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Statement by
David M. Lilly
Member, Board of Governors of the Federal Reserve System

Before the
Subcommittee on Economic Stabilization
of the
Committee on Banking, Finance and Urban Affairs
of the
United States House of Representatives
Wednesday, March 30, 1977

I appreciate the opportunity to appear before you this
morning to discuss Federal Government loan guarantees.

I would like

to say at the outset, that I am not an expert on the wide range of
specific guarantee programs.

I intend, therefore, to focus my remarks

on the general question of the economic implications of loan guarantees
and the treatment of such guarantees in the budgetary process.
The volume of guaranteed loans has been rising rapidly in
recent years, reflecting growth under longstanding programs as well
as the introduction of additional programs established to foster a
variety of new public policy objectives.

Congress has also been deluged

of late with proposals that would further expand existing guarantee
programs or would involve the use of the Government's guarantee of
loans for a number of new purposes, particularly in the energy field.
These developments clearly point to the need for Congress to make a
thorough assessment of the public policy implications of programs
that utilize the Federal Government's credit standing and to improve
procedures for evaluating and accounting for such programs.
As you noted in your letter, the character of the Government's
loan guarantee activities has been changing.

Old, well-established

programs generally have involved the provision of a guarantee on
relatively small loans in the agricultural, mortgage, or small business

Under these programs, risk has been spread among a large number


of borrowers and over a wide geographical area, and default rates have
proven to be low and fairly predictable.

In the case of FHA

Section 203b insured mortgages, as an outstanding example, premiums
charged for this insurance have more than covered all losses to
Most of these older programs were established to remedy
imperfections thought to exist in the private credit markets that
resulted in a smaller flow of credit into certain uses than seemed
warranted by underlying economic circumstances.

Such imperfections

were attributed to lenders' inability to pool large amounts of risk,
their lack of knowledge about the characteristics of borrowers, and/or
their reluctance to innovate new lending terms.

It was, in part, to

acquaint lenders with new opportunities that these programs were
administered in ways that involved the private sector in the origination,
servicing and even coinsurance of loans.

This strategy has often

In the home mortgage area, for example, an active and

expanding private sector has increasingly assumed the risk taking
functions originally performed by the Government.
Many of the loan guarantee programs established more recently
have been quite different in nature.

They have involved the use of

the Government's guarantee of loans to underwrite spending that has
been judged to yield desirable social objectives, but which may offer
only indifferent prospects of being financially successful.


such as student loans and assistance for low and moderate income home
buyers, for example, would appear to involve a sizable element of risk


to the Government and subsidy to the recipients, since the full
repayment of these loans is recognized to be uncertain.
Other newly proposed programs would involve use of loan
guarantees to aid in the financing of projects, particularly in the
energy area, whose exceptionally large size relative to the borrowing
unit virtually precludes private lenders from providing funds on an
unassisted basis.

Also, in some cases, there is considerable uncertainty

as to the feasibility of the technology to be used or as to whether the
economic conditions likely to prevail in the future will justify the under­

Thus, in these instances, the Government would incur a contingent

liability whose size while unknown can be presumed to be quite large.
Moreover, even though such programs are to be authorized in
the form of loan guarantees, private involvement in a large percentage
of them is likely to be modest, because the Federal Financing Bank
probably will originate, service, and hold the great bulk of these

As you know, since it began operating in 1974, the FFB has

not only made direct loans to Government agencies, but has acquired
a substantial volume of Government guaranteed loans as well.


is, in any case, little substantive difference between a direct loan
and a guaranteed loan held by a private borrower in which risk of
failure to repay is assumed by the U.S. Government.

The FFB's acquisition

of guaranteed loans further blurs this distinction, however, and in
effect converts guaranteed loans into direct loans.


There are, however, clear advantages gained when the Federal
Financing Bank acquires guaranteed loans.

Such acquisitions serve to

consolidate and bring order to the process of issuing Government
guaranteed debt instruments.

Potential disruptions to the functioning

of securities markets that could be caused by numerous public sales
of guaranteed security issues are thus avoided.

In addition, the FFB

loans funds which it has borrowed from the Treasury, and it is therefore
able to hold the interest rates it charges to levels that are just above
the rates the Treasury pays when it borrows in the market.


loans, when placed in private hands, normally carry interest rates
significantly higher than rates on Treasury securities of similar maturity,
because such loans lack the liquidity of direct Treasury issues.


savings realized by what, in effect, amounts to the substitution of
direct Treasury debt for guaranteed loans can accrue either to the borrower
through lower interest charges, or to the taxpayer if a fee is levied
on the guaranteed loan.
Concerns have been expressed in some quarters that the advantages
offered by the FFB may be encouraging growth of guaranteed loans.
my view such concerns are perhaps misdirected.


I would prefer to attribute

the growth of such loans to the way they have been treated in the budgetary

As you are well aware? the exclusion of loan guarantee programs

from the regular appropriation process eases their initiation and impedes
their subsequent control.

The amount of guaranteed loans does not appear

in functional categories of the budget, and some individual guarantee
programs extend over many years, with little periodic zero base


review or control other than overall limits set by Congress.


new loan guarantee programs have little or no impact on current budgets.
There is no formal mechanism in many programs for establishing reserves
when loan guarantees are made in order to cover defaults that might occur
while the loans are outstanding.

Instead, losses on guaranteed loans

are reflected in the budget at the time they occur.
Loan guarantee programs also impose other costs on the taxpayer.
In some guarantee programs, such as guaranteed student loans, subsidies
are provided explicitly to those receiving guarantees.

In addition,

there are programs in which the cost of processing loan applications and
servicing loans are borne by the Government.

Loan guarantees also tend

to raise the amount of interest that must be paid on the national debt.
This occurs because instruments bearing the full faith and credit
guarantee of the Federal Government are viewed as close substitutes for
direct Government debt by many investors, and the competition from such
instruments might tend to increase the cost of the Treasury's own debt
financing operations.
Loan guarantees also have other significant effects on the
economy which are difficult to quantify and almost never find their way
into budgetary discussions.

These effects are the shifts in resource

allocation patterns caused by the operation of loan guarantees.


principal reason for loan guarantees, of course, is to redistribute
credit to favored sectors so as to stimulate production of particular
types of goods or services.

In the case of many programs, the credit

provided finances activities that would not otherwise have been undertaken.


Many of the programs proposed for energy developments, for example,
are of this latter type.

In the case of other programs, guaranteed

loans may not produce an equivalent increase in spending in the
area because funds might be shifted by the borrower from one use to
another or because credits obtained under a guarantee may simply replace
borrowing that would have otherwise occurred.

But even in these latter

cases, it seems quite likely that the reduced cost of finance induces
some additional outlays.
While loan guarantees generally result in a net increase in
credit used to finance selected types of expenditures, it must be
stressed that coincidentally the volume of funds available for
loans to borrowers not favored by such programs tends to be diminished
and the cost of these funds may be raised.

As a result, the additional

spending on projects backed by loan guarantees will be offset to
some extent by reduced expenditures for other purposes.
To sum up then, loan guarantees, as well as other forms of
Federal credit assistance, make funds available to finance certain types
of spending that have been deemed through the legislative process to
be of high social value.

These funds are not provided without cost,

Defaults on guaranteed loans result in a direct drain on the

Treasury's tax revenues, and there are other types of attendant costs
including the higher interest rates on Treasury debt caused by enlarging


the supply of securities carrying the full faith and credit of the
Federal Government.
Recognition that loan guarantees are not costless or without
side effects does not necessarily lead to the conclusion that such
programs should be eliminated.

But it does highlight the need for

careful evaluation of the relationship between their benefits and costs.
I do not believe this is being done adequately at present, since budgetary
procedures do not establish for Congress a suitable framework for
making such assessments.
While there is widespread agreement that reforms in the budget
treatment of credit programs are desirable, there is little consensus
on what a revised budget should contain.

Some budget authorities have

argued that all the credit activities of the Federal Government should
be incorporated in the unified budget.

Under this approach, outlays

would include all loan contracts guaranteed by the Government and its
agencies as well as all direct loans.

The budget would then measure

the increase in the actual and potential financial liability of the
Government, thereby providing a comprehensive accounting of the Government's
involvement in the credit markets.
An all inclusive budget would also focus attention on the total
resource allocation effects of Government activity.

Congressional Committees

responsible for various functional areas of the budget would be better able


to consider Federal credit programs in tandem with taxation and
expenditure programs.

Thus, judgment on the advisability of adopting

alternative approaches to achieving budgetary goals would be improved
and a better understanding of the overall impact of the Government
on the economy would be obtained.
An alternative approach to the budgetary treatment of credit
activities would be one in which Federal credit extensions, whether
involving direct loans or guaranteed loans, would be excluded from
the unified budget and kept track of in a separate set of accounts.
This approach has been recommended by analysts who emphasize the difference
between outlays that involve the acquisition of financial assets, on the
one hand, and purchases of goods and services or transfers of income on
the other.

In the former case, the Government receives a claim on a

borrower as an offset to its provision of funds; in the latter it does
By affording similar status to direct and guaranteed loans
and carrying them in a separate loan account, this approach would also
highlight the Federal Government's impact on the credit allocation process.
At the same time, the unified budget would conform more closely to a
business firm's statement of income and expense.

Loan transactions under

this approach would not be reflected in the unified budget except to the
extent that defaults and/or subsidies on these loans give rise to outlays.
In a proper accounting scheme, of course, these types of costs should
enter the budget on an accrual

F><the potential liability is

incurred, rather than on a cas


X^ \

;tpie of default.

To implement this


procedure, Congress would have to estimate the potential for defaults on loans
made in any year, and then appropriate sufficient funds to be held
in a reserve account to cover the defaults as they occur.
Requiring current estimates of eventual costs to taxpayers
might well produce a more careful appraisal of various Federal credit

But the difficulties that would be encountered in making

these estimates would be substantial, especially in the case of programs
instituted or proposed more recently that involve large elements of
unknown risk.

Yet, it is clear that some estimates, however tenuous,

would be preferable to current practice which in general ignores
possible future costs of such programs.
The need to distinguish between Federal credit programs
and other expenditures was recognized by the 1967 Presidential
Commission on the Budget.

Specifically, with respect to direct loans

the Commission advised that while such transactions should be placed
in the comprehensive budget, they should be set apart from other

Such a different treatment was advised in order to permit the

calculation of an expenditure account surplus or deficit and to
facilitate analysis of the impact of direct loans.

The Commission

also recommended that subsidy elements in direct loans should be
estimated and reflected in expenditure accounts.
With regard to the budgetary treatment of loan guarantees,
the Commission offered no specific recommendations because it had not
had time to study this question sufficiently.

It indicated, however,

that coordinated surveillance of direct and guaranteed loans was desirable


and that a summary should be prepared along with the budget, setting
forth amounts of guaranteed and insured loans outstanding as well as
direct loans.
In adopting the Unified Budget concept in 1968, the President
accepted the Commission's recommendation to include direct loans in the

The recommendation to delineate between loan disbursements and

other outlays was also adopted initially but this practice has been
abandoned in recent budgets.

Also, the recommendation for estimating subsidy

elements was introduced in only a very few instances.

Over the years,

greater attention has been brought to bear on loan guarantees, as
they have been reviewed in some detail —

along with direct loans —


a chapter of the Special Analysis document that accompanies the budget.
This approach, however, is obviously no substitute for one that would
require consideration of Federal credit programs in the formal budget
process, and it was disappointing that the Budget Control Act of 1974
did not mandate such treatment.
The problems of budgetary management of Federal credit programs
under review by this Committee are obviously as complex as they are

Careful study and deliberation will be required before a

comprehensive budgetary system can be derived that will best serve the
various needs of the Congress.

I will not attempt to offer specific

recommendations for a program that might best serve these objectives,
but I would like to mention several points that I believe deserve careful
consideration in your deliberations.


First, if it is decided to continue including the direct
loans of government-owned agencies in the budget, it seems clear
to me that all such loans should be so treated.

In this regard,

last year's Congressional decision to return the Export-Import Bank
to the Budget was a salutary development.

Similar treatment,

I believe, should be considered for other agencies, including the
Federal Financing Bank.

There is no difference in substance between

a direct Federal loan and a loan that is guaranteed by a Government
agency and acquired by the FFB.

If one type of loan is included,

then so should the other.
A problem that could very well arise from including the
FFB in the budget, however, is that its lending and investing operations
could become an easy target for those wanting to make pseudo cuts in the

In that case, the financing of loans guaranteed by Federal

agencies might tend to be shifted back to the piecemeal and costly
approach that prevailed prior to the initiation of the FFB.


any changes in the budgetary status of the FFB would have to be
accompanied by other measures that prevent the loss of the cost
saving benefits which are provided by the FFB.

Perhaps, legislation

could be enacted that would require agencies to place certain types
of loan guarantees exclusively with the FFB.

This point clearly

would need detailed exploration.
Second, should the decision be made to continue to keep
privately-held loan guarantees off the budget, it is imperative that


steps be taken to achieve more effective Congressional surveillance
and control of these programs.

At a minimum all such loans should

be included on a separate line in the concurrent budget resolution.
This highlighting of the total of Government-1oan guarantees will
provide both the Congress and the public with a more complete picture
of the Government's involvement in the economy.
Congress should also establish rules requiring reconsideration
of ^ach loan guarantee program on a yearly basis.

In carrying out

this task, I would further advise the iniation of zero base budgeting;
that is, Congress should ask whether a program continues to be necessary
before it decides to continue and expand it.
Finally, Congress should require the formulation of estimates
of the potential defaults on loans that have been guaranteed and should
make provisions for these losses in the budget by setting up reserve

Such reserves are not needed for direct loans or guaranteed

loans held by Government agencies, if they are already reflected as
outlays in the budget.
In concluding, I would like to say that we at the Board regard
the passage of the Congressional Budget Act, and its implementation
in the past two years, as a major advance in the interests of sound
budget management.

The reforms in the treatment of Federal credit

programs and loan guarantee programs which may result from the efforts
of this Committee would constitute an additional substantial step toward
this important goal.