The Heritage Foundation

Backgrounder #774 on Economy

June 28, 1990

June 28, 1990 | Backgrounder on Economy

The Six Trillion Dollar Debt Iceberg; A Review of the Government'sRisk Exposure

(Archived document, may contain errors)

774 June 28,1990 THE SIX lRULION DOLLAR DEBT ICEBERG A REVIEW OF THJ3 GOWRNMENTS RISK EXPOSURE INTRODUCIION In a congressional floor speech last spring decrying the cost of the savings and loan S&L) bailout, no w estimated at between $150 billion and $300 billion, Representative Major Owens, the New York Democrat, declared that he believed there had never been a single item in peacetime that cost the government so much money. Owens raised an intriguing question, and research into federal budget history reveals that he was right. Only World War 11 cost more than the S&L bailout, at least in nominal dollars. But an examination of the finances of other government-backed agencies indicates that the bailout may be jus t the tip of a fiscal iceberg about to strike the American taxpayer. The total financial obligation of agencies underwritten by the federal government is now some $5.8 trillion and much of that obligation is in bad shape.

The S&L disaster represents an sta ggering breakdown of government, and the hidden costs to Americans likely will turn out to be several times the amount that the hapless taxpayer is scheduled to pay directly in extra taxes. It will take years to unravel what really happened and why. But o ne thing is clear: the governments mega-billion dollar commitment to guarantee the deposits of the savings and loans insured by the Federal Savings and Loan In surance Corporation (FSLIC) was grossly mismanaged.Tbis and

e perverse incentives offered by the insurance program led to the wholesale looting of hundreds of thrift institutions.

Worsening Daily. As the S&L bailout legislation went through Congress most lawmakers tried to convince Americans that the crisis was just an iso lated incident, however c ostly, and that the vast bulk of the government credit programs are well-managed andpose little risk to the taxpayer. While. taxpayers may wish for this to be so, a cursory examination of the federal governments vast credit empire actually reveals repeate d instances of huge financial risks that are worsening by the day. In fact, the $958.9 billion in S&L deposits insured by the FSLIC at the end of 1989 represents just a small frac tion of the financial liabilities the federal government has assumed through its many direct lending, loan guarantee, and insurance programs. The $4.2 bil lion loss at the Federal Housing Administration revealed in May 1989 in a General-Accounting Office.(GAO) audit and the Office of Management and Budgets Om) projection that the l osses continue, are just among the latest hint of a vast liability that could land in the lap of taxpayers.The governments total risk exposure of nearly $6 trillion dollars is more than twice the national debt held by the public and more than five times t h e an nual federal budget countering serious financial problems. Others could join them over the next year, depending upon how the economy performs. Like the FSLIC, some of these programs require immediate attention to stanch enormous losses and limit pote n tial future claims on the taxpayer. Unfortunately, no such com prehensive effort is under way in Congress or the White House. Worse still, to the extent that credit-related legislation is being considered by Congress some of it would make the situation ev e n worse sential that steps be undertaken immediately to place the governments vast array of financial activities on a sound basis. This requires enactment of an Omnibus Credit Solvency Act that would fundamentally restructure these many programs to reduce the taxpayers exposure to costly program failures.

Such an act would improve underwriting standards and financial controls tighten management, and eliminate or reform the most costly programs Comprehensive Effort Needed. A number of these programs already are en Because the potential costs of ignoring these problems are so huge, it is es THE RISKS FACED BY TAXPAYERS The $6 trillion risk exposure is spread among deposit insurance programs loan and pension guarantees, direct loans, other forms of insurance, and the debt of the five multi-billion dollar government-sponsored enterprises I 1)DepositInsurance In addition to the $958.9 billion in savings and loan deposits insured by the FSLIC, another $1.806 trillion of deposits at commercial banks and savings ba n ks are insured by the Federal Deposit Insurance Corporation (FDIC In addition, approximately $161 billion in credit union deposits are insured by the National Credit Union Administration. Total deposit guarantees amounted to 2.9 trillion in 1989 I 2) Loan s and Guarantees The federal government stands behind nearly half a billion dollars in guaranteed Veterans Administration (VA) and Federal Housing Adminisea 2 tion (FHA) mortgages 48 billion in guaranteed student loans, and a host of other guarantees rangi n g from rural electrification to ship building loans, and from small business disaster loans to loans for building plants to convert grain to ethanol. Altogether, the contingent liability associated with the govern ments loan and deposit guarantees total a pproximately 3.5 trillion at the end of fiscal 19

88. Other insurance programs, such as flood insurance, add about another half-trillion dollars to this liability 3) Pension Programs Added to these loan and insurance risks are 105,000 single-employer pen s ion plans, and 2,300 multi-employer pension plans protected by the federal governments Pension Benefit Guaranty Corporation. The governments potential obligation for these pension programs is estimated at $819 billion for 1989 4) Direct Loan Programs The g overnment also acts as a financial institution, extending loans to eligible borrowers. Major direct loan programs include the Export-Import Bank, the Small Business Administration, College Housing, and the Rural Telephone Bank. The portfolio of outstandin g loans held by the federal government as of the end of fiscal 1989 amounted to $207 billion 5) Government -Sponsored Enterprises The government has created a number of off-budget enterprises and is responsible for their finances. These government-sponsore d enterprises GSEs) technically are private organizations, but in practice are treated and act as extensions of the federal government. Several of these enterprises add to the real estate exposure due the troubled mortgage insurance schemes.

One of the GSEs, the Federal National Mortgage Association (FNMA for instance, held 110 billion in mortgage loans and guaranteed another $208 billion in outstanding mortgage-backed securities at the end of 19

89. Its com panion, the Federal Home Loan Mortgage Corporation (FHLMC), holds few mortgages but guarantees $257 billion in mortgage-backed securities. Collec tively, the five government-sponsored enterprises had an outstanding debt obligation of $763 bill ion at the end of 1989; and they are the fastest -growing source of federal credit exposure.

Although these privatelyGowned but government-sponsored -enterprises maintain the fiction that they are independent of government and thus pose no liability to the taxpayer if they fail, recent experience suggests that the government will in fact bail them out to maintain their solvency during periods of adversity. The fiction of independence, for instance, did not 1 These GSEs are the Student Loan Marketing Associ a tion, the Federal National Mortgage Association, the Farm Credit System, the Federal Home Loan Bank System, and the Federal Home Loan Mortgage Corporation. prevent the 1987 bailout of the independent Farm Credit Administration I with an estimated final co s t of between $2 billion and $3 billion THE RISING TIDE OF RISK EXPOSURE As the $958.9 billion pool of insured savings and loan deposits has un raveled, Americans have.become.paiMy aware, of the risks associated with such programs, and the enormous potenti a l cost of mismanagement and failure to correct emerging problems. Yet the FSLIC is by no means the only federal credit program confronted with staggering losses. Default rates in many of the government direct loan and loan guarantee programs are rising at an alarming rate and could lead to huge losses which will have to be met by the taxpayer. The FDIC and the FHA posted their first-ever losses in 1988 and repeated that performance in 19

89. With the residential and commercial real estate markets still weak, this trend could continue through 1990.

Many of the government-sponsored enterprises and insurance programs moreover, have inadequate net worth and reserves to support the risks to which they are exposed. The FHA, for example, has seen the level of cla ims against its shrinking resexves rise nearly three-fold over the last three years.

Further, half of the farm loans made by the Farmers Home Administration are in default, and half of these defaulted loans have been in that condition for more than three years. Yet even that dismal performance appears almost praiseworthy when compared to the 100 percent default rate experienced by the Economic Development Administrations loan guarantees for the steel in dustry and the equally disastrous performance of the ethanol production loan guaranteesissued by the Departments of Agriculture and Interior.

Has Congress learned any lessons from these and the many other troubled loan programs? The answer appears to be, it seems, no, judging from recent legislative initiat ives. Indeed, some proposed congressional legislation actually would aggravate the problem. Example: Some in Congress would ex pand FHA exposure to markets already served by the private sector and on terms leading to a greater likelihood of default. And a l though the Bush Ad ministration has proposed many valuable reforms in its 1991 budget to reduce the total risk to the taxpayer, much more needs to be done WHAT NEEDS TO BE DONE The savings and loan fiasco could be just the beginning of a costly stream of f inancial disasters that will end up in the lap of the American taxpayer. Ur gent action must be taken to reduce the potential price tag. Fortunately, it is not too late to avoid several potential collapses. But a comprehensive legisla tive package is need ed soon. The appendix to this paper details the principal federal financial programs and lays out a reform strategy for groups of similar programs that should be included in an Omnibus Credit Solvency Act.

Among its necessary provisions 4 Establish premium incentives and operational practices to encourage both government providers and private sector users to act in a fiscally pru dent fashion and to rebuild reserves Many of the credit programs most in trouble cannot help but lose money because of poorly co n ceived, yet congressionally required, underwriting standards that actually forbid federal program managers from rejecting poor credit risks. Indeed, some programs, such as the Farmers Home Administra tion, are designed specifically to serve poor-credit ri s ks. For the same reason many of the programs cannot charge premiums that correspond to likely (or actual) losses, and so are required to run at a deficit, such as the Pension Benefit Guarantee Corporation or the Federal Housing Administration Eliminate co s tly programs that have outlived their usefulness, such as many of those created during the Depression of the 1930s Another source of the problem is the continued operation of programs that have long since outlived their usefulness and now expose the gover n ment and the taxpayer to needless risk. Many of the Depression-era programs created to meet a national emergency long ago have completed their job and should be retired gracefully.The Rural Electrification Administration which met its goal in the mid-l950 s , nonetheless continues to expand at ever rising costs Thus an omnibus bill should provide for a thorough review of the need of each program and an assessment of the potential for private sector al ternatives programs and government-sponsored enterprises h ave come to dominate and monopolize certain segments of the economy.The U.S. has a long tradition of concern over excessive concentration of market power, and several of the GSEs now dominate the market in degrees of concentration seldom seen in the priva t e market. Government intrusion into the housing finance market for instance, is very extensive. This exposes the taxpayers to risk and dis courages private entities from offering the same senrice; this concentration in the mortgage market, for example, wa s a contributor to the weakening of the S&L industry. An omnibus credit bill thus should consider ways in which this responsibility and risk can be decentralized and returned to the private sector where it belongs Establish uniform accounting and financial controls that would quickly and accurately reveal program losses Also exacerbating the structural weakness of these programs are a series of management, information, and control problems that make it difficult or im possible to properly supervise these pr o grams. As the GAO audits have revealed, many of these programs have primitive accounting systems that hide more than they reveal. Moreover, standards of accounting between agen cies also differ, making it difficult to make comparisons between programs Any omnibus credit reform bill thus should include the requirement that ac counting and financial control systems be overhauled and standardized. It should also include the requirement for accurate quarterly reporting so that The review also should consider t h e extent to which federal credit 5 public officials can have timely and understandable information on program I status CONCLUSION The vast system of federal credit programs, with their $5.8 trillion in out standing obligations, serious .trouble. It c o sts-the .taxpayers.billions of dol lars a year in bailouts, defaults, and unneeded subsidies. Beyond these direct costs to American taxpayers is a host of indirect costs due to the disruption they cause to U.S. financial markets and the countrys ability t o deploy its capital resources in an efficient and productive fashion.

Facing the Fact. This national embarrassment and potential catastrophe must be brought under control as swiftly as possible through an Omnibus Credit Reform Bill that makes fundamental changes in the way these programs are structured and operated. Many of the reforms that should be contained in such a measure already have the support of the Administration and in Congress. Unfortunately, the reform approach to this date has been piecemea l , and thus misses the opportunity to achieve comprehensive reform, dealing with problems before they worsen. Congress must at last face up to the fact that the savings and loan crisis, and the other emerging problems associated with federal credit and gua rantee programs, are not iso lated and unconnected. Rather, they indicate systemic flaws.The solution is system-wide reform.

Prepared for The Heritage Foundation by Ronald Utt, Ph.D Dr. Ug a\\ -on-based economist, was the 1989-1990 John M. Oh Fellow at The Heritage Foundation 6 APPENDIX THE FEDERAL GOVERNMENTS CREDIT OBLIGATIONS GROUP k- THEHOUSINGCREDIT PROGRAMS Despite the prevailing popular view that the 1980s was a decade of govern ment retrenchment, there was in fact a rapid growth of government credit programs, often at the expense of private financial institutions unable to com pete with generous government subsidies. Indeed, one factor in the S&L col lapse was aggressive government mortgage lending activity that depressed the earnings generated from t raditional savings and loan lending activities. In the residential housing mortgage market, for example, expanding government programs led to the effective federalization of much of the nations housing finance market, and to the assumption of multi-billio n dollar liabilities by the taxpayer. Federal and federally-sponsored mortgage credit support ac counted for just 17 percent of outstanding mortgages in 1980, but by the end of 1989,41 percent of outstanding home mortgages had been guaranteed by federal ag e ncies or securitized by GSEs as the Federal National Mortgage As sociation, the Federal Housing Administration, the Government National Mortgage Association, and the Federal Home Loan Mortgage Association widened their activities and displaced private pro v iders of mortgage credit and insurance. There has been similar growth in the agriculture sector, with a vast array of subsidized federal credit support programs for farmers adding momentum to the agriculture debt crisis that first emerged in the middle of the decade.

What is ironic about this rapid growth in credit programs during the economically buoyant 1980s is that the vast majority of the programs were created during the Great Depression to help revive a struggling economy.

But credit programs were n ot dissolved once the apparent need for them had passed. Instead, in predictable bureaucratic fashion, their missions simply were redefined and they continued to grow well beyond the scope and pur pose envisioned by their founders.

I 1) The Federal Housin g Administration The Program. The Federal Housing Administration (FHA) was created in 1934 to revive the badly battered residential housing market by insuring a new type of residential mortgage instrument: the long-term, fixed rate, level payment, fully a m ortized mortgage. The goal of injecting new life into the housing market largely was fulfilled in the early postwar era, when private lending institutions returned in force to the housing finance market. In the early 197Os, the need for a government-opera t ed mortgage insurance enterprise was further diminished when a private mortgage insurance in 7 1 dustry emerged and offered lenders and borrowers essentially the same ser vices as government and at competitive fees The Problem. Despite the shrinking need f or a government mortgage in surance industry, the FHA has attempted to remain in operation by redefin ing its mission and expanding its activities into risky ventures that serve little or no public purpose yet expose the taxpayer to ever-growing potential losses.

Thanks to a policy of lax underwriting standards, low downpayments and ex cessive risk-taking as well as weakeningregional real estate markets, the FHA now is confronted with the very real prospect of financial insolvency.

Rapid increases in claims filed by lenders against the FHA insurance fund have jumped. Since 1987, the cost associated with the acquisition of property and the assignment of mortgages has risen from $4.3 billion to an estimated 6.9 billion in 19

90. Delinquencies of more than sixty days accounted for 6 percent of FHA mortgages in early 1989, compared with 5 percent in the third quarter of 1988 and just 2 percent in 19

79. In early 1990 the delinquency rate has been running at 33 percent, but because reven ues from new in surance premiums are expected to decline with the current slowdown in the real estate market, the FHAs losses could rise at an accelerating rate. The agency is estimated to lose $99 million a month in 1990 Considerable light has been shed recently on the FHAs troubles by a GAO audit which found that FHAs equity, essentially its reserves against los ses, had declined to a negative 2.9 pllion in support of $303 billion of in surance-in-force at the end of 19

88. Since the agencys financial co ndition has been deteriorating, it is quite possible that even these tiny reserves and equity have been completely wiped out, leaving the taxpayer liable to cover all future net losses In his June 9,1990, testimony to the Senate Banking Committee, Housing and Urban Development Secretary Jack Kemp told members that years of neglect and mismanagement have rendered FHA ill equipped to fulfill its mission of promoting homeownership. Kemp noted the rapid financial deterioration of the FHAs Mutual Mortgage Insur a nce Fund the major program for insuring mortgages on single family dwellings. He stated that under the existing programs arrangements each years new busi ness will lose money for FHA at a rate of $200 million, and this ultimately will wipe out the funds n e t worth unless major reforms are made 2 1988 Fmcial Audit: Federal Housing Adninistration, Testimony of Charles A. Bowsher, Comptroller General of the United States before the Housing and Urban Affairs Subcommittee of the Senate Committee on Banking, Hous i ng and Urban Affairs, September 27,1989, p. 1 3 For further details on FHAs financial status see Ronald Utt, S. 565: Pushing the Federal Ho&g Administration Toward Insolvency, Heritage Foundation Issue Bulletin No. 148, June 151989 8 What Needs to be Done First and foremost, congressional efforts to reduce FHA's required downpayment should be rejected. Study after study demonstrates that loan losses rise as downpayments are lowered. Congress and the Administration should work to construct a package of legi s lative reforms that would restore permanent financial solvency to the FHA program. Among the steps, first suggested by The Heriqge Foundation in 1986, needed to bring the FHA's finances under control Restrict FHA insurance to first time buyers with modest incomes Require a minimum downpayment of no less than 5 percent of the cost Hold mortgage insurance limits at their present level of $101,250, as End the practice of allowing borrowers to finance their closing costs Increase FHA resewes to 4 percent of FH A's contingent liabilities by of the property recommended by Secretary Kemp way of increased premiums, higher coinsurance, and better underwriting standards. Charge higher premiums for riskier mortgages.

Last year in response to the GAO's audit report, HUD proposed a series of important interim reforms that Congress adopted. Kemp recently unveiled a package of sensible reforms to reduce the risk associated with low downpay ments and achieve a comprehensive overhaul of the program 2) The Veterans Administra t ion The Program. In 1948 the Veterans Administration (VA now the Depart ment of Veterans Affairs, launched a mortgage guarantee program designed to help eligible veterans to become homeowners. While the FHA insures 100 percent of a mortgage only up to a c ertain dollar limit and requires a mini mum downpayment of between 3 percent to 5 percent, a VA mortgage has no upper dollar limit. VA guarantees only the first 40 percent of principal up to a maximum of $36,000 for loans up to $144,0

00. For loans that ex ceed 144,000, VA will pay 25 percent of the loan up to $46,OOO. VA loans require no downpayment. The VA mortgages do experience higher default rates than the FHA because of the lack of a downpayment requirement,'but the povernment's financial exposure act ually is less than with the FHA because the risk is shared with the lender.

The Problem. Like the FHA, mortgages insured by the VA are experienc ing much higher default rates and losses than anticipated. In many cases, the 4 Stephen Moore How to Defuse the Federal Housing AdmiaistrationThe Bomb Heritage Foundation Backpuder No. 528, July 29,1986 5 See Utt, op. ck for an explanation of the relationship between downpayments and the risk of default 9' losses exceed the governments guarantee, causing losses to the private lender or to the Government National Mortgage Association (GNMA) which adds its own guarantee on top of VAs when the VA loans are securitized through the GNMA program, which provides 100 percent guarantees on its VA/FHA-backed securities.

Betw een 1981 and 1987, VA foreclosure actions increased by 215 percent Over the same period, losses rose from $51 million to $615 million, but by 1990 the annual loss is expected to riseto $792 million. It is expected that VA mortgages written in 1990 eventua l ly will experience a 10.4 percent foreclosure rate. In the past, VA often would cover all the loss on a defaulted mortgage even that portion which exceeded its legal obligation. However Congress in 1984 enacted legislation prohibiting the agency from payi ng out more than its legal obligation.

What Needs to be Done Because the program was established to reward veterans for their service and was not meant to be financially self-sufficient, a reform of the program should aim at bringing the taxpayer liability under control, not at an eventual elimination of taxpayer exposure. To accomplish this a package of reforms should Undertake a thorough review of the VAs underwriting standards to determine whether too many risky borrowers are using the program.The pro g r am was never meant to be a blanket entitlement for all veterans only those who could demonstrate an ability to repay the loan were deemed qualified for a VA guaranteed mortgage Adopt the Bush Administrations most recent reform proposals that would require veterans to make a small downpayment of 4 percent of the amount of the loan above $25,000; charge a 1.75 percent loan fee; and, in crease risk sharing with lenders 3) The Federal National Mortgage Association The Program. The Federal National Mortgage Ass o ciation (FNMA known as Fannie Mae, is a privately-owned, government-sponsored enterprise (GSE chartered and organized by the FHA in 1938 to provide secondary market support for the newly-devised FHA mortgages. In 1968 the FNMA was split into the newly-cre a ted Government National Mortgage GNMA or Ginnie Mae, which took over those FNMA housing assistance programs that were largely targeted to moderate- and low-income households, and a new FNMA, which held onto to the profitable business of borrowing in capit a l markets to buy residential mortgages. The new FNMA became privately owned its shares trade on the New York Stock Exchange but retained several important links to the government including a line of credit with the U.S.Treasury, debt that is eligible for p urchase by the Federal Reserve, and an exemption from registration with the Securities and Ex change Commission. Investors take these privileges to mean that the govern ment will bail out FNMA if required. As a result, FNMA debt hes interest 10 rates just slightly higher than U.S. Treasury securities, and well below those available to its private sector counterparts FNMA also issues mortgage-back ed securities, which are sold to investors and secured by residential mortgages The Problem. By practicing a sa v ings and loan investment strategy of bor rowing short term to fund long-term investments in residential mortgages FNMA is vulnerable to any rise in interest rates which would increase its bor rowing-costs and thus squeeze profits &d reseives:The degree of risk facing FNMA is underscored by a report from the Department of Housing and Urban Development, which notes that the rise in interest rates between 1978 and 1981 reduced the FNMAs mark-to-market net worth from negative $387 million to a staggering negat i ve $11 billion! During this same period the FNMA also faced a growing default problem. The subsequent decline in inter est rates and a massive expansion in its investment program helped reverse the deterioration through much of the 1980s. But by the end o f 1987 the market value of its reserves still had risen to only $1.6 billion to support a portfolio of $97 billi.n of mortgages and $140 billion in mortgage-backed security guarantees. According to the Bush Administrations FY 1991 Budget, At the end of 198 8 each held [FNMA and FHMLC] capital equal to less than 1.5 percent of assets including mortgage-backed securities With such a small margin, the taxpayers are more at risk Recognizing the potential for trouble, HUD conducted a thorough inves tigation of th e FNMA and released its report in January, 1989.The report concludes that FNMAs extensive operations creates serious risks to FNMA and...creates substantial risks of disruption to the housing market and possible calls for help from the Federal Government.g While the FNMA has made some progress in better matching the maturities of its assets and liabilities, it is still vulnerable to interest rate swings and its net worth is well below the level required of savings and loans under the 1989 bailout legisla ti on. Compounding this is the potential risk associated with holding a portfolio of only one kind of asset residential mortgages.

Even more disturbing is that while the FNMA continues to operate under conditions of a limited cushion of reserves, it does so a s an increasingly impor tant participant in the nations residential mortgage market. In part, the grow ing federalization of the mortgage market, noted earlier, is due to the rapid growth of FNMA activities in the 1980s..Approximately 90 percent of-all or i ginated mortgages are eligible for support from the FNMA or its sister in 6 19B7Reporl to Gmgms on the FedemI National Moqpqe Association (Ofice of Policy Development and Resear4 US. Department of Housing and Urban Development unpublished draft dated Janu a ry 19,1989 7 hid 8 Buer ofthe Unired Sraru Govemmmr; Fisd Year 1991 (Washington, DC U.S. Government Printing 9 hid, Chapter l, p. 4 office, 1990 p. 236 11 stitution, the Federal Home Loan Mortgage Corporation (FHLMC In 1986 these two institutions purchase d loans equal to 82 percent of this eligible amount.lo At the same time, virtually all of the FHA and VA loans originated that year were repackaged into GNMAs pass-through securities, which are 100 percent guaranteed by the government.

Given this commandin g presence in the U.S. residential mortgage market a.presence that will increase because of the declining role of the savings and loan industry any financial problems at the FNMA or its compdon institu tions could have devastating implications for the Ame r ican housing market and the financial system as well as for the hapless taxpayer who would no doubt be called upon to bail out the agencies What Needs to be Done To avoid this, major reforms are needed to diminish the risk of insolvency In particular, the FNMAs resemes need to be built up quickly. Studies for HUD by Standard and Poors, and Shearson Lehman, suggest that a capitaliza tion level of about 5 percent of the FNMAs mortgage portfolio (compared with todays level of below 2 percent) and capitalizati on of 2 percent of its mortgage-backed securities obligation, would be appropriate for the risk as sumed and would also allow the FNMA to becomfi truly independent of the implicit government support that it now receives.

Reagan Administration, to achieve t his ratio of reserves to liabilities, the FNMA should Wind down its mortgage portfolio at a rate matching the maturation of its debt obligations. This would have the added benefit of beginning the process of defederalizing the mortgage market, permitting p rivate lenders and secondary market participants to enter the market and compete with the FNMk According to the HUD report submitted to the OMB in the last days of the Cease payment of dividends to shareholders, so that all earnings can be Increase fees t o those mortgage originators (and borrowers) who utilize applied to reserve accumulation and benefit from FNMA support. President Bushs 1991 budget proposes a variation on this, recommending that fees be charged on all new debt and securities issued by the FNMA and the FHLMC.

Recently, the FNMA has acknowledged the existence of the problems and has begun to take significant actions. On May 8,1990, the FNMA announced that it planned to set aside at least $2 billion over the next two years against 10 Bid, Cha pter 4, p. 14 11 Bid, Chapter 3, p. 8 12 possible losses in its mortgage portfolio. Its chairman stated that it lamed to spend most of its profits in this year and the next to meet this goal 4) The Government National Mortgage Association 8 The Program. T h e GNMA was created in 1988 to conduct activities pre viously carried out by the FNMA. Much of the agencys original low-income support activity has since been wound down to minimal levels, and the GNMAs major unction today is to guarantee the payment of pr incipal and interest on what are called GNMA mortgage-backed, pass-through securities.

These securities were developed in the late 1960s as a way of tapping the capi tal markets for funds for housing. The idea was that those investors and in stitutions not willing to invest in residential mortgages would be willing to in vest in government guaranteed securities collateralized by pools of residen tial mortgages that also were guaranteed by the government.

Only FHA-insured and VA-guaranteed mortgages can be used to back GNMA pass-through securities. Although the GNMA charges a nominal fee to t hose entities that issue the securities, it has been assumed that the or ganization is exposed to little risk because of the additional guarantee on the underlying collateral. By the end of fiscal 1990, the outstanding volume of GNMA-guaranteed securities is expected to reach $390 billion.

The Problem. The presumption of safety is now being questioned as past HUD management scandals continue to unfold. For one thing, the financial collapse of one GNMA security issuer revealed that the company had been skim ming off borrower prepayments and not passing them through to the holders of the GNMA securities.The GNMA estimates that the losses as sociated with this issuer alone could cost GNMA as much as $125 million.

Rising defaults inVA mortgages lead to another source of loss for GNMA.

Whereas FHA insures 100 percent of the value of its mortgages, VA guaran tees only 40 percent of the mortgage, up to a maximum amount of $36,000.

Losses beyond this level must be born by the lender or mortgage holder or ultimatel y by the GNMA whenVA loans are used to back GNMA pass through securities. Because of the rise in VA defaults, and a steady increase in losses exceeding the VA obligation, GNMA is facing heavy losses. With more than 10 percent of the VA mortgages written t his year expected to go into foreclosure, the potential GNMA liability could be as high as $2 billihn or more, an amount that exceeds the GNMA reserve fund of $1.7 billion.

What Needs to be Done To rectify these problems and avoid future losses, the GNMA s hould 12 Wahington Post, May 9,1990, p. Fl l3 Rising VA Mortgage Losses Spell Trouble at Other Agency, The New Yo& Tunes, June 29,1989, p. 1 13 Review the capital standards required of its issuers and determine whether they should be raised as a result of the greater rate of mortgage defaults Audit randomly chosen pass-through security issuers to determine that Disqualify immediately those unable to meet the revised standards Raise the guarantee fee, nowset at only 6 bzis points, to at leait the 10 basis p o ints recommended in Ronald Reagans fiscal 1988 budget. As that budget noted, This fee is closer to that charged other issuers of mortgage backed securities and is part of a coordinated effort to increase opportunities for private se or activity in the sec o ndary mortgage market for home mortgages. Although Congress did not enact this proposal, Bush has in cluded it in his 1991 budget the existing standards are being met 16 5) The Federal Home Loan Operations The Program. The government is even more deeply i n volved in mortgage finance, thanks to two other government-sponsored enterprises -the Federal Home Loan Bank System (FHLBS) and the Federal Home Loan Mortgage Corporation (FHLMC).The FHLBS was created in 1932 to provide a central credit facility for savin g s and loan institutions and to supervise and regulate the industry. As of the end of 1989, its outstanding loans were $151.1 billion most of which were in the form of loans to savings and loan institutions. Al though the FHLBS is better capitalized than s ome other government enterprises, the vast majority of its loans are concentrated entirely within the troubled savings and loan industry.

The Problem. The FHLMC was created in 1970 to stimulate the flow of capital into the housing market by establishing an active secondary market for conventional mortgages. While in some respects the corporation can be viewed as the conventional mortgage companion to the FNMA, it differs from the FNMA by largely relying on packaging its mortgages into a form of pass-throug h security and then reselling these securities in the open market.

By securitizing the mortgages, much in the way that the GNMA does with FHA/VA mortgages, the FHLMC aims to attract additional funds to housing.

As of the end of 1989, the FHLMC had $257 billion of these securities out standing, and it is anticipate that this amount will increase by about $40 bil lion to $50 billion per year. l 14 The Bud

of the United Sma Government, Fiscal Year 1988 (Washington, D.C US. Government Printing offie 1988 pp. 5-61. 15 1991 Bud p. A-140 14 I What Needs to Be Done The FHLMC is in better financial condition than FNMA and its interest rate risk exposure is manageable by virtue of its limited portfolio of mortgages held for investment. It is, nevertheless, concent r ated in one asset and, by virtue of its implicit government support, has a competitive advantage over its private sector competitors. One way to diminish the latter advantage would*be.te.requireit to payaxeeto thegovernment.on allsecurities it issues to t h e private market as proposed by the Bush Administration GROUP II: AGRICULTURE CREDIT PROGRAMS The agriculture sector of the U.S. economy also enjoys substantial federal credit support As in many of the other federal credit programs, the govern ment greatl y expanded its agriculture finance business during the Depression although the first major programs were created in 19

17. Because a dispropor tionate share of the bank failures during the Depression were concentrated in rural banks, many farmers were left without any source of credit to finance spring plantings, storage, and general improvements. The federal government stepped into this gap with several programs and institutions to help get the farm economy back on its feet.

When the Depression ended, the se programs did not wither away they were expanded and new ones were added. By 1985, the federal government accounted for more than half of the farm sector's real estate debt and more than a third of the other agriculture-related debt.

But for many farmers, it was too much of a good thing.The generous lend ing policies of the federal government promoted an unsustainable rate of in crease in the price of farm land during the 1970s and early 1980s and induced many farmers to take on more d ebt than they could ever hope to service or pay back unless land and crop prices continued to escalate. But land and crop prices fell in' the 1980s. The end result was a collapse of the agriculture economy that ruined the lives of thousands of farmers, ba n krupted hundreds of rural banks and other businesses, and cost the taxpayers billions of dollars 1) The Farmers Home Administration The Program. The Farmers Home Administration (FmHA), created in 1948, has as its chief objective the provision of temporary credit to hers whose financial situations prevent them from obtaining credit elsewhere at af fordable rates and terms.The FmHA operates two major programs: one makes loans to farmers to finance farm ownership and other agriculture-re lated credit needs, w h ile the other provides mortgage credit to assist farmers and other residents of rural areas to buy their own homes. Unlike the FHA and VA, which insure or guarantee loans made by private lenders at interest rates approximating the market rate of interest, the FmHA makes loans directly to the borrower, at subsidized interest rates, with funds provided by the U.S. Treasury 15 The Problem. A 1988 General Accounting Office (GAO) study has dis covered serious deficiencies in the FmHA loan program. The report no t es that whereas the outstanding volume of FmHA loans increased by 400 per cent between 1976 and 1987, the amount of delinquent payments over that period increased by a staggering 4,300 percent, from $164 million to about $7 billion. Of the $26.2 billion o f loans outstanding at the end of 1987, some 12.8 billion was in default. A disturbing $6.7 billion of this amount had been in default for more .than-three years.1~~~resultinglosses are expected to be significantly more than this. According to the report A l though implementing regulations have not been finalized, FmHA has estimated that approximately 16,200 of its farm borrowers will be eligible for the loan write-down, with about $2.1 billion of debt being written off as a loss. In addition, loan losses fro m other borrowers who will be unable to show repayment of debt even after write-down are es timated at about $6.7 billion. As a result, FmHA es timates total potential losses to be about $8.7 billion by fiscal year 1990.1 As a result of these and other los s es, the FmHA agriculture credit revolv ing fund is estimated to have a negative net worth of $28 billion.18 Unfor tunately, this is not the only taxpayer cost of the program.The same GAO report estimates that FmHA agriculture borrowers received interest r a te sub sidies valued at between $612 million to $1.6 billion over and above the direct costs associated with the high rate of defaults the farm program, but still substantially worse than any of the government's other housing prograk. At the end of fiscal 1988, the FmHA had $26.9 bil lion in loans outstanding to finance homeownership and housing rental programs in rural areas. Section 502 of the 1949 Housing Act created the FmHA's largest subsidy program to finance the purchase of single family homes at de e ply subsidized interest rates. Under the 502 program eligible households with incomes below 80 percent of the median area income may borrow from the FmHA to purchase a home. The risk associated with these loans is particularly high, since no downpayment i s required and borrowers must demonstrate that-they cannot get credit from another source. Loans typi cally are written for 33 years, although they may be as long as 38.The interest The situation in the FmHA housing loan program is marginally better than 1 6 "Farmers Home Administration: Farm Loan Programs Have Become a Continuous Source of Subsidized Credit US. General AccoUntiag Olfice, GAO/RCED-89-3, November 1988, p. 9 17 lbid,p.36 18 1991 Budget, p. 240 16 rate on the loan is subsidized through an inter e st credit. This reduces the ef fective interest rate to as low as 1 percent. According to one sample survey the avera e effective interest rate on outstanding FmHA home loans is 3.4 percent, leading to an estimated subsidy cost of $98 million dollars for j ust those loans that will be made in fiscal 1990.20 18 What Needs to be Done Thehigh costs of-this program suggest-that .homeownership programs are an inappropriate and costly method of assisting low-income rural residents Thus no new FmHA loans should be originated and the existing portfolio should be allowed to wind down through repayments and loan amortization In non-rural areas, such households are assisted through vouchers, rental cer tificates, and other forms of low-income rental assistance. Voucher s are a proven, cost-effective method of providing housing assistance to the poor and the Reagan Administration proposed that a voucher program be sub stituted for the direct loan programs that have pushed too many of rural Americans deeply into debt, ruin i ng their credit rating and costing the tax payer billions. Regrettably, Congress has ignored this request and legislation to reauthorize the existing loan program is now before both the House and the Senate. The Bush Administration, by contrast, recommend s vouchers as a substitute for many of the rural housing loan programs.This recommendation should be supported 2) The Rural Electrification Administration The Program. The Rural Electrification Administration (REA) was created in 1935 to provide loans and l oan guarantees to rural cooperatives for the purpose of providing electrical service to farms. At that time only 12 per cent of the farms had electricity. But by 1964, some 98.1 percent of farms had service. Nonetheless, the program has continued to grow, despite the fact that its Depression-era mission was largely accomplished a quarter of a century ago.

The REA offers two types of credit assistance to eligible borrowers: 100 percent government-guaranteed loans and direct loans with 5 percent inter est ra tes. Guaranteed loans are provided to eligible cooperatives by the Federal Financing Bank (FFB which is part of the U.S.Treasury, or from private lenders with the REA guaranteeing the full payment of principal and interest. The direct loans are made by th e REA to eligible electric coopera tives at a 5 percent interest rate, which is well below that on the guaranteed loans or on the loans a co-ops for-profit competitors must pay in private capi tal markets. As of the end of 1987, the latest year for which a c curate figures are available from OMB documents, there were $22.6 billion in outstanding 19 A Home of Our Own: The Costs and Benefits of the Rural Homeownership Program, A Publication of the Housing Assistance Council, 1988, p. 39 20 OMB, Special Analysis F, 1990, p. F-42. guaranteed loans, most of which were held by the FFB.There were another 13.1 billion in direct loans held by the REA The Problem. In 1988, a special report prepared by the Reagan Ad ministration estimated the cumulative cost of subsidies at about $18 billion between 1973 and 19

86. In addition to this costly subsidy, REA loans have ex perienced a relatively high default rate. Of the more than 20 billion in guaranteed loans outstanding between $8 billion and $9 billion have gone into default.

Beyond the usual problems associated with the bad credit risks typical of federal credit programs, the REA confronts a special challenge in the form of a required 1993 repayment of an interest-free loan from the U.S.Treasuxy.

The REA revolving loan is drifting toward insolvency because of the sharply mounting costs of the deeply subsidized 2 percent and 5 percent loans.

Without substantial reforms, and with this interest-free loan coming due, a major taxpayer bailout will be needed to allow REA to continue operations.

This year, Congress has appropriated approximately $320 million to cover loan payment defaults.

What Needs to Be Done Recognizing that the program has long since achieved its goals and that the continued federal assistance is both cost ly and unjustified, the Reagan Ad ministration proposed reducing the level of taxpayer support by replacing the direct REA loans and the 100 percent guaranteed FFB loans with 70 percent and 80 percent guaranteed loans from private sector lenders?l The Bus h Ad ministration resubmitted the proposal, proposing 70 percent and 90 percent guarantees. Congress should enact legislation to accomplish these reforms, in cluding other steps that ultimately make the co-ops entirely reliant on private sector sources of c redit 3)The Farm Credit System The Program. The Farm Credit System (FCS) has its origins inthe Farm Loan Act of 1916, and took on its current form in 1933.The FCS was substan tially reorganized in 1987 in response to rising loan losses and the threat of i n solvency. Until then it had comprised four major entities:.the Farm Credit Administration (a federal agency) and three separate privately-owned but government-sponsored enterprises -Banks for Cooperatives,-Federal Inter mediate Credit Banks, and Federal Land Banks.

The Problem. Although they are privately-owned GSEs, government spon sorship bestowed significant benefits upon the three farm lending institutions within the Farm Credit System. As is generally the case with GSE's, FCS was provided with a line of credit at theTreasury, made.exempt from federal state and local taxes, made eligible for Federal Reserve open market pur 2l hid, p. F-19 18 chases, given equal standing withTreasury debt as qualified investments for banks, made exempt from Securities a nd Exchange Commission registration and could be treated as collateral for public deposits. With these advantages the banks of the FCS were able to offer below-market rates to their bor rowers and attract business away from their private sector competitor s Thanks to the privileged and subsidized position of the banks, outstanding farm real estate loans held by federal land banks increased by a staggering 588 percent-between-1970 and J983,ampared.with only 272 percent for all farm real estate loans.

This su rge in lending by the land banks displaced billions of dollars of privately-available credit and exposed the federal government to enormous risk. When crop prices fell in the early 1980s so did farm incomes and the value of farm land, the collateral secur i ng the land banks loans. Losses began to mount at many of the Systems banks, and a poorly conceived bailout in 1985 failed to stem the red ink. When the FCS lost $1.9 billion in 1986, emer gency bailout legislation was prepared and signed into law in earl y 19

88. A recen estimate places the total taxpayer cost of the bailout at about $2.9 bil lion.

Although the bailout resolved the short-run problem facing the FCS by in jecting substantial amounts of cash into the system, the structural reforms included i n the measure could further weaken the agriculture credit market exposing farmers, government, and taxpayers to even greater risks in the fu ture.This is because the bailout legislation increased the governments ex plicit liability for the new loans exten ded to the system and created a new federal enterprise that requires the federal government to guarantee the pay ment of principal and interest on new loans extended to farmers by private lenders.

The 1988 legislation also created two new government-sponso red enterprises that will increase the federal governments involvement in agricul ture lending and thus expose the taxpayer to larger losses. These institutions are the Farm Credit Assistance Financial Corporation (FAC) and the Federal Agriculture Mortgag e Corporation (FAMC or Farmer Mac receive capital beyond what it can borrow on its own -particularly for those FCS institutions whose loss-ridden loan portfolios preclude them from bor rowing in private capital markets. Obligations issued by the FAC a e th e guarantee of the federal government, and the U.S. Treasury will pay all or part of the interest cost on most of FACs debt for the next ten years. For those System lenders not eligible for FAC loans because they maintained their financial integrity during the recent period of adversity, the Act will reward them by creating the Farm Credit System Insurance Corporation, a federal agency that will insure all of their debt 0bligations.Thus with one pro 24 The FAC will provide the financing mechanism through wh i ch the FCS can 22 hid, p. F-23 to F-27 19 gram or the other, the federal government can now guarantee explicitly all obligations issued by the many lending institutions that comprise the Farm Credit System As disturbing as this extension of coverage may b e , the FAMC poses an even larger potential risk to the government, the farmer, and the taxpayer The FAMC was established to guarantee the timely repayment of principal and interest on pools of farm mortgages and certain rural housing loans originated by th e FCS banks, commercial banks, savings and loark, and in surance companies. But this will encourage private lenders to make more farm mortgage loans at lower credit standards, since the risk can be trans ferred to the taxpayer. The bailout legislation make s it possible for the vast majority of loans extended to farmers, regardless of source to be insured or guaranteed by the federal government.

Although future risks pervade the new program, the agriculture credit sys tem has improved markedly over the past few years. Farm debt has declined 30 percent since 1983, largely as a consequence of write-offs, and agriculture sector debt-to-equity ratios have declined from 31 percent in 1985 to 22 per cent today What Needs to be Done With the agriculture debt situation of the recent past now largely resolved efforts should be undertaken to diminish gradually the federal role and to en courage more private sector involvement. The 1987 bailout should be viewed as a short-term expedient and the institutions it created should be reduced in scope or transferred to the private sector 4) The Federal Crop Insurance Program The Program. There are several other, sma l ler farm credit and insurance programs that also suffer from relatively high loss rates. For example, the federal crop insurance program (FCIC) was created in 1980 to allow farmers to insure their crops against a variety of natural hazards such as drought and hail The Problem. The FCIC is heavily subsidized with losses and administra tive costs consistently exceeding income. Yet farmer participation has never exceeded 30 percent, in large part because congress h_as always showed a will ingness to bail out farmers regardless of whether they have made &e effort to obtain insurance against such losses. In 1989 the insurance in force was $13 billion and this years loss is expected to be as high as $250 million.

What Needs to be Done Congress should either subst antially reform the program so that premium income matches expected losses, or terminate the program and rely on the ex isting discretionary authority to compensate farmers for losses experienced as a consequence of natural disasters.

GROUP 1II: OTHER MAJ OR INSURANCE AND GUARANTEE PROGRAMS When large segments of the banking industry began to fail during the Great Depression, thousands of depositors lost their lifes savings and credit became unavailable in many communities. Confronted with the risk that de p ositors throughout the country would panic and withdraw their funds from all banks and thrifts, thereby jeopardizing the entire financial system the government responded by creating a system to provide federal insurance to depositors to eliminate the thre a t of a nationwide run on the banks As long as the insured institutions were confined to a narrow range of in vestments offering limited risk, the system worked reasonably well and all los ses were more than covered by the insurance premiums paid by the de p ository institutions. However, when the deregulation process gave banks and S&Ls more freedom to choose their investments, the continued exist ence of federal deposit insurance encouraged the unscrupulous or incom petent managers to take irresponsible ris k s with the knowledge that the government would pick up the pieces and cover the 1osses.This asymmetry of responsibility was one of the key reasons for the S&L debacle I) The Federal Deposit Insurance Corporation The Program. In an effort to stabilize Amer icas financial system during the Depression and restore confidence in depository institutions, Congress enacted the Banking Act of 19

33. Among its many provisions, the Act created the Federal Deposit Insurance Corporation (FDIC) to insure, up to a specifi ed limit (now 100,000 per depositor), deposits held at commercial banks. In 1935, similar coverage was extended to deposits at the savings and loan associations by the creation of the Federal Savings and Loan Insurance Corporation (FSLIC The National Cred i t Union Administration (NCUA also was created to insure deposits at federally-insured credit unions As of the end of 1989, these three federal agencies had insured a total of nearly $2.9 trillion of deposits, with $1,806 billion of this amount at commer c i al banks covered by the FDIC 958.9 billion at savings and loans covered by the FSUC, and $161 billion at credit unions and insured by NCUAThe financial institutions pay the appropriate insuring agency a flat-rate fee repre senting a percentage of their de posits.

The Problem. Confidence in the federal deposit insurance system was shaken when the extensive failures in the savings and loan industry vastly ex ceeded the reserves of the FSLIC, causing it to seek huge infusions of cash from the U.S. Treasury, th e remaining S&Ls, and the taxpayer. Between now 21 and 1999, the total cost of the bailout is estimated to fall somewhere in the range of 150 billion to $300 billionu Although the commercial banking system had at first managed to escape the problems confr o nting its sister industry, solvency problems are beginning to emerge and there is growing concern regarding the ability of the FDIC to fulfill its obligations during a sustained period of financial stress Although thmumber of problem banks dropped to 1,39 4 in 1988 from a peak of 1,575 in 1987, the 200 banks failing that year and the 22 that required financial assistance cost the FDIC $7.3 billion, leading to the first-ever loss ex perienced by the agency. Another 206 banks failed in 1989, costing the FDIC 4.1 billion.The FDICs reserves fell from $18.3 billion in 1987 to $16.3 bil lion at the end of 1988 and to $14.3 billion by 19

89. Reporting on its most recent audit of the FDIC, the GAO concludes that [Tlhe ratio of the FDICs insurance fund balance to ins ured deposits declined to the lowest level ever estimated by the Corporation to be 0.83 percent.24 Recent reports by the GAO and the Office of Management and Budget OMB) offer only qualified support for the view that the worst is behind the FDIC. In its A pril 1989 audit, the GAO notes that The Corporation an ticipates it will have net income in 19

89. However, a downturn in the North east or Southeast or increasing interest rates could result in additional in surance costs to the Corporation Although the G AO was accurate in its predictions, in the next paragraph the GAO notes that In spite of the sig nificant number of bank failures and the potentially adverse conditions which could affect the Corporation, we believe tha it has sufficient funds to handle c u rrent and short-term identifiable needs. Earlier in 1989, OMB had also expressed a cautious view, when it noted in the Presidents 1990 Budget that U.S. banks recorded healthy profits in 1988, after a year of extraordinary los ses. Nevertheless, concerns r e main. Increased levels of nonperforming bank assets in 1988 represent a potential future danger sign. In addition, the FDIC has become increasingly concerned as banks and other institutions appear to Two reports by private analysts, however, express a les s optimistic view than either of these two government agencies. The Shadow Financial Regulatory Committee, an unofficial group of leading banking experts from business and academia, concluded in a late 1988 report that if the FDIC be increasing their conce n tration in high-yield, high-risk junk bon ds 26 23 R. Dan Brumbaugh, Jr Andrew S. Carron, and Robert E. Litan, Cleaning Up the Depository Institutions Mess, Bmkings Pap on Economic Activity k1989, p. 261 24 Ticial Audit: Federal Deposit Insurance Corporat ions 1988 and 1987 Financial Statements, General AccoUnting Office, GAOlAFMD-89-63, April 1989, p. 6 25 lbid,p.7 26 Special Analysis, Budet of the United States Govemmenf, Fiscal Year 1990 (Washington, D.C=.US.

Government Printing Office, Jan~ary 1989 p. F -35 22 were to experience losses that would not be unreasonable to anticipate in view of its recent loss experience and problem b nk estimates, the FDICs reserve balance would be exhausted at present. Using historic failure rates for both problem and nonp roblem banks, and relating these rates to the volume of bank assets at risk and the likely resolution costs, the Shadow Com mittee estimates the total of FDIC booked and unbooked losses at $21.3 billion, an amount exceeding current FDIC reserves.

Even more pessimistic than the Shadow Comniittee is CleaningUp the Deposit Mess, a 1989 report by three private sector economists.The economists question the view that the worst is behind the FDIC, contending that Given the large number and asset size of weak bank s , the extent to which GAAP accounting techniques (Generally Accepted Accounting Prin ciples) hide market value losses, and the potential for rapid asset deteriora tion, it is possible that losses in the commercial banking industry could eclipse those of t he thrift industry, especially if the economy ent rs a reces sion before the weak capitalization of many banks is corrected.

The authors conclusion is based on an analysis of the banking industrys balance sheet and their argument that many banks are very t hinly capitalized having actual reserves below 3 percent of assets.They note that in addition to the approximately 400 banks closed in 1987 and 1988, another 28 large banks with $22.5 billion in assets were still open and insolvent in late 1988, and a fur ther 48 banks holding $43 billion in assets had capital ratios below 3 per cent under GAAP.

Although the potential risk is considerable, any effort to estimate likely los ses and costs are highly speculative and depend heavily upon the projected economic o utlook over the next several years. Nonetheless, the risk is there and much of it follows directly from fundamental flaws in the way the govern ment operates the de osit insurance system. Reviews of the issue by Heritage Foundation analysts conclude that t he problem stems from the fact that depository institutions, particularly the poorly supervised thrifts, have been able to engage in reckless business activities because the federal deposit in surance system takes no account of the riskiness of an institu t ions invest ments when setting premiums. In fact, because institutions making riskier in vestments generally offer higher deposit rates, depositors actually are en couraged to keep their money in them because they are secure in the knowledge that the gove r nment will bail them out if the institution fails. In deed, this perverse incentive is one of the chief reasons why the cost of the S&L bailout grew so rapidly between 1987 and 1989 9 2f 27 Statement of the Shadow Financial Regulatory Committee on the Nee d to Estimate theTrue Economic Condition of the FDIC, Statement No. 36, December 5,1988, p. 1 28 Brumbaugh, op. ci p. 250 29 James L Gattuw, and Dana Joel, Only Structural Reform Can Solve the Long-Term Savings and Loan Crisk, Heritage Foundation Buckpvund er Update No. 92, January 27,19

89. See also Bert Ely, Confronting the Sa- and Loan Industry Crkis, Heritage Foundation Issue Bulletin No. 126, August 13,1986 23 What Needs to be Done Several important reforms have been proposed to reduce the taxpayers ex posure to deposit insurance risks Under one plan, deposit insurance premium rates would rise with the de gree of risk associated with the loans and investments in an institutions portfolio This would force institutions undertaking riskier investments to p ay much higher insurance rates than thosepursuing more conservative invest ment strategies.This would provide better protection for taxpayers and dis courage reckless investment.

Another alternative proposes that the amount of deposit insurance avail able per depositor should be limited to something much less than $100,000 This would improve the current system both by diminishing the outstanding liability assumed by the government and by forcing larger individual depositors to pay more attention to the sou n dness of the institution where they keep their money, just as investors consider the quality of a mutual fund or individual stock when making an investment. For most Americans with only a few thousand dollars in bank deposits, there would be no change: th e y would be fully insured and would not have to worry about the quality of the management of their local bank But even larger depositors would not have to check out each institution It would be unreasonable to expect a typical bank depositor to make inde p e ndent judgments about his or her commercial bank. But in practice rating services such as Standard and Poors, and Moodys would do the work for each depositor in much the way they assess the risk associated with marketable debt instruments. Thus, depositor s could select among triple A or double B banks much as they choose that combination of risk and reward most suitable for other investments.

A third alternative would place a much greater reliance on the resources of the banking system through a system of cross-guarantees. Under this plan the combined reserves of the banking system would serve as the first line of defense against the failure o f any individual bank. FDIC insurance would serve as a back-up in the unlike1 event that a credit crisis exhausted the reserves of the banking system.

Although each of these plans could improve the system, the cross-guaran tee proposal holds the greatest p romise because it would greatly diminish the role of the federal government and create a powerful set of incentives to in duce the banking system to move quickly against those banks whose inept lending practices jeopardize the collective resources of the system d 30 ~ert Ely, MakingDqmit Insumnce Sofe 2bugh 1- oars-Guomntc Washington, D.C National Chamber Formdation, May 1990).

I 2) The Guaranteed Student Loan Program The Program. The Guaranteed Student Loan Program (GSL now referred to in statute as the Stafford Student Loan Program, was created in 1965 to provide financial assistance for students seeking higher education.

Students qualify for GSLs if they are enrolled .at least half time in an eligible institution of higher education or a vocational scho ol. Undergraduates may borrow up to 2,625 in their.first two yearsof schools. Providing they have completed two years, they may borrow up to $4,000 for each succeeding year.

But the maximum amount they may borrow for undergraduate education is 17,2

50. T he actual loans are made by private lenders -mostly depository in stitutions at interest rates subsidized by the federal government.The $12.6 billion in new GSLs expected to be granted in 1990 are projected to entail an interest rate subsidy of just over $ 3.7 billion over the life of the loans The Problem. By the early 1980s, the deep interest rate subsidy and the ab sence of any household income limits on eligibility made GSLs the most at tractive method of financing a college education or vocational trai n ing In 1980 the dollar volume of new student loans granted was equivalent to more than half the amount of tuition received by all colleges and universities?l Some income constraints have since been imposed and the new loan volume is now below 40 percent o f total tuition revenues. Currently, there is $48 bil lion in outstanding GSLs.

The chief problem now confronting the program is an excessive default rate. Loan losses have been rising sharply in recent years. Realized losses reached 1.4 billion in 1988, s oared to $1.9 billion for 1989 and losses are ex pected to exceed $2 billion in 1990 There are a variety of reasons for this sharp increase. One is the advent of fly-by-night" vocational schools that induce unsuspecting individuals to sign up for instruct i onal programs of dubious value and excessive tuition costs by emphasizing that costs will be covered by the GSL program. Upon gradua tion if they make it that far, many of these poorly-trained students often fail to hd adequately-paid employment and defau l t on their loans. At. one techni cal school in Baltimore, Maryland, the default rate was a staggering 83 per cent on the outstanding loans of its students. The former students of many community colleges experience default rates in excess of 50 percent.The for profit trade schools have average default rates of 40 percent, compared with 9 percent at four-year instituti~ns What Needs to be Done In response to the problem, the U.S. Department of Education released new regulations last year designed to force re f orms at those schools with the highest default rates. These schools will be required to reduce their student 31 StcrtisricalAbstmct, Tables No. 257 and No. 259, p. 153 and l54 32 "A Governmental T' Awaits Schools Lax on Student Loan Defaults me Wushhgton P an, June 2,l989 25 1 default rate gradually over several years or face restrictions on the availability of GSL loans to finance tuition This is an inadequate response to the problem; institutions with dihl records will continue to receive federal credit s upport while still providing an inadequate education to young Americans. Many of these schools are nothing more than taxpayer-financed scams that prey on the disadvantaged, leaving them with a poor education and thousands of dollars in debt.

To cut the def ault rate, save the taxpayer more than a billion dollars, and limit the harm to future students, the Department of Education should modi& its existing regulations to require all schools with default rates in ex cess of 30 percent to post a bond equal to t h e dollar volume of defaulted loans in excess of the 30 percent cutoff. Without the bond, these schools would be ineligible to participate in the GSL program. As the school's default rate declined, portions of the bond would be returned to the school. But i f there were to be no progress, the bond would be used to cover defaults in ex cess of the cutoff, and additional bonding would be required to maintain eligibility for GSLs. This potentially costly requirement quickly would force the sham schools out of b u siness. Over time, the 30 percent rate could be reduced to 15 percent, ensuring that the schools that remain in operation are those with a demonstrably positive effect on the careers of their students 3) The Pension Benefit Guarantee Corporation tablished in 1974 underTitle IV of the Employee Retirement Income Security Act (ERISA to protect workers' pension plans when private pen sion trusts are terminated without sufficient assets to meet their commit ments.The insurance program is funded by premiums paid by the defined benefit pension plans covered by the program.The PBGC's liability reached 820 million in 1989.

The Problem. Initially it was believed that a premium of $1.00 per par ticipant per year would be sufficient to provide the revenue needed to bui ld reserves and cover PBGC 1osses.This turned out to be wildly optimistic, and in 1986 the premium was hiked sharply to $8.50 per participant. But even this was insufficient, and the premium was raised yet again in 19

87. Single employer plans now can fac e premiums ranging from $8.50 to $16.00 but a variable charge of up to $34 per partkipant can be levied depending upon a plan's unfunded vested benefits his change in premium structure is an important precedent for federal in surance programs, because it m arks the introduction of a risk-based premium structure in which higher risk participants have to pay higher premiums in order to remain eligible. This could have significant benefits if applied to other programs such as the federal deposit insurance syst ems.

Despite this important reform, and a June 18 ruling by the Supreme Court giving the PBGC the power to force certain employers to take back the responsibility for their troubled pension programs, the corporation still is in The Program. The Pension Ben efit Guaranty Corporation (PBGC) was es 26 trouble, and the taxpayer exposed to potentially huge bailout costs. By 1989 the cumulative PBGC deficit had risen to between $3 billion and $4 billion although that is not reflected it its published reports Even more troubling is information contain d in a 1989 report of the Inspector General at the Department of Labor! According to this report, a series of administrative management and supervisory failings on the part of Departments bureau has seriously jeopardi z ed the well-being of the many pension plans for which the government has ultimate responsibility. The Inspector General made a series of recommendations for better reporting and greater reliance on inde pendent public auditors to maintain close surveillan c e over the plans In that report, the Inspector General stated that the burden of insuring and protecting failed benefit plans will fall upon all taqayers, not just the plan beneficiaries and parties, since the PBGC in the final insurer of these plan as- s e ts. Unless steps are taken now odays S&L bailouts may become tomorrows ERISA nightmare. These remarks were prophetic. In recent testimony to Congress, the PBGCs Executive Director stated that the in- surance funds deficit could rise to $8 billion in the n e ar future as a result of looming corporate bankruptcies.36 What Needs to be Done The Department of Labor should be instructed to hire an independent con sultant to measure the risks and to determine whether the existing premium and supervisory system are s ufficient to keep these risks at a minimum. Until such time as this comprehensive review is completed, the PBGC should fol low the advice of the Department of Labors Inspector General by estab lishing better and more comprehensive auditing procedures. The Inspector General recommends that this task be contracted out to experienced, inde pendent audit firms. In addition, Congress should give the PBGC more flexibility in setting its premium so that revenues cover losses and expenses on a sustained basis e 33 The PBGC reported a cumulative deficit of $1.781 billion in 1986 but then reduced it to $1.480 billion in 1987 based on the attempt to shift the LTV pension obligation back to the company. LTV is a steel producer that 6led for bankruptcy several years ago . LTV has refused to accept the obligation. The issue has gone to court twice and the PBGC has lost on both occasions. Unfunded liabiities of $2.2 billion is at stake and if the PBGC losses on appeal this amount would be added back to the accumulated defic it 34 SemipnnudReport, wce of Inspeclor GenM US. Deporbnmt of trrbar: Odober 1, l988 March 31,1989 Washington, D.C, 1989 36 Fd Swaboda, Tension Fund Called Vulnerable, 7he Wmfigtm Past, June 14,1990 35 Ibid,p.3 21

About the Author