March 12, 1987

To the Congress of the United States:

The Federal government is the Nation's largest financial intermediary. At the end of 1986, it had $252 billion of direct loans and $450 billion of guaranteed loans outstanding. The government provides credit to many different types of borrowers: homeowners, farmers, students, small businesses, exporters, utilities, shipbuilders, and State, local, and foreign governments. Over the past 20 years, Federal direct loans and guaranteed loans outstanding have grown at a 9 percent annual rate.

Despite the vast size of Federal credit, and its obvious importance to the economy, the present budgetary treatment of Federal credit programs does not show the real cost of these programs. The result is the misallocation of resources and ineffective budgetary control.

Federal credit is provided on more favorable terms and conditions than those available in the private sector. The present value of this difference is a subsidy to the borrower. This subsidy to federally assisted borrowers comes at the expense of taxpayers and of all other borrowers, who pay higher interest rates or fees than they otherwise would have paid, or who are not able to borrow at all.

For direct loans, the present budget measures new loans to borrowers and any associated interest or other costs minus repayments (or sales) of previous loans and interest and fees received. This is misleading in four ways. Disbursement of new loans overstates the cost to the government because the government now owns a financial asset with market value. However, the fact that loans are expected to be repaid leaves the impression that, over time, they are costless; this is not so because Federal credit programs provide subsidies to the borrowers. The subtraction from disbursements related to new loans of repayments and interest on previous loans obscures the effect of current decisions. The budget accounts do not sort through this confusion to show how much of a new loan is a financial asset and how much is a subsidy or expenditure.

For loan guarantees, the present budget does not record any cost unless and until defaults occur. At the time the commitment to guarantee a loan is made, the guarantee is treated as a free good compared with a purchase, a grant, or a direct loan.

The appropriation of budget authority does not provide meaningful control of either direct loans or loan guarantees. Most direct loans are made from revolving funds. Defaults on guaranteed loans are a legal obligation of the government. In both cases, appropriations are unrelated to decisions to provide credit subsidies.

Because of these inadequacies, a separate credit budget was created to record and to limit the volume of new direct loan obligations and new guaranteed loan commitments. The credit budget has the advantage of focusing attention on the decisions that commit the government to new expenditures. But it does not show the cost of these expenditures -- the subsidies. Instead, it shows the total volume of credit assisted. Thus, it does not distinguish between programs with deep subsidies and those with small ones. Moreover, the credit budget is separate from the unified budget, so trade-offs between credit and other spending cannot be made.

In my Budget Message last January, I promised to send to the Congress legislation "whereby the true cost to the economy of Federal credit programs would be counted in the budget.'' The proposed legislation I am transmitting today, the ``Federal Credit Reform Act of 1987,'' carries out that pledge. This legislation was developed by the Federal Credit Policy Working Group of the Economic Policy Council. It builds on recommendations made by the President's Commission on Budget Concepts in 1967, on analyses by the Office of Management and Budget and the Congressional Budget Office, and on proposals made in recent years by various members of Congress.

The bill is intended to provide the Congress and the Administration with accurate measures of the benefits of Federal credit programs, to place their cost on a budgetary basis equivalent to other Federal spending, to encourage the delivery of benefits in the form most appropriate to the needs of beneficiaries, to improve the allocation of resources among credit programs and between credit and other spending, and to provide for the efficient financing of obligations issued, sold, or guaranteed by Federal agencies.

To achieve these goals, the bill would change the budgetary treatment of credit transactions by charging Federal agencies for the amount of subsidies inherent in credit programs. These subsidies are the present value of the difference between the terms and conditions on which direct loans or loan guarantees are available to borrowers in the private sector and the easier ones provided by Federal credit programs. If the borrower were given a grant equivalent to this subsidy and then obtained a private loan or loan guarantee, the borrower would be equally well off.

The draft bill would record this grant-equivalent subsidy of credit programs in the budgets of Federal credit agencies. The Congress would be asked to appropriate funds for these subsidies, thereby allocating resources on an equivalent basis among credit programs and between credit programs and other government spending.

The unsubsidized portion of a Federal direct loan is a financial asset. This is the present value of the expected interest and repayments by the borrower. The bill creates a Federal Credit Revolving Fund in the Department of the Treasury to finance the financial asset portion of direct loans.

The most direct way to divide a new loan between its "grant'' and "loan'' components is to sell it promptly, competitively, and without any government guarantee of future repayment. The bill proposes that agencies do so as an agent for the Fund, unless exempt because of foreign policy or other program considerations.

The most direct way to identify the subsidy inherent in a federally guaranteed loan is to purchase reinsurance in the private market. The cost of purchasing reinsurance, minus any fees paid by the borrower, is the grant equivalent of providing a Federal guarantee. The bill proposes that agencies arrange for the purchase of reinsurance as an agent of the Fund, in order to measure this subsidy.

The Federal Credit Revolving Fund, in consultation with the Federal agency, would be responsible for estimating the subsidy in Federal loans and loan guarantees, using the information from the sales and reinsurance or using standard methods when loans are not sold or reinsured. The Fund would establish an automated accounting and control system to keep track of the status of the Fund's accounts and to ensure that agency credit activity is limited to the amounts appropriated for subsidy costs. In addition, the Fund would serve as a central financing mechanism -- providing the financial asset portion of new direct loans, assuming the contingent liability for new guaranteed loans, and receiving subsidy payments from the agencies, all fees, interest, repayments, proceeds from the sale of new loans, and collateral acquired through defaults on guaranteed loans.

Nothing in the bill changes the credit programs that the Congress enacted or changes the existing authority of agencies to operate credit programs. Agencies would continue to arrange and approve direct loans and loan guarantees as they do now, would service those that had not been sold or reinsured, and would arrange for sale or reinsurance. The legal rights of borrowers would not be changed.

The proposed budgetary treatment of credit affects the deficit only to the extent that loan assets are sold and guaranteed loans are reinsured. The net effects of our planned sales and reinsurance were estimated in my 1988 Budget. The "scoring'' of this credit reform proposal, itself, is otherwise deficit neutral.

Because the Congress requested submission of the 1988 Budget nearly a month early -- and we met that goal -- we were not able to include the effect of this credit reform proposal, account by account, in our January 5th and January 28th documents. I am now sending the necessary budget amendments and appropriations language to the Congress. I hope that you will be able to include them in your consideration of the 1988 Budget.

Credit reform is one of numerous management improvement initiatives that I will be transmitting to you in the FY 1988 Management Report. I look forward to working cooperatively with the Congress to make these reforms in the budgetary treatment of credit and in the management of Federal credit programs.

Ronald Reagan

The White House,

March 12, 1987.