: it increases the incentive for the private sector to improve the rate of collection. To enhance the credit of the loan package, the FmHA and the underwriters employed a form of self-insurance referred to as "overcollateralization." BX this, a pool of loans ("Class B Bonds") from the purchased portfolio were set aside to be substituted for loans which default among the main pool of loan-backed securities designated as "Class A Bonds." Other buyers may choose a specially formed consortium of insurers, the American Loan Guarantee Association, to purchase default insurance for some loans.
Third, repayments from loans would need to be collected and records kept after the sale. To do this, the FmHA and Manufacturers Hanover arranged for
General Electric Credit Corporation to coordinate billing and collections. Finally, to package the offering as a block, sales managers had to agree on a common interest rate and maturity on over 7,700 loans, with interest charges ranging from 3 percent to over 12 percent--some involving repayments for the next 40 years. They did this by creating five separate series of Class A Bonds with the same interest rate (4.5 percent) but five different maturities. Thanks to careful work by the FmHA, its advisors, and the underwriters, the bonds received a triple A rating--the highest possible rating by Standard and Pooes.
Selling New Issued ImanL Washington would boost future loan sales, thus helping to cut the deficit, by mandating the sale of new government loan originations. This would remove the market's uncertainty over the continuation of the sales, maintain Wall Street's enthusiasm, and stimulate the creation of an efficient secondary market that would strengthen the prices paid to the government for the loans. The time-consunu*ng procedures necessary for the successful sale showed the difficulties of selling existing portfolios of agency loans. Documentation is often shoddy, borrower rights unclear, and default rates very high by private sector standards. These problems make this month's successful sale all the more significant. * Selling newly issued loans would avoid these problems. The paper work for these loans could be designed to conform to market standards, making them easier to sell and likely yielding a higher sale price for the government.
In selling loan assets, Washington does not forgo future income and interest ayments. In almost every instance, the sale of government loans to the private uyers yields far more than the present capital value of future repayments if the loans were to remai in government hands. The same is true of other government assets. The reason is that the price offered by a private purchaser reflects that purchasees estimate of the income he or she expects to generate as owner of the asset; it does not reflect the government's anticipated income. Thus if any potential private buyers believe that they can earn more than the current government owners--given the incentives in the private market, this is normally the case--the market sale price will exceed the present value in government hands. Hence, loans written off by government could still fetch a price in the market. Poorly performing loans have to be sold at a discount, but even this discount is normally less than the losses which would be incurred under continued government ownership.
Largest Stock Offering. The capital markets in the industrialized countries have signaled their strong support for privatization. In Britain, record-shattering public stock offerings of such former government assets as British Telecom and British Airways have been extremely popular with even small investors, leading to a three-fold increase in share-owning households and a steady appreciation in the share prices of privatized companies. In the U.S., the $1.65 billion sale of Conrail, the largest public stock offering in the nation's history, was highly successful. The share price of Conrail has increased by nearly 30 percent since March's public offering.
Ile sale of Community Program loans demonstrates that the U.S. bond market welcomes privatization. Following close on the heels of this first sale win be $1 billion worth of FmHA Rural Housing loans, and $500 million of the Department of Education's College Housing loans. It is now time for Congress to recognize the worldwide success of asset sales and to develop a more comprehensive, permanent program.
John E. Buttarazzi Research Associate