Dissatisfaction Guaranteed

The federal government should stop guaranteeing loans.

Each time an auto company, small business, or homeowner receives a politically motivated loan guarantee, the giveaway creates yet another unfunded liability for future taxpayers. Now, in response to the economic crisis, the feds have provided more than $8 trillion in new guarantees. Aside from attempting to halt an alarming decline in lending, the loans' supporters give four justifications for the programs.

First, they claim certain entities are being denied access to credit through no fault of their own. Supposedly, even in boom times, lenders pass over many opportunities to issue loans to borrowers who, despite appearances to the contrary, are creditworthy. This argument sounds especially persuasive at a time like now, when interbank lending is frozen and subprime lending has disappeared.

Second, loan advocates argue that the recipients will generate economic growth that otherwise would not occur.

Third, they say additional social goods can be derived from goosing the credit markets. Widespread homeownership, for example, is seen as increasing the country's stability and prosperity.

Finally, there is the notion that keeping particular firms alive enhances the common good, whether because they provide essential consumer services, add to competition in certain markets, or employ significant numbers of people. In some cases, politicians call for supplying credit to an entire industry (e.g., the banking system) or a huge portion of it (e.g., U.S.-owned automakers).

The federal government guarantees loans to induce banks to lend money to credit-risky borrowers. If the borrower defaults, the government reimburses the lender for either the entire loss that the lender would otherwise sustain or a large fraction of it. With this guarantee, banks are willing not only to lend money to high-risk borrowers who couldn't get loans without it but also to grant more favorable terms to existing customers.

In a normal year, Washington guarantees roughly $150 billion in loans through more than 20 programs. The Small Business Administration has six loan guarantee programs that total $40 billion. The Department of Energy has a program that places nearly $40 billion in taxpayers' money at risk each year. The Department of Housing and Urban Development guarantees another $40 billion.

Of course, 2008 was not a normal year. Within just three months, the federal government guaranteed almost $8 trillion in investment, deposits, and loans as part of the financial bailout. On the loan side, Washington will be backing the bulk of Citigroup's $300 billion portfolio; it will also guarantee an unquantifiable amount of modified subprime loans and lines of credit to the cash-hungry auto industry. In addition, the government will continue subsidizing, through taxpayer guarantees, the expansion of the government-sponsored mortgage buyers Freddie Mac and Fannie Mae.

Before the financial crisis, total taxpayer exposure via loan programs—the cost if every borrower defaulted—was about $500 billion, taking interest into account. With the additional guarantees now totaling more than half of GDP, taxpayers' exposure has grown exponentially while their ability to repay the loans has if anything shrank.

Such a risk would seem to call for strict oversight of how these loans turn out, both in terms of default rates and social goods. Yet until now the federal government has refused to systematically measure the performance of its 40 existing loan programs. Why? Perhaps because the data show that most of them never deliver any of the promised social and economic value.

Historically, loans guaranteed by the government have a very high default rate. The Congressional Budget Office has calculated that the risk of default on the Department of Energy's nuclear loan guarantee program, for example, is well above 50 percent. The Small Business Administration (SBA), according to its own Inspector General's Office, has a long-term default rate of roughly 17 percent. This compares to 4.3 percent for credit cards and 1.5 percent forbank loans guaranteed by the Federal Deposit Insurance Corporation.

Faced with this track record, lawmakers often counter that the programs charge lenders a fee for each loan to offset the costs that defaults impose on taxpayers. But these fees are rarely high enough to cover the true cost of defaults, especially during economic downturns.

Federally backed loans create a classic moral hazard. Because the loan amount is guaranteed, banks have less incentive to evaluate applicants thoroughly or apply proper oversight. Not only are the borrowers high-risk to begin with, but it's not necessarily cost-effective for lenders to identify the best of these bad applicants.

These bad incentives are among the reasons for the financial crisis to begin with. For years, the government has encouraged banks to extend credit to noncreditworthy borrowers and to make larger loans than a market would normally bear even to creditworthy borrowers. It did this by explicitly and implicitly guaranteeing certain banks' losses.

It's irresponsible to keep encouraging banks to lend money to borrowers they wouldn't assist if their own money were on the line. It is a good thing that banks today won't lend money to people who can't afford to pay it back. That doesn't mean all credit markets are, or should be, frozen. Even in the current housing market, for instance, borrowers with decent credit histories and down payments still have access to mortgages.

It's also worth noting that interbank lending froze completely when the bailout was announced. Why take the risk when Washington can force taxpayers to take it for you?

Nor are such programs likely to stave off massive job losses. In a 2003 speech to the National Economists Club in Washington, D.C., then–Federal Reserve Governor Edward M. Gramlich argued that loan guarantee programs are unable to save failing industries. Lack of access to credit markets is caused by serious industrial problems, he explained, not vice versa. If an applicant's business plan cannot be made to show a profit under reasonable economic assumptions, private lenders are unlikely to issue a loan.

Then why is the federal government still guaranteeing loans? Because it serves two powerful constituencies: lawmakers and bankers.

Politicians love loan programs because they're a wonderful way to reward interest groups while hiding the costs. When the programs are established, the mathematical certainty of future defaults and their potential effect on the deficit are never considered. It's like buying a house on credit without having a trace of the transaction on your credit report.

But the true beneficiaries are lenders. Take small business loan guarantees. When a small business defaults on its obligation to repay a loan, bankers do not bear most of the cost; taxpayers do. Meanwhile, lenders make large profits on SBA loans by pooling the guaranteed portions and selling investors trust certificates that represent claims to the cash flows.

How profitable is this? Testifying before Congress in April 2006, David Bartram, the president of the SBA Division of U.S. Bancorp, the nation's sixth-largest financial services company, explained that "return on equity of SBA loans can exceed 70 percent." A 70 percent return on equity (RoE) is remarkably high. Right now, the five-year average RoEs for the two biggest banks in America—Citigroup and Bank of America—are 16.2 percent and 14.5 percent, respectively.

For years, banks have reaped the profits from loan guarantees, whether for small businesses or homeowners. Now that the skim has been exposed, taxpayers, not banks, are asked not only to pay the cost of the defaults but to bail out the irresponsible lenders. And the government has decided to encourage more lenders to take more chances by guaranteeing yet more loans to high-risk borrowers. The only guarantee for these loans is that our children will be paying billions to cover the losses.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.