Maritime Administration: Weaknesses Identified in Management of  
the Title XI Loan Guarantee Program (15-MAY-03, GAO-03-728T).	 
                                                                 
Title XI of the Merchant Marine Act of 1936, as amended, is	 
intended to help promote growth and modernization of the U.S.	 
merchant marine and U.S. shipyards by enabling owners of eligible
vessels and shipyards to obtain financing at attractive terms.	 
The program has guaranteed more than $5.6 billion in ship	 
construction and shipyard modernization costs since 1993, but has
experienced several large-scale defaults over the past few years.
One borrower, American Classic Voyages, defaulted on five loan	 
guarantees in amounts totaling $330 million, the largest of which
was for the construction of Project America cruise ships. Because
of concerns about the scale of recent defaults, GAO was asked to 
(1) determine whether MARAD complied with key program		 
requirements, (2) describe how MARAD's practices for managing	 
financial risk compare to those of selected private-sector	 
maritime lenders, and (3) assess MARAD's implementation of credit
reform. We are currently considering a number of recommendations 
to reform the Title XI program. Because of the fundamental flaws 
we have identified, we question whether MARAD should approve new 
loan guarantees without first addressing these program		 
weaknesses.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-728T					        
    ACCNO:   A06875						        
  TITLE:     Maritime Administration: Weaknesses Identified in	      
Management of the Title XI Loan Guarantee Program		 
     DATE:   05/15/2003 
  SUBJECT:   Financial management				 
	     Loans						 
	     Merchant marine					 
	     Shipyards						 
	     Loan defaults					 
	     Construction costs 				 

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GAO-03-728T

Testimony Before the Committee on Commerce, Science, and Transportation,
U. S. Senate

United States General Accounting Office

GAO For Release on Delivery Expected at 2: 30 p. m. EDT Thursday, June 5,
2003 MARITIME

ADMINISTRATION Weaknesses Identified in Management of the Title XI Loan
Guarantee Program

Statement of Thomas J. McCool, Managing Director Financial Markets and
Community Investment

GAO- 03- 728T

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.

Partially Completed Project America Cruise Ship Financed under Title XI
Program on Its Way to Foreign Shipyard after Default and Sale Source:
Northrop Grumman Corporation Ship Systems Ingalls Operations. Title XI of
the Merchant Marine Act of 1936, as amended, is intended to

help promote growth and modernization of the U. S. merchant marine and U.
S. shipyards by enabling owners of eligible vessels

and shipyards to obtain financing at attractive terms. The program has
guaranteed more than $5. 6 billion in ship construction and shipyard
modernization costs since

1993, but it has experienced several large- scale defaults over the past
few years. One borrower, American Classic Voyages, defaulted on five loan
guarantees in amounts totaling $330 million, the largest of which was for
the construction of Project America cruise ships. Because of concerns
about the scale of recent defaults, GAO was asked to (1) determine whether
the Maritime Administration (MARAD) complied

with key program requirements, (2) describe how MARAD*s practices for
managing financial risk compare to those of selected private- sector
maritime lenders, and (3) assess MARAD*s implementation of credit reform.
GAO is currently considering a number of recommendations to reform the
Title XI program. Because of the fundamental flaws identified, GAO
questions whether

MARAD should approve new loan guarantees without first addressing these
program weaknesses.

www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 728T. To view the full product,
including the scope and methodology, click on the link above. For more
information, contact Tom McCool at (202) 512- 8678 or mccoolt@ gao. gov.
Highlights of GAO- 03- 728T, a testimony

before the Committee on Commerce, Science, and Transportation, U. S.
Senate

June 5, 2003

MARITIME ADMINISTRATION

Weaknesses Identified in Management of the Title XI Loan Guarantee Program

Page 1 GAO- 03- 728T

Mr. Chairman and Members of the Committee: I am pleased to be here today
to discuss the results of our review of the Maritime Administration*s
(MARAD) Title XI loan guarantee program. Title XI was created to help
promote growth and modernization of the U. S. merchant marine and U. S.
shipyards by enabling owners of eligible vessels and shipyards to obtain
long- term financing on terms and conditions that might not otherwise be
available. Under the program, MARAD guarantees the payment of principal
and interest to purchasers of bonds issued by

vessel and shipyard owners. These owners may obtain guaranteed financing
for up to 87.5 percent of the total cost of buying or constructing a
vessel or buying or modernizing a shipyard.

Under Title XI, MARAD committed to guarantee more than $5.6 billion in
shipyard modernization and ship construction projects over the last 10
years. During this period, MARAD experienced nine defaults on these loan
guarantee commitments totaling over $1.3 billion. The defaulted amounts

associated with these nine loan guarantee commitments totaled $489
million. 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..

Page 2 GAO- 03- 728T

While Title XI of the Merchant Marine Act of 1936, as amended, established
the requirements of the loan guarantee program, the loan guarantees are
also subject to the Federal Credit Reform Act of 1990 (FCRA). Under the
FCRA, federal agencies must account for the estimated costs of direct and
guaranteed loans on a net present value basis, over the full term of the
credit, and agencies must receive appropriations for these costs before
they disburse a loan or enter into loan guarantee commitments.

Because of concerns about the scale of recent defaults experienced by
MARAD, particularly those associated with AMCV, you asked us to conduct a
study of the Title XI loan guarantee program. Specifically, you asked us
to (1) determine whether MARAD complied with key Title XI program
requirements in approving initial and subsequent agreements, monitoring
and controlling funds, and handling defaults; (2) describe how MARAD*s
practices for managing financial risk compare to those of selected
private- sector maritime lenders; and (3) assess MARAD*s implementation of
credit reform as it relates to the Title XI program.

To determine whether MARAD complied with key Title XI program
requirements, we identified key program requirements and reviewed how
these were applied to the management of five loan guarantee projects. To
determine how MARAD*s practices for managing financial risk compare to
those of selected private- sector maritime lenders, we interviewed three
maritime lenders to learn about lending practices, and compared these
practices to MARAD*s. To assess MARAD*s implementation of credit reform,
we analyzed MARAD*s subsidy cost estimation and reestimation processes and
examined how the assumptions MARAD uses to calculate subsidy cost
estimates compare to MARAD*s actual program experience.

We conducted our work in Washington, D. C., and New York, N. Y., between
September 2002 and April 2003 in accordance with generally accepted
government auditing standards.

In summary:  MARAD has not fully complied with some key Title XI program

requirements. We found that MARAD generally complied with requirements to
assess an applicant*s economic soundness before issuing loan guarantees.
However, MARAD used waivers or modifications, which, although permitted by
MARAD regulations, allowed MARAD to approve some applications even though
borrowers had not met all financial requirements. MARAD did not fully
comply with regulations and established practices pertaining to project
monitoring and fund

Page 3 GAO- 03- 728T

disbursement. Finally, while MARAD has guidance governing the disposition
of defaulted assets, adherence to this guidance is not mandatory, and
MARAD did not always follow it in the defaulted cases we reviewed.

 Private- sector maritime lenders we interviewed told us that to manage
financial risk, they among other things: (1) 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 systematic
approach to monitoring the progress of projects; and (4) primarily employ
independent parties to survey and appraise defaulted projects. They try to
be very selective when originating loans for the shipping industry. MARAD

could benefit from considering the internal control practices employed by
the private sector to more effectively utilize its limited resources while
maximizing its ability to accomplish its mission.  MARAD uses a
relatively simplistic cash flow model that is based on

outdated assumptions, which lack supporting documentation, to prepare its
estimates of defaults and recoveries. While the nature and characteristics
of the Title XI program make it difficult to estimate subsidy

costs, MARAD has not performed the basic analyses necessary to assess and
improve its estimates, which differ significantly from recent actual
experience. Specifically, we found that in comparison with recent actual
experience, MARAD*s default estimates have significantly understated
defaults, and its recovery estimates have significantly overstated
recoveries. Agencies should use sufficient reliable historical data to
estimate credit subsidies and update* reestimate* these estimates annually
based on an analysis of actual program experience. However, MARAD has
never evaluated the performance of its loan guarantee projects to
determine if its subsidy cost reestimates were comparable to actual costs.
Finally, the Office of Management and Budget (OMB) has provided little
oversight of MARAD*s subsidy cost estimate and reestimate calculations.

Because MARAD does not operate the Title XI loan guarantee program in a
businesslike fashion, it lacks assurance that it is effectively promoting
growth and modernization of the U. S. merchant marine and U. S. shipyards
or minimizing the risk of financial loss to the federal government.
Consequently, the Title XI program could be vulnerable to waste, fraud,
abuse, and mismanagement. Also, MARAD*s questionable subsidy cost
estimates do not provide Congress a basis for knowing the true costs of
the Title XI program and Congress cannot make well- informed policy
decisions when providing budget authority. If the pattern of recent

Page 4 GAO- 03- 728T

experiences were to continue, MARAD would have significantly
underestimated the costs of the program.

To review our findings in more detail, let me start by describing MARAD*s
management of the Title XI program. MARAD has not fully complied with some
key Title XI program

requirements. We found that MARAD generally complied with requirements to
assess an applicant*s economic soundness before issuing loan guarantees.
However, MARAD used waivers or modifications, which, although permitted by
MARAD regulations, allowed MARAD to approve some applications even though
borrowers had not met all financial requirements. Additionally, MARAD did
not fully comply with regulations and established practices pertaining to
project monitoring and fund disbursement. Finally, while MARAD has
guidance governing the disposition of defaulted assets, adherence to this
guidance is not mandatory, and MARAD did not always follow it in the
defaulted cases we reviewed. We looked at five MARAD- financed projects
(see table 1).

Table 1: Projects Included in Our Review Project Year loan committed
Original

amount (millions) 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 data. Note: MARAD
places projects into one of seven risk categories that, from lowest to
highest, are 1A,

1B, 1C, 2A, 2B, 2C, and 3.

MARAD Has Not Fully Complied with Some Key Title XI Program Requirements

Page 5 GAO- 03- 728T

MARAD regulations do not permit MARAD to guarantee a loan unless the
project is determined to be economically sound. 3 MARAD generally complied
with requirements to assess an applicant*s economic soundness before
approving loan guarantees, and we were able to find documentation
addressing economic soundness criteria for the projects included in our
review. Specifically, we were able to find documentation addressing supply
and demand projections and other economic soundness criteria for the
projects included in our review. 4 In 2002, MARAD*s Office of Statistical
and Economic Analysis found a lack of a standardized approach for
conducting market analyses. Because of this concern, in November 2002, it
issued guidance for conducting market research on marine transportation
services. However, adherence to these guidelines is not required. Finally,
while MARAD may not waive economic soundness

criteria, officials from the Office of Statistics and Economic Analysis
expressed concern that their findings regarding economic soundness might
not always be fully considered when MARAD approved loan guarantees. 5 They
cited a recent instance where they questioned the economic soundness of a
project that was later approved without their concerns being addressed.
According to the Associate Administrator for Shipbuilding, all concerns,
including economic soundness concerns, are considered by the MARAD
Administrator.

Shipowners and shipyard owners are also required to meet certain financial
requirements during the loan approval process. However, MARAD used waivers
or modifications, which, although permitted by Title XI regulations,
allowed MARAD to approve some applications even though

3 All projects must be determined to be economically sound, and borrowers
must have sufficient operating experience and the ability to operate the
vessels or employ the technology on an economically sound basis.
Particularly, MARAD regulations contain language stating that (1) long-
term demand must exceed supply; (2) documentation must be provided on the
projections of supply and demand; (3) outside cash flow should be shown,
if in the short- term the borrower is unable to service indebtedness; and
(4) operating cash flow ratio must be greater than one (sufficient cash
flow to service the debt). 4 Economic soundness analyses are prepared by
the Office of Subsidy and Insurance and the Office of Statistical and
Economic Analysis. It should be noted that we did not assess the substance
of these economic analyses.

5 In another case, Congress statutorily waived economic soundness
criteria. Specifically, the Coast Guard Authorization Act of 1996
contained a provision waiving the economic soundness requirement for
reactivation and modernization of certain closed shipyards in the United
States. Previously, MARAD had questioned the economic soundness of the MHI

proposal and rejected the application. MARAD Used Waivers and

Modifications to Approve Loans That Would Otherwise Not Be Approved

Page 6 GAO- 03- 728T

borrowers had not met all financial requirements that pertained to working
capital, long- term debt, net worth, and owner- invested equity 6 For
example, AMCV*s Project America, Inc., did not meet the qualifying
requirements for working capital, among other things. Although MARAD
typically requires companies to have positive working capital, an excess
of current assets over current liabilities, the accounting requirements
for unterminated passenger payments significantly affect this calculation
because this deferred revenue is treated as a liability until earned. 7
Because a cruise operator would maintain large balances of current

liabilities, MARAD believed it would be virtually impossible for AMCV to
meet a positive working capital requirement if sound cash management
practices were followed. 8 Subsequently, MARAD used cash flow tests for
Project America, Inc., in lieu of working capital requirements for
purposes of liquidity testing.

According to MARAD officials, waivers or modifications help them meet the
congressional intent of the Title XI program, which is to promote the
growth and modernization of the U. S. merchant marine industry. Further,
they told us that the uniqueness of the Title XI projects and marine
financing lends itself to the use of waivers and modifications. However,
by waiving or modifying financial requirements, MARAD officials may be
taking on greater risk in the loans they are guaranteeing. Consequently,
the use of waivers or modifications could contribute to the number or
severity of loan guarantee defaults and subsequent federal payouts. In a
recent review, the Department of Transportation Inspector General (IG)
noted

that the use of modifications increases the risk of the loan guarantee to
the government and expressed concern about MARAD undertaking such
modifications without taking steps to mitigate those risks. 9 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. 6 MARAD may waive or
modify financial terms or requirements upon determining that there is
adequate security for the guarantees. 7 Unterminated passengers are
individuals who pay for a cruise, but do not actually take the cruise, and
the payment is not refunded. However, the passenger may take the trip at a
later date.

8 Cash management is a financial management technique used to accelerate
the collection of debt, control payments to creditors, and efficiently
manage cash. 9 U. S. Department of Transportation, Office of Inspector
General, Maritime Administration Title XI Loan Guarantee Program
(Washington, D. C.: Mar. 27, 2003).

Page 7 GAO- 03- 728T

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. 10
MARAD did so without documenting this change in the loan agreement.
Ultimately, weaknesses in MARAD*s monitoring practices could increase the
risk of loss to the federal government.

MARAD regulations specify that the financial statements of a company in
receipt of a loan guarantee shall be audited at least annually by an
independent certified public accountant. In addition, MARAD regulations
require companies to provide semiannual financial statements. However,
MARAD could not demonstrate that it had received required annual and
semiannual statements. For example, MARAD could not locate several annual
or semiannual financial statements for the Massachusetts Heavy Industries
(MHI) project. Also, MARAD could not find the 1999 and 2000 semiannual
financial reports for AMCV. The AMCV financial statements were later
restated, as a result of a Securities and Exchange Commission (SEC)
finding that AMCV had not complied with generally accepted accounting
principles in preparing its financial statements. 11 In addition, several
financial statements were missing from MARAD records for Hvide Van Ommeran
Tankers (HVIDE) and Global Industries Ltd. When MARAD could provide
records of financial statements, it was unclear how the

information was used. Further, the Department of Transportation IG in its
review of the Title XI program found that MARAD had no established
procedures or policies incorporating periodic reviews of a company*s
financial well- being once a loan guarantee was approved.

10 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.

11 On June 25, 2001, AMCV restated losses from $6.1 million to $9.1
million for the first quarter of 1999. MARAD Did Not Follow

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

Page 8 GAO- 03- 728T

An analysis of financial statements may have alerted MARAD to financial
problems with companies and possibly given it a better chance to minimize
losses from defaults. For example, between 1993 and 2000, AMCV had net
income in only 3 years and lost a total of $33.3 million. Our analysis
showed a significant decline in financial performance since 1997.
Specifically, AMCV showed a net income of $2.4 million in 1997, with

losses for the next 3 years, and losses reaching $10.1 million in 2000.
Although AMCV*s revenue increased steadily during this period by a total
of 25 percent, or nearly $44 million, expenses far outpaced revenue during

this period. For example, the cost of operations increased 29 percent, or
$32.3 million, while sales and general and administrative costs increased
over 82 percent or $33.7 million. During this same period, AMCV*s debt
also increased over 300 percent. This scenario combined with the decline
in tourism after September 11, 2001, caused AMCV to file for bankruptcy.
On May 22, 2001, Ingalls notified AMCV that it was in default of its
contract due to nonpayment. Between May 22 and August 23, 2001, MARAD
received at least four letters from Ingalls, the shipbuilder, citing its
concern about the shipowner*s ability to pay construction costs. However,
it was not until August 23 that MARAD prepared a financial analysis to
help determine the likelihood of AMCV or its subsidiaries facing
bankruptcy or another catastrophic event.

MARAD could not always demonstrate that it had linked disbursement of
funds to progress in ship construction, as MARAD requires. We were not
always able to determine from available documents the extent of progress

made on the projects included in our review. For example, a number of
Project America, Inc. *s, disbursement requests did not include
documentation that identified the extent of progress made on the project.
Also, while MARAD requires periodic on- site visits to verify the progress

on ship construction or shipyard refurbishment, we did not find evidence
of systematic site visits and inspections. For Project America, Inc.,
MARAD did not have a construction representative committed on site at
Ingalls Shipyard, Inc., until May 2001, 2 months after the MARAD*s Office
of Ship Design and Engineering Services recommended a MARAD

representative be located on- site. For the Searex Title XI loan
guarantee, site visits were infrequent until MARAD became aware that
Ingalls had cut the vessels into pieces to make room for other projects.
For two projects rated low- risk, Hvide Van Ommeran Tankers and Global
Industries, Ltd., we found MARAD conducted site visits semiannually and
annually, respectively. We reviewed MHI*s shipyard modernization project,
which was assigned the highest risk rating, and found evidence that
construction representatives conducted monthly site visits. However, in
most instances, we found that a project*s risk was not linked to the
extent of project

Page 9 GAO- 03- 728T

monitoring. Further, MARAD relied on the shipowner*s certification of
money spent in making decisions to approve disbursements from the escrow
fund.

We also found that, in a break with its own established practice, MARAD
permitted a shipowner to define total costs in a way that permitted
earlier disbursement of loan funds from the escrow fund. MARAD regulations
require that shipowners expend from their own funds at least 12.5 percent
or 25 percent, depending on the type of vessel or technology, of the
actual cost of a vessel or shipyard project prior to receiving MARAD-
guaranteed loan funds. In practice, MARAD has used the estimated total
cost of the project to determine how much equity the shipowner should
provide. In the case of Project America, Inc., the single largest loan
guarantee in the history of the program, we found that MARAD permitted the
shipowner to exclude certain costs in determining the estimated total
costs of the ship at various points in time, thereby deferring owner-
provided funding while receiving MARAD- guaranteed loan funds. This was
the first time MARAD used this method of determining equity payments, and
MARAD did not document this agreement with the shipowner as required by
its policy. In September 2001, MARAD amended the loan commitment for this
project, permitting the owner to further delay the payment of equity. By
then, MARAD had disbursed $179 million in loan funds. Had MARAD followed
its established practice for determining equity payments, the shipowner
would have been required to provide an additional $18 million. Because
MARAD had not documented its agreements with AMCV, the amount of equity
the owner should have provided was not apparent during this period.
Further, MARAD systems do not flag when the shipowner has provided the
required equity payment for any of the projects it finances.

MARAD officials cited several reasons for its limited monitoring of Title
XI projects, including insufficient staff resources and travel budget
restrictions. For example, officials of MARAD*s Office of Ship
Construction, which is responsible for inspection of vessels and
shipyards, told us that they had only two persons available to conduct
inspections, and that the office*s travel budget was limited. The MARAD
official with overall responsibility for the Title XI program told us
that, at a minimum, the Title XI program needs three additional staff. The
Office of Ship Financing needs two additional persons to enable a more
through review of company financial statements and more comprehensive
preparation of

credit reform materials. Also, the official said that the Office of the
Chief Counsel needs to fill a long- standing vacancy to enable more timely
legal review. With regard to documenting the analysis of financial
statements, MARAD officials said that, while they do require shipowners
and shipyard

Page 10 GAO- 03- 728T

owners to provide financial statements, they do not require MARAD staff to
prepare a written analysis of the financial condition of the Title XI
borrower.

Inconsistent monitoring of a borrower*s financial condition limits MARAD*s
ability to protect the federal government*s financial interests. For
example, MARAD would not know if a borrower*s financial condition had
changed so that it could take needed action to possibly avoid defaults or
minimize losses. Further, MARAD*s practices for assessing project

progress limit its ability to link disbursement of funds to progress made
by shipowners or shipyard owners. This could result in MARAD disbursing
funds without a vessel or shipyard owner making sufficient progress in
completing projects. Likewise, permitting project owners to minimize their
investment in MARAD- financed projects increases the risk of loss to the
federal government.

MARAD has guidance governing the disposition of defaulted assets. However,
MARAD is not required to follow this guidance, and we found that MARAD
does not always adhere to it. MARAD guidelines state that an independent,
competent marine surveyor or MARAD surveyor shall survey all vessels,
except barges, as soon as practicable, after the assets are taken

into custody. In the case of filed or expected bankruptcy, an independent
marine surveyor should be used. In the case of Searex, MARAD conducted on-
site inspections after the default. However, these inspections were not
conducted in time to properly assess the condition of the assets. With
funds no longer coming in from the project, Ingalls cut the vessels into
pieces to make it easier to move the vessels from active work- in- process
areas to other storage areas within the property. The Searex lift boat and
hulls were cut before MARAD inspections were made. According to a MARAD
official, the cutting of one Searex vessel and parts of the other two
Searex vessels under construction reduced the value of the defaulted
assets. The IG report on the Title XI program released in March 2003 noted

that site visits were conducted on guaranteed vessels or property only in
response to problems or notices of potential problems from third parties
or from borrowers. The guidelines also state that sales and custodial
activities shall be conducted in such a fashion as to maximize MARAD*s
overall recovery with respect to the asset and debtor. Market appraisals
(valuations) of the assets shall be performed by an independent appraiser,
as deemed appropriate, to assist in the marketing of the asset. Relying on
an interested party in determining the value of defaulted assets may not
have MARAD Does Not Have

Requirements in Place to Govern the Handling of Defaulted Assets

Page 11 GAO- 03- 728T

maximized MARAD*s financial recovery. In the case of Project America I and
II, MARAD relied on the shipbuilder, Ingalls, to provide an estimate of
the cost of making the Project America I vessel seaworthy. According to
MARAD officials, their only option was to rely on Ingalls to provide this

estimate. Ingalls* initial estimate in April 2002 was $16 million. Based
on this estimate, MARAD rejected two bids to purchase the unfinished hull
of Project America I ($ 2 million and $12 million respectively). 12
Subsequently, on May 17, 2002, MARAD advised Ingalls that it should
dispose of the assets of Project America I and remit the net savings, if
any, to MARAD. In a June 28, 2002, agreement between Northrup Grumman Ship
Systems, Inc. (formerly Litton Ingalls Shipbuilding), Northrup Grumman
advised that it would cost between $9 and $12 million to preserve and make
Project America I seaworthy for delivery to the prospective purchaser. Had
the $9 to $12 million estimate been made earlier in April 2002, MARAD
would have accepted the $12 million dollar bid and would have disposed of
the Project America I asset. By accepting Ingalls* original estimate of
$16 million to make the ship seaworthy, MARAD may have incurred several
months of unnecessary preservation expenses and possibly lowered its
recovery amount. According to MARAD officials, as of March 2003, MARAD had
received $2 million from the sale of the Project America I and II vessels.

Rather than obtaining a market appraisal to assist in marketing the asset,
MARAD hired the Defense Contract Audit Agency (DCAA) to verify the costs
incurred by Northrop Grumman Ship Systems, Inc., since January 1, 2002,
for preparing and delivering Project America I in a weathertight condition
suitable for ocean towing in international waters. A MARAD official said
that the DCAA audit would allow MARAD to identify any unsupported costs
and recover these amounts from the shipyard. The DCAA review was used to
verify costs incurred, but not to make a judgment as to the reasonableness
of the costs. DCAA verified costs of approximately $17 million.

MARAD officials cite the uniqueness of the vessels and projects as the
reason for using guidelines instead of requirements for handling defaulted
assets. However, certain practices for handling defaulted assets can be
helpful regardless of the uniqueness of a project. Among these are steps
to immediately assess the value of the defaulted asset. Without a
definitive

12 The bids were for the purchase of the unfinished hull for Project
America I in seaworthy condition.

Page 12 GAO- 03- 728T

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.

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. MARAD Techniques

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

Page 13 GAO- 03- 728T

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.

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 Private-
sector Lenders

Separate Key Lending Functions

Page 14 GAO- 03- 728T

impact of market factors on the economic soundness of projects. This
office reports to the Associate Administrator for Policy and International
Trade rather than the Associate Administrator for Shipbuilding. However,
the Associate Administrator for Shipbuilding also is primarily responsible
for overseeing the underwriting and approving of loan guarantees. Title XI
program management is primarily handled by offices that report to the

Associate Administrator for Shipbuilding. In addition, the same Associate
Administrator controls, in collaboration with the Chief of the Division of
Ship Financing Contracts 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.

The private- sector lenders we interviewed said they apply rigorous
financial tests for underwriting maritime loans. They analyze financial
statements such as balance sheets, income statements, and cash flow
statements, and use certain financial ratios such as liquidity and
leverage ratios that indicate the borrower*s ability to repay. Private-
sector maritime lenders told us they rarely grant waivers, or exceptions,
to underwriting

requirements or approve applications when borrowers do not meet key
minimum requirements. Each lender we interviewed said any approved
applicants were expected to demonstrate stability in terms of cash on

hand, financial strength, and collateral. One lender told us that on the
rare occasions when exceptions to the underwriting standards were granted,
an audit committee had to approve any exception or waiver to the standards
after reviewing the applicant*s circumstances. In contrast, we Private-
sector Practices

Employ Less Flexible Lending Standards

Page 15 GAO- 03- 728T

found in the cases we reviewed that MARAD often permits waivers or
modifications of key financial requirements, often without a deliberative
process, according to a MARAD official. For example, MARAD waived the
equity and working capital financial requirements at the time of the loan
guarantee closing for MHI*s shipyard modernization project. Also, a recent
IG report found that MARAD routinely modifies financial requirements in
order to qualify applicants for loan guarantees. Further, the IG noted
that MARAD reviewed applications for loan guarantees primarily with in-
house

staff and recommended that MARAD formally establish an external review
process as a check on MARAD*s internal loan application review. 13 A MARAD
official told us that MARAD is currently developing the procedures for an
external review process.

These private- sector lenders also indicated that preparing an economic
analysis or an independent feasibility study assists in determining
whether or not to approve funding based on review and discussion of the
marketplace, competition, and project costs. Each private- sector lender
we interviewed agreed that performance in the shipping industry was
cyclical and timing of projects was important. In addition, reviewing
historical data provided information on future prospects for a project.
For example, one lender uses these economic analyses to evaluate how
important the project will be to the overall growth of the shipping
industry. Another lender uses the economic analyses and historical data to
facilitate the sale of a financed vessel. In the area of economic
soundness analysis, MARAD requirements appear closer to those of the
private- sector lenders, in that external market studies are also used to
help determine the overall economic soundness of a project. However,
assessments of economic soundness prepared by the Office of Statistical
and Economic Analysis may not be fully considered when MARAD approves loan
guarantees. Private- sector lenders 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

13 The IG also recommended that MARAD impose compensating factors for loan
guarantees to mitigate risks. Private- sector Lenders Use

a More Systematic Approach to Loan Monitoring

Page 16 GAO- 03- 728T

financial statements such as income statements and balance sheets. The
third lender evaluated financial statements quarterly. Based on the
results of these financial statement reviews, private- sector lenders then
reviewed and evaluated the risk ratings that had been assigned at the time
of approval. Two lenders commented that higher risk ratings indicated a
need for closer supervision, and they then might require the borrower to
submit monthly or quarterly financial statements. In addition, a borrower
might be required to increase cash reserves or collateral to mitigate the
risk of a loan. Further, the lender might accelerate the maturity date of
the

loan. Private- sector lenders used risk ratings in monitoring overall
risk, which in turn helped to maintain a balanced maritime portfolio.

At MARAD, we found no evidence that staff routinely analyzed or evaluated
financial statements or changed risk categories after a loan was approved.
For example, we found in our review that for at least two financial
statement reporting periods, MARAD was unable to provide financial
statements for the borrower, and, in one case, one financial statement was
submitted after the commitment to guarantee funds. Our review of the
selected Title XI projects indicated that risk categories were primarily
assigned for purposes of estimating credit subsidy costs at the time of
application, not for use in monitoring the project. Further, we found no
evidence that MARAD changed a borrower*s risk category when its financial
condition changed. In addition, neither the support office that was
initially responsible for reviewing and analyzing financial statements

nor the office currently responsible maintained a centralized record of
the financial statements they had received. Further, while one MARAD
official stated that financial analyses were performed by staff and
communicated verbally to top- level agency officials, MARAD did not
prepare and maintain a record of these analyses.

Private- sector lenders also manage financial risk by linking the
disbursement of loan funds to the progress of the project. All the lenders
we interviewed varied project monitoring based on financial and technical
risk, familiarity with the shipyard, and uniqueness of the project. Two
lenders thought that on- site monitoring was very important in determining
the status of projects. Specifically, one lender hires an independent
marine surveyor to visit the shipyard to monitor construction progress.
This lender also requires signatures on loan disbursement requests from
the shipowner, shipbuilder, and loan officer before disbursing any loan
funds. This lender also relies on technical managers and classification
society

Page 17 GAO- 03- 728T

representatives who frequently visit the shipyard to monitor progress. 14
Shipping executives of this lender make weekly, and many times daily,
calls to shipowners to further monitor the project based on project size
and complexity. This lender also requires shipowners to provide monthly
progress reports so the progress of the project could be monitored.

MARAD also relied on site visits to verify construction progress. However,
the linkage between the progress of the project and the disbursement of
loan funds was not always clear. MARAD tried to adjust the number of site
visits based on the amount of the loan guarantee, the uniqueness of
project (for example, whether the ship is the first of its kind for the
shipowner), the degree of technical and engineering risk, and familiarity
with the shipyard. However, the frequency of site visits was often
dependent upon the availability of travel funds, according to a MARAD
official.

Private- sector 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. 14 Classification society representatives are individuals who
inspect the structural and mechanical fitness of ships and other marine
vessels for their intended purpose. Private- sector Lenders Use

Industry Expertise to Value Defaulted Assets

Page 18 GAO- 03- 728T

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.
15 Private- sector lenders employ internal controls such as a systematic
review of waivers during the application phase and risk ratings of
projects during the monitoring phase. However, MARAD does neither. Without
a more systematic review of underwriting waivers, MARAD might not be
giving sufficient consideration to the additional risk such decisions
represent. Likewise, without a systematic process for assessing changes in
payment risk, MARAD cannot use its limited monitoring resources most

efficiently. Further, by relying on interested parties to estimate the
value of defaulted loan assets, MARAD might not maximize the recovery on
those assets. Overall, by not employing the limited internal controls it
does possess, and not taking advantage of basic internal controls such as
those private- sector lenders employ, MARAD cannot ensure it is
effectively utilizing its limited administrative resources or the
government*s limited financial resources.

15 U. S. General Accounting Office, Standards for Internal Control in the
Federal Government, GAO/ AIMD- 00- 21.3.1 (Washington, D. C.: November
1999) and Internal Control Management and Evaluation Tool, GAO- 01- 1008G
(Washington, D. C.: August

2001). MARAD Cites Mission as

the Difference in Management of Financial Risk Compared to Privatesector
Lenders

Page 19 GAO- 03- 728T

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.

The Federal Credit Reform Act of 1990 (FCRA) was enacted, in part, to
require that the federal budget reflect a more accurate measurement of the
government*s subsidy costs for loan guarantees. 16 To determine the
expected cost of a credit program, agencies are required to predict or
estimate the future performance of the program. For loan guarantees, this
cost, known as the subsidy cost, is the present value of estimated cash
flows from the government, primarily to pay for loan defaults, minus
estimated loan guarantee fees paid and recoveries to the government.
Agency management is responsible for accumulating relevant, sufficient,
and reliable data on which to base the estimate and for establishing and
using reliable records of historical credit performance. In addition,
agencies are supposed to use a systematic methodology to project expected
cash flows into the future. To accomplish this task, agencies are
instructed to develop a cash flow model, using historical information and
various assumptions including defaults, prepayments, recoveries, and the
timing of these events, to estimate future loan performance.

MARAD uses a relatively simplistic cash flow model, which contains five
assumptions* default amount, timing of defaults, recovery amount, timing

16 The Federal Accounting Standards Advisory Board developed the
accounting standard for credit programs, Statement of Federal Financial
Accounting Standards No. 2, *Accounting for Direct Loans and Loan
Guarantees,* which generally mirrors FCRA and which established guidance
for estimating the cost of guaranteed loan programs. MARAD*s Credit

Subsidy Estimates and Reestimates Are Questionable

MARAD*s Credit Subsidy Estimates Are Questionable

Page 20 GAO- 03- 728T

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. 17 According to MARAD officials, these
assumptions were developed in 1995 based on actual loan guarantee
experience of the previous 10 years and

have not been evaluated or updated. MARAD could not provide us with
supporting documentation to validate its estimates, and we found no
evidence of any basis to support the assumptions used to calculate these
estimates. MARAD also uses separate default and recovery assumptions for
each of seven risk categories to differentiate between levels of risk and
costs for different loan guarantee projects.

We attempted to analyze the reliability of the data supporting MARAD*s key
assumptions, but we were unable to do so because MARAD could not provide
us with any supporting documentation for how the default and recovery
assumptions were developed. Therefore, we believe MARAD*s

subsidy cost estimates to be questionable. Because MARAD has not evaluated
its default and recovery rate assumptions since they were developed in
1995, the agency does not know whether its cash flow model is reasonably
predicting borrower behavior and whether its estimates of loan program
costs are reasonable. The nature and characteristics of the Title XI
program make it difficult to

estimate subsidy costs. Specifically, MARAD approves a small number of
guarantees each year, leaving it with relatively little experience on
which to base estimates for the future. In addition, each guarantee is for
a large dollar amount, and projects have unique characteristics and cover
several sectors of the market. Further, when defaults occur, they are
usually for large dollar amounts and may not take place during easily
predicted time frames. Recoveries may be equally difficult to predict and
may be affected by the condition of the underlying collateral. This leaves
MARAD with

relatively limited information upon which to base its credit subsidy
estimates. Also, MARAD may not have the resources to properly implement
credit reform. MARAD officials expressed frustration that they 17 MARAD*s
recovery assumption assumes a 50 percent recovery rate within 2 years of
default. However, 2 years have not yet elapsed for several of the defaults
and so we could

not yet determine how the estimated timing of recoveries compares to the
actual timing of recoveries.

Page 21 GAO- 03- 728T

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 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. 18 We found that actual
loan performance has differed significantly from agency estimates. For
example, when defaults occurred, they took place much sooner than
estimated. On average, defaults occurred 4 years after loan origination,
while MARAD had estimated that, depending on the risk category, peak
defaults would occur between years 10* 18. Also, actual default costs thus
far have been much greater than estimated. We estimated, based on MARAD
data, that MARAD would experience $45.5 million in defaults to date on
loans originated since 1996. However, as illustrated by figure 1,

MARAD has consistently underestimated the amount of defaults the Title XI
program would experience. In total, $487.7 million has actually defaulted
during this period* more than 10 times greater than estimated.

18 Our analysis focused on loans beginning in 1996 because (1) this was
the first year in which MARAD implemented its risk category system, and
(2) MARAD could not provide us with any supporting data for its default
and recovery assumptions for loans originating before 1996. Further, only
one default occurred between 1993* 1996, representing less than 1 percent
of MARAD*s total defaults between 1993* 2002.

Page 22 GAO- 03- 728T

Even when we excluded AMCV, which represents about 68 percent of the
defaulted amounts, from our analysis, we found that the amount of defaults
MARAD experienced greatly exceeded what MARAD estimated it would
experience by $114.6 million (or over 260 percent).

Figure 1: Estimated and Actual Defaults of Title XI Loan Guarantees (1996*
2002)

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 2. Although actual

recoveries on defaulted amounts since 1996 have taken place within 1* 3
years of default, most of these recoveries were substantially less than
estimated, and two defaulted loans have had no recoveries to date. For the
actual defaults that have taken place since 1996, MARAD would have
estimated, using the 50 percent recovery rate assumption, that it would

recover approximately $185.3 million dollars. However, MARAD has only
recovered $78.2 million or about 42 percent of its estimated recovery

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 23 GAO- 03- 728T

amount. Even when we excluded AMCV, which represents about 68 percent of
the defaulted amounts, from our analysis, we still found that MARAD has
overestimated the amount it would recover on defaulted loans by $6.8
million (or about 10 percent). If this pattern of recent default and
recovery experiences were to continue, MARAD would have significantly
underestimated the costs of the program.

Figure 2: Estimated and Actual Recoveries on Title XI Loan Defaults (1996*
2002)

a Estimated recoveries are based on applying MARAD*s 50 percent recovery
rate within 2 years to the actual default amounts. Our analysis of
recovery estimates includes estimated recovery amounts for two of the five
defaulted AMCV loans, even though 2 years have not elapsed, because,
according to MARAD officials, no additional recoveries are expected on
these two loans. Thus, our recovery calculation was based on $370.6 of the
$487.7 million in defaulted loans, which includes defaults for which 2
years have elapsed, as well as the two AMCV defaults for which no
additional recoveries are expected. With its 50 percent recovery
assumption, MARAD would have estimated that, at this point, it should have
recovered $185.3 million of these defaulted loans. b We calculated the
actual recovery rate by comparing the total actual recoveries to the
$370.6 million

in relevant actual defaulted amounts. At the time of our review, MARAD had
recovered $78.2 out of this $370.6 million.

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

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 15

0 0 0 0 47

39 30

15

Page 24 GAO- 03- 728T

not provide us with any documentation about how the risk categories and
MARAD*s related numerical weighting system originally were developed. 19
According to OMB guidance, risk categories are subdivisions of a group of
loans that are relatively homogeneous in cost, given the facts known at
the

time of designation. Risk categories combine all loan guarantees within
these groups that share characteristics that are statistically predictive
of defaults and other costs. OMB guidance states that agencies should
develop statistical evidence based on historical analysis concerning the
likely costs of expected defaults for loans in a given risk category.
MARAD has not done any analysis of the risk category system since it was

implemented in 1996 to determine whether loans in a given risk category
share characteristics that are predictive of defaults and other costs and
thereby comply with guidance. In addition, according to a MARAD official,
MARAD*s risk category system is partially based on outdated MARAD
regulations and has not been updated to reflect changes to these
regulations. Further, MARAD*s risk category system is flawed because it
does not

consider concentrations of credit risk. To assess the impact of
concentration risk on MARAD*s loss experience, we analyzed the defaults
for loans originated since 1996 and found that five of the eight defaults,
totaling $330 million or 68 percent of total defaults, involved loan
guarantees that had been made to one particular borrower, AMCV. Assessing
concentration of credit risk is a standard practice in 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

19 MARAD*s risk category system incorporates ten factors that are set out
in Title XI, which specifies that MARAD is to establish a system of risk
categories based on these factors. How MARAD weighs and interprets these
factors is described in program guidance. MARAD*s Credit Subsidy

Reestimates Are Also Questionable

Page 25 GAO- 03- 728T

recorded in accounting records, and expected changes in future economic
performance. The reestimates are to include all aspects of the original
cost estimate such as prepayments, defaults, delinquencies, recoveries,
and

interest. Reestimates allow agency management to compare original budget
estimates with actual costs to identify variances from the original
estimates, assess the reasonableness of the original estimates, and adjust
future program estimates, as appropriate. When significant differences

between estimated and actual costs are identified, the agency should
investigate to determine the reasons behind the differences, and adjust
its assumptions, as necessary, for future estimates and reestimates.

We attempted to analyze MARAD*s reestimate process, but we were unable to
do so because the agency could not provide us with any supporting data on
how it determined whether a loan should have an upward or downward
reestimate. According to agency management, each loan guarantee is
reestimated separately based on several factors

including the borrower*s financial condition, a market analysis, and the
remaining balance of the outstanding loans. However, without conducting
our own independent analysis of these and other factors, we were unable to
determine whether any of MARAD*s reestimates were reasonable. Further,
MARAD has reestimated the loans that were disbursed in fiscal years 1993,
1994, and 1995 downward so that they now have negative subsidy costs,
indicating that MARAD expects these loans to be profitable. However,
according to the default assumptions MARAD uses to calculate its subsidy
cost estimates, these loans have not been through the period of peak
default, which would occur in years 10* 18 depending on the risk

category. MARAD officials told us that several of these loans were paid
off early, and the risk of loss in the remaining loans is less than the
estimated fees paid by the borrowers. However, MARAD officials were unable
to provide us with any supporting information for its assessment of the
borrowers* financial condition and how it determined the estimated default
and recovery amounts to assess the reasonableness of these reestimates.
Our analysis of MARAD*s defaults and recoveries demonstrates that, when
defaults occur, they occur sooner and are for far

greater amounts than estimated, and that recoveries are smaller than
estimated. As a result, we question the reasonableness of the negative
subsidies for the loans that were disbursed in fiscal years 1993, 1994,
and 1995.

MARAD*s ability to calculate reasonable reestimates is seriously impacted
by the same outdated assumptions it uses to calculate cost estimates as
well as by the fact that it has not compared these estimates with the
actual default and recovery experience. As discussed earlier, our analysis
shows

Page 26 GAO- 03- 728T

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.

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. The FCRA assigns

responsibility to OMB for coordinating credit subsidy estimates,
developing estimation guidelines and regulations, and improving cost
estimates, including coordinating the development of more accurate
historical data and annually reviewing the performance of loan programs to
improve cost estimates. Had OMB provided greater review and oversight of
MARAD*s estimates and reestimates, it would have realized the assumptions
were outdated and did not track with actual recent experience. In
conclusion, Mr. Chairman, MARAD does not operate the Title XI loan

guarantee program in a businesslike fashion. MARAD does not (1) fully
comply with its own requirements and guidelines, (2) have a clear
separation of duties for handling loan approval and fund disbursement
functions, (3) exercise diligence in considering and approving
modifications and waivers, (4) adequately secure and assess the value of
defaulted assets, and (5) know what its program costs. Because of these
shortcomings, MARAD lacks assurance that it is effectively promoting
growth and modernization of the U. S. merchant marine and U. S. shipyards
or minimizing the risk of financial loss to the federal government.
Consequently, the Title XI program could be vulnerable to waste, fraud,
abuse, and mismanagement. Finally, MARAD*s questionable subsidy cost
estimates do not provide Congress a basis for knowing the true costs of
the Title XI program, and Congress cannot make well- informed policy
decisions when providing budget authority. If the pattern of recent OMB
Has Provided Little

Oversight of MARAD*s Estimates and Reestimates

Conclusions

Page 27 GAO- 03- 728T

experiences were to continue, MARAD would have significantly
underestimated the costs of the program.

We are currently considering a number of recommendations to reform the
Title XI program, including actions Congress could take to clarify
borrower equity contribution requirements and incorporate concentration
risk in the approval of loan guarantees, as well as actions MARAD could
take to improve its processes for approving loan guarantees, monitoring
and controlling funds, and managing and disposing of defaulted assets. In
addition, we are considering recommendations to help MARAD better
implement its responsibilities under FCRA. Because of the fundamental
flaws we have identified, we question whether MARAD should approve new
loan guarantees without first addressing these program weaknesses.

This concludes my prepared statement. I will be happy to respond to any
questions you or the other members of the Committee may have.

For further information on this testimony, please contact Mathew J. Scire
at (202) 512- 6794. Individuals making key contributions to this statement
include Kord Basnight, Daniel Blair, Rachel DeMarcus, Eric Diamant, Donald
Fulwider, Grace Haskins, Rachelle Hunt, Carolyn Litsinger, Marc Molino,
and Barbara Roesmann. Recommendations

Contacts and Staff Acknowledgments

(250139)

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