• Borrows money from the treasury
• Gives it directly to borrowers
• Government services the loan- collects payments regularly
• Government forecloses and/or attempts to collect money if it cant be paid

• Private lender gives loan to borrower
• Ex- Commercial Bank or Mortgage Lender
• Private lender originates loan, secures government guarantee and services loan according to government regulations
• Government agrees to pay full or partial payment to lender if borrower defaults

• Measures the extent to which a tool RESTRICTS individual or group behavior as opposed to merely encouraging or discouraging it.
• There is a dichotomy between the extension of credit and the
effort to collect on loans and avoid defaults.
Extension of Credit
• Borrower may object to the amount of paperwork and personal disclosure required
Payment of Loan
• Direct Loan- keep income tax rebate, suspend a school from eligibility for federal student loan programs
• Loan Guarantee- sanctions to lenders who underwrite or service loans improperly, sanctions against direct borrowers

• Measures the extent to which the entity authorizing or inaugurating a program is involved in executing it.
Direct Loan
• Allows government to have more information about borrowers because it deals directly with them.
Loan Guarantees
• Private lenders have info on borrowers and don’t always give it to government
Ex- Dept of Agriculture
• Servicing center then local office will attempt to reinstate timely loan payments
• local office will attempt to mitigate loss and may foreclose.
Ex- Dept of Education
• Uses schools to originate the loans, contractors to service loans and mitigate losses
Ex- U.S. Small Business Administration
• Lender originates ,services and forecloses on the loan
• Lender makes a claim to the government for their fraction of the loss on the defaulted loan.

• Measures the extent to which a tool utilizes an existing
administrative structure to produce its effects rather than
having to create its own administrative apparatus.
Direct Loans
• Give Loans- Not Direct
– have to create a delivery system to originate and service loans
• Collect Loan- Not Direct
Loan Guarantees
• Give Loans- Direct
– Uses existing private financial services system
• Collect Loans- Not Direct

• Measures the extent to which the resources devoted to the tool show up in the normal budget process
Direct Loans
• Before 1990 Credit Reform Act-
Visible
– Year given: Withdrawal of full loan amount
– Years paid back: Deposit of repayment amount
Loan Guarantees
• Before 1990 Credit Reform Act- Not
Visible- Clear Budgetary Advantage
– Year given: Not on budget
– Year defaulted: Withdrawal when lender paid

• True cost of a loan is not captured by the cash flow in any one year
• Net value over the life of the loan
• Subsidy Cost- Net present value of expected cash inflows and outflows over the life of the loan
(discounted for each year)
• Includes the cost of estimated future loan defaults or claims against a government loan guarantee
• Includes preferential interest rates on the loans
• Offset by any fees that are charged by the program
• Annual budget request includes funds required to cover credit subsidies for new loans or guarantees for the up coming year.
Example: Direct Loan:
• Government will make loans totaling $2,000
• Present Value Loan- $100
• Present Value of Inflows- $90
• Subsidy Cost- $10
• Subsidy Rate- 10%
• Government will seek appropriations of 10% or
$200

Doing Good
• Serving worthy constituencies
Doing Well
• Assuring loans are rigorously underwritten
• Assuring they are serviced
• Assuring they are foreclosed on if need be.

• Most beneficial economically if borrowers are those that are not creditworthy enough for private loans, but still creditworthy enough to handle the loan
• FHA-
• Was very conservative and didn’t give out much credit
• Then switched and gave lots of financially unsound people credit
• Took years to determine a balance

Forms of Subsidies
• Paying some interest
• Grace period before borrower has to start paying interest
• Charging lower fees
• Tax exemptions of interest receipts
• If subsidy rate is over 30% then its like giving a grant but its “justified” because the loan will be repaid
• Before the Credit Reform Act of 1990 Congress gave credit to failing companies
• Now they would have to figure out a credit subsidy and appropriate funds in the budget

Collateral is a way of reducing financial Risk
Secured Loans
• For Real Property
– Collateral Required
(usually the property itself)
– FHA, Veterans Administration
(VA), Rural Housing Service, SBA
– Foreclosing can have unacceptable political costs (ie-a homeowner with a SBA disaster relief loan)
Consumer-Type Loans
• Student Loans
– Collateral Not Required

• With Lenders or private parties (participating schools)
• They gain a stake in managing the origination and servicing of the loans
• With no financial risk the incentives become distorted
• Finding a balance is important
– 20 % may not be enough if the return is greater at the beginning (interest paid first)
– BUT, 20 % may deter firms from giving credit to are not as creditworthy
Direct Loans
• Improve alignment of incentives
• State may pay servicers a % of what they collect each month in repayment
Loan Guarantees
Ex-Student Loan Programs
• Lenders share 5% of financial risk
• Any greater and they may not give disadvantaged students loans

• Include
• fees and interest rates
• size of loan
• Maturities
• conditions of default
• Most successful federal programs
– FHA- 30 year self-amortizing mortgage, allows long term funding
• Replaced “balloon mortgages” that required refinancing every few years
– Private mortgage insurance reduces the risks of a levelpayment mortgage so private industry has adopted this type of mortgage.

Borrowers-
• Limiting the maximum loan-to-value requirements assures borrowers have a significant equity stake in homes and will then pay mortgage loans on time.
Government-
• The Credit Reform Act increased the governments financial accountability so they will avoid programs with high default rates

• The largest programs provide credit for housing, education, agriculture and business purposes
– In the last 20-30 years the number of loan guarantees have grown significantly, direct loans have remained constant.
• History
– WWI: War Finance Corporation (WFC) that became a peace time emergency finance corporation- ended in 1929
– 1932: Reconstruction Finance Corporation (RFC)- gave direct loans and stock subscriptions
– Roosevelt Administration- Started FHA, SBA, Export-Import Bank of U.S.
• These revived confidence in the markets with the strength of the federal government backing them.
– 1973-1984: Farmers Home Administration (FmHA)- bailed out lenders hit by the agricultural downturn.
– Reagan Administration- Curtail budget resources.
• Push from Direct Loans to Loan Guarantees which continued until the Credit Reform Act

• Have less financial capacity than the federal government
• Bonds are the most common form of state credit programs
• State Bond Banks
– Local governments pool together and receive lower costs and more favorable terms.
• State Revolving Loan Fund
– Credit to businesses or localities to help finance long-term economic development of environmental projects
– Begins with a federal grant or long-term loan.
– As money is repaid it is put back into the revolving loan fund to be given to new borrowers.

• Germany- “Landesbanken”- provide real estate, trade, commercial loans
• Japan- Government Housing Loan Corporation (GHLC)
– Provides 40% of the country’s mortgage credit though heavily subsidized loans
• France- Used the “Credit Foncier de France”, a quasi-governmental mortgage bank.
– Provides subsidized credit for income-eligible homeowners.
– Now use private mortgage credit banks to issue mortgage-backed bonds and fund mortgages
• United Kingdom- Student Loan Company Ltd.- non-profit adjunct of U.K
Dept. of Education.
– Provides income contingent repayment of student loans though the tax department
• China- Government has given mass amounts of money to wasteful activities.
• Roman Republic- 352 BCE- provided direct loans and loan guarantees to provide relief to poor debtors.
• King George III- Loans for infrastructure improvements and relieve economic distress
• Germany: Post WWII- Reconstruction Finance Corporation (RFC)- provided support for reconstruction after the war

• Develop regulations, contractual agreements, loan documents that reflect the laws that authorize the program.
• Develop forms and procedures to screen borrowers for eligibility.
• Loan guarantee- procedures to certify/decertify lenders as to edibility to participate in program.

•
•
– At first they were 100% guaranteed by the government, but expensive to service
– Large private lenders created specialized student loan businesses to purchase loans from originating banks to lower the costs of servicing them.
– Then student loans were more widely given.

• The process of actually extending a loan.
– Requires a contractual agreement between lender and borrower stating terms of the loan.
– Requires underwriting- determining if the borrower is capable of repaying the loan.
• Federal business loans and home loans require using the business or house as collateral.
– Federally guaranteed loans require the lender to sign a contract with the government for repayment of a defaulted loan.
• Direct Loans- Government originates the loan.
• Loan Guarantee- Private lender originates the loan.
• MORAL HAZARD: Government guarantee distorts the usual economic behavior of the lender.
– Enough fees and interest may make the lender indifferent about the loan defaulting.
– Government monitors default rates and lender performance to combat this.

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•
•

1.
Arranging to receive timely payments from the borrower
2.
Receiving and accounting for funds as borrowers remit them
– Grace period: when repayment isn't necessary right away as with a student loan.
– Delinquent: when the borrowers is late making a scheduled payment.
– Default: when the borrower has been delinquent for a previously established period of time
• Requires either restructuring the loan or foreclosure on the loan.
• Direct Loans- serviced by the government
 Federal agencies are starting to contract with private firms for this
• Loan Guarantees- serviced by the lenders
• MORAL HAZARD:
• Loan Guarantees-Private lenders are more carful servicing their own unguaranteed loans than they are with their government-guaranteed loans.
• Direct Loans- The same can happen if the government contracts out their loans.

• It is more economic to bundle up smaller loans and sell them to larger companies that can service them at a lower cost.
Ex- Home Mortgages
• Ginnie Mae- a secondary market institution that helps lenders to secure government-guaranteed home mortgages.
– Lenders originate a large number of mortgages
– They bundle them together in a trust structure
– They allow investors to buy shares in the cash flow from the mortgage to the trust.
– Ginnie Mae guarantees that they will receive timely repayments of both the interest and the principle.
Ex- Student Loans
• State Agencies or nonprofit organizations issue tax exempt bonds to fund pools of student loans that they purchase from the originating lenders.

• The government uses loan asset sales as a way to receive value from loans that it holds.
– Both direct loans and defaulted guaranteed loans
• In the 1980s and 90s HUD sold billions of nonperforming loans that they couldn’t collect on.
• SBA used this as a way to reduce its workload burdens when the agency downsized.
• The government can structure incentives so the private sector can collect on nonperforming loans without treating the borrowers unfairly.

• Prepayment- when the borrower pays off the loan ahead of time.
• Loan Guarantees- federal government is responsible for some, others it requires the private lenders to be responsible for.
– Either foreclose or forced sale of home/business
– Lender then collects the federal guarantee from the government.
• Some federal programs found that borrowers are current with private obligations, but let federally guaranteed loans default.
– Credit Alert Interactive Voice Response System- help screen applicants for federal loans. This finds if they defaulted before and requires that they pay that before getting new credit.
– Federal Tax Income Offset- Allows federal credit agencies to use a borrowers income tax credit to offset some of the loss of a defaulted loan.

• A loan is written-off when there are no further remedies available to mitigate the loss.
– Written-off loans have no value
• No incentives for recognizing this financial loss.
• Sometimes Disincentives.
– Offices may use them as a way to keep more staff
– China- Reluctant to close down state-owned enterprises that are in debt.
• They use this as an excuse to make large-scale mistakes that will cost the economy for years.

 Definition: some flaw in the market that deprives creditworthy borrowers access to credit on appropriate terms.
– Credit programs are most effective when they overcome a market imperfection.
– Provide credit without risk of high levels of default.
Examples:
• Economy is in disarray- Great Depression
• Restrictive Legislation- confining banks to geographic locations
• Discrimination- FHA: income and race
• Student Loans- given even if there isn't a long history of credit
 Market Imperfections are hard to find in good times.

• The government may give out preferential terms even when there isn't a market imperfection.
Example-
Export-Import Bank of the United States: Give subsidized loans so foreign governments wont give their own loans and deprive U.S. firms of those markets.
• Government does not always made wise decisions when giving a subsidy.
– Creditworthy people may need credit and not subsidies
– Non-creditworthy people may need subsidies or grants and not credit.

• FHA- pioneered the 30 year level payment mortgage that private lenders use today.
• By giving disadvantages borrowers credit they can show private lenders that those borrowers are profitable credit risks.
• The government has to be willing to turn over large numbers of creditworthy borrowers when their program succeeds.

•
•
•

•
•
– Lender can earn the fees and interest
– Lender develops a relationship with the borrower which may lead to more loans in the future.
– Lenders see direct loans as a competitive threat
• Unless they are to the least creditworthy borrowers

• Lenders provide a strong base for the program and inertia to maintain the features of the program.
• Ex- Dept. of Education
– Developed formalistic standards of performance to keep defaults low
• Lenders objected- used performance based standards
– Now the Dept. is trying to switch to performance based measures
• Lenders objected- don’t want the rules to change again

• When constituencies emerge Congress may expand the program to include borrowers not originally helped by the program.
Ex-Student Loans
– Students that could not show financial need were permitted to take out loans.
Ex- FHA- was middle-class and suburbs
– Included central cities-low income renters and homebuyers

• Credit Reform Act of 1990- All credit programs are subject to annual budget constraints.
• Congress then reduces the amount of subsidy provides so the amount appropriated can serve more people.
Ex- Student Loans
– Students could take out unsubsidized loans regardless of financial need.
– Students make interest payments on these, which the government only makes payments for the subsidized loans.
Ex- SBA
– Increased the amount of risk sharing with private lenders.
– Increased the loan-related fees for borrowers.

• Maintain balance between doing “good” and doing “well”
• Extend credit to creditworthy borrowers that need it while ensuring the program does not incur unacceptable losses.
• Financial problems take years to become apparent which gives them time to accumulate large amount of potential losses.
• Political environments
Ex- congress will give the SBA funds to help business in need, but not money to cover servicing or foreclosure.
• Wholly government owned organizations do this the best.
– They are meant to be self-sustaining

• Availability of staff and systems to maintain program
– Hiring freezes and mandatory staff reductions
Ex- Ginnie Mae
– 1993: 70 staff for hundreds of billions of dollars in mortgage-backed securities
– 1999: 56 staff for $540 Billion in securities
• Policymakers will allocate more money to the programs with the most defaults
• Staff Quality and Training
– Less young professionals with new ideas and technology-hiring freezes
– More prosperous alternatives in the private market
• “Hollow Government”
• Government contracts out, but needs staff to assure relationship between government and contractors.

• Government is devoting increased resources to monitoring performance
Ex- Ginney Mae
– 1980s- mortgage backed securities defaulted
• Agency added an information system to tract loan originators.
• Monitor default rates and delinquencies so they can act before there is an unacceptable financial loss.
• Effectiveness depends on legal authority given to agency
– Ex- Student Loans- Dept. of Education could take action against schools and the number of defaulting loans has dropped.
• Accountability- status of defaulted individuals now has to be reported to the credit bureaus.

• Private lenders want to keep the most profitable loans and send less profitable ones to the government.
• Many credit programs will only take people that have been turned down by private firms.
• Government credit is at a standard price so private firms want to offer a better price to more creditworthy borrowers.
– As they leave government programs the government is left with a higher proportion of less creditworthy borrowers.
– FHA mortgages were 1.9 times more likely to default before and are not 4.4 times more likely.

• Programs have used the financial strength of the government to experiment with new types of loans and give underserved borrowers credit.
• Less effective when they convey a subsidy without proving they will be profitable.
• Changes in credit markets make it hard to help those that deserve credit while protecting the programs from high numbers of defaults.
• New technologies allow more flexible data management, real-time biases, better customer service.

• After Great Depression- improved efficiency of markets.
• Do so now when helping borrowers that are neglected by private markets.
• Increases in efficiency within private markets have made some programs obsolete.
• Government credit encourages indebtedness.
– Federal school loans have helped facilitate the dept of many of today's students.

•
•
•

• Policymakers favor credit because of the expectation that the money will be paid back.
• Most popular
– SBA- helps people that were creditworthy, but have suddenly come upon a hardship.
• When credit programs fail they hurt borrowers and the tax payers that must pay for them.

• The available tasks for government credit are more diminished than ever before.
• Credit programs require high quality of institution that administers the program, financial soundless of program, and a good exit strategy so the program will end as a success.
• Need to improve design and management of institutions and learn from past experiences.