Maritime Administration
Weaknesses Identified in Management of the Title XI Loan Guarantee Program
Gao ID: GAO-03-728T May 15, 2003
Title XI of the Merchant Marine Act of 1936, as amended, is intended to help promote growth and modernization of the U.S. merchant marine and U.S. shipyards by enabling owners of eligible vessels and shipyards to obtain financing at attractive terms. The program has guaranteed more than $5.6 billion in ship construction and shipyard modernization costs since 1993, but has experienced several large-scale defaults over the past few years. One borrower, American Classic Voyages, defaulted on five loan guarantees in amounts totaling $330 million, the largest of which was for the construction of Project America cruise ships. Because of concerns about the scale of recent defaults, GAO was asked to (1) determine whether MARAD complied with key program requirements, (2) describe how MARAD's practices for managing financial risk compare to those of selected private-sector maritime lenders, and (3) assess MARAD's implementation of credit reform. We are currently considering a number of recommendations to reform the Title XI program. Because of the fundamental flaws we have identified, we question whether MARAD should approve new loan guarantees without first addressing these program weaknesses.
The Maritime Administration (MARAD) has not fully complied with some key Title XI program requirements. While MARAD generally complied with requirements to assess an applicant's economic soundness before issuing loan guarantees, MARAD did not ensure that shipowners and shipyard owners provided required financial statements and disbursed funds without sufficient documentation of project progress. Overall, MARAD does not employ procedures that would help it adequately manage the financial risk of the program. MARAD could benefit from following the practices of selected private-sector maritime lenders. These lenders separate key lending functions, offer less flexibility on key lending standards, use a more systematic approach to loan monitoring and rely on experts to estimate the value of defaulted assets. With regard to credit reform implementation, MARAD uses a simplistic cash flow model to calculate cost estimates, which have not reflected recent experience. If this pattern of recent experience were to continue, MARAD will have significantly underestimated the cost of the program. MARAD does not operate the program in a businesslike fashion. Consequently, MARAD cannot maximize the use of its limited resources to achieve its mission and the program is vulnerable to fraud, waste, abuse, and mismanagement. Also, because MARAD's subsidy estimates are questionable, Congress cannot know the true costs of the program.
GAO-03-728T, Maritime Administration: Weaknesses Identified in Management of the Title XI Loan Guarantee Program
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Testimony:
Before the Committee on Commerce, Science, and Transportation,
U.S. Senate:
United States General Accounting Office:
GAO:
For Release on Delivery Expected at 2:30 p.m. EDT:
Thursday, June 5, 2003:
Maritime Administration:
Weaknesses Identified in Management of the Title XI Loan Guarantee
Program:
Statement of Thomas J. McCool, Managing Director Financial Markets and
Community Investment:
GAO-03-728T:
GAO Highlights:
Highlights of GAO-03-728T, a testimony before the Committee on
Commerce, Science, and Transportation, U.S. Senate
Why GAO Did This Study:
Title XI of the Merchant Marine Act of 1936, as amended, is intended
to help promote growth and modernization of the U.S. merchant marine
and U.S. shipyards by enabling owners of eligible vessels and
shipyards to obtain financing at attractive terms. The program has
guaranteed more than $5.6 billion in ship construction and shipyard
modernization costs since 1993, but it has experienced several large-
scale defaults over the past few years. One borrower, American
Classic Voyages, defaulted on five loan guarantees in amounts totaling
$330 million, the largest of which was for the construction of Project
America cruise ships. Because of concerns about the scale of recent
defaults, GAO was asked to (1) determine whether the Maritime
Administration (MARAD) complied with key program requirements, (2)
describe how MARAD‘s practices for managing financial risk compare to
those of selected private-sector maritime lenders, and (3) assess
MARAD‘s implementation of credit reform.
GAO is currently considering a number of recommendations to reform the
Title XI program. Because of the fundamental flaws identified, GAO
questions whether MARAD should approve new loan guarantees without
first addressing these program weaknesses.
What GAO Found:
MARAD has not fully complied with some key Title XI program
requirements. While MARAD generally complied with requirements to
assess an applicant‘s economic soundness before issuing loan
guarantees, MARAD did not ensure that shipowners and shipyard owners
provided required financial statements, and it disbursed funds without
sufficient documentation of project progress. Overall, MARAD did not
employ procedures that would help it adequately manage the financial
risk of the program.
MARAD could benefit from following the practices of selected private-
sector maritime lenders. These lenders separate key lending
functions, offer less flexibility on key lending standards, use a more
systematic approach to loan monitoring, and rely on experts to
estimate the value of defaulted assets.
With regard to credit reform implementation, MARAD uses a simplistic
cash flow model to calculate cost estimates, which have not reflected
recent experience. If this pattern of recent experience were to
continue, MARAD would have significantly underestimated the cost of
the program.
MARAD does not operate the program in a businesslike fashion.
Consequently, MARAD cannot maximize the use of its limited resources
to achieve its mission and the program is vulnerable to fraud, waste,
abuse, and mismanagement. Also, because MARAD‘s subsidy estimates are
questionable, Congress cannot know the true costs of the program.
www.gao.gov/cgi-bin/getrpt?GAO-03-728T.
To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Tom McCool at (202) 512-8678 or
mccoolt@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss the results of our review of
the Maritime Administration's (MARAD) Title XI loan guarantee program.
Title XI was created to help promote growth and modernization of the
U.S. merchant marine and U.S. shipyards by enabling owners of eligible
vessels and shipyards to obtain long-term financing on terms and
conditions that might not otherwise be available. Under the program,
MARAD guarantees the payment of principal and interest to purchasers of
bonds issued by vessel and shipyard owners. These owners may obtain
guaranteed financing for up to 87.5 percent of the total cost of buying
or constructing a vessel or buying or modernizing a shipyard.
Under Title XI, MARAD committed to guarantee more than $5.6 billion in
shipyard modernization and ship construction projects over the last 10
years. During this period, MARAD experienced nine defaults on these
loan guarantee commitments totaling over $1.3 billion. The defaulted
amounts associated with these nine loan guarantee commitments totaled
$489 million.[Footnote 1] Five of these defaults were by subsidiaries
of American Classic Voyages Company (AMCV), a shipowner. AMCV defaults
represented 67 percent of all defaulted amounts experienced by MARAD
during this period, with this borrower having defaulted on guaranteed
loan projects in amounts totaling $330 million. The largest loan
guarantee ever approved by MARAD, for over $1.1 billion, was for
Project America, Inc., a subsidiary of AMCV. Project America, Inc., had
entered into a contract in March 1999 with Northrup Grumman (formerly
Litton Ingalls Shipbuilding) in Pascagoula, Mississippi, for the
construction of two cruise ships. In October 2001, AMCV filed for
bankruptcy, defaulting on $187 million in loan guarantees associated
with Project America.
As of December 31, 2002, MARAD's portfolio included approximately $3.4
billion in executed loan guarantees, representing 103 projects for 818
vessels and four shipyard modernizations.[Footnote 2] At the end of
fiscal year 2002, MARAD had approximately $20 million in unexpended,
unobligated budget authority that had been appropriated in prior years.
In its 2004 budget, the administration requested no new funds for the
Title XI program.
While Title XI of the Merchant Marine Act of 1936, as amended,
established the requirement of the loan guarantee program, the loan
guarantees are also subject to the Federal Credit Reform Act of 1990
(FCRA). Under the FCRA, federal agencies must account for the estimated
costs of direct and guaranteed loans on a net present value basis, over
the full term of the credit, and agencies must receive appropriations
for these costs before they disburse a loan or enter into loan
guarantee commitments.
Because of concerns about the scale of recent defaults experienced by
MARAD, particularly those associated with AMCV, you asked us to conduct
a study of the Title XI loan guarantee program. Specifically, you asked
us to (1) determine whether MARAD complied with key Title XI program
requirements in approving initial and subsequent agreements, monitoring
and controlling funds, and handling defaults; (2) describe how MARAD's
practices for managing financial risk compare to those of selected
private-sector maritime lenders; and (3) assess MARAD's implementation
of credit reform as it relates to the Title XI program.
To determine whether MARAD complied with key Title XI program
requirements, we identified key program requirements and reviewed how
these were applied to the management of five loan guarantee projects.
To determine how MARAD's practices for managing financial risk compare
to those of selected private-sector maritime lenders, we interviewed
three maritime lenders to learn about lending practices, and compared
these practices to MARAD's. To assess MARAD's implementation of credit
reform, we analyzed MARAD's subsidy cost estimation and reestimation
processes and examined how the assumptions MARAD uses to calculate
subsidy cost estimates compare to MARAD's actual program experience. We
conducted our work in Washington, D.C., and New York, N.Y., between
September 2002 and April 2003 in accordance with generally accepted
government auditing standards.
In summary:
* MARAD has not fully complied with some key Title XI program
requirements. We found that MARAD generally complied with requirements
to assess an applicant's economic soundness before issuing loan
guarantees. However, MARAD used waivers or modifications, which,
although permitted by MARAD regulations, allowed MARAD to approve some
applications even though borrowers had not met all financial
requirements. MARAD did not fully comply with regulations and
established practices pertaining to project monitoring and fund
disbursement. Finally, while MARAD has guidance governing the
disposition of defaulted assets, adherence to this guidance is not
mandatory, and MARAD did not always follow it in the defaulted cases we
reviewed.
* Private-sector maritime lenders we interviewed told us that to manage
financial risk, they among other things: (1) established a clear
separation of duties for carrying out different lending functions; (2)
adhered to key lending standards with few, if any, exceptions; (3) used
a more systematic approach to monitoring the progress of projects; and
(4) primarily employed independent parties to survey and appraise
defaulted projects. They try to be very selective when originating
loans for the shipping industry. MARAD could benefit from considering
the internal control practices employed by the private sector to more
effectively utilize its limited resources while maximizing its ability
to accomplish its mission.
* MARAD uses a relatively simplistic cash flow model that is based on
outdated assumptions, which lack supporting documentation, to prepare
its estimates of defaults and recoveries. While the nature and
characteristics of the Title XI program make it difficult to estimate
subsidy costs, MARAD has not performed the basic analyses necessary to
assess and improve its estimates, which differ significantly from
recent actual experience. Specifically, we found that in comparison
with recent actual experience, MARAD's default estimates have
significantly understated defaults, and its recovery estimates have
significantly overstated recoveries. Agencies should use sufficient
reliable historical data to estimate credit subsidies and update--
reestimate--these estimates annually based on an analysis of actual
program experience. However, MARAD has never evaluated the performance
of its loan guarantee projects to determine if its subsidy cost
reestimates were comparable to actual costs. Finally, the Office of
Management and Budget (OMB) had provided little oversight of MARAD's
subsidy cost estimate and reestimate calculations.
Because MARAD does not operate the Title XI loan guarantee program in a
businesslike fashion, it lacks assurance that it is effectively
promoting growth and modernization of the U.S. merchant marine and U.S.
shipyards or minimizing the risk of financial loss to the federal
government. Consequently, the Title XI program could be vulnerable to
waste, fraud, abuse, and mismanagement. Also, MARAD's questionable
subsidy cost estimates do not provide Congress a basis for knowing the
true costs of the Title XI program and Congress cannot make well-
informed policy decisions when providing budget authority. If the
pattern of recent experiences were to continue, MARAD would have
significantly underestimated the costs of the program.
To review our findings in more detail, let me start by describing
MARAD's management of the Title XI program.
MARAD Has Not Fully Complied with Some Key Title XI Program
Requirements:
MARAD has not fully complied with some key Title XI program
requirements. We found that MARAD generally complied with requirements
to assess an applicant's economic soundness before issuing loan
guarantees. However, MARAD used waivers or modifications, which,
although permitted by MARAD regulations, allowed MARAD to approve some
applications even though borrowers had not met all financial
requirements. Additionally, MARAD did not fully comply with regulations
and established practices pertaining to project monitoring and fund
disbursement. Finally, while MARAD has guidance governing the
disposition of defaulted assets, adherence to this guidance is not
mandatory, and MARAD did not always follow it in the defaulted cases we
reviewed. We looked at five MARAD-financed projects (see table 1).
Table 1: Projects Included in Our Review:
Project: (AMCV) Project America, Inc.; Year Loan Committed: 1999;
Original Amount (millions): $1,079.5; Risk Category: 2A;
Status: Default.
Project: Searex; Year Loan Committed: 1996; Original Amount
(millions): $77.3; Risk Category: 2B; : Status: Default.
Project: Massachusetts Heavy Industries (MHI); Year Loan Committed:
1997; Original Amount (millions): $55.0; Risk Category: 3;
Status: Default.
Project: Hvide Van Ommeran Tankers (HVIDE); Year Loan Committed:
1996; Original Amount (millions): $43.2; Risk Category: 2C;
Status: Active.
Project: Global Industries; Year Loan Committed: 1996;
Original Amount (millions): $20.3; Risk Category: 1C;
Status: Active.
Source: MARAD data.
Note: MARAD places projects into one of seven risk categories that,
from lowest to highest, are 1A, 1B, 1C, 2A, 2B, 2C, and 3.
[End of table]
MARAD Used Waivers and Modifications to Approve Loans That Would
Otherwise Not Be Approved:
MARAD regulations do not permit MARAD to guarantee a loan unless the
project is determined to be economically sound.[Footnote 3] MARAD
generally complied with requirements to assess an applicant's economic
soundness before approving loan guarantees, and we were able to find
documentation addressing economic soundness criteria for the projects
included in our review. Specifically, we were able to find
documentation addressing supply and demand projections and other
economic soundness criteria for the projects included in our
review.[Footnote 4] In 2002, MARAD's Office of Statistical and Economic
Analysis found a lack of a standardized approach for conducting market
analyses. Because of this concern, in November 2002, it issued guidance
for conducting market research on marine transportation services.
However, adherence to these guidelines is not required. Finally, while
MARAD may not waive economic soundness criteria, officials from the
Office of Statistics and Economic Analysis expressed concern that their
findings regarding economic soundness might not always be fully
considered when MARAD approved loan guarantees.[Footnote 5] They cited
a recent instance where they questioned the economic soundness of a
project that was later approved without their concerns being addressed.
According to the Associate Administrator for Shipbuilding, all
concerns, including economic soundness concerns, are considered by the
MARAD Administrator.
Shipowners and shipyard owners are also required to meet certain
financial requirements during the loan approval process. However, MARAD
used waivers or modifications, which, although permitted by Title XI
regulations, allowed MARAD to approve some applications even though
borrowers had not met all financial requirements that pertained to
working capital, long-term debt, net worth, and owner-invested
equity.[Footnote 6] For example, AMCV's Project America, Inc., did not
meet the qualifying requirements for working capital, among other
things. Although MARAD typically requires companies to have positive
working capital, an excess of current assets over current liabilities,
the accounting requirements for unterminated passenger payments
significantly affect this calculation because this deferred revenue is
treated as a liability until earned.[Footnote 7] Because a cruise
operator would maintain large balances of current liabilities, MARAD
believed it would be virtually impossible for AMCV to meet a positive
working capital requirement if sound cash management practices were
followed.[Footnote 8] Subsequently, MARAD used cash flow tests for
Project America, Inc., in lieu of working capital requirements for
purposes of liquidity testing.
According to MARAD officials, waivers or modifications help them meet
the congressional intent of the Title XI program, which is to promote
the growth and modernization of the U. S. merchant marine industry.
Further, they told us that the uniqueness of the Title XI projects and
marine financing lends itself to the use of waivers and modifications.
However, by waiving or modifying financial requirements, MARAD
officials may be taking on greater risk in the loans they are
guaranteeing. Consequently, the use of waivers or modifications could
contribute to the number or severity of loan guarantee defaults and
subsequent federal payouts. In a recent review, the Department of
Transportation Inspector General (IG) noted that the use of
modifications increases the risk of the loan guarantee to the
government and expressed concern about MARAD undertaking such
modifications without taking steps to mitigate those risks. The IG
recommended that MARAD require a rigorous analysis of the risks from
modifying any loan approval criteria and impose compensating
requirements on borrowers to mitigate these risks.
MARAD Did Not Follow Requirements for Monitoring the Financial
Condition of Projects and for Controlling the Disbursement of Loan
Funds:
MARAD did not fully comply with requirements and its own established
practices pertaining to project monitoring and fund disbursement.
Program requirements specify periodic financial reporting, controls
over the disbursement of loan funds, and documentation of amendments to
loan agreements. MARAD could not always demonstrate that it had
complied with financial reporting requirements. In addition, MARAD
could not always demonstrate that it had determined that projects had
made progress prior to disbursing loan funds. Also, MARAD broke with
its own established practices for determining the amount of equity a
shipowner must invest prior to MARAD making disbursements from the
escrow fund.[Footnote 9] MARAD did so without documenting this change
in the loan agreement. Ultimately, weaknesses in MARAD's monitoring
practices could increase the risk of loss to the federal government.
MARAD regulations specify that the financial statements of a company in
receipt of a loan guarantee shall be audited at least annually by an
independent certified public accountant. In addition, MARAD regulations
require companies to provide semiannual financial statements. However,
MARAD could not demonstrate that it had received required annual and
semiannual statements. For example, MARAD could not locate several
annual or semiannual financial statements for the Massachusetts Heavy
Industries (MHI) project. Also, MARAD could not find the 1999 and 2000
semiannual financial reports for AMCV. The AMCV financial statements
were later restated, as a result of a Securities and Exchange
Commission (SEC) finding that AMCV had not complied with generally
accepted accounting principles in preparing its financial
statements.[Footnote 10] In addition, several financial statements were
missing from MARAD records for Hvide Van Ommeran Tankers (HVIDE) and
Global Industries Ltd. When MARAD could provide records of financial
statements, it was unclear how the information was used. Further, the
Department of Transportation IG in its review of the Title XI program
found that MARAD had no established procedures or policies
incorporating periodic reviews of a company's financial well-being once
a loan guarantee was approved.[Footnote 11]
An analysis of financial statements may have alerted MARAD to financial
problems with companies and possibly given it a better chance to
minimize losses from defaults. For example, between 1993 and 2000, AMCV
had net income in only 3 years and lost a total of $33.3 million. Our
analysis showed a significant decline in financial performance since
1997. Specifically, AMCV showed a net income of $2.4 million in 1997,
with losses for the next 3 years, and losses reaching $10.1 million in
2000. Although AMCV's revenue increased steadily during this period by
a total of 25 percent, or nearly $44 million, expenses far outpaced
revenue during this period. For example, the cost of operations
increased 29 percent, or $32.3 million, while sales and general and
administrative costs increased over 82 percent or $33.7 million. During
this same period, AMCV's debt also increased over 300 percent. This
scenario combined with the decline in tourism after September 11, 2001,
caused AMCV to file for bankruptcy. On May 22, 2001 Ingalls notified
AMCV that it was in default of its contract due to nonpayment. Between
May 22 and August 23, 2001, MARAD received at least four letters from
Ingalls, the shipbuilder, citing its concern about the shipowner's
ability to pay construction costs. However, it was not until August 23,
that MARAD prepared a financial analysis to help determine the
likelihood of AMCV or its subsidiaries facing bankruptcy or another
catastrophic event.
MARAD could not always demonstrate that it had linked disbursement of
funds to progress in ship construction, as MARAD requires. We were not
always able to determine from available documents the extent of
progress made on the projects included in our review. For example, a
number of Project America, Inc.'s, disbursement requests did not
include documentation that identified the extent of progress made on
the project. Also, while MARAD requires periodic on-site visits to
verify the progress on ship construction or shipyard refurbishment, we
did not find evidence of systematic site visits and inspections. For
Project America, Inc., MARAD did not have a construction representative
committed on site at Ingalls Shipyard, Inc., until May 2001, 2 months
after the MARAD's Office of Ship Design and Engineering Services
recommended a MARAD representative be located on-site. For the Searex
Title XI loan guarantee, site visits were infrequent until MARAD became
aware that Ingalls had cut the vessels into pieces to make room for
other projects. For two projects rated low-risk, Hvide Van Ommeran
Tankers and Global Industries, Ltd., we found MARAD conducted site
visits semiannually and annually, respectively. We reviewed MHI's
shipyard modernization project, which was assigned the highest risk
rating, and found evidence that construction representatives conducted
monthly site visits. However, in most instances, we found that a
project's risk was not linked to the extent of project monitoring.
Further, MARAD relied on the shipowner's certification of money spent
in making decisions to approve disbursements from the escrow fund.
We also found that, in a break with its own established practice, MARAD
permitted a shipowner to define total costs in a way that permitted
earlier disbursement of loan funds from the escrow fund. MARAD
regulations require that shipowners expend from their own funds at
least 12.5 percent or 25 percent, depending on the type of vessel or
technology, of the actual cost of a vessel or shipyard project prior to
receiving MARAD-guaranteed loan funds. In practice, MARAD has used the
estimated total cost of the project to determine how much equity the
shipowner should provide. In the case of Project America, Inc., the
single largest loan guarantee in the history of the program, we found
that MARAD permitted the shipowner to exclude certain costs in
determining the estimated total costs of the ship at various points in
time, thereby deferring owner-provided funding while receiving MARAD-
guaranteed loan funds. This was the first time MARAD used this method
of determining equity payments, and MARAD did not document this
agreement with the shipowner as required by its policy. In September
2001, MARAD amended the loan commitment for this project, permitting
the owner to further delay the payment of equity. By then, MARAD had
disbursed $179 million in loan funds. Had MARAD followed its
established practice for determining equity payments, the shipowner
would have been required to provide an additional $18 million. Because
MARAD had not documented its agreements with AMCV, the amount of equity
the owner should have provided was not apparent during this period.
Further, MARAD systems do not flag when the shipowner has provided the
required equity payment for any of the projects it finances.
MARAD officials cited several reasons for its limited monitoring of
Title XI projects, including insufficient staff resources and travel
budget restrictions. For example, officials of MARAD's Office of Ship
Construction, which is responsible for inspection of vessels and
shipyards, told us that they had only two persons available to conduct
inspections, and that the office's travel budget was limited. The MARAD
official with overall responsibility for the Title XI program told us
that, at a minimum, the Title XI program needs three additional staff.
The Office of Ship Financing needs two additional persons to enable a
more through review of company financial statements and more
comprehensive preparation of credit reform materials. Also, the
official said that the Office of the Chief Counsel needs to fill a
long-standing vacancy to enable more timely legal review. With regard
to documenting the analysis of financial statements, MARAD officials
said that, while they do require shipowners and shipyard owners to
provide financial statements, they do not require MARAD staff to
prepare a written analysis of the financial condition of the Title XI
borrower.
Inconsistent monitoring of a borrower's financial condition limits
MARAD's ability to protect the federal government's financial
interests. For example, MARAD would not know if a borrower's financial
condition had changed so that it could take needed action to possibly
avoid defaults or minimize losses. Further, MARAD's practices for
assessing project progress limit its ability to link disbursement of
funds to progress made by shipowners or shipyard owners. This could
result in MARAD disbursing funds without a vessel or shipyard owner
making sufficient progress in completing projects. Likewise, permitting
project owners to minimize their investment in MARAD-financed projects
increases the risk of loss to the federal government.
MARAD Does Not Have Requirements in Place to Govern the Handling of
Defaulted Assets:
MARAD has guidance governing the disposition of defaulted assets.
However, MARAD is not required to follow this guidance, and we found
that MARAD does not always adhere to it. MARAD guidelines state that an
independent, competent marine surveyor or MARAD surveyor shall survey
all vessels, except barges, as soon as practicable, after the assets
are taken into custody. In the case of filed or expected bankruptcy, an
independent marine surveyor should be used. In the case of Searex,
MARAD conducted on-site inspections after the default. However, these
inspections were not conducted in time to properly assess the condition
of the assets. With funds no longer coming in from the project, Ingalls
cut the vessels into pieces to make it easier to move the vessels from
active work-in-process areas to other storage areas within the
property. The Searex lift boat and hulls were cut before MARAD
inspections were made. According to a MARAD official, the cutting of
one Searex vessel and parts of the other two Searex vessels under
construction reduced the value of the defaulted assets. The IG report
on the Title XI program released in March 2003 noted that site visits
were conducted on guaranteed vessels or property only in response to
problems or notices of potential problems from third parties or from
borrowers.
The guidelines also state that sales and custodial activities shall be
conducted in such a fashion as to maximize MARAD's overall recovery
with respect to the asset and debtor. Market appraisals (valuations) of
the assets shall be performed by an independent appraiser, as deemed
appropriate, to assist in the marketing of the asset. Relying on an
interested party in determining the value of defaulted assets may not
have maximized MARAD's financial recovery. In the case of Project
America I and II, MARAD relied on the shipbuilder, Ingalls, to provide
an estimate of the cost of making the Project America I vessel
seaworthy. According to MARAD officials, their only option was to rely
on Ingalls to provide this estimate. Ingalls' initial estimate in April
2002 was $16 million. Based on this estimate, MARAD rejected two bids
to purchase the unfinished hull of Project America I ($2 million and
$12 million respectively).[Footnote 12] Subsequently, on May 17, 2002,
MARAD advised Ingalls that it should dispose of the assets of Project
America I and remit the net savings, if any, to MARAD. In a June 28,
2002, agreement between Northrup Grumman Ship Systems, Inc. (formerly
Litton Ingalls Shipbuilding), Northrup Grumman advised that it would
cost between $9 and $12 million to preserve and make Project America I
seaworthy for delivery to the prospective purchaser. Had the $9 to $12
million estimate been made earlier in April 2002, MARAD would have
accepted the $12 million dollar bid and would have disposed of the
Project America I asset. By accepting Ingalls' original estimate of $16
million to make the ship seaworthy, MARAD may have incurred several
months of unnecessary preservation expenses and possibly lowered its
recovery amount. According to MARAD officials, as of March 2003, MARAD
had received $2 million from the sale of the Project America I and II
vessels.
Rather than obtaining a market appraisal to assist in marketing the
asset, MARAD hired the Defense Contract Audit Agency (DCAA) to verify
the costs incurred by Northrop Grumman Ship Systems, Inc., since
January 1, 2002, for preparing and delivering Project America I in a
weathertight condition suitable for ocean towing in international
waters. A MARAD official said that the DCAA audit would allow MARAD to
identify any unsupported costs and recover these amounts from the
shipyard. The DCAA review was used to verify costs incurred, but not to
make a judgment as to the reasonableness of the costs. DCAA verified
costs of approximately $17 million.
MARAD officials cite the uniqueness of the vessels and projects as the
reason for using guidelines instead of requirements for handling
defaulted assets. However, certain practices for handling defaulted
assets can be helpful regardless of the uniqueness of a project. Among
these are steps to immediately assess the value of the defaulted asset.
Without a definitive strategy and clear requirements, defaulted assets
may not always be secured, assessed, and disposed of in a manner that
maximizes MARAD's recoveries--resulting in unnecessary costs and
financial losses to the federal government.
MARAD Techniques to Manage Financial Risk Contrast to Techniques of
Selected Private-sector Maritime Lenders:
Private-sector maritime lenders we interviewed told us that it is
imperative for lenders to manage the financial risk of maritime lending
portfolios. In contrast to MARAD, they indicated that to manage
financial risk, among other things, they (1) establish a clear
separation of duties for carrying out different lending functions; (2)
adhere to key lending standards with few, if any, exceptions; (3) use a
more systematic approach to monitoring the progress of projects; and
(4) primarily employ independent parties to survey and appraise
defaulted projects. The lenders try to be very selective when
originating loans for the shipping industry. While realizing that MARAD
does not operate for profit, it could benefit from the internal control
practices employed by the private sector to more effectively utilize
its limited resources and to enhance its ability to accomplish its
mission. Table 2 describes the key differences in private-sector and
MARAD maritime lending practices used during the application,
monitoring, and default and disposition phases.
Table 2: Comparison of Private-sector and MARAD Maritime Lending
Practices:
Application:
Phases of the lending process: Private-sector practices: Application: *
Permit few exceptions to key financial underwriting requirements for
maritime loans; * Seek approval of exceptions or waivers from Audit
Committee; * Perform an in-depth analysis of a business plan for
applications received for start-up businesses or first-in-class
shipyard vessels; Phases of the lending process: MARAD practices:
Application: * Permit waivers of key financial requirements; * Have no
committee oversight regarding the approval of exceptions or waivers of
program requirements; * Employ little variation in the depth of review
of business plans based on type of vessel, size of loan guarantee, or
history of borrower.
Monitoring:
Phases of the lending process: Private-sector practices: *
Set an initial risk rating at the time of approval and review rating
annually to determine risk rating of the loan; * Use industry expertise
for conducting periodic on-site inspections to monitor progress on
projects and potential defaults; * Perform monitoring that is dependent
on financial and technical risk, familiarity with the shipyard, and
uniqueness of the project; * Analyze the borrower's financial
statements to identify significant changes in borrower's financial
condition and to determine appropriate level and frequency of continued
monitoring at least annually; Phases of the lending process: MARAD
practices: * Assign one risk rating during the application
phase. No subsequent ratings assigned during the life of the loan; *
Use in-house staff to conduct periodic on-site inspections to monitor
progress of projects; * Perform monitoring based on technical risk,
familiarity with shipyard, uniqueness of project, and availability of
travel funds; * Have no documentation of analyses of borrowers'
financial statements.
Default and Disposition:
Phases of the lending process: Private-sector practices: *
Contract with an independent appraiser to prepare a valuation of a
defaulted project; * Enlist a technical manager to review the ship
after default to assist in determining structural integrity and
percentage of completion; Phases of the lending process: MARAD
practices: * Permit an interested party or MARAD official
to value assets; * Permit an interested party or MARAD official to
perform technical review of Title XI assets.
Sources: GAO analysis of MARAD and private-sector data.
[End of table]
Private-sector Lenders Separate Key Lending Functions:
Private-sector lenders manage financial risk by establishing a
separation of duties to provide a system of checks and balances for
important maritime lending functions. Two private-sector lenders
indicated that there is a separation of duties for approving loans,
monitoring projects financed, and disposing of assets in the event of
default. For example, marketing executives from two private-sector
maritime lending institutions stated that they do not have lending
authority. Also, separate individuals are responsible for accepting
applications and processing transactions for loan underwriting.
In contrast, we found that the same office that promotes and markets
the MARAD Title XI program also has influence and authority over the
office that approves and monitors Title XI loans. In February 1998,
MARAD created the Office of Statistical and Economic Analysis in an
attempt to obtain independent market analyses and initial
recommendations on the impact of market factors on the economic
soundness of projects. This office reports to the Associate
Administrator for Policy and International Trade rather than the
Associate Administrator for Shipbuilding. However, the Associate
Administrator for Shipbuilding also is primarily responsible for
overseeing the underwriting and approving of loan guarantees. Title XI
program management is primarily handled by offices that report to the
Associate Administrator for Shipbuilding. In addition, the same
Associate Administrator controls, in collaboration with the Chief of
the Division of Ship Financing Contracts Office within the Office of
the Chief Counsel, the disposition of assets after a loan has
defaulted. Most recently, MARAD has taken steps to consolidate
responsibilities related to loan disbursements. In August 2002, the
Maritime Administrator gave the Associate Administrator for
Shipbuilding sole responsibility for reviewing and approving the
disbursement of escrow funds. According to a senior official, prior to
August 2002 this responsibility was shared with the Office of Financial
and Rate Approvals under the supervision of the Associate Administrator
for Financial Approvals and Cargo Preference. As a result of the
consolidation, the same Associate Administrator who is responsible for
underwriting and approving loan guarantees and disposing of defaulted
assets is also responsible for approval of loan disbursements and
monitoring financial condition. MARAD undertook this consolidation in
an effort to improve performance of analyses related to the calculation
of shipowner's equity contributions and monitoring of changes in
financial condition. However, as mentioned earlier, MARAD does not have
controls for clearly identifying the shipowner's required equity
contribution. The consolidation of responsibilities for approval of
loan disbursements does not address these weaknesses and precludes any
potential benefit from separation of duties.
Private-sector Practices Employ Less Flexible Lending Standards:
The private-sector lenders we interviewed said they apply rigorous
financial tests for underwriting maritime loans. They analyze financial
statements such as balance sheets, income statements, and cash flow
statements, and use certain financial ratios such as liquidity and
leverage ratios that indicate the borrower's ability to repay. Private-
sector maritime lenders told us they rarely grant waivers, or
exceptions, to underwriting requirements or approve applications when
borrowers do not meet key minimum requirements. Each lender we
interviewed said any approved applicants were expected to demonstrate
stability in terms of cash on hand, financial strength, and collateral.
One lender told us that on the rare occasions when exceptions to the
underwriting standards were granted, an audit committee had to approve
any exception or waiver to the standards after reviewing the
applicant's circumstances. In contrast, we found in the cases we
reviewed that MARAD often permits waivers or modifications of key
financial requirements, often without a deliberative process, according
to a MARAD official. For example, MARAD waived the equity and working
capital financial requirements at the time of the loan guarantee
closing for MHI's shipyard modernization project. Also, a recent IG
report found that MARAD routinely modifies financial requirements in
order to qualify applicants for loan guarantees. Further, the IG noted
that MARAD reviewed applications for loan guarantees primarily with in-
house staff and recommended that MARAD formally establish an external
review process as a check on MARAD's internal loan application
review.[Footnote 13] A MARAD official told us that MARAD is currently
developing the procedures for an external review process.
These private-sector lenders also indicated that preparing an economic
analysis or an independent feasibility study assists in determining
whether or not to approve funding based on review and discussion of the
marketplace, competition, and project costs. Each private-sector lender
we interviewed agreed that performance in the shipping industry was
cyclical and timing of projects was important. In addition, reviewing
historical data provided information on future prospects for a project.
For example, one lender uses these economic analyses to evaluate how
important the project will be to the overall growth of the shipping
industry. Another lender uses the economic analyses and historical data
to facilitate the sale of a financed vessel. In the area of economic
soundness analysis, MARAD requirements appear closer to those of the
private-sector lenders, in that external market studies are also used
to help determine the overall economic soundness of a project. However,
assessments of economic soundness prepared by the Office of Statistical
and Economic Analysis may not be fully considered when MARAD approves
loan guarantees.
Private-sector Lenders Use a More Systematic Approach to Loan
Monitoring:
Private-sector lenders minimized financial risk by establishing loan
monitoring and control mechanisms such as analyzing financial
statements and assigning risk ratings. Each private-sector lender we
interviewed said that conducting periodic reviews of a borrower's
financial statements helped to identify adverse changes in the
financial condition of the borrower. For example, two lenders stated
that they annually analyzed financial statements such as income
statements and balance sheets. The third lender evaluated financial
statements quarterly. Based on the results of these financial statement
reviews, private-sector lenders then reviewed and evaluated the risk
ratings that had been assigned at the time of approval. Two lenders
commented that higher risk ratings indicated a need for closer
supervision, and they then might require the borrower to submit monthly
or quarterly financial statements. In addition, a borrower might be
required to increase cash reserves or collateral to mitigate the risk
of a loan. Further, the lender might accelerate the maturity date of
the loan. Private-sector lenders used risk ratings in monitoring
overall risk, which in turn helped to maintain a balanced maritime
portfolio.
At MARAD, we found no evidence that staff routinely analyzed or
evaluated financial statements or changed risk categories after a loan
was approved. For example, we found in our review that for at least two
financial statement reporting periods, MARAD was unable to provide
financial statements for the borrower, and, in one case, one financial
statement was submitted after the commitment to guarantee funds. Our
review of the selected Title XI projects indicated that risk categories
were primarily assigned for purposes of estimating credit subsidy costs
at the time of application, not for use in monitoring the project.
Further, we found no evidence that MARAD changed a borrower's risk
category when its financial condition changed. In addition, neither the
support office that was initially responsible for reviewing and
analyzing financial statements nor the office currently responsible
maintained a centralized record of the financial statements they had
received. Further, while one MARAD official stated that financial
analyses were performed by staff and communicated verbally to top-level
agency officials, MARAD did not prepare and maintain a record of these
analyses.
Private-sector lenders also manage financial risk by linking the
disbursement of loan funds to the progress of the project. All the
lenders we interviewed varied project monitoring based on financial and
technical risk, familiarity with the shipyard, and uniqueness of the
project. Two lenders thought that on-site monitoring was very important
in determining the status of projects. Specifically, one lender hires
an independent marine surveyor to visit the shipyard to monitor
construction progress. This lender also requires signatures on loan
disbursement requests from the shipowner, shipbuilder, and loan officer
before disbursing any loan funds. This lender also relies on technical
managers and classification society representatives who frequently
visit the shipyard to monitor progress.[Footnote 14] Shipping
executives of this lender make weekly, and many times daily, calls to
shipowners to further monitor the project based on project size and
complexity. This lender also requires shipowners to provide monthly
progress reports so the progress of the project could be monitored.
MARAD also relied on site visits to verify construction progress.
However, the linkage between the progress of the project and the
disbursement of loan funds was not always clear. MARAD tried to adjust
the number of site visits based on the amount of the loan guarantee,
the uniqueness of project (for example, whether the ship is the first
of its kind for the shipowner), the degree of technical and engineering
risk, and familiarity with the shipyard. However, the frequency of site
visits was often dependent upon the availability of travel funds,
according to a MARAD official.
Private-sector Lenders Use Industry Expertise to Value Defaulted
Assets:
Private-sector maritime lenders said they regularly use independent
marine surveyors and technical managers to appraise and conduct
technical inspections of defaulted assets. For example, two lenders
hire independent marine surveyors who are knowledgeable about the
shipbuilding industry and have commercial lending expertise to inspect
the visible details of all accessible areas of the vessel, as well as
its marine and electrical systems. In contrast, we found that MARAD did
not always use independent surveyors. For example, we found that for
Project America, the shipbuilder was allowed to survey and oversee the
disposition of the defaulted asset. As mentioned earlier, MARAD hired
DCAA to verify the costs incurred by the shipbuilder to make the
defaulted asset ready for sale; however, MARAD did not verify whether
the costs incurred were reasonable or necessary. For Searex,
construction representatives and officials from the Offices of the
Associate Administrator of Shipbuilding and the Chief of the Division
of Ship Financing Contracts were actively involved in the disposition
of the assets.
MARAD Cites Mission as the Difference in Management of Financial Risk
Compared to Private-sector Lenders:
According to top-level MARAD officials, the chief reason for the
difference between private-sector and MARAD techniques for approving
loans, monitoring project progress, and disposing of assets is the
public purpose of the Title XI program, which is to promote growth and
modernization of the U.S. merchant marine and U.S. shipyards. That is,
MARAD's program purposefully provides for greater flexibility in
underwriting in order to meet the financing needs of shipowners and
shipyards that otherwise might not be able to obtain financing. MARAD
is also more likely to work with borrowers that are experiencing
financial difficulties once a project is under way. MARAD officials
also cited limited resources in explaining the limited nature of
project monitoring.
While program flexibility in financial and economic soundness standards
may be necessary to help MARAD meet its mission objectives, the strict
use of internal controls and management processes are also important.
Otherwise, resources that could have been used to further the program
might be wasted. To aid agencies in improving internal controls, we
have recommended that agencies identify the risks that could impede
their ability to efficiently and effectively meet agency goals and
objectives.[Footnote 15] Private-sector lenders employ internal
controls such as a systematic review of waivers during the application
phase and risk ratings of projects during the monitoring phase.
However, MARAD does neither. Without a more systematic review of
underwriting waivers, MARAD might not be giving sufficient
consideration to the additional risk such decisions represent.
Likewise, without a systematic process for assessing changes in payment
risk, MARAD cannot use its limited monitoring resources most
efficiently. Further, by relying on interested parties to estimate the
value of defaulted loan assets, MARAD might not maximize the recovery
on those assets. Overall, by not employing the limited internal
controls it does possess, and not taking advantage of basic internal
controls such as those private-sector lenders employ, MARAD cannot
ensure it is effectively utilizing its limited administrative resources
or the government's limited financial resources.
MARAD's Credit Subsidy Estimates and Reestimates Are Questionable:
MARAD uses a relatively simplistic cash flow model that is based on
outdated assumptions, which lack supporting documentation, to prepare
its estimates of defaults and recoveries. These estimates differ
significantly from recent actual experience. Specifically, we found
that in comparison with recent actual experience, MARAD's default
estimates have significantly understated defaults, and its recovery
estimates have significantly overstated recoveries. If the pattern of
recent experience were to continue, MARAD would have significantly
underestimated the costs of the program. Agencies should use sufficient
reliable historical data to estimate credit subsidies and update--
reestimate--these estimates annually based on an analysis of actual
program experience. While the nature and characteristics of the Title
XI program make it difficult to estimate subsidy costs, MARAD has never
performed the basic analyses necessary to determine if its default and
recovery assumptions are reasonable. Finally, OMB has provided little
oversight of MARAD's subsidy cost estimate and reestimate calculations.
MARAD's Credit Subsidy Estimates Are Questionable:
The Federal Credit Reform Act of 1990 (FCRA) was enacted, in part, to
require that the federal budget reflect a more accurate measurement of
the government's subsidy costs for loan guarantees.[Footnote 16] To
determine the expected cost of a credit program, agencies are required
to predict or estimate the future performance of the program. For loan
guarantees, this cost, known as the subsidy cost, is the present value
of estimated cash flows from the government, primarily to pay for loan
defaults, minus estimated loan guarantee fees paid and recoveries to
the government. Agency management is responsible for accumulating
relevant, sufficient, and reliable data on which to base the estimate
and for establishing and using reliable records of historical credit
performance. In addition, agencies are supposed to use a systematic
methodology to project expected cash flows into the future. To
accomplish this task, agencies are instructed to develop a cash flow
model, using historical information and various assumptions including
defaults, prepayments, recoveries, and the timing of these events, to
estimate future loan performance.
MARAD uses a relatively simplistic cash flow model, which contains five
assumptions--default amount, timing of defaults, recovery amount,
timing of recoveries, and fees--to estimate the cost of the Title XI
loan guarantee program. We found that relatively minor changes in these
assumptions can significantly affect the estimated cost of the program
and that, thus far, three of the five assumptions, default and recovery
amounts and the timing of defaults, differed significantly from recent
actual historical experience.[Footnote 17] According to MARAD
officials, these assumptions were developed in 1995 based on actual
loan guarantee experience of the previous 10 years and have not been
evaluated or updated. MARAD could not provide us with supporting
documentation to validate its estimates, and we found no evidence of
any basis to support the assumptions used to calculate these estimates.
MARAD also uses separate default and recovery assumptions for each of
seven risk categories to differentiate between levels of risk and costs
for different loan guarantee projects.
We attempted to analyze the reliability of the data supporting MARAD's
key assumptions, but we were unable to do so because MARAD could not
provide us with any supporting documentation for how the default and
recovery assumptions were developed. Therefore, we believe MARAD's
subsidy cost estimates to be questionable. Because MARAD has not
evaluated its default and recovery rate assumptions since they were
developed in 1995, the agency does not know whether its cash flow model
is reasonably predicting borrower behavior and whether its estimates of
loan program costs are reasonable.
The nature and characteristics of the Title XI program make it
difficult to estimate subsidy costs. Specifically, MARAD approves a
small number of guarantees each year, leaving it with relatively little
experience on which to base estimates for the future. In addition, each
guarantee is for a large dollar amount, and projects have unique
characteristics and cover several sectors of the market. Further, when
defaults occur, they are usually for large dollar amounts and may not
take place during easily predicted time frames. Recoveries may be
equally difficult to predict and may be affected by the condition of
the underlying collateral. This leaves MARAD with relatively limited
information upon which to base its credit subsidy estimates. Also,
MARAD may not have the resources to properly implement credit reform.
MARAD officials expressed frustration that they do not have and,
therefore, cannot devote, the necessary time and resources to
adequately carry out their credit reform responsibilities.
Notwithstanding these challenges, MARAD has not performed the basic
analyses necessary to assess and improve its estimates. According to
MARAD officials, they have not analyzed the default and recovery rates
because most of their loan guarantees are in about year 7 out of the
25-year term of the guarantee, and it is too early to assess the
reasonableness of the estimates. We disagree with this assessment and
believe that an analysis of the past 5 years of actual default and
recovery experience is meaningful and could provide management with
valuable insight into how well its cash flow models are predicting
borrower behavior and how well its estimates are predicting the loan
guarantee program's costs. We further believe that, while difficult, an
analysis of its risk category system is meaningful for MARAD to ensure
that it appropriately classified loan guarantee projects into risk
category subdivisions that are relatively homogenous in cost.
Of loans originated in the past 10 years, nine have defaulted, totaling
$489.5 million in defaulted amounts. Eight of these nine defaults,
totaling $487.7 million, occurred since MARAD implemented its risk
category system in 1996. Because these eight defaults represent the
vast majority (99.6 percent) of MARAD's default experience, we compared
the performance of all loans guaranteed between 1996-2002 with MARAD's
estimates of loan performance for this period.[Footnote 18] We found
that actual loan performance has differed significantly from agency
estimates. For example, when defaults occurred, they took place much
sooner than estimated. On average, defaults occurred 4 years after loan
origination, while MARAD had estimated that, depending on the risk
category, peak defaults would occur between years 10-18. Also, actual
default costs thus far have been much greater than estimated. We
estimated, based on MARAD data, that MARAD would experience $45.5
million in defaults to date on loans originated since 1996. However, as
illustrated by figure 1, MARAD has consistently underestimated the
amount of defaults the Title XI program would experience. In total,
$487.7 million has actually defaulted during this period--more than 10
times greater than estimated. Even when we excluded AMCV, which
represents about 68 percent of the defaulted amounts, from our
analysis, we found that the amount of defaults MARAD experienced
greatly exceeded what MARAD estimated it would experience by $114.6
million (or over 260 percent).
Figure 1: Estimated and Actual Defaults of Title XI Loan Guarantees
(1996-2002):
[See PDF for image]
[A] We excluded estimates for risk categories 1a, 1b, and 1c, because
estimated defaults for these categories totaled only $1.5 million or
3.4 percent of total estimated defaults.
[End of figure]
In addition, MARAD's estimated recovery rate of 50 percent of defaulted
amounts within 2 years of default is greater than the actual recovery
rate experienced since 1996, as can be seen in figure 2. Although
actual recoveries on defaulted amounts since 1996 have taken place
within 1-3 years of default, most of these recoveries were
substantially less than estimated, and two defaulted loans have had no
recoveries to date. For the actual defaults that have taken place since
1996, MARAD would have estimated, using the 50 percent recovery rate
assumption, that it would recover approximately $185.3 million dollars.
However, MARAD has only recovered $78.2 million or about 42 percent of
its estimated recovery amount. Even when we excluded AMCV, which
represents about 68 percent of the defaulted amounts, from our
analysis, we still found that MARAD has overestimated the amount it
would recover on defaulted loans by $6.8 million (or about 10 percent).
If this pattern of recent default and recovery experiences were to
continue, MARAD would have significantly underestimated the costs of
the program.
Figure 2: Estimated and Actual Recoveries on Title XI Loan Defaults
(1996-2002):
[See PDF for image]
[A] Estimated recoveries are based on applying MARAD's 50 percent recovery
rate within 2 years to the actual default amounts. Our analysis of
recovery estimates includes estimated recovery amounts for two of the
five defaulted AMCV loans, even though 2 years have not elapsed,
because, according to MARAD officials, no additional recoveries are
expected on these two loans. Thus, our recovery calculation was based
on $370.6 of the $487.7 million in defaulted loans, which includes
defaults for which 2 years have elapsed, as well as the two AMCV
defaults for which no additional recoveries are expected. With its 50
percent recovery assumption, MARAD would have estimated that, at this
point, it should have recovered $185.3 million of these defaulted
loans.
[B] We calculated the actual recovery rate by comparing the total
actual recoveries to the $370.6 million in relevant actual defaulted
amounts. At the time of our review, MARAD had recovered $78.2 out of
this $370.6 million.
[End of figure]
We also attempted to analyze the process MARAD uses to designate risk
categories for projects, but were unable to do so because the agency
could not provide us with any documentation about how the risk
categories and MARAD's related numerical weighting system originally
were developed.[Footnote 19] According to OMB guidance, risk categories
are subdivisions of a group of loans that are relatively homogeneous in
cost, given the facts known at the time of designation. Risk categories
combine all loan guarantees within these groups that share
characteristics that are statistically predictive of defaults and other
costs. OMB guidance states that agencies should develop statistical
evidence based on historical analysis concerning the likely costs of
expected defaults for loans in a given risk category. MARAD has not
done any analysis of the risk category system since it was implemented
in 1996 to determine whether loans in a given risk category share
characteristics that are predictive of defaults and other costs and
thereby comply with guidance. In addition, according to a MARAD
official, MARAD's risk category system is partially based on outdated
MARAD regulations and has not been updated to reflect changes to these
regulations.
Further, MARAD's risk category system is flawed because it does not
consider concentrations of credit risk. To assess the impact of
concentration risk on MARAD's loss experience, we analyzed the defaults
for loans originated since 1996 and found that five of the eight
defaults, totaling $330 million or 68 percent of total defaults,
involved loan guarantees that had been made to one particular borrower,
AMCV. Assessing concentration of credit risk is a standard practice in
private-sector lending. According to the Federal Reserve Board's
Commercial Bank Examination Manual, limitations imposed by various
state and federal legal lending limits are intended to prevent an
individual or a relatively small group from borrowing an undue amount
of a bank's resources and to safeguard the bank's depositors by
spreading loans among a relatively large number of people engaged in
different businesses. Had MARAD factored concentration of credit into
its risk category system, it would likely have produced higher
estimated losses for these loans.
MARAD's Credit Subsidy Reestimates Are Also Questionable:
After the end of each fiscal year, OMB generally requires agencies to
update or "reestimate" loan program costs for differences among
estimated loan performance and related cost, the actual program costs
recorded in accounting records, and expected changes in future economic
performance. The reestimates are to include all aspects of the original
cost estimate such as prepayments, defaults, delinquencies, recoveries,
and interest. Reestimates allow agency management to compare original
budget estimates with actual costs to identify variances from the
original estimates, assess the reasonableness of the original
estimates, and adjust future program estimates, as appropriate. When
significant differences between estimated and actual costs are
identified, the agency should investigate to determine the reasons
behind the differences, and adjust its assumptions, as necessary, for
future estimates and reestimates.
We attempted to analyze MARAD's reestimate process, but we were unable
to do so because the agency could not provide us with any supporting
data on how it determined whether a loan should have an upward or
downward reestimate. According to agency management, each loan
guarantee is reestimated separately based on several factors including
the borrower's financial condition, a market analysis, and the
remaining balance of the outstanding loans. However, without conducting
our own independent analysis of these and other factors, we were unable
to determine whether any of MARAD's reestimates were reasonable.
Further, MARAD has reestimated the loans that were disbursed in fiscal
years 1993, 1994, and 1995 downward so that they now have negative
subsidy costs, indicating that MARAD expects these loans to be
profitable. However, according to the default assumptions MARAD uses to
calculate its subsidy cost estimates, these loans have not been through
the period of peak default, which would occur in years 10-18 depending
on the risk category. MARAD officials told us that several of these
loans were paid off early, and the risk of loss in the remaining loans
is less than the estimated fees paid by the borrowers. However, MARAD
officials were unable to provide us with any supporting information for
its assessment of the borrowers' financial condition and how it
determined the estimated default and recovery amounts to assess the
reasonableness of these reestimates. Our analysis of MARAD's defaults
and recoveries demonstrates that, when defaults occur, they occur
sooner and are for far greater amounts than estimated, and that
recoveries are smaller than estimated. As a result, we question the
reasonableness of the negative subsidies for the loans that were
disbursed in fiscal years 1993, 1994, and 1995.
MARAD's ability to calculate reasonable reestimates is seriously
impacted by the same outdated assumptions it uses to calculate cost
estimates as well as by the fact that it has not compared these
estimates with the actual default and recovery experience. As discussed
earlier, our analysis shows that, since 1996, MARAD has significantly
underestimated defaults and overestimated recoveries to date. Without
performing this basic analysis, MARAD cannot determine whether its
reestimates are reasonable and it is unable to improve these reestimate
calculations over time and provide Congress with reliable cost
information to make key funding decisions. In addition, and, again, as
discussed earlier, MARAD's inability to devote sufficient resources to
properly implement credit reform appears to limit its ability to
adequately carry out these credit reform responsibilities.
OMB Has Provided Little Oversight of MARAD's Estimates and Reestimates:
Based on our analysis, we believe that OMB provided little review and
oversight of MARAD's estimates and reestimates. OMB has final authority
for approving estimates in consultation with agencies; OMB approved
each MARAD estimate and reestimate, explaining to us that they delegate
authority to agencies to calculate estimates and reestimates. However,
MARAD has little expertise in the credit reform area and has not
devoted sufficient resources to developing this expertise. The FCRA
assigns responsibility to OMB for coordinating credit subsidy
estimates, developing estimation guidelines and regulations, and
improving cost estimates, including coordinating the development of
more accurate historical data and annually reviewing the performance of
loan programs to improve cost estimates. Had OMB provided greater
review and oversight of MARAD's estimates and reestimates, they would
have realized the assumptions were outdated and did not track with
actual recent experience.
Conclusions:
In conclusion, Mr. Chairman, MARAD does not operate the Title XI loan
guarantee program in a businesslike fashion. MARAD does not (1) fully
comply with its own requirements and guidelines, (2) have a clear
separation of duties for handling loan approval and fund disbursement
functions, (3) exercise diligence in considering and approving
modifications and waivers, (4) adequately secure and assess the value
of defaulted assets, and (5) know what its program costs. Because of
these shortcomings, MARAD lacks assurance that it is effectively
promoting growth and modernization of the U.S. merchant marine and U.S.
shipyards or minimizing the risk of financial loss to the federal
government. Consequently, the Title XI program could be vulnerable to
waste, fraud, abuse, and mismanagement. Finally, MARAD's questionable
subsidy cost estimates do not provide Congress a basis for knowing the
true costs of the Title XI program, and Congress cannot make well-
informed policy decisions when providing budget authority. If the
pattern of recent experiences were to continue, MARAD would have
significantly underestimated the costs of the program.
Recommendations:
We are currently considering a number of recommendations to reform the
Title XI program, including actions Congress could take to clarify
borrower equity contribution requirements and incorporate
concentration risk in the approval of loan guarantees, as well as
actions MARAD could take to improve its processes for approving loan
guarantees, monitoring and controlling funds, and managing and
disposing of defaulted assets. In addition, we are considering
recommendations to help MARAD better implement its responsibilities
under FCRA. Because of the fundamental flaws we have identified, we
question whether MARAD should approve new loan guarantees without first
addressing these program weaknesses.
This concludes my prepared statement. I will be happy to respond to any
questions you or the other members of the Committee may have.
Contacts and Staff Acknowledgments:
For further information on this testimony, please contact Mathew J.
Scirč at (202) 512-6794. Individuals making key contributions to this
statement include Kord Basnight, Daniel Blair, Rachel DeMarcus, Eric
Diamant, Donald Fulwider, Grace Haskins, Rachelle Hunt, Carolyn
Litsinger, Marc Molino, and Barbara Roesmann.
FOOTNOTES
[1] Defaulted amounts may include disbursed loan guarantee funds,
interest accrued, and other costs.
[2] Loan guarantees are legal obligations to pay off debt if an
applicant defaults on a loan.
[3] All projects must be determined to be economically sound, and
borrowers must have sufficient operating experience and the ability to
operate the vessels or employ the technology on an economically sound
basis. Particularly, MARAD regulations contain language stating that
(1) long-term demand must exceed supply; (2) documentation must be
provided on the projections of supply and demand; (3) outside cash flow
should be shown, if in the short-term the borrower is unable to service
indebtedness; and (4) operating cash flow ratio must be greater than
one (sufficient cash flow to service the debt).
[4] Economic soundness analyses are prepared by the Office of Subsidy
and Insurance and the Office of Statistical and Economic Analysis. It
should be noted that we did not assess the substance of these economic
analyses.
[5] In another case, Congress statutorily waived economic soundness
criteria. Specifically, the Coast Guard Authorization Act of 1996
contained a provision waiving the economic soundness requirement for
reactivation and modernization of certain closed shipyards in the
United States. Previously, MARAD had questioned the economic soundness
of the MHI proposal and rejected the application.
[6] MARAD may waive or modify financial terms or requirements upon
determining that there is adequate security for the guarantees.
[7] Unterminated passengers are individuals who pay for a cruise, but
do not actually take the cruise, and the payment is not refunded.
However, the passenger may take the trip at a later date.
[8] Cash management is a financial management technique used to
accelerate the collection of debt, control payments to creditors, and
efficiently manage cash.
[9] An escrow fund is an account in which the proceeds from sales of
MARAD-guaranteed obligations are held until requested by the borrower
to pay for activities related to the construction of a vessel or
shipyard project or to pay interest on obligations.
[10] On June 25, 2001, AMCV restated losses from $6.1 million to $9.1
million for the first quarter of 1999.
[11] U.S. Department of Transportation, Office of Inspector General,
Maritime Administration Title XI Loan Guarantee Program (Washington,
D.C.: Mar. 27, 2003).
[12] The bids were for the purchase of the unfinished hull for Project
America I in seaworthy condition.
[13] The IG also recommended that MARAD impose compensating factors for
loan guarantees to mitigate risks.
[14] Classification society representatives are individuals who inspect
the structural and mechanical fitness of ships and other marine vessels
for their intended purpose.
[15] U.S. General Accounting Office, Standards for Internal Control in
the Federal Government, GAO/AIMD-00-21.3.1 (Washington, D.C.: November
1999) and Internal Control Management and Evaluation Tool, GAO 01-1008G
(Washington, D.C.: August 2001).
[16] The Federal Accounting Standards Advisory Board developed the
accounting standard for credit programs, Statement of Federal Financial
Accounting Standards No. 2, "Accounting for Direct Loans and Loan
Guarantees," which generally mirrors FCRA and which established
guidance for estimating the cost of guaranteed loan programs.
[17] MARAD's recovery assumption assumes a 50 percent recovery rate
within 2 years of default. However, 2 years have not yet elapsed for
several of the defaults and so we could not yet determine how the
estimated timing of recoveries compares to the actual timing of
recoveries.
[18] Our analysis focused on loans beginning in 1996 because (1) this
was the first year in which MARAD implemented its risk category system,
and (2) MARAD could not provide us with any supporting data for its
default and recovery assumptions for loans originating before 1996.
Further, only one default occurred between 1993-1996, representing less
than 1 percent of MARAD's total defaults between 1993-2002.
[19] MARAD's risk category system incorporates ten factors that are set
out in Title XI, which specifies that MARAD is to establish a system of
risk categories based on these factors. How MARAD weighs and interprets
these factors is described in program guidance.