7. CREDIT AND INSURANCE
Federal credit programs offer direct loans and loan
guarantees for a wide range of activities, primarily
housing, education, business and community development,
and exports. At the end of 2004, there were $219
billion in Federal direct loans outstanding and $1,231
billion in loan guarantees. Through its insurance programs,
the Federal Government insures bank, thrift,
and credit union deposits, guarantees private definedbenefit
pensions, and insures against other risks such
as natural disasters, all up to certain limits.
The Federal Government also enhances credit availability
for targeted sectors indirectly through Government-
Sponsored Enterprises (GSEs)—privately owned
companies and cooperatives that operate under Federal
charters. GSEs increase liquidity by guaranteeing and
securitizing loans, as well as by providing direct loans.
In return for serving social purposes, GSEs enjoy many
privileges which differ across GSEs. In general, GSEs
can borrow from Treasury in amounts ranging up to
$4 billion at Treasury’s discretion, GSEs’ corporate
earnings are exempt from State and local income taxation,
GSE securities are exempt from SEC registration,
and banks and thrifts are allowed to hold GSE securities
in unlimited amounts and use them to collateralize
public deposits. These privileges leave many people
with the impression that GSE securities are risk-free.
GSEs, however, are not part of the Federal Government,
and their securities are not federally guaranteed.
By law, GSE securities carry a disclaimer of any U.S.
obligation.
This chapter discusses the roles and risks of these
diverse programs in the context of evolving financial
markets and assesses their effectiveness and efficiency.
• The first section analyzes the roles of Federal
credit and insurance programs. Federal programs
play useful roles when market imperfections prevent
the private market from efficiently providing
credit and insurance. Financial evolution has partly
corrected many imperfections and generally
weakened the justification for Federal intervention.
The roles of Federal programs, however, may
still be critical in some areas.
• The second section examines how credit and insurance
programs were gauged by the Program Assessment
Rating Tool (PART) and discusses special
features of credit programs that may need
to be considered in interpreting and refining this
tool.
• The third section discusses Federal credit programs
and GSEs in four sectors: housing, education,
business and community development, and
exports. The discussions focus on program objectives,
recent developments, performance, and future
plans for each program.
• The final section reviews Federal deposit insurance,
pension guarantees, disaster insurance, and
insurance against terrorism and other security-related
risks in a context similar to that for credit
programs.
I. FEDERAL PROGRAMS IN CHANGING FINANCIAL MARKETS
The Federal Role
In most cases, private lending and insurance companies
efficiently meet societal demands by allocating resources
to the most productive uses. Market imperfections,
however, can cause inadequate provision of credit
or insurance in some sectors. Federal credit and insurance
programs improve economic efficiency if they effectively
fill the gaps created by market imperfections.
On the other hand, Federal credit and insurance programs
that have little to do with correcting market
imperfections may be ineffective, or can even be
counter-productive; they may simply do what the private
sector would have done in their absence, or interfere
with what the private sector would have done better.
Federal credit and insurance programs also help
disadvantaged groups. This role alone, however, may
not be enough to justify credit and insurance programs.
For the purpose of helping disadvantaged groups, direct
subsidies are generally more effective and less
distortionary.
Market imperfections that can justify Federal intervention
include insufficient information, limited ability
to secure resources, imperfect competition, and
externalities.
Insufficient Information. Financial intermediaries
promote economic growth by allocating credit to the
most productive uses. This critical function, however,
may not be performed effectively when there is little
objective information about borrowers. Some groups of
borrowers, such as start-up businesses, start-up farmers,
and students, have limited incomes and credit histories.
Many creditworthy borrowers belonging to these
groups may fail to obtain credit or be forced to pay
excessively high interest. Government intervention,
such as loan guarantees, can reduce this inefficiency
by enabling these borrowers to obtain credit more easily
and cheaply and also by providing opportunities for
lenders to learn more about those borrowers.
Limited Ability to Secure Resources. The ability
of private entities to absorb losses is more limited than
86 ANALYTICAL PERSPECTIVES
that of the Federal Government, which has general taxing
authority. For some events potentially involving a
very large loss concentrated in a short time period,
therefore, Government insurance commanding more resources
can be more credible and effective. Such events
include massive bank failures and some natural and
man-made disasters that can threaten the solvency of
private insurers. Private entities also face some liquidity
constraints. Small lenders operating in a local market,
for example, may have limited access to capital
and occasionally be forced to pass up good lending opportunities.
Imperfect competition. Competition is imperfect in
some markets because of barriers to entry, economies
of scale, and foreign government intervention. If the
lack of competition forces some borrowers to pay excessively
high interest on loans, Government credit programs
aiming to increase the availability of credit and
lower the borrowing cost in those markets may improve
economic efficiency.
Externalities. Decisions at the individual level are
not socially optimal when individuals do not capture
the full benefit (positive externalities) or bear the full
cost (negative externalities) of their activities. Examples
of positive and negative externalities are education and
pollution. The general public benefits from the high
productivity and good citizenship of a well-educated
person and suffers from pollution. Without Government
intervention, people will engage less than socially optimal
in activities that generate positive externalities and
more in activities that generate negative externalities.
Federal programs can address externalities by influencing
individuals’ incentives.
Effects of Changing Financial Markets
Financial markets have become much more efficient,
thanks to technological advances and financial services
deregulation. By facilitating the gathering and processing
of information and lowering transaction costs,
technological advances have significantly contributed to
improving the screening of credit and insurance applicants,
enhancing liquidity, refining risk management,
and spurring competition. Deregulation, represented by
the Riegle-Neal Interstate Banking and Branching Act
of 1997 and the Financial Services Modernization Act
of 1999, has increased competition and prompted consolidation
by removing geographic and industry barriers.
These changes have reduced market imperfections,
and hence weakened the role of Federal credit and insurance
programs. The private market now has more
information and better technology to process it, has
better means to secure resources, and is more competitive.
As a result, the private market is more willing
and able to serve the populations traditionally targeted
by Federal programs. The benefits of technological advances
and deregulation, however, have been uneven
across sectors and populations. To remain effective,
therefore, Federal credit and insurance programs need
to focus more narrowly on those sectors that have been
less affected by financial evolution and those populations
that still have difficulty in obtaining credit from
private lenders. The Federal Government also needs
to pay more attention to new challenges introduced by
financial evolution and other economic developments.
Even those changes that are beneficial overall often
bring new risks and challenges.
The Federal role of alleviating the information problem
is generally not as important as it once was. Nowadays,
lenders and insurers have easy access to large
databases, powerful computing devices, and sophisticated
analytical models. This advancement in communication
and information processing technology enables
lenders to evaluate the risk of borrowers more objectively
and accurately. As a result, creditworthy borrowers
are less likely to be turned down, while highrisk
borrowers are less likely to be approved for credit.
The improvement, however, may be uneven across sectors.
The prevalence of credit scoring (an automated
process that converts relevant borrower characteristics
into a numerical score indicating creditworthiness) is
a good sign that the information problem is not serious.
Credit scoring is widely applied to home mortgages and
consumer loans, but for small business loans and agricultural
loans, its application is largely limited to small
loans. Credit scoring is still difficult to apply to some
borrowers with unique characteristics that are difficult
to standardize.
Financial evolution has also alleviated resource constraints
faced by private entities. Advanced financial
instruments have enabled lenders and insurers to manage
risks more effectively and secure needed funds
more easily. Thus, it is less likely that a large potential
loss discourages an insurer from offering an actuarially
fair contract or that the lack of liquid funds prevents
a lender from lending to creditworthy borrowers. Financial
derivatives, such as options, swaps, and futures,
have improved the market’s ability to manage and
share various types of risk such as price risk, interest
rate risk, credit risk, and even catastrophe-related risk.
An insurer can distribute the risk of a natural or manmade
catastrophe among a large number of investors
through catastrophe-related derivatives. The extent of
risk sharing in this way, however, is still limited because
of the small size of the market for those products.
Securitization (pooling a certain type of asset and selling
shares of the asset pool to investors) facilitates fund
raising and risk management. By securitizing loans,
even a lender with limited access to capital can make
a large amount of loans while limiting its exposure
to credit and interest risk.
Imperfect competition is much less likely in general,
thanks to financial deregulation and improved communication
technology. Financial deregulation removed geographic
and industry barriers to competition. As a result,
major financial holding companies offer both banking
and insurance products nationwide. Internet-based
financial services have lowered the cost of financial
transactions and reduced the importance of physical
location. These developments have been particularly
87 7. CREDIT AND INSURANCE
SUMMARY OF PART SCORES
Purpose
and
Design
Strategic
Planning
Program
Management
Program
Results
Credit and Insurance Programs
Average ......................................................... 0.773 0681 0.853 0.541
Standard Deviation ........................................ 0.207 0.222 0.215 0.165
Other Programs (all others excluding credit
and insurance programs)
Average ......................................................... 0.865 0.723 0.805 0.463
Standard Deviation ........................................ 0185 0.246 0.185 0.269
more beneficial to small and geographically isolated
customers, as lower transaction costs make it easier
to offer good prices to small customers. In addition,
there are more financing alternatives for both commercial
and individual borrowers that used to rely heavily
on banks. Many commercial firms borrow directly in
capital markets, bypassing financial intermediaries; the
use of commercial paper (short-term financing instruments
issued by corporations) has been particularly notable.
Venture capital has become a much more important
financing source for small businesses. Finance
companies have gained market shares both in business
and consumer financing.
Problems related to externalities may persist because
the price mechanisms that drive the private market
ignore the value of externalities. Externalities, however,
are a general market failure, rather than a financial
market failure. Thus, credit and insurance programs
are not necessarily the best means to address
externalities, and their effectiveness should be compared
with other forms of Government intervention,
such as tax incentives and grants. In particular, if a
credit program was initially intended to address multiple
problems including externalities, and those other
problems have been alleviated, then there may be a
better way to address the remaining externalities.
Overall, the financial market has become more efficient
and safer. Financial evolution and other economic
developments, however, are often accompanied by new
risks. In addition, security-related risks unexpectedly
emerged in recent years, prompting Government intervention.
Federal agencies need to be vigilant to identify
and manage new risks to the Budget. For example,
financial derivatives enable their users either to decrease
or to increase risk exposure. If some beneficiaries
of Federal programs use financial derivatives to take
more risk, the costs of Federal programs, especially insurance
programs, can rise sharply. The sheer size of
some financial institutions has also created a new risk.
While well-diversified institutions are generally safer,
even a single failure of a large private institution or
a GSE, such as Fannie Mae, Freddie Mac, and Federal
Home Loan Banks could shake the entire financial market.
A more visible risk today is the Pension Benefit
Guaranty Corporation (PBGC) of the Department of
Labor. PBGC is facing serious financial challenges due
to unfavorable economic conditions in recent years and
to flaws in program structure.
The September 11 attacks have increased securityrelated
risks. The Federal Government had to intervene,
due to the reluctance of private insurers to offer
sufficient coverage. Managing insurance programs covering
security-related risks is challenging because security-
related events, such as terrorism and war, are
highly uncertain in terms of both the frequency of occurrence
and the magnitude of potential loss.
II. PERFORMANCE OF CREDIT AND INSURANCE PROGRAMS
The Program Assessment Rating Tool (PART) produces
an assessment of the performance of federal programs
designed to be consistent across programs. This
section analyzes the PART score for credit and insurance
programs as a group to identify the strengths
and weaknesses of credit and insurance programs.
PART Scores
The PART classifies performance into four categories
(program purpose and design, strategic planning, program
management, and program results) and assigns
a numerical score (0 to 100 percent) to each category.
The overall rating (effective, moderately effective, adequate,
ineffective, or results not demonstrated) is determined
based on the numerical scores and some other
factors.
There are 23 credit programs (defined as those involving
repayment obligations) and 3 insurance programs
among 607 programs that have been rated by
the PART. For the group as a whole, credit and insurance
programs have fairly similar PART scores to those
for other programs (see Table ‘‘Summary of PART
Scores’’). When appropriately weighted, higher scores
for credit and insurance programs in two categories
are roughly offset by lower scores in the other two
categories. The overall ratings for credit and insurance
programs, however, are more clustered around the middle;
the rating of ‘‘adequate’’ is much more common
for credit and insurance programs (48 percent, compared
with 25 percent for other programs), while the
ratings of ‘‘effective’’ (4 percent, compared with 15 percent
for other programs) and ‘‘results not demonstrated’’
88 ANALYTICAL PERSPECTIVES
(15 percent, compared with 30 percent for other programs)
are rarer. The clustering around the middle suggests
that most credit and insurance programs make
useful contributions, but need to improve their effectiveness.
Across categories, credit and insurance programs
show some similarities to other types of programs. For
most programs that have been rated by the PART, the
scores are relatively high for program purpose and design
and for program management, while the scores
are low for program results. This general pattern holds
for credit and insurance programs. Relative to other
programs, however, credit and insurance programs
scored low in program purpose and design and high
in program results.
The PART indicates that most credit and insurance
programs have clear purposes. Many credit and insurance
programs, however, fail to score high in program
design. Some are duplicative of other federal programs
or private sources, and some have flawed designs limiting
their effectiveness and efficiency. Flawed designs
are generally correctable. If some programs have become
redundant or duplicative of the private sector’s
activities due to financial evolution, however, those programs
need to be reviewed carefully. They may need
to be refocused on activities that have been affected
less by financial evolution, or to be discontinued.
In the program management category, while most
credit and insurance programs are strong in basic financial
and accounting practices, such as spending
funds for intended purposes, some programs show
weaknesses in more sophisticated financial management,
such as cost control. Overall, credit and insurance
programs are somewhat better in financial management
than other programs. Given that these programs
deal with highly complex financial problems,
however, credit and insurance programs may still need
to make significant improvements and show superior
performance in financial management.
Program results, the most important category of performance,
are a weak area for credit and insurance
programs, as well as for some other programs assessed
by the PART. A particularly troubling indication from
detailed analyses is that many credit and insurance
programs show deficiencies in program effectiveness
and achieving results. Based on this finding, the managers
of credit and insurance programs need to place
much more emphasis on results-driven management.
Common Features
Credit programs share many features that distinguish
them from other programs. For example, the cost
is uncertain because of various risks, such as default
risk, prepayment risk, and interest rate risk. Most credit
programs are also intended to address imperfections
in financial markets. These common features are discussed
in relation to the four areas of the PART. Although
this section focuses on credit programs, much
of the discussion also applies to insurance programs.
For example, the cost is uncertain for insurance programs,
too, because insured events occur unexpectedly.
Financial market imperfections are also the main justification
for insurance programs. Understanding common
features should help to interpret PART results
and to devise adequate steps to improve performance.
Program purpose and design. Program purposes
vary widely across credit programs. They include increasing
homeownership, increasing the number of college
graduates, promoting entrepreneurship, and promoting
exports. The private market serves some of
these distinctive purposes better now than it did in
the past. Thus, changes in financial markets may have
significantly affected the usefulness of some credit programs.
Examining the effect of financial evolution may
be a critical part of achieving effective reforms.
Credit programs share many critical elements of design.
They try to correct imperfections in financial markets
by making credit available to those borrowers who
would not be able to obtain credit at reasonable cost
without government assistance. To target the right borrowers,
the program design needs to takes into account
various factors, such as borrowers’ incentives, accessibility,
the state of financial markets, and general economic
conditions. Credit programs also need to deal
with many complexities, such as screening borrowers,
servicing loans, and collecting defaulted loans. Given
these complexities, most credit programs may benefit
from the private sector’s expertise. To be effective, however,
partnership with the private sector should be designed
such that the private partner’s profit is closely
tied to its contribution to increasing the program’s effectiveness
and efficiency. Private lenders are generally
better at screening borrowers, but their incentive to
screen borrowers effectively evaporates if the Government
provides a 100-percent loan guarantee.
Strategic planning. Credit programs operate in
rapidly changing financial markets. Thus, an important
aspect of strategic planning for credit programs is to
adapt to changes in financial markets. To achieve maximum
efficiency, program managers need to adapt their
programs quickly to new developments. For example,
private lenders are more willing to serve many customers
to whom they did not want to lend in the past.
Thus, some Federal credit programs may find themselves
serving a narrower pool of riskier customers and
need to adjust their policies and cost estimates accordingly.
Quickly adopting new technologies is also important,
because financial institutions are increasingly applying
advanced technologies to risk management. Falling
behind, Federal credit and insurance programs can
be left with much riskier customers as private entities
attract better-risk customers away from Federal programs.
Program management. Credit programs face some
unique challenges. To assess how credit programs manage
the challenges, the PART adds two extra items
for credit programs; one item addresses managing risks
and the other addresses estimating the program’s cost
and risk. Credit programs share similar risks as does
the lending business. To manage those risks effectively,
89 7. CREDIT AND INSURANCE
program managers need to monitor the credit quality
of loans and practice tight financial management. For
credit programs, accurately estimating the program cost
is a critical element of effective management. The
cashflow is uncertain for credit programs; some loans
default, while some others are prepaid. Thus, the program
cost must be estimated based on the expected
default, prepayment, and recovery rates. An inaccurate
estimation would result in inadequate budgeting and
incorrect program evaluation.
Some other management issues are more important,
though not unique, for credit programs than they are
for other programs. Data collection, for example, is critical
for effective risk management and accurate cost
estimation. Effective risk management requires accurate
and timely information on loan performance. The
key ingredients of predicting loan performance are loan
performance histories and detailed data on borrower
and lender characteristics.
Program Results. The main difficulty in evaluating
program performance is measuring the net outcome of
the program (improvement in the intended outcome net
of what would have occurred in the absence of the
program). Suppose that an education program is intended
to increase the number of college graduates.
Although it is straightforward to measure the number
of college graduates who were assisted by the program,
it is difficult to tell how many of those would not have
obtained a college degree without the program’s assistance.
Credit programs face an additional difficulty of
estimating the program cost accurately. In evaluating
programs, the outcome must be weighed against the
cost. In the above example, the ultimate measure of
effectiveness is not the net number of college graduates
produced by the program but the net number per Federal
dollar spent on the program. Thus, an inaccurate
cost estimation would lead to incorrect program evaluation;
an underestimation (overestimation) of the cost
would make the program appear unduly effective (ineffective).
Results for credit programs need to be interpreted
in conjunction with the accuracy of cost estimation.
The net outcome of a credit program can change
quickly because it depends on the state of financial
markets, which are very dynamic. The net outcome can
decrease, as private entities become more willing to
serve those customers whom they were reluctant to
serve in the past, or it can increase if financial markets
fail to function smoothly due to some temporary disturbances.
Thus, the effect of financial evolution needs
to be analyzed carefully. A sub-par performance by a
credit program could be related to financial market developments;
the program might have failed to adapt
to rapid changes in financial markets, or its function
might have become obsolete due to financial evolution.
The program should be restructured in the former case,
and discontinued in the latter case.
PART Cross-Cut for Credit Programs
As one of the world’s largest lenders, with a portfolio of nearly $1.5 trillion in direct loans and loan guarantees,
the Federal Government has a great interest in efficient risk management. This need is even stronger when considered
in the context of the Government’s target borrower population: those whose risk profiles prevent them
from obtaining private credit on reasonable terms. Given the higher default probability and the substantial portfolio
size, lax management can result in a large increase in the cost to the Government. Thus, the Government
must adopt effective risk management techniques to keep defaults in check and increase recoveries when defaults
do occur.
At the same time, the Government must ensure that it is effectively serving its intended borrowers. A number of
credit program PART scores indicate that many agencies lack the data, processes, or overall understanding of the
credit lifecycle (origination, loan servicing/lender monitoring, liquidation, and debt collection) to achieve these
dual, and occasionally conflicting, goals.
Over the next year, OMB will conduct a PART cross-cut examining the major credit agencies’ programs. This effort
will be supported by a Credit Council comprised of OMB and agency representatives. The Council will identify
agency and private sector best practices that can be implemented across the major credit agencies, leading to
higher program and management efficiencies, budgetary savings, and improved PART scores.
III. CREDIT IN FOUR SECTORS
Housing Credit Programs and GSEs
The Federal Government makes direct loans, provides
loan guarantees, and enhances liquidity in the housing
market to promote homeownership among low- and
moderate-income people and to help finance rental
housing for low-income people. While direct loans are
largely limited to low-income borrowers, loan guarantees
are offered to a much larger segment of the population,
including moderate-income borrowers. Increased
liquidity achieved through GSEs benefits virtually all
borrowers in the housing market.
90 ANALYTICAL PERSPECTIVES
Federal Housing Administration
In June 2002, the President issued America’s Homeownership
Challenge to increase first-time minority
homeowners by 5.5 million through 2010. During the
first two and a quarter years since the goal was announced,
over 1.9 million minority families have become
homeowners. HUD’s Federal Housing Administration
(FHA) accounted for over 400,000 of these first-time
minority homebuyers through its insurance funds,
mainly the Mutual Mortgage Insurance Fund. FHA
mortgage insurance provides access to homeownership
for people who lack the traditional financial resources
or credit history to qualify for a home mortgage in
the conventional marketplace. In 2004, FHA insured
$107 billion in mortgages for almost 900 thousand
households. Over 70 percent of these were people buying
their first homes, many of whom were minorities.
For 2006, FHA is proposing two new mortgage programs
that reduce the biggest barriers to homeownership—
the down payment and impaired credit. The Zero
Down mortgage allows first-time buyers with a strong
credit record to finance 100 percent of the purchase
price and closing costs. For borrowers with limited or
weak credit histories, Payment Incentives initially
charges a higher insurance premium, but reduces the
borrower’s premiums once they have established a history
of regular payments, thereby demonstrating their
creditworthiness.
The program was evaluated under the PART. The
assessment found that the program is meeting its statutory
objective to serve underserved borrowers while
maintaining an adequate capital reserve. In 2004, 73
percent of FHA-insured loans were to first-time homeowners,
and 37 percent were to minority homebuyers.
However, the program lacks quantifiable annual and
long-term performance goals which measure FHA’s ability
to achieve its statutory mission. In addition, the
program’s credit model does not accurately predict
losses to the insurance fund, nor can FHA demonstrate
its ability to reduce fraud in the program.
In response to these findings, in 2006 FHA will establish
performance goals for the percentage of FHA Single
Family endorsements for first-time and minority homeowners,
and performance goals for fraud detection and
prevention. FHA will also continue development of a
credit model that more accurately and reliably predicts
claims costs.
VA Housing Program
The Department of Veterans Affairs (VA) assists veterans,
members of the Selected Reserve, and active
duty personnel to purchase homes as recognition of
their service to the Nation. The program substitutes
the Federal guarantee for the borrower’s down payment.
In 2004, VA provided $35 billion in guarantees
to assist 270,571 borrowers.
Since the main purpose of this program is to help
veterans, lending terms are more favorable than loans
without a VA guarantee. In particular, VA guarantees
zero down payment loans. VA provided 109,493 zero
down payment loans in 2004.
To help veterans retain their homes and avoid the
expense and damage to their credit resulting from foreclosure,
VA plans aggressive intervention to reduce the
likelihood of foreclosures when loans are referred to
VA after missing three payments. VA was successful
in 44 percent of its 2004 interventions, and its goal
is to achieve at least a 47 percent success rate in 2006.
Rural Housing Service
The U.S. Department of Agriculture’s Rural Housing
Service (RHS) offers direct and guaranteed loans and
grants to help very low- to moderate-income rural residents
buy and maintain adequate, affordable housing.
The single family guaranteed loan program guarantees
up to 90 percent of a private loan for low- to moderateincome
(115 percent of median income or less) rural
residents. The programs’ emphasis is on reducing the
number of rural residents living in substandard housing.
In 2004, over $4.5 billion in assistance was provided
by RHS for homeownership loans and loan guarantees;
$3.23 billion of guarantees went to 34,800
households, of which 30 percent went to very low- and
low-income families (with income 80 percent or less
than median area income).
For the section 502 guaranteed loan program, the
2005 appropriation bill increased the guarantee fee on
new loans to 2.0 percent. This was coupled with language
that would allow the guarantee fee to be financed
as part of the loan. The ability to finance the guarantee
fee is more in line with the housing industry, including
HUD and VA, and will allow more lower-income rural
Americans to realize the dream of home ownership.
The guarantee fee for refinance loans remains 0.5 percent.
The guarantee fees are expected to remain at
the same rate in 2006. Funding in 2006 stands at $3
billion for purchase loans, and $225 million for refinance
loans.
RHS programs differ from other Federal housing loan
guarantee programs. RHS programs are means-tested
and more accessible to low-income, rural residents. In
addition, the RHS section 502 direct loans offer extraordinary
assistance to lower-income homeowners by reducing
the interest rate down to as low as 1 percent
for such borrowers. The section 502 direct program
helps the ‘‘on the cusp’’ borrower obtain a mortgage,
and requires graduation to private credit as the borrower’s
income and equity in their home increases over
time. The interest rate depends on the borrower’s income.
Each loan is reviewed annually to determine the
interest rate that should be charged on the loan in
that year based on the borrower’s projected annual income.
The direct program cost is balanced between interest
subsidy and defaults. For 2006, RHS expects to
provide $1.0 billion in loans with a subsidy cost of
11.39 percent.
RHS also offers multifamily rental housing loans, and
loans and grants for farm labor housing. Direct loans
are provided to private, public, and non-profit borrowers
91 7. CREDIT AND INSURANCE
to construct, rehabilitate, and repair multi-family rental
housing for very low- and low-income residents, either
through general occupancy properties or elderly and
handicapped housing. To help achieve affordable rents,
the interest rate is subsidized to a level between 1
and 2 percent. Many very low- and low-income residents’
rents are further reduced to 30 percent of their
adjusted income through rental assistance grants. During
2006, $641 million for Section 521 rental assistance
will be directed primarily to continue existing commitments.
RHS recently received a contracted study that addressed
the preservation issues surrounding the over
40-year old program. A long-term initiative has been
shaped to address the revitalization of the 17,400-property
portfolio. During 2006, $214 million will be directed
to begin the revitalization initiative, primarily
to transition existing residents in properties leaving the
program. The $27 million loan program level for the
direct rural rental housing will be used to address repair
and rehabilitation needs of preservation worthy
properties. Additionally, the farm labor housing combined
grant and loan level will provide $56 million in
2006 for new construction as well as repair and rehabilitation.
RHS also guarantees multifamily rental
housing loans. RHS expects to be able to guarantee
$200 million in loans for 2006, which is double the
amount from 2005.
Housing GSEs
Fannie Mae and Freddie Mac were chartered by Congress
to increase the liquidity of mortgages and to promote
access to mortgage credit for groups that historically
have been underserved by private markets. Fannie
Mae and Freddie Mac do not participate directly in
the origination of mortgages. They carry out their chartered
mission primarily by purchasing residential mortgages
or guaranteeing mortgage-backed securities
(MBS) consisting of residential mortgages. The guaranteed
MBS are held by investors, mortgage lenders, and
increasingly by Fannie Mae and Freddie Mac themselves.
Fannie Mae and Freddie Mac finance their acquisition
of loans and MBS assets by issuing debt; both
also charge fees to mortgage originators who exchange
a pool of loans for MBS issued and guaranteed by one
of the enterprises.
As Government-Sponsored Enterprises (GSEs),
Fannie Mae and Freddie Mac have a unique status
among private financial institutions. They are publicly
held companies but were granted certain privileges to
facilitate their chartered mission, including exemption
from most state and local taxes and registration requirements
with the Securities and Exchange Commission
(SEC). Also, their debt and MBS may be held
without limit by federally chartered depository institutions.
Regulatory oversight of Fannie Mae and Freddie Mac
is shared among multiple agencies across the Government.
The Office of Federal Housing Enterprise Oversight
(OFHEO), an independent agency in the Department
of Housing and Urban Development (HUD), is
the primary safety and soundness regulator of Fannie
Mae and Freddie Mac. HUD is responsible for the establishment
and enforcement of affordable housing
goals for the enterprises, ensuring their compliance
with fair housing laws and their charters, and reviewing
new activities and programs in consultation with
OFHEO. The Treasury Department has discretionary
authority to approve or disapprove the issuance of the
GSEs’ debt, and the SEC now regulates Fannie Mae
under the Securities Exchange Act of 1934. Freddie
Mac has not yet registered under the 1934 Act, but
has publicly committed to do so when able.
The Federal Home Loan Bank System (FHLBS) was
established by Congress to provide liquidity to home
mortgage lenders who are members of the individual
Banks. The System comprises 12 separate, regional
Federal Home Loan Banks (FHLBs, or Banks), each
of which is a member-owned cooperative. The Banks
issue debt for which the Banks are jointly and severally
liable, and use the proceeds principally to make advances
(secured loans) to their members. Member institutions
primarily secure advances with residential
mortgages and other housing-related assets. Like
Fannie Mae and Freddie Mac, the Banks have been
granted special privileges as part of their Government
charter, including exemption of their corporate earnings
from Federal income tax and from State and local taxes.
In addition, the Secretary of the Treasury has authority
to purchase up to $4 billion of these entities’ debt securities.
In recent years, some FHLBs have begun to purchase
mortgages from their members. At the end of
2003, the 12 FHLBs held about $115 billion of mortgages,
equivalent to 7 percent of the combined total
of $1.5 trillion held by Fannie Mae and Freddie Mac.
In addition, as of 2003, the FHLBs held about $774
billion in debt, while Fannie Mae held $976 billion,
and Freddie Mac held $757 billion.
The Federal Housing Finance Board (FHFB) regulates
the mission and the safety and soundness of the
FHLBs. As it does with respect to Fannie Mae and
Freddie Mac, the Treasury Department has discretionary
authority over the issuance of FHLB debt. The
FHFB recently required that the FHLBs register with
the SEC, and registration is expected for most if not
all of the FHLBs later this year.
GSE Borrowing Advantage
Their unique status enables all three housing GSEs
to borrow at rates lower than investors would ordinarily
accept, theoretically to pay higher prices to originating
lenders for mortgages, and in the case of the FHLBs
to make low-cost advances to member institutions. Although
the prospectus for each GSE security clearly
states that it is not backed by the U.S. Government,
the misperception exists among many investors that
the Government backs the GSEs. In 2004 the Congressional
Budget Office estimated the implicit Federal subsidy
to the three housing GSEs was $23 billion during
the previous year. A Federal Reserve study suggests
92 ANALYTICAL PERSPECTIVES
that over one-half of the implicit subsidy to Fannie
Mae and Freddie Mac accrues to the GSEs’ shareholders.
Risk
As with all financial institutions, risk is inherent in
the way the housing GSEs conduct their business. By
assuming and managing some of the risks arising from
mortgage lending, the GSEs generate some benefits for
consumers and significant profits for their owners.
However, the mix of benefits and risks varies depending
on how the GSEs conduct their businesses.
Credit Risk. By issuing and guaranteeing securities
based on pools of mortgages they purchase from lenders,
Fannie Mae and Freddie Mac assume some portion
of credit risk, which enhances liquidity to the mortgage
market and thereby reduces the cost of credit to borrowers.
Fannie Mae and Freddie Mac control their credit
risk by using underwriting standards to evaluate the
mortgages they purchase for securitization. Their risk
is further limited by statutory provisions that require
private mortgage insurance or equivalent protection on
high loan-to-value ratio mortgages. Credit losses for the
enterprises, as a percentage of the face value of mortgages
they purchased, averaged 5.4 basis points for a
fifteen-year period ending in 2002 and have been declining.
Viewed in isolation, Fannie Mae and Freddie Mac’s
assumption of credit risk arising from guarantees of
MBS held by other investors benefits the market and
homebuyers while incurring a risk that is easily managed
and well-understood.
Interest Rate Risk. A more challenging form of risk
arises from the effect that interest rate movements can
have on portfolios of mortgages and mortgage-backed
securities. Interest rate risk arises from the changing
market values of the GSEs’ interest-sensitive assets and
liabilities. Interest rate movements can cause the interest
margins between their mortgage and other assets
and their liabilities to grow or shrink, potentially
changing the mark-to-market value of their equity capital
and estimated future earnings dramatically in a
short period. Historically, the FHLBs assumed interest
rate risk by issuing debt and using the proceeds to
make loans, often of comparable maturities, to member
institutions to support their mortgage lending and other
investments; this risk is somewhat mitigated since they
often require prepayment penalties on advances to
member institutions. Much more recently, however,
some of the Banks have created mortgage purchase
programs that assume interest rate risk for pools of
mortgages.
Fannie Mae, and more recently Freddie Mac, have
built large portfolios of mortgages and repurchased
MBS. However, by choosing to borrow substantially in
order to build large retained portfolios of mortgages
and mortgage-backed securities, they assume a different,
more challenging set of risks and increase the
complexity of their operations. Their ability to repurchase
large volumes of their own MBS is driven by
their ability to finance these mortgages with lower-cost
debt than other investors, thanks to market
misperceptions of a unique status for the enterprises
that allow them to borrow at lower rates. Federal Reserve
economists have found no evidence that these
repurchases provide any additional benefit to borrowers.
They clearly provide an opportunity for the
GSEs to increase their earnings, however.
1990 1992 1994 1996 1998 2000 2002
0
500
1,000
1,500
2000
2,500
MBS Outstanding
Retained Portfolio
1990 1992 1994 1996 1998 2000 2002
MBS Outstanding
Retained Portfolio
Chart 7-1. Total Mortgages,
1990-2003
Fannie Mae Freddie Mac
Billions of dollars Billions of dollars
93 7. CREDIT AND INSURANCE
At the end of 2003, Fannie Mae’s retained portfolio
as a percentage of its MBS outstanding (held by others)
was 69.4 percent, or almost $900 billion; Freddie Mac’s
retained portfolio as a percentage of MBS outstanding
was 78.1 percent, or over $600 billion. In periods of
declining interest rates, mortgage refinancings increase,
so higher-yielding mortgages prepay, exposing holders
of these mortgages or securities based on them to the
risk of having to reinvest these funds at lower rates.
As Federal Reserve Chairman Greenspan has noted,
Fannie Mae and Freddie Mac have chosen not to offset
the interest rate risk arising from their portfolio operations
by increasing capital but to attempt to manage
that risk by issuing callable debt and by purchasing
derivative financial instruments, such as interest rate
swaps and options on swaps. For example, they might
hedge fixed-rate mortgages, which drop in value when
interest rates increase, using derivative instruments
that increase in value under the same scenario. The
techniques necessary to manage interest rate risk and
its potential effect on earnings are complex, and their
management becomes increasingly difficult with increases
in the size and complexity of the portfolio to
be managed. Chairman Greenspan has also noted that
the sophistication of the operations required to hedge
prepayment risk with little capital places an enormous
burden on these institutions.
Like other financial institutions, the housing GSEs
attempt to limit their interest rate exposure and the
effect of interest rate movements on their earnings.
Chairman Greenspan has suggested statutory limits on
the dollar amount of the debt held by Fannie Mae
and Freddie Mac relative to the dollar amounts of mortgages
securitized and held by other investors, and limiting
the ability of the FHLBs to hold mortgages and
mortgage-backed securities directly, as additional ways
to manage the interest rate risk of the GSEs.
Operations risk. Recent events reinforced concerns
over the risks posed by the GSEs and their existing
regulatory framework. These events have illustrated
how the burden of managing interest rate risk mixed
with management deficiencies can lead to operational
failings. In 2003, Freddie Mac reported that it had understated
its earnings by $5 billion over three years,
and eventually acknowledged substantial issues with
accounting, management practices, and internal controls.
OFHEO subsequently assessed substantial financial
penalties on the company, and its senior management
was replaced. A year-long investigation into the
accounting, internal controls, and management practices
at Fannie Mae by OFHEO led to findings of inappropriate
accounting procedures and practices, internal
control deficiencies, and questionable management
oversight. The SEC concurred in the finding of inappropriate
accounting practices and directed that Fannie
restate its earnings for 2001–2004. These findings led
Fannie Mae to replace its Chairman and CEO, and
its CFO. The Enterprise estimated it would be forced
to recognize $9 billion in losses, reducing its capital
below the regulatory minimum requirement. During the
same period, two of the twelve FHLBs entered into
written agreements with FHFB that required review
of operational practices and controls, announcing that
their accounting practices needed revision and, in one
instance, that earnings required restatement.
These developments now reveal some of the ways
that the assumption of large-scale interest rate risk
complicates the operational challenges facing the GSEs.
The techniques necessary to manage interest rate risk
and its potential effect on earnings are complex, and
their management becomes increasingly difficult with
increases in the size and complexity of the portfolio
to be managed. While other large financial institutions
may face similar challenges, the management of interest
rate risk and operations risk is a particular challenge
for the GSEs, given their size, regulatory structure,
and the lack of full market discipline.
The rules governing accounting for derivatives likewise
are complex. Interpreting and applying the accounting
rules have posed challenges to companies that
use derivatives. Out of concern that firms were using
inconsistent methods to account for the use of derivatives
to hedge interest rate risk and the potential that
their use could obscure a company’s true position or
misrepresent earnings, in 1998 the Financial Accounting
Standards Board (FASB) promulgated the rule
known as FAS 133; it became effective in 2000. In
part, this rule requires companies, with narrow exceptions,
to reflect on their balance sheets the amount
that derivatives rise or fall in value, even if derivatives
contracts are still open and gains or losses are not
yet locked in.
In 2004, OFHEO found, and the SEC concurred, that
Fannie did not adequately document its hedges and
routinely violated FAS 133 in a number of ways. For
example, Fannie Mae, in its treatment of hedges when
it changed financial strategies and, with no new testing
or proof of effectiveness, took derivatives that were initially
paired with one liability, and paired them with
another. The SEC also found that Fannie Mae failed
to comply in material respects with FAS 133. At
OFHEO’s behest, Fannie Mae agreed to cease all hedge
accounting that did not conform with FAS 133 by the
first quarter of CY 2005, and to ensure going forward
that all hedge accounting complies with this requirement.
Fannie Mae has already stated that this correction
will reduce its capital and its earnings by $9 billion
from 2001 through mid-2004. This leaves Fannie Mae
below the minimum regulatory capital requirement and
subjects it to further regulatory actions. This follows
upon the events of 2003, when Freddie Mac discovered
substantial accounting and internal control issues, including
issues with the application of FAS 133, leading
to replacement of senior management and restatement
of its financial statements over the 2000–2003 timeframe.
The SEC and the Department of Justice have
continued to investigate both Fannie Mae and Freddie
Mac.
During the same period, the FHFB announced a written
agreement with the FHLB of Chicago which re94
ANALYTICAL PERSPECTIVES
sulted in a review of the Bank’s accounting practices,
changes to certain accounting methods under FAS 133,
and subsequently, a delay in the Bank’s issuance of
its third quarter 2004 financial statements.
The failure of Fannie Mae and Freddie Mac and,
to a lesser extent, the FHLBs to account for the use
of derivatives and hedges consistent with Generally Accepted
Accounting Principles (GAAP) prompted their
regulators to investigate for the presence of control deficiencies
and weaknesses in corporate governance, which
they have identified. Fannie Mae and Freddie Mac were
cited within a nine-month period for serious and systemic
operational control deficiencies that contributed
in part to the need for massive earnings restatements.
The cited deficiencies included management cultures
that stressed earnings stability at the expense of other
considerations, ineffective processes for developing accounting
policies, and absence of independent internal
controls for review of certain transactions. These developments
highlight the risks inherent in the GSEs’ operations,
risks that because of their size and relationships
with other institutions could have far-reaching effects
should one of them falter.
Systemic Risk. The risks undertaken by the GSEs,
if not properly managed, may pose a threat to their
solvency. Under some circumstances, they also may
threaten the stability or solvency of other financial institutions
and the economy. Current Federal law explicitly
exempts the securities of the GSEs from the statutory
limitation on commercial banks’ investment in the
‘‘investment securities’’ of individual firms. In a February
2003 study conducted by OFHEO utilizing FDIC
data, over 2,000 commercial banks held at least 51
percent of their capital in the form of debt issued by
Fannie Mae; and almost 1,000 commercial banks held
at least 51 percent of their capital in the form of debt
issued by Freddie Mac.
Should a financial crisis affecting the GSEs and other
financial actors develop, the market’s misperception of
Government backing of GSE securities could affect its
course and resolution. A September 2004 Federal Reserve
Bank of Atlanta study indicated concern that severe
stress to one of the GSEs might contribute to
weakness in other financial institutions that hold significant
GSE obligations, especially if the path to resolution
of the crisis and the potential for Government
intervention are misunderstood.
The potential for systemic risk arising from the GSEs’
size and their central role in mortgage markets combined
with the difficulty of managing the risks inherent
in a large mortgage portfolio raise fundamental questions
about the value they add through their support
for mortgage lending and reduced costs to borrowers
relative to the risks their current operations pose. Some
research by Federal Reserve economists suggests that
GSE securitization activities have a relatively small effect
on mortgage interest rates—just a few dollars a
month on an average mortgage—and that their practice
of holding mortgages in portfolio has almost no effect
on mortgage costs. Instead of being leaders in increasing
historically underserved groups’ access to credit,
the GSEs have actually trailed the market averages
in a number of dimensions. The Administration has
sought to narrow the gap by lessening the risks posed
by the GSEs and increasing the benefits they offer to
the public.
Enhancing Safety and Soundness
Events of the past year reinforced concerns over the
risks posed by the GSEs and highlighted the need for
meaningful GSE reform. A strengthened regulator
would have the in-house expertise to monitor accounting
methodology and to detect any problems, as well
as the authority and expertise to monitor regulatory
standards for the development and implementation of
systems and controls. A strong regulator would also
hold the authority to place a failing entity into receivership
similar to that held by the other financial safety
and soundness regulators.
The Administration intends that any proposed new
regulatory framework for the GSEs follows the principles
for regulation of financial institutions established
by the international Basel Committee, principles accepted
throughout the world as requirements for firstclass
regulation. As described in the President’s FY
2005 Budget, these principles involve increasing market
discipline, strengthening supervision, and ensuring appropriate
capital requirements.
Market Discipline. Chief among the factors that guide
a company in its decision-making is the discipline imposed
by the market. Investors can discipline the GSEs
to the extent that they have adequate information
about their risks and financial condition. Current market
discipline is hindered by a misperception that the
Federal Government would back GSE securities in the
event of a GSE default, and because GSE investors
do not enjoy the same level of disclosure, or oversight
of disclosures, as investors in other public companies.
Ironically, at the times when investors would most benefit
from detailed information about the enterprises’ finances,
they are left without adequate information for
months or years.
The Administration in 2002 called upon the three
housing GSEs to register voluntarily their equity securities
under the 1934 Securities Exchange Act. In June
2004, the FHFB adopted a final rule that will require
each FHLB to register a class of its stock by June
30, 2005, leading to improved disclosures. Fannie Mae
voluntarily registered and began filing disclosures with
the SEC in 2003. However, because of its recent accounting
problems, Fannie Mae is no longer able to
provide these disclosures. Freddie Mac does not anticipate
being in compliance with SEC standards before
the second quarter of 2006. Since the GSEs are not
subject to the same market discipline as other public
companies, market discipline by itself is not always
sufficient to ensure safety and soundness.
Supervision. An effective financial regulator must
possess authorities commensurate with its responsibilities
and capabilities. The Administration determined
95 7. CREDIT AND INSURANCE
PERCENTAGE OF FANNIE MAE AND FREDDIE MAC LOANS TO
FIRST-TIME MINORITY HOMEBUYERS COMPARED TO THE
FULL MARKETPLACE, 2001–2003 AVERAGES 1
Fannie
Mac
Freddie
Mac
Both
GSEs
Full Market
2
All Race/Ethnicity Groups ............. 25.7% 26.1% 25.9% 39.1%
African American and Hispanic .... 4.7% 3.5% 4.2% 9.0%
All Minorities .................................. 7.5% 6.1% 6.9% 12.3%
Source: Department of Housing and Urban Development.
1 The first-time homebuyer definition for the market analysis is homebuyers who
have never owned a home. The definition for the GSEs is purchasers who have not
owned a home within the past three years. The percentages show first-time homebuyer
mortgages by race/ethnicity category as a share of all home purchase mortgages purchased
by the GSE or originated in the market.
2 ‘‘Market’’ means conventional, conforming home purchase loans.
that the safety and soundness regulators of the housing
GSEs lack sufficient powers and stature to meet their
responsibilities. The President’s 2005 Budget reflected,
therefore, that both OFHEO, regulator of Fannie Mae
and Freddie Mac, and the FHFB, regulator of the
FHLBS, should be replaced with a new, consolidated
regulatory regime, empowered with expanded enforcement
authority, receivership authority, and access to
its funding independent of the annual appropriations
process.
A new regulator, like other Federal regulators of financial
institutions, must have full authority together
with accountability for the prudential supervision of
the enterprises, which includes the authority to approve
new activities of the enterprises. It would have authority
to review their ongoing business activities and reject
new ones if they would be inconsistent with their charter
or prudential operations or incompatible with the
public interest. HUD would continue to be consulted
on new activities in order to ensure that the GSEs
are in compliance with their charters and that the
GSEs carry out their public mission.
Currently, the means by which the failure of a GSE
could be resolved differs between Fannie Mae and
Freddie Mac, on the one hand, and the FHLBs, on
the other. In the case of a failed FHLB, the FHFB
has power to liquidate such institution, subject to certain
limitations relating to the whole number of Banks
in the system. OFHEO, on the other hand, lacks the
power to place an entity into bankruptcy or receivership.
The Federal banking regulators have broad powers
to place a failed institution into receivership, and to
conduct the orderly wind-down of a failed bank in such
a way that systemic disruption is minimized. Giving
such uniform powers to a Federal regulator of GSEs
could likewise help prevent dislocation in financial markets
in the event of the insolvency of such an institution.
Further, such powers would address any
misperception that the GSEs are backed by the Government.
By providing clarity to the markets that the
GSEs (and their creditors) are subject to the same business
risks as are other corporate entities, an even
greater level of market discipline might be brought to
bear on the GSEs’ operations. In general, this type
of market discipline has proven very effective in ensuring
that businesses operate in a prudential, and safe
and sound manner.
Capital requirements. Because neither investors nor
regulators can predict all possible errors by a company
or unexpected economic changes, requirements that ensure
that the GSEs hold capital adequate to cushion
such shocks are essential. Capital requirements must
be set with an eye to both known risks and unknown
or unquantifiable risks. Losses from unknown risks can
well exceed losses from measured risks, as shown by
the rapid depletion of capital in 1998 for the highly
leveraged hedge fund, Long-Term Capital Management.
For this reason, it is essential that the new regulator
of the housing GSEs have unambiguous authority to
adjust both risk-based and minimum capital requirements.
Affordable Housing Mission
One of the public purposes of the GSEs is to promote
access to mortgage credit for low- and moderate income
families. By law, HUD establishes annual affordable
housing goals for Fannie Mae and Freddie Mac. In
2004, HUD established the affordable housing goals for
Fannie Mae and Freddie Mac for 2005 through 2008.
The low and moderate income goal will increase from
50 percent (of the minimum share of housing units
financed by a GSE’s mortgage purchases in a particular
year) in 2004 to 56 percent by 2008; the underserved
areas goal will increase from 36 percent in 2004 to
39 percent by 2008; and the special affordable housing
goal will increase from 20 percent in 2004 to 27 percent
by 2008.
The table below shows how Fannie Mae and Freddie
Mac have trailed the marketplace in lending to firsttime
minority homebuyers in the 2001–2003 timeframe.
It is likely that, as a result of these new, higher goals,
they will need to improve their efforts to reach out
to low-income and minority first-time homebuyers.
With their growth as a share of the mortgage marketplace,
Fannie Mae and Freddie Mac have faced increased
market competition in the acquisition of mortgages
and MBS; the increase in affordable housing
goals and subgoals may mean that Fannie Mae and
Freddie Mac must be more innovative or aggressive
in purchasing loans that meet the goals classifications.
They can do this in part by using a larger portion
of the subsidy they enjoy as a result of their Government
ties to support purchases of goals-qualifying
loans.
Part of the Administration’s proposal for a strengthened
regulatory framework would provide HUD with
the authority to penalize Fannie Mae and Freedie Mac
if they fail to reach the affordable housing goals. Current
law does not permit the Secretary of HUD to impose
timely and appropriate penalties for a GSE’s failure
to reach a goal.
The FHLBs address their affordable housing obligations
in a different fashion. For instance, by statute,
96 ANALYTICAL PERSPECTIVES
each FHLB is assessed ten percent of its net income
for support of affordable housing. This assessment enables
each FHLB member to provide subsidized and
other low-cost funding to create affordable rental and
homeownership opportunities, and support for commercial
and economic development activities that benefit
low- and moderate-income neighborhoods.
With their large subsidy, and with their substantial
market share, the GSEs should lead the market in
creating homeownership opportunities for less advantaged
Americans. However, HUD has conducted analyses
showing that private lenders operating without
the benefits and subsidies enjoyed by the GSEs contribute
more to affordable housing than do Fannie Mae
and Freddie Mac. One purpose of a stronger regulatory
approach is to ensure that all three housing GSEs fulfill
their charter obligations.
Education Credit Programs and GSEs
The Federal Government guarantees loans through
intermediary agencies and makes direct loans to students
to encourage post-secondary education. The Student
Loan Marketing Association (Sallie Mae), created
in 1972 as a GSE to develop the secondary market
for guaranteed student loans, has now been privatized.
Student Loans
The Department of Education helps finance student
loans through two major programs: the Federal Family
Education Loan (FFEL) program and the William D.
Ford Federal Direct Student Loan (Direct Loan) program.
Eligible institutions of higher education may participate
in one or both programs. Loans are available
to students regardless of income. However, borrowers
with low family incomes are eligible for loans with additional
interest subsidies. For low-income borrowers, the
Federal Government subsidizes loan interest costs
while borrowers are in school, during a six-month grace
period after graduation, and during certain deferment
periods.
In 2006, over 9 million borrowers will receive over
15.1 million loans totaling over $95 billion. Of this
amount, more than $62 billion is for new loans, and
the remainder reflects the consolidation of existing
loans. Loan levels have risen dramatically over the past
10 years as a result of rising educational costs and
an increase in eligible borrowers.
The FFEL program provides loans through an administrative
structure involving over 3,500 lenders, 35
State and private guaranty agencies, roughly 50 participants
in the secondary market, and approximately
6,000 participating schools. Under FFEL, banks and
other eligible lenders loan private capital to students
and parents, guaranty agencies insure the loans, and
the Federal Government reinsures the loans against
borrower default. In 2006, FFEL lenders will make over
11.5 million loans totaling over $72 billion in principal,
roughly a third of which involve consolidations of existing
loans. Lenders bear two percent of the default risk,
and the Federal Government is responsible for the remainder.
The Department also makes administrative
payments to guaranty agencies and, at certain times,
pays interest subsidies on behalf of borrowers to lenders.
The William D. Ford Direct Student Loan program
was authorized by the Student Loan Reform Act of
1993. Under the Direct Loan program, the Federal Government
provides loan capital directly to more than
1,100 schools, which then disburse loan funds to students.
In 2006, the Direct Loan program will generate
almost 3.6 million loans with a total value of nearly
$23 billion, including over $7 billion in consolidations
of existing loans. The program offers a variety of flexible
repayment plans including income-contingent repayment,
under which annual repayment amounts vary
based on the income of the borrower and payments
can be made over 25 years with any residual balances
forgiven.
The Administration is strongly committed to the lender-
based FFEL program and expects it to continue as
the primary source of loans to students in the years
ahead. In addition, the Administration will continue
to maintain a DL program to ensure that no eligible
student is denied access to student loans in the event
a student or school cannot find a suitable lender.
However, problems in the structures of the current
student loan programs prevent them from meeting current
policy and program objectives. Specifically, the
Federal Government assumes almost all of the risk for
the loans, while federal subsidies to intermediaries
lenders and guaranty agencies are set high enough to
allow the less efficient ones to generate a profit. These
problems lead to unnecessary costs for taxpayers and
prevent the program from achieving the efficiencies the
market is designed to provide.
The 2006 Budget proposes a package of reforms to
both the FFEL and DL loan programs to achieve significant
cost savings and improve effectiveness. These reforms
will link subsidy payments for lenders and guaranty
agencies more closely to their costs and will modify
interest rates for borrowers who are no longer in
school and have just consolidated their loans. The
Budget achieves $34 billion in savings over ten years
by cutting unnecessary subsidies and payments to lenders,
state guaranty agencies, and loan consolidators,
and by placing a larger share of the loan risks on
lenders. These savings will be used to increase the Pell
Grant maximum award, pay off the current $4 billion
Pell shortfall, and improve benefits to students in
school by increasing loan limits for first year students
and extending the current favorable interest rate
framework.
Sallie Mae
The Student Loan Marketing Association (Sallie Mae)
was created as a shareholder-owned government sponsored
enterprise (GSE) by the Education Amendments
of 1972 to expand funds available for student loans
by providing liquidity to lenders engaged in the Federal
Family Education Loan Program (FFELP), formerly the
97 7. CREDIT AND INSURANCE
guaranteed student loan program (GSLP). Sallie Mae
was reorganized in 1997 pursuant to the authority
granted by the Student Loan Marketing Association Reorganization
Act of 1996. Under the Reorganization Act,
the GSE became a wholly owned subsidiary of SLM
Corporation and was required to be wound down and
liquidated by January 30, 2008. On June 30, 2004, the
SLM Corporation first purchased FFELP student loans
through non-GSE affiliates and, as a result, the GSE
was required by statute to terminate purchases of
FFELP student loans. Accordingly, the GSE is no
longer a source of liquidity for SLM Corporation for
the purchase of student loans, and the GSE-related financing
activities have primarily been limited to refinancing
the remainder of its assets through non-GSE
sources. As of September 2004, the Company had substantially
completed the wind-down of the GSE and,
on November 1, 2004, SLM Corporation sent notices
to the Secretary of Education and the Secretary of the
Treasury that it intended to wind-down and dissolve
the GSE on December 31, 2004 or as soon as practicable
thereafter, three years in advance of the statutory
deadline. The dissolution was completed on December
29, 2004.
All GSE debt that remains outstanding upon completion
of these wind-down activities will be defeased
through the creation of a fully collateralized trust. The
collateral, consisting of cash and financial instruments
backed by the full faith and credit of the U.S. government,
will generate cash flows that provide for the interest
and principal obligations of the defeased debt.
Business and Rural Development Credit
Programs and GSEs
The Federal Government guarantees small business
loans to promote entrepreneurship. The Government
also offers direct loans and loan guarantees to farmers
who may have difficulty obtaining credit elsewhere and
to rural communities that need to develop and maintain
infrastructure. Two GSEs, the Farm Credit System and
the Federal Agricultural Mortgage Corporation, increase
liquidity in the agricultural lending market.
Small Business Administration
The Small Business Administration (SBA) helps entrepreneurs
start, sustain, and grow small businesses.
As a ‘‘gap lender’’ SBA works to supplement market
lending and provide access to credit where private lenders
are reluctant to do so without a Government guarantee.
Additionally, SBA assists home- and businessowners
cover the uninsured costs of recovery from disasters.
The 2006 Budget requests $307 million, including administrative
funds, for SBA to leverage more than $25
billion in financing for small businesses and disaster
victims. The 7(a) General Business Loan program will
support $16.5 billion in guaranteed loans while the 504
Certified Development Company program will support
$5.5 billion in guaranteed loans. SBA will supplement
the capital of Small Business Investment Companies
(SBICs) with $3 billion in long-term loans for venture
capital investments in small businesses.
To continue to serve the needs of small businesses,
SBA will focus program management in three areas:
1) Targeting economic assistance to the neediest small
businesses
SBA seeks to target assistance more effectively to
credit-worthy borrowers who would not be well-served
by the commercial markets in the absence of a Government
guarantee to cover defaults. SBA is actively encouraging
financial institutions to increase lending to
start-up firms, low-income entrepreneurs, and borrowers
in search of financing below $150,000. Preliminary
evidence shows that SBA’s outreach for the 7(a)
program has been successful. Average loan size has
decreased from $258,000 in 2000 to $167,000 in 2004,
while the number of small businesses served has grown
from 43,748 to 81,133 during the same time period.
2) Improving program and risk management
Improving management by measuring and mitigating
risks in SBA’s $57 billion business loan portfolio is
one of the agency’s greatest challenges. As the agency
delegates more responsibility to the private sector to
administer SBA guaranteed loans, oversight functions
become increasingly important. SBA established the Office
of Lender Oversight, which is responsible for evaluating
individual SBA lenders. This office has made
progress in employing a variety of analytical techniques
to ensure sound financial management by SBA and to
hold lending partners accountable for performance.
These techniques include financial performance analysis,
industry concentration analysis, portfolio performance
analysis, selected credit reviews, and credit scoring
to compare lenders’ performance. The oversight program
is also developing on-site safety and soundness
examinations and off-site monitoring of SBLCs and
compliance reviews of SBA lenders. In addition, the
office will develop incentives for lenders to minimize
defaults and to adopt sound performance measures.
Improving risk management also means improving
SBA’s ability to estimate more accurately the cost of
subsidizing small businesses. During 2003 and 2004,
SBA followed through on its commitment to improve
its accuracy in estimating the cost of its major credit
programs by developing loan-level credit and reestimate
models for the Section 504, Disaster, 7(a), and Secondary
Market Guarantee programs. The 2006 Budget
reflects net upward reestimates of the lifetime expected
taxpayer costs for outstanding loans—of $408 million
for the 7(a) program, $123 million for the Section 504
program, $267 million for Disaster Loans, and $922
million for SBIC Participating Securities. A net downward
reestimate of $60 million is also reflected for the
SBIC Debentures program. The 2006 upward trend in
reestimates generally reflects technical corrections to
credit subsidy models (e.g., the 7(a) subsidy model
failed to account for purchased interest on defaulted
loans), higher interest rates and the agency’s shift from
98 ANALYTICAL PERSPECTIVES
the traditional approach (based on historical account
activity) to the balances approach for performing reestimates.
In adopting the balances approach, SBA uncovered
that its historical records did not reconcile to the
credit programs’ asset and liability balances currently
recorded with Treasury. SBA is working to improve
its financial record keeping to mitigate future accounting
discrepancies.
Total budgetary cost increases over the past 3 years
totaled $4.0 billion ($3.1 billion in reestimates and $0.9
billion for interest on the reestimates) for existing SBAguaranteed
loans and $1.7 billion ($1.1 billion for reestimates
and the remainder for interest on reestimates)
for existing direct loans. While most of these budgetary
cost increases related to the weak performance of the
SBIC Participating Securities program and Disaster
Loan asset sales, the agency’s two largest business programs
also generated significant budgetary cost increases
for taxpayers. Over the three-year period, the
net budgetary cost increase was $636 million for outstanding
7(a) guarantees ($330 million in reestimates)
and $180 million ($87 million in reestimates) for outstanding
Section 504 guarantees.
The 2006 Budget supports $3 billion in guaranteed
venture capital investments for small businesses
through the SBIC Debentures program, which provides
credit financing to small business investment companies.
However, the 2006 budget does not support new
guaranteed investments for the Participating Securities
program. Over ten years of operations, the Participating
Securities program has realized and projected losses
of approximately $2.2 billion out of $6.2 billion in disbursements.
These losses reflect a structurally flawed
program in which the Federal Government contributes
up to two-thirds of investment capital but only receives
up to ten percent of profits. Further, as the Program
Assessment Rating Tool (PART) analysis revealed,
SBICs do not have incentives to repay capital expeditiously,
extending the Government’s risk exposure.
Rather than make new investments through this program,
SBA will continue to improve efforts to monitor
and mitigate risk in approximately $9 billion in commitments
in the program’s portfolio. The program had
already ceased making new guaranteed investments on
October 1, 2004 because sufficient borrower fees to
cover the program’s costs were not enacted.
3) Operating more efficiently
To operate more efficiently, SBA is piloting an automated
loan origination system for the Disaster Loan
program. As a result, loan-processing costs, times, and
errors will decrease, while Government responsiveness
to the needs of disaster victims will increase. SBA is
also transforming the way that staff perform loan management
functions in both the 7(a) and 504 programs.
In 2004, SBA implemented new procedures for Section
504 loan processing. Results have been positive with
the average loan processing time reduced from four
weeks to only a few days. In 2005, SBA will streamline
its 7(a) loan origination functions. Similarly, SBA is
also centralizing its loan liquidation functions for the
Section 504 program and requiring intermediaries to
assume increased liquidation responsibilities.
USDA Rural Infrastructure and Business Development
Programs
USDA provides grants, loans, and loan guarantees
to communities for constructing facilities such as
health-care clinics, day-care centers, and water and
wastewater systems. Direct loans are available at lower
interest rates for the poorest communities. These programs
have very low default rates. The cost associated
with them is due primarily to subsidized interest rates
that are below the prevailing Treasury rates.
The program level for the Water and Wastewater
(W&W) treatment facility loan and grant program in
the 2006 President’s Budget is $1.5 billion. These funds
are available to communities of 10,000 or fewer residents.
The program finances W&W facilities through
direct or guaranteed loans and grants. Applicant communities
must be unable to finance their needs through
their own resources or with commercial credit. Priority
is given based on their median household income, poverty
levels, and size of service population as determined
by USDA. The community typically receives a grant/
loan combination. The grant is usually for 35–45 percent
of the project cost (it can be up to 75 percent).
Loans are for 40 years with interest rates based on
a three-tiered structure (poverty, intermediate, and
market) depending on community income. The community
facility programs are targeted to rural communities
with fewer than 20,000 residents and have a program
level of $527 million in 2006. USDA also provides
grants, direct loans, and loan guarantees to assist rural
businesses, including cooperatives, to increase employment
and diversify the rural economy. In 2006, USDA
proposes to provide $899 million in loan guarantees
to rural businesses (these loans serve communities of
50,000 or less).
USDA also provides loans through the Intermediary
Relending Program (IRP), which provides loan funds
at a 1 percent interest rate to an intermediary such
as a State or local government agency that, in turn,
provides funds for economic and community development
projects in rural areas. In 2006, USDA expects
to retain or create over 74,784 jobs through its business
programs, which will be achieved primarily through the
Business and Industry guarantee and the IRP loan programs.
Electric and Telecommunications Loans
USDA’s Rural Utilities Service (RUS) programs provide
loans for rural electrification, telecommunications,
distance learning, telemedicine, and broadband, and
also provide grants for distance learning and telemedicine.
See the Budget Appendix for more information
on these programs.
Providing funding and services to needy areas is of
concern to USDA. Many rural cooperatives provide
service to areas where there are high poverty rates.
Based on PART findings, USDA is reviewing its current
99 7. CREDIT AND INSURANCE
method of issuing telecommunications loans, ‘‘first in;
first out’’, to determine if it allows for adequate support
for areas with the highest priority needs. In addition,
to ensure the electric and telecommunications programs’
focus on rural areas, USDA will require recertification
of rural status for each electric and telecommunications
borrower on the first loan request received
in or after FY 2006 and on the first loan request
received after each subsequent Census. Legislation will
be sought to allow for the rescission of loans that are
more than ten years old.
The Budget includes $2.5 billion in direct electric
loans, $670 million in direct telecommunications loans,
$359 million in broadband loans and $25 million in
DLT grants. The budget proposes blocking the mandatory
broadband funding and providing discretionary
funding. The demand for loans to rural electric cooperatives
has been increasing and is expected to increase
further as borrowers replace many of the 40-year-old
electric plants. RUS electric borrowers are expected to
upgrade 225 rural electric systems, which will benefit
over 3.4 million customers. The telecommunications
borrowers are expected to fund over 50 telecommunication
systems for advanced telecommunications services,
which will provide broadband and high-speed
Internet access and benefit over 300 thousand rural
customers. DLT grants are expected to support the provision
of distance learning facilities to 150 schools, libraries,
and rural education centers and also to provide
telemedicine equipment to 150 rural health care providers,
benefiting millions of residents in rural America.
The Administration proposes to establish the process
and terms to implement a dissolution of the Rural Telephone
Bank (RTB). Dissolution will allow the RTB to
close as the demand for loans has been fulfilled through
other sources. In addition, the stock holders will obtain
a cash payout for their stock while removing this cumbersome
program from the Government. This proposal
avoids the privatization of a bank that will either fail
or need continued Government support to remain in
operation.
Loans to Farmers
The Farm Service Agency (FSA) assists low-income
family farmers in starting and maintaining viable farming
operations. Emphasis is placed on aiding beginning
and socially disadvantaged farmers. FSA offers operating
loans and ownership loans, both of which may
be either direct or guaranteed loans. Operating loans
provide credit to farmers and ranchers for annual production
expenses and purchases of livestock, machinery,
and equipment. Farm ownership loans assist producers
in acquiring and developing their farming or ranching
operations. As a condition of eligibility for direct loans,
borrowers must be unable to obtain private credit at
reasonable rates and terms. As FSA is the ‘‘lender of
last resort,’’ default rates on FSA direct loans are generally
higher than those on private-sector loans. However,
in recent years the loss rate has decreased to
3.6 percent in 2004, compared to 4.7 percent in 2003.
FSA guaranteed farm loans are made to more creditworthy
borrowers who have access to private credit
markets. Because the private loan originators must retain
10 percent of the risk, they exercise care in examining
the repayment ability of borrowers. As a result,
losses on guaranteed farm loans remain low with default
rates of 0.69 percent in 2004, as compared to
0.71 percent in 2003. The subsidy rates for these programs
have been fluctuating over the past several
years. These fluctuations are mainly due to the interest
component of the subsidy rate.
In 2004, FSA provided loans and loan guarantees
to approximately 26,000 family farmers totaling $3.1
billion. The number of loans provided by these programs
has fluctuated over the past several years. The
average size for farm ownership loans has been increasing.
The majority of assistance provided in the operating
loan program is to existing FSA farm borrowers.
In the farm ownership program, new customers receive
the bulk of the benefits furnished. The demand for FSA
direct and guaranteed loans continues to be high due
to crop/livestock price decreases and some regional production
problems. In 2006, USDA’s FSA proposes to
make $3.8 billion in direct and guaranteed loans
through discretionary programs.
A PART evaluation conducted in 2004 showed that
the FSA’s direct loan program functions well in general.
To improve program effectiveness further, FSA is conducting
an in-depth review of its direct and guaranteed
loan portfolios to assess program performance, including
the effectiveness of targeted assistance and the ability
of borrowers to graduate to private credit. The results
of this review will assist FSA in improving the
delivery of its services and the economic viability of
farmers and ranchers.
The Farm Credit System and Farmer Mac
The Farm Credit System (FCS or System) and the
Federal Agricultural Mortgage Corporation
(FarmerMac) are Government-Sponsored Enterprises
(GSEs) that enhance credit availability for the agricultural
sector. The FCS provides production, equipment,
and mortgage lending to farmers and ranchers, aquatic
producers, their cooperatives, related businesses, and
rural homeowners, while Farmer Mac provides a secondary
market for agricultural real estate and rural
housing mortgages.
The Farm Credit System
During 2004, the financial condition of the System’s
banks and associations continued a 15-year trend of
improving financial health and performance. As of September
30, 2004, capital increased 11.1 percent for the
year and stood at $18.0 billion. These capital numbers
exclude $2.1 billion of restricted capital held by the
Farm Credit System Insurance Corporation (FCSIC).
Loan volume has increased since 1989 to $94.9 billion
in September 2004. The rate of asset growth for the
preceding three-year period (2001-2003) has been averaging
7.4 percent. However, the rate of capital accumulation
has been greater, resulting in total capital (in100
ANALYTICAL PERSPECTIVES
cluding restricted capital) equaling 16.2 percent of total
assets at year-end 2003, compared to 15.3 percent at
year-end 2000. Nonperforming loans decreased significantly
to 0.88 percent of total loans in September 2004,
compared to 1.38 percent in September 2003. Competitive
pressures, higher balances of lower yielding investments,
and a low interest rate environment have narrowed
the FCS’s year-to-date net interest margin to
2.52 percent for September 2004 from 2.62 percent in
2003. The current interest rate environment and strong
competition in the lending markets are likely to continue
placing pressure on the net interest margin. Consolidation
continues to affect the structure of the FCS.
In January 1995, there were nine banks and 232 associations;
by September 2004, there were five banks and
97 associations.
The FCSIC ensures the timely payment of principal
and interest on FCS obligations. FCSIC manages the
Insurance Fund which supplements the System’s capital
and supports the joint and several liability of the
System banks. On September 30, 2004 the Insurance
Fund’s net assets totaled $1.9 billion, of which $40 million
was allocated to the Allocated Insurance Reserve
Accounts (AIRAs) held for the System banks and the
Financial Assistance Corporation’s stockholders. Not including
the AIRAs, the Insurance Fund was at 2.01
percent of adjusted insured debt obligations of the System
banks, slightly above the statutory minimum of
2 percent.
Improvement in the FCS’s financial condition is also
reflected in the examinations by the Farm Credit Administration
(FCA), its regulator. Each of the System
institutions is rated under the FCA Financial Institution
Rating System (FIRS) for capital, asset quality,
management, earnings, liquidity, and sensitivity. At the
beginning of 1995, 197 institutions carried the best
FIRS ratings of 1 or 2, 36 were rated 3, one institution
was rated 4, no institutions were rated 5, and 26 institutions
were under enforcement action. In September
2004, all 102 banks and associations had ratings of
1 or 2, and no institution was under an enforcement
action.
Over the past 12 months, the System’s loans outstanding
have grown by $3.6 billion, or 3.9 percent,
while over the past five years they have grown $25.2
billion, or 36.2 percent. The volume of lending secured
by farmland increased 51.5 percent, while farm-operating
loans have increased 34.7 percent since 1999. Agricultural
producers represented the largest borrower
group, with $76.9 billion including loans to rural homeowners
and leases, or 81.1 percent of the dollar amount
of loans outstanding. International loans (export financing)
represent 3.0 percent of the System’s loan portfolio.
Loans to young, beginning, and small farmers and
ranchers represented 12.9, 18.7, and 31.8 percent, respectively,
of the total dollar volume outstanding in
2003, which is slightly higher than in 2002. These percentages
cannot be summed given significant overlap
in these categories. Providing credit and related services
to young, beginning, and small farmers and ranchers
is a legislated mandate and a high priority for the
System.
The System, while continuing to record strong earnings
and capital growth, remains exposed to a variety
of risks, including concentration risk, possible changes
to government programs, the volatility of agricultural
exports and commodity prices, animal and plant diseases,
and concerns about future off-farm employment
prospects, given the trends in job outsourcing and global
competition.
Farmer Mac
Farmer Mac was established in 1987 to facilitate a
secondary market for farm real estate and rural housing
loans. Since the Agricultural Credit Act of 1987,
there have been several amendments to Farmer Mac’s
chartering statute. Perhaps the most significant amending
legislation for Farmer Mac was the Farm Credit
System Reform Act of 1996 that transformed Farmer
Mac from a guarantor of securities backed by loan pools
into a direct purchaser of mortgages, enabling it to
form pools to securitize. The 1996 Act increased Farmer
Mac’s ability to provide liquidity to agricultural mortgage
lenders. Since the passage of the 1996 Act, Farmer
Mac’s program activities and business have increased
significantly.
Farmer Mac continues to meet core capital and regulatory
risk-based capital requirements. Farmer Mac’s
total program activity (loans purchased and guaranteed,
and AgVantage bonds purchased) as of September
30, 2004, totaled $5.5 billion. That volume represents
1.8 percent reduction from program activity at September
30, 2003. Of total program activity, $2.2 billion
were on-balance sheet loans and agricultural mortgagebacked
securities and $3.3 billion were off-balance sheet
obligations. Total assets were $3.8 billion at the close
of the calendar third quarter, with non-program investments
accounting for $1.4 billion of those assets. Farmer
Mac’s net income to common stockholders for the
first three quarters of 2004 was $18.4 million, a decrease
of $1.74 million, or 8.7 percent from the same
period in 2003.
International Credit Programs
Seven Federal agencies—the Department of Agriculture
(USDA), the Department of Defense, the Department
of State, the Department of the Treasury,
the Agency for International Development (USAID), the
Export-Import Bank, and the Overseas Private Investment
Corporation (OPIC)—provide direct loans, loan
guarantees, and insurance to a variety of foreign private
and sovereign borrowers. These programs are intended
to level the playing field for U.S. exporters, deliver
robust support for U.S. manufactured goods, stabilize
international financial markets, and promote sustainable
development.
Leveling the Playing Field
Federal export credit programs counter subsidies that
foreign governments, largely in Europe and Japan, provide
their exporters, usually through export credit agen101
7. CREDIT AND INSURANCE
cies (ECAs). The U.S. Government has worked since
the 1970’s to constrain official credit support through
a multilateral agreement in the Organization for Economic
Cooperation and Development (OECD). This
agreement has significantly constrained direct interest
rate subsidies and tied-aid grants. Further negotiations
resulted in a multilateral agreement that standardized
the fees for sovereign lending across all ECAs beginning
in April 1999. Fees for non-sovereign lending, however,
continue to vary widely across ECAs and markets,
thereby providing implicit subsidies.
The Export-Import Bank attempts to strategically
‘‘level the playing field’’ and to fill gaps in the availability
of private export credit. The Export-Import Bank
provides export credits, in the form of direct loans or
loan guarantees, to U.S. exporters who meet basic eligibility
criteria and who request the Bank’s assistance.
USDA’s ‘‘GSM’’ programs similarly help to level the
playing field. Like programs of other agricultural exporting
nations, GSM programs guarantee payment
from countries and entities that want to import U.S.
agricultural products but cannot easily obtain credit.
The U.S. has been negotiating in the OECD the terms
of agricultural export financing, the outcome of which
could affect the GSM programs.
Stabilizing International Financial Markets
In today’s global economy, the health and prosperity
of the American economy depend importantly on the
stability of the global financial system and the economic
health of our major trading partners. The United States
can contribute to orderly exchange arrangements and
a stable system of exchange rates by providing resources
on a multilateral basis through the IMF (discussed
in other sections of the Budget), and through
financial support provided by the Exchange Stabilization
Fund (ESF).
The ESF may provide ‘‘bridge loans’’ to other countries
in times of short-term liquidity problems and financial
crises. In the past, ‘‘bridge loans’’ from ESF
provided dollars to a country over a short period before
the disbursement of an IMF loan to the country. Also,
a package of up to $20 billion of medium-term ESF
financial support was made available to Mexico during
its crisis in 1995. Such support was essential in helping
to stabilize Mexican and global financial markets. Mexico
paid back its borrowings under this package ahead
of schedule in 1997, and the United States earned almost
$600 million more in interest than it would have
without the lending. There was zero subsidy cost for
the United States as defined under credit reform, as
the medium-term credit carried interest rates reflecting
an appropriate country risk premium.
The United States also expressed a willingness to
provide ESF support in response to the financial crises
affecting some countries such as South Korea in 1997
and Brazil in 1998. It did not prove necessary to provide
an ESF credit facility for Korea, but the United
States agreed to guarantee through the ESF up to $5
billion of a $13.2 billion Bank for International Settlements
(BIS) credit facility for Brazil. In the event, the
ESF guaranteed $3.3 billion in BIS credits to Brazil
and earned $140.3 million in commissions. Such support
helped to provide the international confidence
needed by these countries to begin the stabilization
process.
Using Credit to Promote Sustainable Development
Credit is an important tool in U.S. bilateral assistance
to promote sustainable development. USAID’s Development
Credit Authority (DCA) allows USAID to use
a variety of credit tools to support its development activities
abroad. This unit encompasses newer DCA activities,
such as municipal bond guarantees for local
governments in developing countries, as well as
USAID’s traditional microenterprise and urban environmental
credit programs. DCA provides non-sovereign
loans and loan guarantees in targeted cases where credit
serves more effectively than traditional grant mechanisms
to achieve sustainable development. DCA is intended
to mobilize host country private capital to finance
sustainable development in line with USAID’s
strategic objectives. Through the use of partial loan
guarantees and risk sharing with the private sector,
DCA stimulates private-sector lending for financially
viable development projects, thereby leveraging hostcountry
capital and strengthening sub-national capital
markets in the developing world. While there is clear
demand for DCA’s facilities in some emerging economies,
the utilization rate for these facilities is still very
low.
OPIC also supports a mix of development, employment,
and export goals by promoting U.S. direct investment
in developing countries. OPIC pursues these goals
through political risk insurance, direct loans, and guarantee
products, which provide finance, as well as associated
skills and technology transfers. These programs
are intended to create more efficient financial markets,
eventually encouraging the private sector to supplant
OPIC finance in developing countries. OPIC has also
created a number of investment funds that provide equity
to local companies with strong development potential.
Ongoing Coordination
International credit programs are coordinated
through two groups to ensure consistency in policy design
and credit implementation. The Trade Promotion
Coordinating Committee (TPCC) works within the Administration
to develop a National Export Strategy to
make the delivery of trade promotion support more effective
and convenient for U.S. exporters.
The Interagency Country Risk Assessment System
(ICRAS) standardizes the way in which agencies budget
for the cost associated with the risk of international
lending. The cost of lending by the agencies is governed
by proprietary U.S. government ratings, which correspond
to a set of default estimates over a given maturity.
The methodology establishes assumptions about
default risks in international lending using averages
102 ANALYTICAL PERSPECTIVES
of international sovereign bond market data. The
strength of this method is its link to the market and
an annual update that adjusts the default estimates
to reflect the most recent risks observed in the market.
For 2006, OMB updated the default estimates using
the default estimate methodology introduced in FY
2003 and the most recent market data. The 2003 default
estimate methodology implemented a significant
revision that uses more sophisticated financial analyses
and comprehensive market data, and better isolates the
expected cost of default implicit in interest rates
charged by private investors to sovereign borrowers.
All else being equal, this change expands the level of
international lending an agency can support with a
given appropriation. For example, the Export-Import
Bank will be able to provide generally higher lending
levels using lower appropriations in 2006.
Adapting to Changing Market Conditions
Overall, officially supported finance and transfers account
for a tiny fraction of international capital flows.
Furthermore, the private sector is continuously adapting
its size and role in emerging markets finance to
changing market conditions. In response, the Administration
is working to adapt international lending at
Export-Import Bank and OPIC to dynamic private sector
finance. The Export-Import Bank, for example, is
developing a sharper focus on lending that would otherwise
not occur without Federal assistance. Measures
under development include reducing risks, collecting
fees from program users, and improving the focus on
exporters who truly cannot access private export finance.
OPIC in the past has focused relatively narrowly on
providing financing and insurance services to large U.S.
companies investing abroad. As a result, OPIC did not
devote significant resources to its mission of promoting
development through mobilizing private capital. In
2003, OPIC implemented new development performance
measures and goals that reflect the mandate to revitalize
its core development mission.
These changes at the Export-Import Bank and at
OPIC will place more emphasis on correcting market
imperfections as the private sector’s ability to bear
emerging market risks becomes larger, more sophisticated,
and more efficient.
IV. INSURANCE PROGRAMS
Deposit Insurance
Federal deposit insurance promotes stability in the
U.S. financial system. Prior to the establishment of
Federal deposit insurance, failures of some depository
institutions often caused depositors to lose confidence
in the banking system and rush to withdraw deposits.
Such sudden withdrawals caused serious disruption to
the economy. In 1933, in the midst of the Depression,
the system of Federal deposit insurance was established
to protect small depositors and prevent bank failures
from causing widespread disruption in financial markets.
The federal deposit insurance system came under
serious strain in the late 1980s and early 1990s when
over 2,500 banks and thrifts failed. The Federal Government
responded with a series of reforms designed
to improve the safety and soundness of the banking
system. These reforms, combined with more favorable
economic conditions, helped to restore the health of depository
institutions and the deposit insurance system.
The Federal Deposit Insurance Corporation (FDIC)
insures deposits in banks and savings associations
(thrifts) through separate insurance funds: the Bank
Insurance Fund (BIF) and the Savings Association Insurance
Fund (SAIF). The National Credit Union Administration
(NCUA) administers the insurance fund
for most credit unions (certain credit unions are privately
insured and not covered by the fund). FDIC and
NCUA insure deposits up to $100,000 per account.
FDIC insures $3.6 trillion of deposits at 7,660 commercial
banks and 1,365 savings institutions. NCUA insures
about 9,113 credit unions with $495 billion in
insured shares.
Current Industry and Insurance Fund Conditions
The bank industry continues to earn record profits.
In the quarter ending September 30, 2004, banks reported
record-high earnings for the sixth time in the
last seven quarters. In fiscal year 2004, industry net
income totaled $122 billion, an increase of 7 percent
over fiscal year 2003. The quality of loans continues
to improve as net charge-offs fell to a four-year low.
Despite the improving trends, some risks remain. Rising
interest rates, for example, might cause stresses
in certain real-estate markets and strains on banks
in some regions.
Only four BIF members and one SAIF member with
a combined $175 million dollars in assets failed during
fiscal year 2004. In comparison, in the last five years,
assets associated with BIF failures have averaged $857
million per year, while failures associated with SAIF
averaged $455 million. At the height of the banking
crisis in 1989, failed assets rose to over $150 billion
in one year. The FDIC currently classifies 95 institutions
with $25 billion in assets as ‘‘problem institutions,’’
compared to 116 institutions with $30 billion
in assets a year ago.
In fiscal year 2004, the reserve ratio (ratio of insurance
reserves to insured deposits) of BIF stayed above
the 1.25-percent statutory target. As of September 30,
2004, BIF had estimated reserves of $34 billion, or 1.32
percent of insured deposits. Factors that helped BIF
stay above the statutory target in fiscal year 2004 include
fewer bank failures, slow growth of insured deposits,
and increases in unrealized gains on securities
available for sale. The SAIF reserve ratio also remained
above the designated reserve ratio throughout the year.
103 7. CREDIT AND INSURANCE
As of September 30, 2004, SAIF had reserves of $12.5
billion, or 1.33 percent of insured deposits. Through
June 30, 2005, the FDIC will continue to maintain deposit
insurance premiums in a range from zero for the
healthiest institutions to 27 cents per $100 of assessable
deposits for the riskiest institutions. In May, the
FDIC will set assessment rates for July through December
of this year. Due to the strong financial condition
of the industry and the insurance funds, less than 10
percent of banks and thrifts paid insurance premiums
in 2004.
During 2004, 22 Federally insured credit unions with
$120 million in assets failed (including assisted mergers).
In comparison, in 2003, 8 Federally insured credit
unions with $25 million in assets failed. The National
Credit Union Share Insurance Fund (NCUSIF) ended
fiscal year 2004 with assets of $6.3 billion and an equity
ratio of 1.28 percent, below the NCUA-set target
ratio of 1.30 percent. Each insured credit union is required
to deposit and maintain an amount equal to
1 percent of its member share accounts in the fund.
Premiums were waived during 2004 because the ratio
stayed above 1.25 percent. As the Fund’s equity ratio
did not exceed 1.30 percent, NCUA did not provide
a dividend to credit unions in fiscal year 2004.
The Federal banking regulators (the Federal Deposit
Insurance Corporation, the Office of the Comptroller
of the Currency, the Office of Thrift Supervision, and
the Federal Reserve) are planning a rulemaking that
would implement the new Basel Capital Accord (Basel
II). The original Basel Capital Accord is an international
agreement establishing a uniform capital
standard across nations. It adopted a risk-based capital
requirement that applies differing risk weights to a
few broad categories of assets. Basel II proposes several
ways to improve the risk-based capital requirement,
including refining risk categories and applying sophisticated
models calculating the risk of various assets. U.S.
regulators are considering implementing the modelbased
capital requirement for the largest banks (about
20) that have complex financial structures and expertise
to apply sophisticated models. The new capital requirement
would be a major change because those
banks hold the overwhelming majority of U.S. banking
assets.
As a result of consolidation, fewer large banks control
an increasingly substantial share of banking assets.
Thus, the failure of even one of these large institutions
could strain the insurance fund. Banks are increasingly
using sophisticated financial instruments such as assetbacked
securities and financial derivatives, which could
have unforeseen effects on risk levels. Whether or not
these new instruments add to risk, they do complicate
the work of regulators who must gauge each institution’s
financial health and the potential for deposit insurance
losses that a troubled institution may represent.
Federal Deposit Insurance Reform
While the deposit insurance system is in good condition,
the Administration supports reforms to make improvements
in the operation and fairness of the deposit
insurance system for banks and thrifts. In 2003, the
Treasury Department and federal banking regulatory
agencies submitted to Congress a proposal that would
accomplish this objective. Specifically, the proposal
would merge the BIF and the SAIF. A single merged
fund would be stronger and better diversified than either
fund alone and would prevent the possibility that
institutions posing similar risks would again pay significantly
different premiums for the same product.
Under the current system, the FDIC is required to
maintain a ratio of insurance fund reserves to total
insured deposits of 1.25 percent. If insurance fund reserves
fall below the 1.25 ratio, the FDIC must charge
either sufficient premiums to restore the reserve ratio
to 1.25 percent within one year, or no less than 23
basis points if the reserve ratio remains below 1.25
percent for more than one year. The Administration’s
proposal would give the FDIC authority to adjust the
ratio periodically within prescribed upper and lower
bounds and greater discretion in determining how
quickly it restores the ratio to target levels. This flexibility
would help reduce potential pro-cyclical effects
by stabilizing industry costs over time and avoiding
sharp premium increases when the economy may be
under stress. Finally, the FDIC has been prohibited
since 1996 from charging premiums to ‘‘well-capitalized’’
and well-run institutions as long as insurance
fund reserves equal or exceed 1.25 percent of insured
deposits. Therefore, less than 10 percent of banks and
thrifts pay insurance premiums, allowing a large number
of financial institutions to increase their insured
deposits rapidly without any contribution to the insurance
fund. The Administration proposal would repeal
this prohibition to ensure that institutions with rapidly
increasing insured deposits or greater risks appropriately
compensate the insurance fund.
Pension Guarantees
The Pension Benefit Guaranty Corporation (PBGC)
insures most defined-benefit pension plans sponsored
by private employers. PBGC pays the benefits guaranteed
by law when a company with an underfunded pension
plan becomes insolvent. PBGC’s exposure to claims
relates to the underfunding of pension plans, that is,
to any amount by which vested future benefits exceed
plan assets. In the near term, its loss exposure results
from financially distressed firms with underfunded
plans. In the longer term, additional loss exposure results
from the possibility that currently healthy firms
become distressed and currently well-funded plans become
underfunded due to inadequate contributions or
poor investment results.
PBGC monitors troubled companies with underfunded
plans and acts, in bankruptcies, to protect its
beneficiaries and the future of the program. Such pro104
ANALYTICAL PERSPECTIVES
tections include, where necessary, initiating plan termination.
Under its Early Warning Program, PBGC negotiates
settlements with companies that reduce losses
in the event the plan terminates.
PBGC’s single-employer program suffered record annual
losses from underfunded plan terminations in
2001 through 2004. As a result of these record losses,
the program’s deficit at FY 2004 year-end stood at
$23.3 billion, compared to $11.2 billion a year earlier
and a $9.7 billion surplus at FY 2000 year-end. Large
underfunded terminations include: in FY 2002, LTV,
a steel company, with a claim of nearly $2 billion,
which was PBGC’s largest to date; in FY 2003, Bethlehem
Steel, with a claim of about $3.6 billion, National
Steel, and US Airways’ Pilots Plan; and in FY 2004,
Kaiser Aluminum’s Salaried Plan, Pillowtex, and
Weirton Steel. More important in FY 2004 than claims
for completed terminations was the increase in claims
for ‘‘probable’’ terminations to $16.9 billion from $5.2
billion in FY 2003.
Additional risk and exposure may remain for the future
because of economic uncertainties and significant
underfunding in single-employer pension plans, which
exceed an estimated $450 billion at fiscal year-end,
compared to $350 billion at the end of FY 2003 and
$50 billion at the end of December 2000. PBGC’s exposure
to ‘‘reasonably possible’’ terminations, the amount
of unfunded vested benefits in pension plans sponsored
by companies at greater risk of default, stood at $96
billion at the end of December 2003, up from $82 billion
a year earlier.
The smaller multiemployer program guarantees pension
benefits of certain unionized plans offered by several
employers in an industry. It ended 2003 with its
first deficit in over 20 years, of about $261 million.
The deficit fell to $236 million in 2004. However, estimated
underfunding in multiemployer plans approximated
$150 billion at year-end, up from over $100 billion
at the end of FY 2003.
With assets of $39 billion, the agency can meet its
obligations for a number of years into the future, but,
with $62 billion of liabilities in the single-employer program,
it is clear that the financial integrity of the federal
pension insurance program is at risk.
Looking to the long term, to avoid benefit reductions,
strengthen PBGC, and help stabilize the defined-benefit
pension system, the 2006 Budget proposes legislative
reforms to:
• Require employers to fully fund their plans by
making up their funding shortfall over a reasonable
period of time and give companies added
flexibility to contribute more in good economic
times.
• Require that funding be based on a more accurate
measure of liabilities and establish appropriate
funding targets based on a plan’s risk of termination.
• Update the variable-rate premium to reflect the
new funding targets and provide for the PBGC
Board to reexamine it periodically to cover the
cost of expected claims and to improve PBGC’s
financial position; and adjust the flat-rate premium
to reflect the growth in worker wages.
• Require employers to forego benefit increases if
the sponsor is financially weak or has a significantly
underfunded pension plan.
• Require plans to provide timely information on
the true financial health of pension plans to workers
and make such information publicly available
to other stakeholders.
The Administration’s comprehensive reforms will
strengthen funding for workers’ defined-benefit pensions;
provide more accurate information about pension
liabilities and plan underfunding; and ensure PBGC’s
continued ability to safeguard pension benefits for 44
million Americans.
Disaster Insurance
Flood Insurance
The Federal Government provides flood insurance
through the National Flood Insurance Program (NFIP),
which is administered by the Emergency Preparedness
and Response Directorate of the Department of Homeland
Security (DHS). Flood insurance is available to
homeowners and businesses in communities that have
adopted and enforced appropriate flood plain management
measures. Coverage is limited to buildings and
their contents. By 2005, the program is projected to
have approximately 4.9 million policies from more than
19,000 communities with $828 billion of insurance in
force.
Prior to the creation of the program in 1968, many
factors made it cost prohibitive for private insurance
companies alone to make affordable flood insurance
available. In response, the NFIP was established to
make insurance coverage widely available. The NFIP
requires building standards and other mitigation efforts
to reduce losses, and operates a flood hazard mapping
program to quantify the geographic risk of flooding.
These efforts have made substantial progress.
The number of policies in the program has grown
significantly over time. The number of enrolled policies
grew from 2.4 to 4.3 million between 1990 and 2002,
and by about 85,000 policies in 2004, bringing the policy
total to 4.5 million. DHS is using three strategies
to increase the number of flood insurance policies in
force: lender compliance, program simplification, and
expanded marketing. DHS is educating financial regulators
about the mandatory flood insurance requirement
for properties that are located in flood plains and have
mortgages from federally regulated lenders. The NFIP
also has a multi-pronged strategy for reducing future
flood damage. The NFIP offers mitigation insurance to
allow flood victims to rebuild to code, thereby reducing
future flood damage costs. Further, through the Community
Rating System, DHS adjusts premium rates to
encourage community and State mitigation activities
beyond those required by the NFIP.
105 7. CREDIT AND INSURANCE
Despite these efforts, the program faces financial
challenges. The program’s financing account, which is
a cash fund, has sometimes had expenses greater than
its revenue, preventing it from building sufficient longterm
reserves. This is mostly because a large portion
of the policyholders pay subsidized premiums. DHS
charges subsidized premiums for properties built before
a community adopted the NFIP building standards.
Properties built subsequently are charged actuarially
fair rates. The creators of the NFIP assumed that eventually
the NFIP would become self-sustaining as older
properties left the program. The share of subsidized
properties in the program has fallen, but remains substantial;
it was 70 percent in 1978 and is 28 percent
today.
Until the mid-1980s, Congress appropriated funds periodically
to support subsidized premiums. However,
the program has not received appropriations since 1986.
During the 1990s, FEMA, which is now part of DHS,
relied on Treasury borrowing to help finance its loss
expenses (the NFIP may borrow up to $1.5 billion).
As of October 31, 2002, the NFIP had repaid all of
its outstanding debt.
Although the program is generally well run, it receives
some criticism about the low participation rate
and the inclusion of subsidized properties, especially
those that are repetitively flooded. The program has
identified approximately 11,000 properties for mitigation
action. To the extent they are available; funds will
come from the Hazard Mitigation Grant Program, the
Predisaster Mitigation Grant Program, and the Flood
Mitigation Grant Program. The Flood Insurance Reform
Act of 2004 defines the criteria that qualify these repetitively-
damaged properties for special mitigation. The
legislation also extended the NFIP’s authority through
September 30, 2008. An additional problem is the fairly
low participation rate. Currently, less than half of the
eligible properties in identified flood plains participate
in this program. In comparison, the participation rate
for private wind and hurricane insurance is nearly 90
percent in at-risk areas. Given that flood damage
causes roughly $6 billion in property damage annually,
DHS is in the process of evaluating its incentive structure
to attract more participation in the program, while
not encouraging misuse of the program.
Crop Insurance
Subsidized Federal crop insurance administered by
USDA’s Risk Management Agency (RMA) plays an important
role in assisting farmers to manage yield and
revenue shortfalls due to bad weather or other natural
disasters. RMA continues to evaluate and, provide new
products so that the Government can further reduce
the need for ad-hoc disaster assistance payments to
the agriculture community in bad years.
The USDA crop insurance program is a cooperative
effort between the Federal Government and the private
insurance industry. Private insurance companies sell
and service crop insurance policies. These companies
rely on reinsurance provided by the Federal Government
and also by the commercial reinsurance market
to manage their individual risk portfolio. The Federal
Government reimburses private companies for the administrative
expenses associated with providing crop insurance
and reinsures the private companies for excess
insurance losses on all policies. The Federal Government
also subsidizes premiums for farmers. The Agricultural
Risk Protection Act of 2000 (ARPA) increased
premium subsidy levels to encourage farmers to purchase
higher and more effective levels of coverage.
RMA renegotiated the Standard Reinsurance Agreement
(SRA) in 2004. The SRA contains the operational
and financial risk sharing terms between the Federal
Government and the private companies. The ARPA allowed
these terms to be renegotiated once between the
2001 and 2005 reinsurance years. RMA utilized this
opportunity to strengthen the document to address such
issues as company oversight and quality control. As
a result of these negotiations, company administrative
expense reimbursements were reduced by approximately
3 percent, and a 5 percent net book quota share
was introduced to better balance profit potential between
the companies and the Federal Government. The
new SRA is expected to generate annual program cost
savings of approximately $36 million.
In addition to these changes, the 2006 Budget includes
a legislative proposal that would require any
farmer that receives a Federal commodity payment for
his/her crop to buy crop insurance at a minimum coverage
level of 50/100. This proposal is intended to ensure
farmers have adequate protection in the event of
a natural disaster without resorting to ad hoc disaster
assistance. Additionally, the Administration’s proposal
will lower the imputed premium on Catastrophic Crop
Insurance (CAT) by 25 percent and charge an administrative
fee on CAT equal to the greater of $100 or
25 percent of the (restated) imputed CAT premium,
subject to a maximum fee of $5,000. The proposal will
also reduce premium subsidies by 5 percentage points
on policies with a coverage level of 70 percent or below
(75 percent for Group Risk Protection (GRP)) and by
2 percentage point on policies with a coverage level
of 75 percent or above (80 percent for GRP). Plus the
proposal reduces the A&O reimbursement on all buyup
coverage by 2 percentage points and increases the
net book quota share to 22 percent, but provides a
ceding commision to the companies of 2 percent. These
changes are expected to be in effect in 2007 and will
save $140 million a year.
There are various types of insurance programs. The
most basic type of coverage is CAT, which compensates
the farmer for losses in excess of 50 percent of the
individual’s average yield at 55 percent of the expected
market price. The CAT premium is entirely subsidized,
and farmers pay only an administrative fee. Commercial
insurance companies deliver the product to the producer
in all states. Additional coverage is available to
producers who wish to insure crops above the CAT
coverage level. Premium rates for additional coverage
depend on the level of coverage selected and vary from
106 ANALYTICAL PERSPECTIVES
crop to crop and county to county. The additional levels
of insurance coverage are more attractive to farmers
due to availability of optional units, other policy provisions
not available with CAT coverage, and the ability
to obtain a level of protection that permits them to
use crop insurance as loan collateral and to achieve
greater financial security. Private companies sell and
service the catastrophic portion of the crop insurance
program, and also provide higher levels of coverage,
which are also federally subsidized. Approximately 82
percent of eligible acres participated in one or more
crop insurance programs in 2004.
For producers purchasing the additional levels of insurance,
there are a wide range of yield- and revenuebased
insurance products available through the Federal
crop insurance program. Revenue insurance programs
protect against loss of revenue stemming from low
prices, poor yields, or a combination of both. These programs
extend traditional multi-peril crop insurance protection
by adding price variability to production history.
Indemnities are due when any combination of yield and
price results in revenue that is less than the revenue
guarantee. The price component common to these plans
uses the commodity futures market for price discovery.
Revenue products have gained wide acceptance among
producers and have played an integral role in providing
more effective risk management options for the nation’s
agricultural producers. In crop year 2004, these revenue
products accounted for over 52 percent of all policies
earning premium, 59 percent of net insured acres, and
55 percent of total program liability.
USDA also continues to expand coverage. In 2004,
a sugar beet stage removal pilot program was introduced.
In addition, approval was given to a pilot program
of crop insurance for Silage Sorghum in two
states and to make Adjusted Gross Revenue-Lite available
in five additional states, both effective for the 2005
crop year. USDA also expanded the availability of the
Livestock Risk Protection plan of insurance to additional
states and for additional types of livestock. Further,
RMA has issued 4 contracts for development of
new risk management tools for pasture, rangeland and
forage. ARPA directed FCIC to establish the development
of a pasture, rangeland and forage program as
one of its highest research and development priorities.
RMA continues to pursue a number of avenues to increase
program participation among underserved states
and commodities.
For more information and additional crop insurance
program details, please reference RMA’s web site:
(www.rma.usda.gov).
Insurance against Security-Related Risks
The Federal Government offers terrorism risk insurance
and Airline War Risk Insurance on a temporary
basis, and has created the smallpox injury compensation
program. After the September 11 attacks, private
insurers became reluctant to insure against securityrelated
risks such as terrorism and war. Those events
are so uncertain in terms of both the frequency of occurrence
and the magnitude of potential loss that private
insurers have difficulty estimating the expected loss.
Furthermore, terrorism can produce a large loss that
could wipe out private insurers’ capital. These uncertainties
make the private sector reluctant to provide
security-related insurance. Thus, it is necessary for the
smooth functioning of our economy that the Federal
Government insure against some security-related risks
until the private sector learns enough to be comfortable
about estimating those risks.
Terrorism Risk Insurance
On November 26, 2002, President Bush signed into
law the Terrorism Risk Insurance Act of 2002. The
Act was designed to address disruptions in economic
activity caused by the withdrawal of many insurance
companies from the marketplace for terrorism risk insurance
in the aftermath of the terrorist attacks of
September 11, 2001. Their withdrawal in the face of
great uncertainty as to their risk exposure to future
terrorist attacks led to a moratorium in construction
projects, increased business costs for the insurance that
was available, and substantial shifting of risk from reinsurers
to primary insurers, and from insurers to policyholders
(e.g., investors, businesses, and property
owners). Ultimately, these costs were borne by American
workers and communities through decreased development
and economic activity.
The Act established a temporary Federal program
that provides for a system of shared public and private
compensation for insured commercial property and casualty
losses arising from acts of terrorism. The program
is administered by the Treasury Department and is
scheduled to sunset on December 31, 2005.
Under the Act, insurance companies included under
the program must make available to their policyholders
during the first two years of the program coverage for
losses from
