Maritime Administration: Weaknesses Identified in Management of  
the Title XI Loan Guarantee Program (30-JUN-03, GAO-03-657).	 
                                                                 
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 committed to guarantee 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. 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.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-657 					        
    ACCNO:   A07424						        
  TITLE:     Maritime Administration: Weaknesses Identified in	      
Management of the Title XI Loan Guarantee Program		 
     DATE:   06/30/2003 
  SUBJECT:   Financial management				 
	     Merchant marine					 
	     Shipyards						 
	     Noncompliance					 
	     Federal law					 
	     Risk management					 
	     MARAD Title XI Loan Guarantee Program		 

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GAO-03-657

Report to the Chairman, Committee on Commerce, Science, and
Transportation, U. S. Senate

United States General Accounting Office

GAO

June 2003 MARITIME ADMINISTRATION

Weaknesses Identified in Management of the Title XI Loan Guarantee Program

GAO- 03- 657

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 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.

Estimated and Actual Defaults and Recoveries to Date for Loans Originated
between

95

0 100

200 300

400 500

Dollars in millions Recoveries Defaults

Actual Estimated

Sources: MARAD (data); GAO (presentation). 45

488 185

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
committed to guarantee more than $5. 6 billion in ship

construction and shipyard modernization costs since 1993, but it has
experienced several largescale

defaults over the past few years. 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.

GAO recommends that Congress consider providing no new funds for new loan
guarantees under the Title XI program until certain controls have been
instituted and MARAD has updated its default and recovery assumptions to
more accurately reflect costs. GAO also

recommends that MARAD undertake several reforms to help improve program
management. In written comments, the Department of Transportation

disagreed with some report findings, however, recognized that program
improvements were needed. www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 657.
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. Highlights of GAO- 03-
657, a report to the

Chairman, Senate Committee on Commerce, Science, and Transportation

June 2003

MARITIME ADMINISTRATION

Weaknesses Identified in Management of the Title XI Loan Guarantee Program

Page i GAO- 03- 657 Maritime Administration Letter 1 Results in Brief 2
Background 4 MARAD Has Not Fully Complied with Some Key Title XI Program
Requirements 8 MARAD Techniques to Manage Financial Risk Contrast to

Techniques of Selected Private- sector Maritime Lenders 17 MARAD*s Credit
Subsidy Estimates and Reestimates Are Questionable 23 Conclusions 31
Matters for Congressional Consideration 31 Recommendations for Executive
Action 32 Agency Comments 34 Appendix I Scope and Methodology 41

Appendix II Comments from the Department of Transportation 43

Appendix III Comments from the Office of Management and Budget 49

Appendix IV GAO Contacts and Staff Acknowledgments 51 GAO Contacts 51
Staff Acknowledgments 51 Tables

Table 1: Projects Included in Our Review 9 Table 2: Comparison of Private-
sector and MARAD Maritime Lending Practices 17 Table 3: Projects Selected
for Our Review 41 Figures

Figure 1: MARAD*s Defaulted Projects (1993* 2002) 6 Contents

Page ii GAO- 03- 657 Maritime Administration Figure 2: Estimated and
Actual Defaults of Title XI Loan Guarantees (1996* 2002) 27 Figure 3:
Estimated and Actual Recoveries on Title XI Loan

Defaults (1996* 2002) 28 Abbreviations

AMCV American Classic Voyages, Co. DCAA Defense Contract Audit Agency DOT
Department of Transportation FCRA Federal Credit Reform Act IG Department
of Transportation Inspector General MARAD Maritime Administration MHI
Massachusetts Heavy Industries, Inc.

OMB Office of Management and Budget SEC Securities and Exchange Commission

This is a work of the U. S. Government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. It may contain
copyrighted graphics, images or other materials. Permission from the
copyright holder may be necessary should you wish to reproduce copyrighted
materials separately from GAO*s product.

Page 1 GAO- 03- 657 Maritime Administration June 30, 2003 The Honorable
John McCain

Chairman Committee on Commerce, Science, and Transportation United States
Senate

Dear Mr. Chairman: Under the Title XI Loan Guarantee Program, the Maritime
Administration (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 associated with
these loan guarantee commitments totaling over $1.3 billion. The defaulted
amounts associated with these nine loan guarantee commitments totaled $489
million. 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 Corporation (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. 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.

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.

United States General Accounting Office Washington, DC 20548

Page 2 GAO- 03- 657 Maritime Administration 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. Appendix I contains a full description of

our scope and methodology. MARAD has not fully complied with some key
Title XI program requirements. In approving loan guarantees, MARAD
generally complied with requirements to assess an applicant*s economic
soundness. MARAD used waivers or modifications, which, although permitted
by Title XI regulations, allowed MARAD to approve applications where
borrowers did not meet all financial requirements. In monitoring projects
it financed, MARAD did not ensure that shipowners and shipyard owners
provided

required financial statements. Overall, we could not always track
financial reporting because of missing or incomplete documentation.
Without a systematic analysis of changes in the financial condition of its
borrowers, MARAD cannot take the appropriate steps to minimize losses.
Further, MARAD disbursed loan funds without sufficient documentation of
project progress. MARAD also permitted a shipowner to minimize its
investment in a project before receiving guaranteed loan funds. With
respect to the disposition of assets, MARAD has guidelines, but no
requirements, in place

to ensure that it maximizes recoveries. Results in Brief

Page 3 GAO- 03- 657 Maritime Administration Selected private- sector
maritime lenders told us that they manage financial risk by (1)
establishing a clear separation of duties for key lending

functions; (2) permitting few, if any, exceptions to key underwriting
standards; (3) using a more systematic approach to monitoring the progress
of projects; and (4) employing independent parties to survey and appraise
defaulted assets. Private- sector representatives we interviewed stated
that they were very selective when originating loans for the shipping
industry. While MARAD cites its mission as an explanation as to why it
does not employ these practices, these controls would actually help it to
accomplish its mission while managing financial risk.

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. While the nature and characteristics of the
Title XI program make it difficult to estimate subsidy

costs and may affect MARAD*s ability to produce reliable cost estimates,
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 significantly understate defaults, and its
recovery estimates significantly overstate recoveries. If this pattern of
recent experiences 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. 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, while the Office of Management
and Budget (OMB) approved each MARAD estimate and reestimate, its review
was not sufficient since it did not identify that MARAD*s assumptions were
outdated and lacked adequate support.

This report makes several recommendations to help MARAD improve its
management of the Title XI loan guarantee program, including its processes
for approving loan guarantees, monitoring and controlling funds, and
managing and disposing of defaulted assets, and better implementing its
responsibilities under the Federal Credit Reform Act (FCRA). We also
recommend that Congress consider legislation to clarify borrower equity
contribution requirements and incorporate concentration risk in the
approval of loan guarantees. Because of the fundamental flaws we have
identified, we question whether MARAD should approve new loan guarantees
without first addressing these program weaknesses.

Page 4 GAO- 03- 657 Maritime Administration We provided a draft of this
report to the Department of Transportation for its review and comment.
MARAD noted that it has already begun to take steps to improve the
operations of the Title XI program, consistent with

several of our recommendations. MARAD disagreed with the manner in which
we characterized some report findings, and provided additional information
and data that we have incorporated into our analyses and report as
appropriate. We also provided a copy of the draft report to OMB for its
review and comment. OMB agreed that recent recovery expectations should be
incorporated into future reestimates, but disagreed that it had provided
little or no oversight over the program*s subsidy cost estimates. However,
we believe that had OMB provided greater review and oversight of MARAD*s
estimates and reestimates, it would have realized that MARAD did not have
adequate support for its default and recovery assumptions.

Title XI of the Merchant Marine Act of 1936, as amended, authorizes the
Secretary of Transportation to guarantee debt issued for the purpose of
financing or refinancing the construction, reconstruction, or
reconditioning of U. S.- flag vessels or eligible export vessels built in
U. S. shipyards and the construction of advanced and modern shipbuilding
technology of general shipyard facilities located in the United States. 3
Title XI guarantees are backed by the full faith and credit of the United
States. 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 constructing a vessel or
modernizing a shipyard. Borrowers obtain funding for guaranteed debt
obligations in the private sector, primarily from banks, pension funds,
life insurance companies, and the general public. MARAD loan guarantees
represent about 10 percent of the U. S.- flagged maritime financing
market, 3 Vessels eligible for Title XI assistance generally include
commercial vessels such as

passenger, bulk, container, cargo and oceanographic research; also
eligible tankers, tugs, towboats, barges, dredges, floating power barges,
offshore oil rigs and support vessels, and floating dry docks. Eligible
technology generally includes proven technology, techniques,

and processes to enhance the productivity and quality of shipyards; novel
techniques and processes designed to improve shipbuilding; and related
industrial production that advances U. S. shipbuilding. Background

Page 5 GAO- 03- 657 Maritime Administration according to MARAD officials.
However, MARAD plays a greater role in certain segments of the maritime
finance market. For example, according to a private- sector maritime
lender, MARAD guarantees financing on about

15 percent of the country*s inland barge market. Over the last 10 years,
MARAD experienced defaults in amounts that totaled $489 million. One
borrower, AMCV, defaulted on five loan guarantee projects in amounts
totaling $330 million, 67 percent of the total defaulted amounts. Figure 1
shows the nine defaults experienced by MARAD over the past 10 years, five
of which were associated with AMCV

and which are shown in gray.

Page 6 GAO- 03- 657 Maritime Administration Figure 1: MARAD*s Defaulted
Projects (1993* 2002)

Once an applicant submits a Title XI application to MARAD, and prior to
execution of a guarantee, MARAD must determine the economic soundness of
the project, as well as the applicant*s capability to construct or operate
the ship or shipyard. For example, the shipowner or shipyard must have
sufficient operating experience and the ability to operate the vessels or
employ the technology on an economically sound basis. The shipowner or
shipyard must also meet certain financial requirements with respect to
working capital and net worth.

The amount of the obligations that MARAD may guarantee for a project is
based on the ship or shipyard costs. Title XI permits guarantees not
exceeding 87. 5 percent of the actual cost of the ship or shipyard, with

0 100 200 Defaulted amounts in millions of dollars Surf Express

HAM Marine Great Independence

Great Pacific NW Cape May Light Cape Cod Light

Massachusetts Heavy Industries

Searex Project America

Source: GAO. Non- AMCV- related

AMCV- related

Page 7 GAO- 03- 657 Maritime Administration certain projects limited to 75
percent financing. The interest rate of the guaranteed obligations is
determined by the private sector. 4 MARAD also levies certain fees
associated with the Title XI program. For example,

applicants must pay a nonrefundable filing fee of $5,000. In addition,
prior to issuance of the commitment letter, the applicant must pay an
investigation fee against which the filing fee is then credited.
Participants must also pay a guarantee fee, which is calculated by
determining the amount of obligations expected to be outstanding and
disbursed to the shipowner or shipyard during each year of financing.

The Title XI program is also subject to the Federal Credit Reform Act
(FCRA) of 1990, which was enacted to require that agency budgets reflect a
more accurate measurement of the government*s subsidy costs for direct
loans and loan guarantees. FCRA is intended to provide better cost
comparisons both among credit programs and between credit and noncredit
programs. The credit subsidy cost is the government*s estimated net cost,
in present value terms, of direct or guaranteed loans over the entire
period the loans are outstanding. Credit reform was intended to ensure
that the full cost of credit programs would be reflected in the budget so
that the executive branch and Congress might consider these costs when
making budget decisions. Each year, as part of the President*s Budget,
agencies prepare estimates of the expected subsidy costs of new

lending activity for the upcoming year. Unless OMB approves an alternative
proposal, agencies are also required to reestimate this cost annually. OMB
has oversight responsibility for federal loan program compliance with FCRA
requirements and has responsibility for approving subsidy estimates and
reestimates.

All credit programs automatically receive any additional budget authority
that may be needed to fund reestimates. 5 For discretionary programs this
means there is a difference in the budget treatment of the original
subsidy cost estimates and of subsidy cost reestimates. The original
estimated subsidy cost must be appropriated as part of the annual
appropriation process and is counted under any existing discretionary
funding caps.

4 MARAD must determine that the interest rate is reasonable. 5 Congress
recognized that data were limited or unreliable in the early years of
credit reform and that this could impede the ability of agencies to make
reliable estimates. Thus, Congress provided for permanent, indefinite
budget authority for upward reestimates of subsidy costs. Agencies with
discretionary credit programs then could reestimate subsidy costs as
required without being limited by the constraints of budgetary spending
limits.

Page 8 GAO- 03- 657 Maritime Administration However, any additional
appropriation for upward reestimates of subsidy cost is not constrained by
any budget caps. This design could result in a

tendency to underestimate the initial subsidy costs of a discretionary
program. Portraying a loan program as less costly than it really is when
competing for funds means more or larger loans or loan guarantees could be
made with a given appropriation because the program then could rely on a
permanent appropriation for subsequent reestimates to cover any
shortfalls. This built- in incentive is one reason to monitor subsidy

reestimates. Monitoring reestimates is a key control over tendencies to
underestimate costs as well as a barometer of the quality of agencies*
estimation processes.

When credit reform was enacted, it generally was recognized that agencies
did not have the capacity to implement fully the needed changes in their
accounting systems in the short- term and that the transition to budgeting
and accounting on a present- value basis would be difficult. However,
policy makers expected that once agencies established a systematic
approach to subsidy estimation based on auditable assumptions, present
value- based budgeting for credit would provide them with significantly
better information.

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. 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. We
looked at five MARAD- financed projects (see table 1). MARAD Has Not Fully

Complied with Some Key Title XI Program Requirements

Page 9 GAO- 03- 657 Maritime Administration Table 1: Projects Included in
Our Review Dollars in millions Project Year loan committed Original

amount Risk category Status

(AMCV) Project America, Inc. 1999 $1,079.5 2A Default Searex 1996 $77.3 2B
Default Massachusetts Heavy Industries (MHI) 1997 $55.0 3 Default Hvide
Van Ommeran Tankers (HVIDE) 1996 $43.2 2C Active

Global Industries 1996 $20.3 1C Active Source: MARAD. Note: MARAD places
projects into one of seven risk categories that, from lowest to highest,
are 1A, 1B, 1C, 2A, 2B, 2C, and 3.

MARAD regulations do not permit MARAD to guarantee a loan unless the
project is determined to be economically sound. 6 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. 7 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.
According to the Department of Transportation (DOT)

Assistant Secretary for Administration, the market research guidelines 6
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). 7 Economic soundness analyses are prepared by
the Office of Insurance and Shipping

Analysis which is responsible for recommending approval or disapproval of
loans from an economic soundness perspective, and the Office of
Statistical and Economic Analysis. It should be noted that we did not
assess the substance of these economic analyses. MARAD Used Waivers and

Modifications to Approve Loans That Would Otherwise Not Be Approved

Page 10 GAO- 03- 657 Maritime Administration developed by the Office of
Statistical and Economic Analysis were neither requested nor approved by
Title XI program management. Finally, while

MARAD may not waive economic soundness criteria, officials from the Office
of Statistics and Economic Analysis which is responsible for providing
independent assessment of the market impact on economic soundness
expressed concern that their findings regarding economic soundness might
not always be fully considered when MARAD approved loan guarantees. 8 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. 9 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. 10
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. 11 Subsequently, MARAD used cash flow tests for

8 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. 9 MARAD may waive or modify
financial terms or requirements upon determining that there is adequate
security for the guarantees.

10 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.

11 Cash management is a financial management technique used to accelerate
the collection of debt, control payments to creditors, and efficiently
manage cash.

Page 11 GAO- 03- 657 Maritime Administration Project America, Inc., in
lieu of working capital requirements for purposes of liquidity testing.
According to the Assistant Secretary for

Administration, one of the major cruise lines uses cash flow tests as a
measure of its liquidity.

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. 12 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 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. 13
MARAD did so without documenting this change in the loan

12 U. S. Department of Transportation, Office of Inspector General,
Maritime Administration Title XI Loan Guarantee Program (Washington, D.
C.: March 27, 2003). 13 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. MARAD Did Not
Follow

Requirements for Monitoring the Financial Condition of Projects and for
Controlling the Disbursement of Loan Funds

Page 12 GAO- 03- 657 Maritime Administration 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. 14 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 Inspector
General (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.

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.

14 On June 25, 2001, AMCV restated losses from $6.1 million to $9.1
million for the first quarter of 1999.

Page 13 GAO- 03- 657 Maritime Administration On May 22, 2001 Litton
Ingalls Shipbuilding 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., 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 routinely linked to the extent of project
monitoring. Further, without a systematic approach to on- site visits,
MARAD relied principally on the shipowner*s certification and
documentation 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

Page 14 GAO- 03- 657 Maritime Administration 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, travel budget
restrictions and limited enforcement tools. 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 thorough 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. MARAD Assistant Secretary for
Administration noted that if financial documents were not submitted after
a request for missing documents was made, MARAD*s only legal recourse was
to call the loan in default, pay off the Title XI debt and then seek
recovery against the borrower.

He said that MARAD tries to avoid takings these steps. We found no
evidence that MARAD routinely requested missing financial statements or
did any analysis. Also, the IG report on the Title XI program released in
March 2003 noted that MARAD does not closely monitor the financial health
of its borrowers over the term of their loans. We recognize that

Page 15 GAO- 03- 657 Maritime Administration MARAD has limited enforcement
resources, however, for such publicly traded companies as AMCV, financial
statements filed with the Securities

and Exchange Commission could be used. However, we found no evidence that
MARAD attempted to use SEC filings.

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 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. MARAD did
not have a MARAD Does Not Have

Requirements in Place to Govern the Handling of Defaulted Assets

Page 16 GAO- 03- 657 Maritime Administration market appraisal for the
defaulted Project America assets. Also, MARAD relied on an interested
party to determine the cost of making Project

America I seaworthy. An appraisal of Project America assets immediately
after default would have assisted MARAD in preparing a strategy for
offering the hull of Project America I and the parts of Project America II
for sale. According to MARAD officials, as of March 2003, MARAD had
received $2 million from the sale of the Project America I and II vessels.
15 Without a market appraisal, it is unclear whether this was the maximum

recovery MARAD could have received. 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 weather- tight 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.

15 MARAD has no financial interest in the equipment purchased for Project
America II , and therefore has no right to sale proceeds for this vessel.

Page 17 GAO- 03- 657 Maritime Administration 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 Phases of the lending process Private- sector practices MARAD
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

 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

 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

 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  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

 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.

MARAD Techniques to Manage Financial Risk Contrast to Techniques of
Selected Privatesector Maritime Lenders

Page 18 GAO- 03- 657 Maritime Administration 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. Today, 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 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 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 Lenders

Separate Key Lending Functions

Page 19 GAO- 03- 657 Maritime Administration 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. However, according to one
MARAD official the waivers are often made without a deliberative process.
Nonetheless, MARAD points to its concurrence system as a deliberative
process for key agency officials to concur on loan guarantees and major
waivers and modifications. However, as mentioned

earlier, the official responsible for performing a macro analysis of the
market is not always included in the concurrence process. We found in the
cases we reviewed that MARAD often permits waivers or modifications of key
financial requirements. Also, a recent IG report found that MARAD

routinely modified 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. 16 A MARAD official
told us that MARAD is currently developing the procedures for an external
review process of waivers and modifications. 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

16 The IG also recommended that MARAD impose compensating factors for loan
guarantees to mitigate risks. Private- sector Practices

Employ Less Flexible Lending Standards

Page 20 GAO- 03- 657 Maritime Administration 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 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. MARAD notes that in certain cases, such as a loan guarantee to a
subsidiary of Enron, it already uses such requirements. The DOT IG noted
that MARAD should place covenants in its loan guarantees concerning the
required financial performance and condition of its borrowers, as well as
measures to which MARAD is entitled should these provisions be violated.
However, the IG expressed concern that MARAD*s minimum monitoring approach
would not provide financial information in a timely and sufficient manner.
Private- sector lenders use 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 Private-
sector Lenders Use

a More Systematic Approach to Loan Monitoring

Page 21 GAO- 03- 657 Maritime Administration 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. 17 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.

17 Classification society representatives are individuals who inspect the
structural and mechanical fitness of ships and other marine vessels for
their intended purpose.

Page 22 GAO- 03- 657 Maritime Administration 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. 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 is 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.
18 18 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). Private- sector Lenders Use

Industry Expertise to Value Defaulted Assets

MARAD Cites Mission as the Difference in Management of Financial Risk
Compared to Privatesector Lenders

Page 23 GAO- 03- 657 Maritime Administration 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 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 and Reestimates Are Questionable

Page 24 GAO- 03- 657 Maritime Administration 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. 19 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. 20 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.

19 The Federal Accounting Standards Advisory Board developed the
accounting standard for credit programs in 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. 20 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. MARAD*s Credit Subsidy

Estimates Are Questionable

Page 25 GAO- 03- 657 Maritime Administration 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 25year 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

Page 26 GAO- 03- 657 Maritime Administration 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. 21 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 2,

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).

21 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.

Page 27 GAO- 03- 657 Maritime Administration Figure 2: Estimated and
Actual Defaults of Title XI Loan Guarantees (1996* 2002)

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.

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 3. 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 $94.9 million or about 51 percent of its estimated recovery
amount. When we excluded AMCV, which represents about 68 percent of the
defaulted amounts, from our analysis, we found that MARAD has more

accurately estimated the amount it would recover on defaulted loans, and
in fact, has underestimated the actual amount by about $10 million (or
about 15 percent). If the overall pattern of recent default and recovery
experiences were to continue, MARAD would have significantly
underestimated the costs of the program.

8 59

Default dollars in millions Default dollars in millions Risk category

Actual Estimated a

Sources: MARAD (data); GAO (presentation).

2B 2C 2A 2A 2B 2C 3 3 Excluding AMCV

187 13

124 14

117 8

59 99

9 0

13 0

0 50

100 150

200 0 50

100 150

200

9 12

Page 28 GAO- 03- 657 Maritime Administration Figure 3: Estimated and
Actual Recoveries on Title XI Loan Defaults (1996* 2002)

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 $94.9 out of this $370.6 million.

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. 22
22 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.

0 20

40 60

80 100

0 20

40 60

80 100 Recoveries (dollars in millions) Recoveries (dollars in millions)

Risk category

Actual b Estimated a

Sources: MARAD (data); GAO (presentation).

2C 2A 2A 2B 2C 3 3 2B Excluding AMCV

94 7

62 47

0 9

30 32 32 0 0 0 0

47 39

30

Page 29 GAO- 03- 657 Maritime Administration 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 privatesector
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.

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
MARAD*s Credit Subsidy

Reestimates Are Also Questionable

Page 30 GAO- 03- 657 Maritime Administration 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 adequate 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 adequate 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.

Page 31 GAO- 03- 657 Maritime Administration 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 it delegates
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. 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, it would have realized that MARAD did
not have adequate support for the default and recovery assumptions it uses
to calculate subsidy cost estimates.

MARAD does not operate the Title XI loan guarantee program in a
businesslike fashion to minimize the federal government*s fiscal exposure.
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 wellinformed 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.

We recommend that Congress consider discontinuing future appropriations
for new loan guarantees under the Title XI program until adequate internal
controls have been instituted to manage risks associated with the program
and MARAD has updated its default and recovery assumptions to more
accurately reflect the actual costs associated with the program and that
Congress consider rescinding the unobligated balances in MARAD*s program
account. We also recommend that OMB Has Provided Little

Oversight of MARAD*s Estimates and Reestimates

Conclusions Matters for Congressional Consideration

Page 32 GAO- 03- 657 Maritime Administration Congress consider clarifying
borrower equity contribution requirements. Specifically, we recommend that
Congress consider legislation requiring

the entire equity down payment, based on the total cost of the project
including total guarantee fees currently expected to be paid over the life
of the project, be paid by the borrower before the proceeds of the
guaranteed

obligation are made available. Further, we recommend that Congress
consider legislation that requires MARAD to consider, in its risk category
system, the risk associated with approving projects from a single borrower
that would represent a large percentage of MARAD*s portfolio.

We recommend that the Secretary of Transportation direct the Administrator
of the Maritime Administration to take immediate action to improve the
management of the Title XI loan guarantee program. Specifically, to better
comply with Title XI loan guarantee program requirements and manage
financial risk, MARAD should

 establish a clear separation of duties among the loan application,
project monitoring, and default management functions;

 establish a systematic process that ensures independent judgments of the
technical, economic, and financial soundness of projects during loan
guarantee approval;

 establish a systematic process that ensures the findings of each
contributing office are considered and resolved prior to approval of loan
guarantee applications involving waivers and exceptions made to program
requirements;

 systematically monitor and document the financial condition of borrowers
and link the level of monitoring to the level of project risk;

 base the borrower*s equity down payment requirement on a reasonable
estimate of the total cost of the project, including total guarantee fees
expected to be incurred over the life of the project;

 make apparent the amount of equity funds a shipowner or shipyard owner
should provide;

 establish a system of controls, including automated controls, to ensure
that disbursements of loan funds are not made prior to a shipowner or
shipyard owner meeting the equity fund requirement; Recommendations for

Executive Action

Page 33 GAO- 03- 657 Maritime Administration  create a transparent,
independent, and risk- based process for verifying and documenting the
progress of projects under construction prior to

disbursing guaranteed loan funds;  review risk ratings of loan guarantee
projects at least annually; and  establish minimum requirements for the
management and disposition of

defaulted assets, including a requirement for an independent evaluation of
asset value. To better implement federal credit reform, MARAD should

 establish and implement a process to annually compare estimated to
actual defaults and recoveries by risk category, investigate any material
differences that are identified, and incorporate the results of these
analyses in its estimates and reestimates;

 establish and implement a process to document the basis for each key
cash flow assumption* such as defaults, recoveries, and fees* and retain
this documentation in accordance with applicable records retention

requirements;  establish and implement a process to document the basis
for each

reestimate, including an analysis of a borrower*s financial condition and
a market analysis;

 review its risk category system to ensure that it appropriately
classifies projects into subdivisions that are relatively homogenous in
cost, given the facts known at the time of designation, and that risks and
changes to risks are reflected in annual reestimates; and

 consider, in its risk category system, the risk associated with
approving projects from a single borrower that would represent a large
percentage of MARAD*s portfolio.

To ensure that the reformed Title XI program is carried out effectively
and in conformity with program and statutory requirements, MARAD should
conduct a comprehensive assessment of its human capital and other resource
needs. Such analysis should also consider the human capital needs to
improve and strengthen credit reform data collection and analyses.

To assist and ensure that MARAD better implements credit reform, and given
the questionableness of MARAD*s estimates and reestimates, we also

Page 34 GAO- 03- 657 Maritime Administration recommend that the Director
of OMB provide greater review and oversight of MARAD*s subsidy cost
estimates and reestimates.

We provided a draft of this report to DOT for its review and comment. We
received comments from the department*s Assistant Secretary for
Administration, who noted that MARAD has already begun to take steps to
improve the operations of the Title XI program consistent with several of
our recommendations. The department disagreed with the manner in which we
characterized some report findings and provided additional information and
data that we have incorporated into our analyses and report as
appropriate. We also provided a copy of the draft report to OMB for its
review and comment. We received comments from OMB*s Program Associate
Director for General Government Programs, and its Assistant

Director for Budget, who agreed that recent recovery expectations should
be incorporated into future reestimates, but disagreed that OMB had
provided little or no oversight over the program*s subsidy cost estimates.

The department noted that its Office of Inspector General recently
identified a number of issues raised in our report and that MARAD is
already addressing these issues. MARAD recognized that aspects of the
program*s operation need improvement and said it is working to fine tune
program operations and create additional safeguards. Specifically, MARAD
has agreed to improve procedures for financial review, seek authorization
for outside assistance in cases of unusual complexity, and expand, within
resource constraints, its processes for monitoring company financial
condition and the condition of assets.

The department pointed out that MARAD is permitted, under Title XI
regulations, to modify or waive financial criteria for loan guarantees.
Before issuing waivers in the future, DOT reported that MARAD will
identify any needed compensatory measures to mitigate associated risks.
MARAD also agreed to consider using outside financial advisors to review
uniquely complicated cases. In addition, DOT reported that MARAD is
working to improve its financial monitoring processes by developing
procedures to better document its regular assessments of each company*s
financial health. The department stated that MARAD plans to highlight the

results of these assessments to top agency management for any Title XI
companies experiencing financial difficulties.

The department also reported that MARAD is developing a system that
leverages limited staff resources for providing more extensive monitoring
of Title XI vessel condition. In this regard, DOT said MARAD is Agency
Comments

Page 35 GAO- 03- 657 Maritime Administration establishing a documentation
process for each vessel that would include improved record keeping of
annual certificates from the U. S. Coast Guard,

vessel classification societies, and insurance underwriters. MARAD hopes
to use this system, together with company financial condition assessments,
to determine whether additional inspections are necessary.

In addition, DOT indicated that MARAD has begun an analysis of the
program*s results covering the full 10- year period since FCRA was
implemented to improve the accuracy of subsidy cost estimates. We agree
that MARAD should conduct this analysis as part of its annual reestimate

process to determine if estimated loan performance is reasonably close to
actual performance and are encouraged that MARAD has been able to obtain
the historical data to conduct such an analysis. We had attempted to
perform a similar analysis to assess the basis MARAD used for its default
and recovery assumptions, but MARAD was unable to provide us with this
data.

The department believes that our analysis may provide results that do not
accurately reflect the management of the program as a whole, and that the
results we report are affected by our sample selection. It points out that
the report is based on an analysis of only 5 projects, representing a
minute segment of the Title XI program*s universe, 3 of which are
defaulted projects, even though the program experienced only 9 defaults
out of 104 projects financed over the last 10 years. We do not contend
that this sample is representative of all of the projects MARAD finances.
However, we do believe that these case studies uncover policies that
permeate the program and do not provide for adequate controls or for the
most effective methods for protecting the government*s interest. In
addition, our conclusions also draw on the work of a recent IG review,
which looked at 42 Title XI projects, as well as a comparison with
practices of selected

private sector lenders and our own experience in analyzing loan guarantee
programs throughout the federal government.

The department also believes that as a result of our emphasis on projects
involving construction financing, a significant portion of the report is
directed at issues associated solely with that type of financing, which
only accounts for about 30 percent of Title XI projects since 1993. The
department believes it is important for us to recognize that most projects
(70 percent) have been for mortgage period financing because there are no
disbursements made from an escrow fund for these types of projects, and

there is virtually no need for agency monitoring of the construction
process for these types of projects because the ship owner does not
receive any Title XI funds until the vessel has been delivered and
certified

Page 36 GAO- 03- 657 Maritime Administration by the regulatory authorities
as seaworthy. We believe that projects involving construction financing
are at greater risk of fraud, waste, abuse,

and mismanagement, and therefore require a greater level of oversight
compared to projects involving only mortgage period financing. Again, as
mentioned above, our overall conclusions are based on more than the

cases we reviewed. DOT asserts that the report*s portrayal of events and
the rationale behind our description of the assessment of defaulted Searex
assets and the verification of the cost for completing Project America I
are inaccurate. In the case of Searex, the department believes that we
implied that had the

program officials rigorously adhered to program guidelines, the vessels
would not have been dismantled. We believe that while the use of rigorous
program guidelines may not have prevented Ingalls from dismantling the
vessels, adherence to existing program guidelines would have provided

evidence of the value and condition of the assets at the time of default.
This documentary evidence would be advantageous if legal action occurred.
In the case of Project America, DOT believes that the report incorrectly
asserts that MARAD relied on an interested party, Ingalls Shipbuilding,
Inc., to determine the value of the Project America I assets. The
department believes that MARAD relied on the shipbuilder only to provide
an estimate of the cost of making Project America seaworthy. We revised
the report to reflect that MARAD did not obtain a market appraisal of the
assets, and that it relied on Ingalls to estimate the cost of making the
vessel seaworthy. We believe that in order to market the Project America
assets, MARAD needs to know the costs of the available options including
the cost of making the hull seaworthy.

The department also believes that the report does not convey a clear
understanding of DCCA*s role in the handling of Project America assets
after default. We disagree with this assertion, and believe that the
report appropriately reflects DCCA*s role as outlined in its report
entitled the Application of Agreed- Upon Procedures Incurred on Project
America.

DOT believes that the report uses a number of examples to show that
granting waivers or *other occurrences* related to program guidelines
somehow contributed to the three defaults among the cases studied and
expresses concern that the report concludes that weak program oversight
contributed to the defaults examined in the draft. First, the report
correctly notes that MARAD is permitted to approve waivers under certain
circumstances. Nonetheless, waiving financial requirements increases the

risk borne by the federal government. MARAD is now recognizing this by
agreeing to implement the IG recommendations calling for compensating

Page 37 GAO- 03- 657 Maritime Administration provisions to mitigate risk
when approving waivers. Second, the program*s vulnerability to fraud,
waste, abuse and mismanagement is not only due to MARAD not complying with
program requirements, but also because

MARAD lacks requirements for the management of defaulted assets, does not
utilize basic internal control practices, such as separation of duties,
and cannot reasonably estimate the program*s cost.

With regard to the private sector comparison, DOT does not agree that
MARAD lacks a deliberative process for loan approvals. The department
believes that, in each written loan guarantee analysis, MARAD discusses
the basis for granting major modifications or waivers. Also, DOT believes
MARAD has a deliberative process through its written concurrence system
whereby key agency offices have to concur on actions authorizing waivers
or modifications. We revised the report to reflect the differing opinions
of MARAD officials regarding the process for approving loan guarantees and

waivers or modifications. We believe that it is not clear that MARAD uses
a deliberative process and our review of the project files showed that key
agency offices were not always included in the concurrence process.

DOT believes that the report should acknowledge that MARAD maintains
separation of duties for disbursement. The report correctly notes that the
ultimate decision to disburse funds is made by the same office that
approves and monitors the Title XI loans. We added the name of the office
that it then instructs to disburse funds.

DOT noted that certain lenders consolidate rather than separate approval
and monitoring functions in order to improve efficiencies. The lenders we
spoke to, who are major marine lenders, do not combine these functions.
They also separate approval and monitoring functions from marketing and
disposition functions. Further, we do not believe that efficiencies
achieved through consolidating these functions outweigh the greater
vulnerability

to fraud, waste, abuse, and mismanagement associated with consolidation.
The department believes that MARAD*s determination of subsidy costs is in
accordance with OMB guidance. While we did not assess MARAD*s compliance
with OMB guidance, MARAD did not comply with other applicable, more
specific guidance, which states that estimated cash flows should be
compared to actuals, and estimates should be based on the best available
data. The guidance is in the Accounting and Auditing Policy Committee*s
Technical Release 3, Preparing and Auditing Direct Loan and Loan Guarantee
Subsidies Under the Federal Credit Reform Act. This guidance was developed
by an interagency group including members

from OMB, Treasury, GAO, and various credit agencies to provide detailed

Page 38 GAO- 03- 657 Maritime Administration implementation guidance on
how to prepare reasonable credit subsidies. Regardless of whether MARAD
complied with all applicable guidance,

because MARAD did not conduct this fundamental analysis to assess whether
its cash flow model was reasonably predicting borrower behavior, it did
not know that for the past 5 years, defaults were occurring at a much
higher rate and costing significantly more than estimated, and

recoveries were significantly less than expected. In addition, MARAD did
not appropriately incorporate these higher default rates and lower
recovery rates into its cash flow models.

The department also stated that the report should recognize that, as a
result of its full compliance with FCRA, MARAD set aside adequate funds
for all defaults to date. While MARAD may have complied with some of the
broad requirements of FCRA in preparing estimates and reestimates, these
estimates were based on outdated assumptions and MARAD could not
demonstrate that the estimates were based on historical data or other
meaningful analyses. Further, DOT*s response does not recognize that the
appropriated funds are to cover expected losses over the life of the loan
guarantee program. Because actual losses for the last 5 years have been
significantly more and recoveries significantly less than expected, in the
future actual losses will need to be significantly less and recoveries
significantly more than estimated for MARAD not to require additional
funding.

In addition, DOT believes that our analysis of MARAD*s subsidy estimates
was inaccurate and based on incomplete or incorrect data, and that we
underreported actual recoveries from one of the defaulted projects (MHI).
We disagree and believe our analysis was accurate, based on the
information MARAD had provided. In its comments, the department provided
new information on recoveries for the MHI project. We have now
incorporated this new data, as appropriate, into our analysis. We did not
include data provided on guarantee fees because these are paid upfront and
should not be included in estimates of recoveries.

The department also provided technical comments, which we have
incorporated as appropriate. The department*s comments appear in appendix
II. OMB agreed that recent recovery expectations on certain defaulted

guarantees cited in our report should be incorporated into future
reestimates, and plans to ensure that these expectations are reflected in
next year*s budget. Further, OMB plans to work with MARAD to review
recovery expectations for other similar loan guarantees. In addition, OMB

Page 39 GAO- 03- 657 Maritime Administration has been working with DOT and
MARAD staff to implement recommendations contained in the IG report, and
expects that resulting

changes will also address many of the concerns raised in our report. OMB
disagreed with our finding that it provided little review and oversight of
MARAD*s subsidy cost estimates and reestimates and points to the
substantial amount of staff time it devotes to working with agencies on
subsidy cost estimates. OMB claims that the data used in our report does
not seem to support our assertion of a lack of OMB oversight and disagrees
with our implication that the overall subsidy rates would be higher if it
had provided oversight. We clarified our report to convey the message that
if OMB had provided greater oversight, it would have realized that MARAD
did not have adequate support for the default and recovery assumptions it
uses to calculate subsidy cost estimates. While

OMB asserts that the number of default claims made between 1992 and 1999
is substantially in line with the assumptions underlying the estimated
subsidy costs, we could not verify the magnitude and timing of defaults

prior to the period included in our review (1996* 2002) because MARAD
could not provide data on historical default experience. Because MARAD
could not provide adequate support for its default and recovery
assumptions, we question the basis for the estimates and whether OMB had
provided sufficient oversight. We continue to believe that MARAD*s recent
actual experience was significantly different than what MARAD had
estimated and OMB had approved. Even when we exclude all of the AMCV
projects, as well as the MHI project, from our analysis, we found that the
amount of defaults MARAD experienced exceeded what MARAD estimated it
would experience by $63.3 million (or about 177 percent). Should the
program receive new funding in the future, the subsidy rate estimates
should be calculated using updated default and recovery assumptions to
incorporate recent actual experience.

OMB also took issue with our use of data on the eight defaults,
particularly those involving AMCV and MHI, in questioning MARAD*s most
recent reestimates of the costs of loans guaranteed between 1992 and 1995.
However, we continue to question the reasonableness of the negative
subsidies for the loans that were disbursed in fiscal years 1993, 1994,
and 1995. First, the loans in these cohorts have not been through what
MARAD considers the period of peak default* years 10* 18 depending on the
risk category. Second, MARAD was unable to provide us with adequate

supporting information for how it determined the estimated default and
recovery amounts. OMB agrees that recent experience should be used to
calculate reestimates and states in its comments that it generally
requires agencies to use all historical data as a benchmark for future
cost estimates

Page 40 GAO- 03- 657 Maritime Administration and agreed that recent
recovery experience should be incorporated into future reestimates.

OMB*s comments appear in appendix III. We are sending copies of this
report to the Secretary of Transportation. We also will make copies
available to others upon request. In addition, the report will be
available at no charge on the GAO web site at http:// www. gao. gov.

If you or your staff have any questions about this report or need
additional information, please contact me, or Mathew Scire at 202- 512-
6794. Major contributors to this report are listed in appendix IV.

Sincerely yours, Thomas J. McCool Managing Director, Financial Markets and
Community Investment

Appendix I: Scope and Methodology Page 41 GAO- 03- 657 Maritime
Administration 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. We
judgmentally selected 5 projects from a universe of 83 projects approved
between 1996 and 2002. The selected projects represent active and
defaulted loans and five of the six risk categories assigned during the
1996* 2002 period. The projects selected include barges, lift boats,
cruise ships, and tankers. (See table 3.) Two of the selected shipowners
had multiple Title XI loan guarantees during 1996* 2002 (HVIDE, five
guarantees; and AMCV, the parent company of Project America, Inc., five).

Table 3: Projects Selected for Our Review Project Year loan committed Type
of project

(AMCV) Project America, Inc. 1999 Cruise ships Searex 1996 Lift boats
Massachusetts Heavy Industries (MHI) 1997 Shipyard

modernization Hvide Van Ommeran Tankers (HVIDE) 1996 Tanker Global
Industries 1996 Barge Source: GAO. We interviewed agency officials and
reviewed provisions of existing

federal regulations set forth in Title 46, Part 298 of the Code of Federal
Regulations to identify the key program requirements that influence the
approval or denial of a Title XI loan guarantee. We reviewed internal
correspondence and other documentation related to the compliance with
program requirements for the approval of the loan guarantee, ongoing
monitoring of the project, and disposition of assets for loans resulting
in default. We interviewed agency officials and staff members from the
Title XI support offices that contribute to the approval and monitoring of
loans and disposal of a loan resulting in default. Also, we interviewed a
retired

MARAD employee involved in one of the projects. In addition, we
interviewed officials that represented AMCV/ Project America, Inc.,
including the former Vice President and General Counsel and former outside
counsel.

To determine how MARAD*s practices of managing financial risk compare to
those of selected private- sector maritime lenders, we interviewed two
leading worldwide maritime lenders, and one leading maritime lender in the
Gulf Coast region. We interviewed these lenders to become familiar
Appendix I: Scope and Methodology

Appendix I: Scope and Methodology Page 42 GAO- 03- 657 Maritime
Administration with private- sector lending policies, procedures, and
practices in the shipping industry. Among the individuals we interviewed
were those

responsible for portfolio management and asset disposition. We did not
verify that the lenders followed the practices described to us.

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 first identified the key cash flow
assumptions MARAD uses to calculate its subsidy cost estimates. Once we
identified these assumptions, we determined whether MARAD had a reliable
basis* whether MARAD had gathered sufficient, relevant, and reliable
supporting data* for the estimates of program cost and for their estimates
of loan performance. We compared estimated program performance to actual
program performance to determine whether variances between the estimates
and actual performance existed. Further, we interviewed those MARAD
officials who are responsible for implementing credit reform and compared
the practices MARAD uses to implement credit reform to the practices
identified in OMB and other applicable credit reform implementation
guidance.

We performed 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.

Appendix II: Comments from the Department of Transportation Page 43 GAO-
03- 657 Maritime Administration Appendix II: Comments from the Department
of Transportation

Appendix II: Comments from the Department of Transportation Page 44 GAO-
03- 657 Maritime Administration

Appendix II: Comments from the Department of Transportation Page 45 GAO-
03- 657 Maritime Administration

Appendix II: Comments from the Department of Transportation Page 46 GAO-
03- 657 Maritime Administration

Appendix II: Comments from the Department of Transportation Page 47 GAO-
03- 657 Maritime Administration

Appendix II: Comments from the Department of Transportation Page 48 GAO-
03- 657 Maritime Administration

Appendix III: Comments from the Office of Management and Budget Page 49
GAO- 03- 657 Maritime Administration Appendix III: Comments from the
Office of Management and Budget

Appendix III: Comments from the Office of Management and Budget Page 50
GAO- 03- 657 Maritime Administration

Appendix IV: GAO Contacts and Staff Acknowledgments Page 51 GAO- 03- 657
Maritime Administration Thomas J. McCool (202) 512- 8678

Mathew J. Scire (202) 512- 6794 In addition to those individuals named
above, Kord Basnight, Daniel Blair, Rachel DeMarcus, Eric Diamant, Donald
Fulwider, Grace Haskins, Rachelle Hunt, Carolyn Litsinger, Marc Molino,
and Barbara Roesmann made key contributions to this report. Appendix IV:
GAO Contacts and Staff

Acknowledgments GAO Contacts Staff Acknowledgments

(250087)

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