Small Business Administration: Accounting Anomalies and Limited  
Operational Data Make Results of Loan Sales Uncertain (03-JAN-03,
GAO-03-87).							 
                                                                 
The Small Business Administration's (SBA) loan asset sales are	 
being closely watched because similar sales are projected for	 
other government agencies as a means of reducing loan assets and 
servicing costs. To assess the progress and effects of SBA's loan
sales, GAO undertook this study to (1) describe the process for  
selling loans, (2) identify how lenders and borrowers have	 
reacted to loan sales, (3) determine whether SBA is properly	 
accounting for its loan sales and their subsequent impact on	 
credit subsidy estimates, and (4) assess whether loan sales	 
generated operational benefits for the agency. GAO did not	 
determine whether SBA maximized proceeds from the loan sales.	 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-87						        
    ACCNO:   A05788						        
  TITLE:     Small Business Administration: Accounting Anomalies and  
Limited Operational Data Make Results of Loan Sales Uncertain	 
     DATE:   01/03/2003 
  SUBJECT:   Financial statements				 
	     Loans						 
	     Sales						 
	     Accounting errors					 
	     Agency debt					 
	     Accounting procedures				 
	     SBA 7(a) Loan Program				 

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GAO-03-87

                                       A

Report to the Ranking Minority Member, Committee on Small Business and
Entrepreneurship, U. S. Senate

January 2003 SMALL BUSINESS ADMINISTRATION Accounting Anomalies and
Limited Operational Data Make Results of Loan Sales Uncertain

GAO- 03- 87

Letter 1 Results in Brief 4 Background 8 SBA*s Sales Process Is Designed
to Satisfy Investor Demands 11 Lenders Expressed Satisfaction with SBA*s
Loan Sales, but SBA*s

Data on Borrowers* Reactions Was Incomplete 20 SBA*s Accounting for Loan
Sales and the Remaining Portfolio Was

Flawed 25 Loan Sales Have Reduced SBA*s Loan Servicing Volume, but Other

Operational Benefits May Be Overstated 33 Conclusions 40 Recommendations
42 Agency Comments 43

Appendixes

Appendix I: Scope and Methodology 48 SBA Field Locations We Visited 51

Appendix II: Types of Borrower Inquiries and Complaints Received by SBA 53

Appendix III: Comments from the Small Business Administration 54

Appendix IV: Comments from the Inspector General of the Small Business
Administration 58

Appendix V: Comments from Cotton and Company 60

Appendix VI: GAO Contacts and Acknowledgments 64 Contacts 64
Acknowledgments 64

Glossary 65 Tables Table 1: Key Information on SBA*s Loan Sales One
through Five 17

Table 2: Loan Receivable Balances of SBA*s Disaster Loan Program 30

Figures Figure 1: Time Line of a Loan Sale 13 Figure 2: Total Balance of
Loans Sold 18

Figure 3: Outlets That SBA Borrowers Use for Inquiries and Complaints
about Loan Sales 23 Figure 4: Gain / Loss Calculation on Previously
Defaulted Sold

Guaranteed Loans 27 Figure 5: Change in Loan Servicing Volume at the
Disaster Home Loan and Commercial Loan Servicing Centers 35

Figure 6: Changes in Number of Employees and Workload per Employee at
Servicing Centers 37

Abbreviations

CFO Chief Financial Officer OMB Office of Management and Budget SBA Small
Business Administration SFFAS Statement of Federal Financial Accounting
Standards

Letter

January 3, 2003 The Honorable Christopher S. Bond Ranking Minority Member
Committee on Small Business and Entrepreneurship United States Senate

Dear Senator Bond: In 1999, the Small Business Administration (SBA) began
a loan asset sales program, at the direction of Office of Management and
Budget (OMB), to reduce the amount of debt the agency owned and serviced.
SBA*s loan asset sales program is of particular interest because OMB has
tentatively planned loan asset sales at other federal credit agencies. OMB
is interested in

increasing loan asset sales in order to improve the management of loan
assets and to transfer loan servicing responsibilities to the private
sector.

SBA guarantees business loans through its lending partners in the 7( a)
program and makes direct loans for disaster assistance to individuals and
businesses. Before SBA began its loan asset sales program in 1999, the

agency had never sold large volumes of loans in bulk. More than $9 billion
in disaster assistance and other direct loans and defaulted business loan
guarantees were eligible for sale. As of January 2002, SBA had conducted
five sales, divesting itself of about 110,000 loans with an outstanding

balance of $4.4 billion. 1 Approximately 85 percent of the loans SBA sold
were direct disaster assistance loans, most of which have below- market
borrower interest rates. When SBA originally made these loans, it received
appropriations to cover expected default costs as well as financing costs
related to offering below- market interest rates to borrowers. The subsidy
allowance account was established to cover these anticipated losses, which
generally range from $17 to $33 for every $100 that SBA lends. This
allowance indicates that the economic value of the loans is less than the

loan balance at inception. The difference between the outstanding loan
balance and the subsidy allowance is the net book value. When investors
determine the price they are willing to pay for SBA*s loans, they also
consider default risks and the low interest rate on most SBA disaster
loans. As a result, investors bid less than the outstanding balance owed
on these

loans. 1 In August 2002, SBA held its sixth sale of about 30,000 loans
with an outstanding balance of $657 million. Additional sales are planned.

In determining whether or not to sell these loans, SBA estimated the
current value to the government, also known as the hold value, 2 in
accordance with OMB Circular A- 11. In essence, the hold value is the
expected net cash flows from the loans, discounted at today*s Treasury

rates. This differs from the net book value recorded on SBA*s books, which
is the expected net cash flows from the loans discounted using Treasury
rates in effect when the loans were disbursed. Therefore, the hold value
takes into account changes in interest rates since the loans were
disbursed, whereas the net book value does not. As a result, changes in
interest rates since the loans were disbursed will not affect the
determination of the benefit of a loan sale to the government based on the
hold value. 3 In contrast, the accounting gain or loss on a loan sale* the
net book value compared with the sales proceeds* will be influenced by
changes in interest rates since the loans were disbursed. SBA received
about $2.7 billion in total proceeds and paid about $200

million in selling costs on its first five sales. These net proceeds
exceeded the hold values of the loans to SBA by about $606 million.
However, as discussed above, properly accounting for the sales and their
subsequent impact on loan program costs is more complex and could render a
different outcome regarding the accounting gain or loss. Our assessment of
SBA*s accounting treatment for these sales is discussed later in this
report.

Because selling loans in bulk is a new and ongoing activity for SBA, and
OMB plans to expand loan sales in federal credit programs, you asked us to
conduct a broad review of the loan asset sales program. Specifically, you

asked us to (1) describe SBA*s process for selling loans, (2) identify how
lenders and borrowers have reacted to loan sales, (3) determine whether
SBA is properly accounting for its loan sales and their subsequent impact
on credit subsidy estimates, and (4) assess whether the loan sales are
generating operational benefits for the agency.

2 The hold value of the loans selected for sale represents the estimated
value to the government of continuing to hold the loans until they are
repaid, either at or before maturity. The hold value is calculated on a
present value basis, with future payments discounted at current interest
rates. This is a detailed loan- by- loan analysis that specifically
considers the cash flows and characteristics of the loans included in the
sales.

3 The hold value is designed to be a decisional tool used to determine
whether or not it is currently advantageous for SBA to sell loans. The
hold value is calculated using current Treasury interest rates in order to
reflect current market conditions in the decisionmaking process.

To respond to these reporting objectives, we reviewed strategic plans,
procedures, and other related documents that SBA used to plan and manage
the loan asset sales program; reviewed the results of the sales in terms
of types of loans sold, and proceeds; interviewed SBA officials,
contractors, investors, and lenders involved in the loan sale process;
reviewed and analyzed inquiries and complaints from borrowers; and
analyzed SBA data related to the impact of the loan sales on loan
servicing workloads and other benefits. We also analyzed relevant budget
and accounting data used to record the results of loan sales for both
budgetary and financial statement purposes, including reestimates of
subsidy costs, the values of loans sold, and proceeds and costs of sales.
We compared these data with the applicable guidance.

To assess SBA*s estimates of hold values for loans sold, we reviewed an
external validation of the hold model used for sales one through three
that was prepared by an SBA contractor, who concluded that the
calculations were accurate and reasonable. Since SBA changed to a more
sophisticated

hold model after sale three, we also reviewed the methodology and
assumptions used in SBA's revised model to estimate hold values for loans
sold in sales four and five, and found the approach to be reasonable. 4
However, we did not audit the data used to calculate the hold values for

each sale and therefore did not conclude on the reasonableness of the hold
values for any of the sales. We discussed SBA*s budgeting and accounting
procedures for loan sales with the agency, with its independent auditor,
and with OMB officials. We reviewed SBA*s audited financial statements for
fiscal years 1999 through 2001 and related audit workpapers for fiscal
years 2000 and 2001.

All of our analyses were based on data from the first five sales, which
occurred between August 1999 and January 2002. The sixth sale, held on
August 6, 2002, was not completed in time for us to include it in our

analyses, because transferring servicing of the loans to the purchasers
and completing accounting adjustments take several weeks after the sale
date. We did not determine whether SBA maximized loan sale proceeds. We
performed our review from January 2002 through October 2002 in

Washington, D. C.; Birmingham, Alabama; Little Rock, Arkansas; Los 4 SBA*s
revised hold model was first used to estimate hold values for sale four.
Hold values from this more sophisticated model were calculated at the loan
level rather than being based on a loan pool approach or averages, and the
revised model*s calculations were based on the actual data from all loans
selected for sale rather than on a sample of data from the

loans selected for sale.

Angeles and Santa Ana, California; Denver, Colorado; and Philadelphia,
Pennsylvania, in accordance with generally accepted government auditing
standards. Appendix I provides a detailed discussion of our scope and
methodology.

Results in Brief A primary objective of SBA*s loan sales is to maximize
proceeds by designing a sales process that attracts and satisfies
investors. In order to

ensure that investors have all the information they need to make informed
bids, SBA has invested resources in developing a carefully structured loan
sale process. SBA field offices and servicing centers review loan files to

determine which loans can be sold, although lenders must approve the sales
of small business loans. A contractor assembles the loan information for
investors, and financial advisers create loan pools and advertise the

sales. Before a sale goes forward, OMB must approve it. OMB generally
approves the sale if the estimate of the value to the government of
holding the loans (based on current interest rates) is less than the
estimated market value calculated by financial advisers. Beginning with
the second sale, SBA has offered primarily performing, secured disaster
assistance loans that share many of the characteristics of home mortgages
and have attracted mostly large commercial and investment banks. SBA has
consulted with investors since the loan sales began in order to structure
the sales in accordance with market demands, and it has developed a
*lessons learned*

process to improve future sales. Most of the investors with whom we spoke
or whose survey responses we reviewed responded favorably to the
information that SBA provides about the loans for sale and the
organization of the loan pools. These investors also reported that they
plan to continue

participating in SBA*s sales. Lenders with whom we spoke that had
participated in the 7( a) business loan guaranty program were satisfied
with the loan sales. Most of the lenders with whom we spoke were pleased
with the proceeds from the sales and viewed participating in the sales
program as a useful way to help manage their portfolios. Some of the
lenders also noted that SBA had improved certain aspects of the program
since the first sale. However, it was more difficult for us to determine
the reaction of borrowers whose business or disaster assistance loans were
sold, as SBA does not have a comprehensive process for documenting and
tracking borrower inquiries and complaints to ensure that borrower
protections are working. Borrower protections included in the loan sale
agreements are limited, requiring only that purchasers affirm they were
qualified to service the loans and agree to use prudent loan servicing
practices. These protections are intended to

ensure that borrowers are not taken advantage of or pressured to change a
loan*s terms or conditions. SBA*s primary mechanism for enforcing these
protections is to follow up on borrower inquiries and complaints, but we
found that the agency did not have a system in place to capture all the
inquiries and complaints received by headquarters or field offices. As a
result, we could not determine how many borrowers had actually contacted
SBA with complaints about the loan sales.

During our review of SBA*s budgeting and accounting for loan sales, 5 we
found errors that could significantly affect the reported results in the
budget and financial statements for fiscal years 2000 and 2001. For
example, SBA incorrectly calculated accounting losses on loan sales, which
were then reported in the footnotes to its financial statements. Further,
OMB budget guidance directs agencies to make reestimates of program

costs for all changes in cash flow assumptions in order to adjust the
subsidy estimate for differences between the original estimated cash flows
and the actual cash flows. 6 However, SBA did not conduct key analyses of
either the loans sold or its remaining portfolio, in order to determine
the

impact of the loan sales on its reestimates of program costs for its
remaining loans. Because of the lack of reliable financial data, we were
unable to determine the actual gain or loss on SBA*s loan sales for the
budget and financial statements. We also found that SBA had significant
unexplained declines in its disaster loan program subsidy allowance
account, to the point of showing that this subsidized program was expected
to generate a profit. Between fiscal years 1998 and 2001, the balance in
this account declined from $1.2 billion to a negative $77 million* that
is, by

over 100 percent* while the outstanding loan balance owed by borrowers
declined by only 42 percent. SBA could not provide support for the balance
or explain the reason for this anomaly. Despite these errors and
uncertainties, SBA*s auditor gave unqualified audit opinions on SBA*s
fiscal years 2000 and 2001 financial statements. 7 We discussed these
issues with SBA*s auditors, who indicated that they are currently
assessing the cause of

5 The accounting standards for loan programs were established to mirror
budget guidance. This mirroring allows for consistency between loan
program cost estimates and the results for the financial statements and
budget.

6 Cash flow assumptions include known and forecasted information about the
characteristics and performance of a loan or group of loans that are used
to estimate future loan performance and program costs.

7 An unqualified audit opinion indicates that the balances in the
financial statements are free of significant errors known as material
misstatements.

the unusual balance in the subsidy allowance account and, if necessary,
plan to reevaluate their audit opinions on the fiscal years 2000 and 2001
financial statements. Until SBA performs further analyses to determine the
full impact of these errors and uncertainties, the financial effect of its
loan

sales and the reliability of the current and future subsidy rates will
remain unknown, and congressional decisionmakers will not receive the
accurate financial data they need to make informed decisions about SBA*s
budget and the level of appropriations the agency should receive.

Though SBA has reported that its loan sales will help the agency realign
its workforce and improve the management of its loan portfolio, these
benefits either have not yet materialized or may be overstated. SBA has
said that loan asset sales are beneficial to the agency because it does
not have the capacity to service all of its loans. In addition, the agency
noted, selling loans should allow it to reallocate the personnel who are
servicing loans to functions that are more critical to SBA*s mission, such
as lender oversight and outreach to small businesses. We found that loan
sales have most reduced the servicing workloads for disaster assistance
loans; they have had less of an impact, however, on servicing workloads
for 7( a)

business loans, as lenders did not always consent to sell these loans.
Further, because the reductions in loan servicing have involved disaster
assistance loans, it was unclear to what extent loan sales would help the
agency realign its workforce in the district offices that primarily serve
small businesses. We found some support for the other benefits SBA

identified, but other factors may also have contributed to some of these
outcomes. For example, SBA has reported that because of loan asset sales,
more borrowers have paid off their loans. However, the increase in the
number of loans paid off per year began prior to loan asset sales,
suggesting that some of these borrowers might have paid off their loans
regardless of whether a loan sale had occurred.

Although loan asset sales may be beneficial to the government, we were
unable to determine the accounting and budgeting effects of SBA*s loan
asset sales because of problems identified in this report. This report
includes recommendations to SBA and its Inspector General. To provide
accurate and reliable information on the impact of the program and to
address the accounting and budgetary problems, we recommend that (1)

SBA improve the process for tracking borrower inquiries and complaints;
(2) SBA correct the accounting and budgeting errors and misstatements
before conducting additional loan sales; (3) the Inspector General work
with SBA*s financial auditors to assess the impact of the errors in the

financial statements; and (4) SBA more thoroughly analyze the benefits and
other effects of the sales on agency operations.

We obtained written comments on a draft of this report from SBA*s Chief
Financial Officer, from the Inspector General, and from Cotton and
Company, SBA*s independent financial statement auditor. In commenting on a
draft of this report, SBA generally agreed with the overall findings and
recommendations, especially the need to better assess the financial impact
of SBA*s loan sales program. SBA noted that it is taking steps to address
the process for documenting and tracking borrower inquiries and
complaints. SBA also stated that it is actively engaging a contractor to
help resolve the accounting and budgetary issues, and that it has worked
extensively with its independent auditor to identify causes and options
for resolving the

issues we identified. SBA did not specifically respond to our
recommendation for a more thorough analysis of the impact of loan sales on
agency operations. SBA requested that we delay issuance of the report
until March 2003. By then it hoped to have determined the causes of the
accounting and budgetary problems, and to be able to propose an
appropriate methodology for resolving them. Though we appreciate the

desire to provide a plan of action for addressing these problems in our
final report, it is not our policy to delay issuance of our reports until
problems we have identified are resolved.

The Inspector General also agreed with our recommendations and is working
with Cotton and Company and SBA management to determine the magnitude of
the errors in SBA*s fiscal years 2000 and 2001 financial statements. The
Inspector General also stated that Cotton and Company informed the IG
office that the audit opinion on the fiscal years 2000 and 2001 financial
statements should no longer be relied upon, as they may be

materially incorrect because of the errors identified in this report. The
comments also stated that Cotton and Company plans to withdraw its
unqualified audit opinion on those financial statements, and to issue
disclaimers of opinion.

Although Cotton and Company agreed with the findings of our report, it
stated that the report would be more fair and balanced if we further
elaborated on the inherent risks and complexities associated with
accounting estimates and loan sales. Cotton and Company also stated that
it believes there is a lack of comprehensive implementation guidance for

agencies on making credit subsidy and loan sale cost estimates. We agree
that accounting for and auditing credit subsidy estimates and loan sales
are inherently complex, and we describe these complexities in the
background

section of the report. Further, the errors we identified in the financial
statements and the related footnotes were primarily concerned with flaws
in the application of existing guidance rather than with insufficient
guidance. In addition, the anomalies in the disaster loan subsidy
allowance account were clearly apparent, and SBA was unable to provide a
viable explanation for these anomalies.

Background The President*s fiscal year 1998 budget proposed that SBA begin
selling disaster and business loans that the agency was servicing and
transition

from the direct servicing of loans to overseeing private- sector
servicers. Before its loan asset sales program began, SBA was servicing
approximately 300,000 loans, with a principal balance of over $9 billion.
About 286,000 of these loans, with a principal balance of $7 billion, were
for disaster assistance.

SBA*s loan asset sales program is part of a governmentwide initiative to
make loan asset sales a potential tool for improving the management of
federal credit programs. In the conference report accompanying the
Treasury, Postal, and General Government Appropriations Act, 1996, 8
congressional conferees directed OMB, in coordination with the federal
agencies involved in credit programs, to evaluate the potential for
selling loan assets to the private sector. Furthermore, the Debt
Collection Improvement Act of 1996 encourages federal agencies that
provide loans to sell delinquent debt when appropriate. 9 In June 2002,
OMB issued guidance requiring agencies to analyze their loan portfolios
and loan management

costs in order to determine whether privatizing functions such as loan
servicing by selling loan assets or outsourcing would produce greater
efficiencies. Other federal credit agencies have significantly larger loan
portfolios than SBA that could be available for loan sales, including the
Departments of Agriculture and Education, which held $78 billion and $96
billion, respectively, as of fiscal year 2001.

SBA*s loan sales include defaulted, formerly guaranteed 7( a) and 504
(development company) business loans and direct disaster assistance loans.
SBA provides small businesses with access to credit, primarily by

8 H. R. Rep. No. 104- 291 at 40* 41 (October 25, 1995), to accompany Pub.
L. No. 104- 52 (Nov. 19, 1995). 9 Pub. L. No. 104- 134, Title III, ch. 10,
S: 31001, 110 Stat. 1321- 358 (1996).

guaranteeing loans through its 7( a) and 504 programs. 10 For the 7( a)
program, SBA guarantees up to 85 percent of the loan amount made by
private lenders to small businesses that are unable to obtain financing
under reasonable terms and conditions through normal business channels.
Under the 504 program, SBA provides its guaranty through certified
development companies* private nonprofit corporations* that sell
debentures that are fully guaranteed by SBA to private investors and lend
the proceeds to qualified small businesses for acquiring real estate,
machinery, and equipment, and for building or improving facilities. When a

7( a) or development company loan defaults, SBA pays the claim and either
relies on the lender to recover as much as it can by liquidating
collateral or takes over the loan servicing and liquidation. 11 Because
SBA has paid the guaranty and thus owns the loan, these defaulted business
loans* whether liquidated by the lender or by SBA* may be included in
SBA*s loan asset sales.

SBA also makes loans directly to businesses and individuals trying to
rebuild in the aftermath of a disaster, and it primarily services these
loans directly. 12 Most of the disaster assistance loans have low interest
rates, sometimes less than 4 percent, and long repayment terms of up to 30
years. Interest rates on disaster loans vary, depending on the borrower*s
ability to obtain credit in the private sector. For example, if a borrower
cannot obtain

credit elsewhere, the interest rate is typically below the market rate,
but a borrower who can obtain credit elsewhere is likely to receive a
higher rate. Since SBA owns the disaster loans, all disaster loans are
eligible to be sold.

The Federal Credit Reform Act of 1990 was enacted to require agencies to
more accurately measure the government*s cost of federal loan programs and
to permit better cost comparisons, both among credit programs and

10 The 7( a) program is established under section 7( a) of the Small
Business Act, 15 U. S. C. S: 636 (2000 S: Supp. 2002). The 504 program is
established under Title V of the Small Business Investment Act of 1958.
See 15 U. S. C. S: 696 et seq. (2000 S: Supp. 20002).

11 Liquidation is the act of enforcing collection on a debt that has
defaulted by selling underlying securities that the borrower has pledged
as collateral. If collateral proceeds are insufficient to cover the
outstanding balance, lenders may pursue personal guarantees or obligations
provided by business owners or others in support of the loan.

12 SBA implemented a pilot, as mandated by the Small Business Programs
Improvement Act of 1996, to outsource 30 percent of the servicing of its
disaster home loan portfolio.

between credit and noncredit programs. 13 The act gave OMB responsibility
for coordinating credit program cost estimates required by the act. OMB is
also responsible for approving all loan sales. Authoritative guidance on
preparing cost estimates for the budget and conducting loan sales is
contained in OMB Circular A- 11, Preparation, Submission, and Execution of
the Budget. The Federal Accounting Standards Advisory Board developed the
accounting standard for credit programs, including loan sales. 14 This
guidance is generally found in Statement of Federal Financial Accounting
Standards No. 2 (Statement 2), Accounting for Direct Loans and Loan
Guarantees, which became effective in fiscal year 1994. This standard,
which generally mirrors the Federal Credit Reform Act and budget guidance,
established accounting guidance for estimating the subsidy cost of loan
programs as well as recording loans and loan sales for financial reporting
purposes. 15 The subsidy cost is the present value of disbursements 16
*over the life of the loan* by the government (loan disbursements and
other payments) minus estimated payments to the government (repayments of
principal, payments of interest, other recoveries, and other payments).

For financial statement purposes, loans are reported at both the
outstanding balance and at the present value of their estimated net cash
inflows, known as the net book value, which is reported on the balance
sheet. The difference between these two amounts is the subsidy allowance,
which is reported along with the outstanding loan balance in the footnotes
of the financial statements. The allowance represents the cost of the loan
program that is not expected to be recovered from borrowers, including
default costs and financing costs from subsidizing below- market rate
loans.

Statement 2 states that when loans are written off, the unpaid principal
of the loans is removed from the loans receivable balance and the same
amount is charged to the subsidy allowance. Prior to the write- off, the

13 Federal Credit Reform Act of 1990, Pub. L. No. 101- 508 S: 13201
(1990), 2 U. S. C. S: 661 et seq. (2000 and Supp. 2002). 14 The board was
created by OMB, Treasury, and GAO to develop accounting standards for the
federal government. 15 In accordance with the Federal Credit Reform Act of
1990, the subsidy cost of loans does not include administrative costs of
the program. 16 Present value is the worth of the future stream of returns
or costs in terms of money paid immediately. In calculating present value,
prevailing interest rates provide the basis for

converting future amounts into their *money now* equivalents.

uncollectible amounts should have been fully provided for in the subsidy
allowance through the subsidy cost estimate or reestimates.

Further, as part of implementing credit reform, agencies are required to
estimate the subsidy cost for budgetary purposes. Generally, these
estimates are updated or reestimated annually after the end of the fiscal
year to reflect any changes in actual loan performance since the estimates
were prepared, as well as any expected changes in assumptions related to
future loan performance. Changes in subsidy cost that are recognized
through reestimates are funded through permanent indefinite budget
authority. Before a loan sale, as part of its approval process, OMB
reviews the hold

value of the loans being sold as compared with their estimated market
value. 17 A contractor that assists SBA with the loan sales estimates a
market value, which indicates the anticipated proceeds on the loan sale
based on current market trends and conditions, and the loans being sold.
Comparing the market value with the hold value determines whether it is

more beneficial for the government to hold or to sell the loans. However,
this determination does not take into account the impact of any changes in
administrative costs that results from the loan sales. The glossary at the
end of this report provides a list of commonly used terms related to
credit program budgeting and accounting.

SBA*s Sales Process Is SBA officials told us that the loan asset sale
process is designed to Designed to Satisfy

maximize SBA*s sales proceeds by attracting as many investors as possible
to the bidding process. The process can take 9 months or longer as
Investor Demands

contractors, SBA field offices, and lending partners work together to
prepare loans for sale. For a sale to take place, SBA must have OMB*s
approval, which partly depends on an analysis of whether the expected
value of the loans to investors is greater than the estimated value to the

government. The price obtained for loans sold and investor interest in the
first five sales depended in part on the characteristics of the loan
pools.

17 Hold value is the estimated value of loans to the government in the
event that the loans were held to maturity or resolution, stated on a
present- value basis, discounted with interest rates from the most recent
President*s budget at the time the estimate is prepared. This is a more
detailed loan value analysis than the credit subsidy estimate, because it
specifically considers the cash flows and characteristics of the loans
included in the sales and is calculated on a loan- by- loan basis.

Large commercial and investment banks have purchased the performing
disaster assistance loans that make up the majority of SBA*s sale
portfolio, and primarily small investors have bought the nonperforming
business

loans. 18 Beginning with the first loan sale, SBA instituted a *lessons
learned* process to analyze and improve its efficiency and investor
satisfaction from sale to sale. Most investors interviewed by us or by SBA
contractors stated that SBA has responded to requests for more information
and is now providing the information needed to calculate bids. Most
investors also said that they plan to continue bidding on future sales.

Loan Sales Require Detailed SBA*s asset sales team, which manages the loan
asset sale program at SBA

Planning and an Investment headquarters, coordinates the efforts of
contractors, SBA field offices, and

of Resources lending partners to execute a loan sale (fig. 1). Two
financial advisers and a

due diligence contractor are involved in each sale. 19 The program
financial adviser is hired on a multiyear contract to supervise the work
of other contractors and consult on strategic planning issues, such as
sale design and loan selection. A transaction financial adviser is also
hired for each sale, to provide marketing and to manage logistics. All
participants in the sales process must work closely together over the
approximately 9 months needed to carry out a loan sale and the 2 months
required to close it out.

18 Small investors are organizations, not individuals. SBA used this term
in documents and conversations with us to describe the more moderately
sized institutions bidding on loan sales.

19 The goal of due diligence is to provide accurate information about the
loans for sale to potential investors so that they may make informed bids.

Figure 1: Time Line of a Loan Sale Transaction

Due diligence SBA SBA field offices 7( a) Lenders financial adviser
contractor Investors Months

Selects loans for sale 1

List of loans to Remove Surveys investor

be sold goes nonqualifying

demands for to field offices

loans from sale process

sale and add 2

other eligible loans

Notifies Send loan files

Consent to or Seeks

Performs due borrowers that

to due diligence reject sale of

lenders' diligence*

3 their loan( s)

contractor loans, and send

consent verifies that

will be sold loan files for

to sell loan files are

Continue sale to due

defaulted complete,

servicing diligence

7( a) loans orders thirdparty

loans to contractor

reports 4

be sold on borrowers

Markets sale and collateral,

to potential images loan

investors documents,

5 and enters key data into

CFO's database

office Stratifies

calculates loans

6 hold

into value

pools 7

Continue Prepares

servicing market-

loans to value

Review be sold

estimate due

OMB 8

diligence approval

material 9 Bid day

Bid on loan pools Prepares

10 lessonslearned

report Winning bidders Sends share of

proceeds to send payments

11 participating

to SBA lenders

Notifies borrowers Transfers loan files

Winning bidders pick of servicing

to winning bidders up loan files from due

12 transfer

diligence contractor and notify borrowers of servicing transfer Source:
GAO analysis of SBA data. SBA and the program financial adviser select the
loans for each sale, and

SBA*s servicing centers and district offices review them, removing any
that

should not be sold, such as loans that are paid in full, are charged off
as a loss in SBA*s accounts, or are in litigation. Before every sale,
SBA*s loan asset sales team sends a detailed procedural notice to field
offices to guide them through every step. The guidance covers loans that
should be removed from the sale, loans that may be added, 20 and
procedures for shipping the loan files when the list is finalized. SBA*s
7( a) lending partners review SBA*s requests to sell defaulted 7( a) loans
and provide consent at their discretion. SBA*s field offices and 7( a)
lenders send the final selection

of loan files to the due diligence contractor. SBA*s due diligence is the
most costly and probably the most important element of the loan sale
process. For sales three through five, 21 due diligence averaged 87
percent of total sales costs, which have reached up to

$32.7 million per sale, not including salaries and expenses for SBA
personnel. SBA officials told us, however, that money invested in due
diligence results in higher bids from investors. In part, due diligence is

costly because SBA*s loan information systems do not capture some data
that investors need to make a purchase decision, such as collateral
information. The due diligence contractor must collect this information
from the loan files and create electronic images of documents. Investors
also want reports such as current credit scores, property appraisals, and
broker price opinions, which the due diligence contractor orders before a
sale. The due diligence contractor extracts the key data elements from the
reports and loan files and enters them into a database that investors can
access.

The transaction financial adviser sorts the loans into relatively
homogeneous pools according to characteristics such as the type of loan,
the type of collateral, and the loan*s status (performing or
nonperforming).

Loan pools vary in size to appeal to different types of investors. Large
commercial and investment banks have been the primary bidders on blocks of
loans (multiple pools with common characteristics), which have an
aggregate unpaid principal balance of at least $115.8 million. Smaller
pools of loans are also created so that other types of investors can
compete in the 20 For example, if a borrower has multiple SBA loans and
one is selected for sale, the field

offices are instructed to add the borrower*s additional loans to the list
of loans for sale. 21 SBA*s loan sale process has evolved, and information
provided by SBA indicated that sales three through five better reflect
SBA*s current sale process and selection of loans for sale than do sales
one and two.

bidding. Between 14 and 25 investors bid in sales one through five, with a
total average of 4.2 bidders for both large blocks and smaller pools of
loans.

Before SBA goes forward with a sale, SBA*s Office of the Chief Financial
Officer estimates the value to SBA of holding these loans to maturity or
of some other resolution, such as a prepayment or default. A *hold* model
was specifically designed to estimate the value to the government of the
loans selected for sale on a present value basis, discounted with current

interest rates. At the same time, the transaction financial adviser
prepares a market value estimate of what SBA would likely receive if it
sold the loans to the private sector. SBA compares these estimates to
determine whether selling the loans would provide a higher expected return
than would holding and servicing them. These estimates are provided to OMB
for its

approval to go forward with a sale. For each of the five sales we
reviewed, the market value estimates were greater than SBA*s estimates of
the hold value, or value to government, and thus OMB approved each sale.

SBA officials and contractors explained that market value estimates have
exceeded hold values because investors are more efficient in collecting on
nonperforming loans than is the government, and investors take different
factors into account in valuing performing loans. As a result, investors
often place a higher value on these loans. According to SBA*s program
financial adviser, private- sector lenders service defaulted loans more
productively than the government because they have greater flexibility in
pursuing workouts, including the ability to treat borrowers differently
based on factors such as creditworthiness. SBA officials told us that
private investors value performing loans largely on the basis of what is
recoverable under the loan contract, including collateral. SBA, however,
lends to borrowers based on their ability to repay, and focuses on getting
them to

make payments. Furthermore, compared with government agencies, private-
sector lenders have a greater number of portfolio management strategies at
their disposal, such as securitization. 22 Securitization generally yields
a higher price than does selling a whole portfolio of loans, because the
seller can split up the portfolio to meet the demands of a wide range of
investors with varying levels of risk tolerance.

22 Securitization of loans is the process of aggregating similar loan
assets and dividing them into groups of investment instruments for sales
that investors will evaluate separately, according to levels of risk.

Sales Results and Investor For each sale, SBA received proceeds from loans
sold that exceeded the

Interest Depended in Part estimated value to the government of the loans,
as calculated by SBA*s hold on the Loan Pools*

model. SBA*s proceeds as a percentage of the unpaid balances of the loans
Characteristics

sold have varied with each sale because, among other factors, the
characteristics of the loans sold differed with each sale. As shown in
table 1, SBA*s return on the sales, expressed as gross proceeds as a
percentage of total unpaid principal balance, ranged from 44.1 percent to
73.6 percent in the first five sales. Although SBA ultimately aimed to
maximize proceeds, the agency selected loans for sale according to its own
constraints and perceived market interests. In the first sale, SBA sold
business loans that SBA had made and serviced directly. According to SBA,
most of these loans were performing and secured by collateral. As shown in
figure 2, disaster assistance loans made up approximately 92 percent of
all loans sold in the other sales. Most disaster assistance loans have low
interest rates* around 4 percent or lower. Because these loans have below-
market interest rates, they offer lower scheduled borrower payments than
do similar loans with higher interest rates. 23 Therefore, investors price
their bids to compensate for the SBA loans* lower scheduled payments. In
sale two, SBA sold disaster assistance loans for the first time, and
according to SBA officials, investors also priced their bids to account
for the risk they saw in

purchasing an unfamiliar loan product. Furthermore, in sale two, SBA
focused on selling a large number of loans serviced by its offices in
Guam, Puerto Rico, and the Virgin Islands, where servicing was more
difficult and costly. In sale four, SBA primarily sold performing, secured
disaster assistance loans, in an effort to enable investors to securitize
these loans purchased from SBA.

23 Similar loans refer to loans with comparable maturities, prepayment
risks, and default risks.

Table 1: Key Information on SBA*s Loan Sales One through Five

Dollars in millions

Sale 1 Sale 2 Sale 3 Sale 4 Sale 5

Unpaid principal balance $332. 1 $1, 200. 7 $1, 105.1 $1,186.1 $600.6
Gross proceeds $195. 1 $530.0 $662.5 $873.3 $402.8 Gross proceeds/ Unpaid

59% 44% 60% 74% 67% principal balance Estimated percentage of

n. a. 88% 95% 99% 76% disaster loans secured Estimated percentage of

n. a. 78% 82% 89% 88% disaster loans performing Estimated percentage of

88% 84% 94% 84% 81% business loans secured Estimated percentage of

61% 37% 32% 36% 10% business loans performing n. a. = not applicable

Source: SBA.

Figure 2: Total Balance of Loans Sold 1,500 Dollars in millions

$1,200.7 $1,186.1

1,200

$162.4 $1,105.1

$52.7 $74.4

$1,133.4 $1,038.3

$1,030.7

900

$600.6

600

$49.8 $550.8

$332.1

300

$332.1

0 Sale 1

Sale 2 Sale 3 Sale 4 Sale 5 Business loans (7a, 504) Disaster assistance
loans (home and business) Source: SBA.

SBA officials and investors told us that large investors, including
investment banks, have bought the performing disaster home loans, and
according to SBA, at least one investor is securitizing and trading them
like other mortgage- backed securities. Most of the 7( a) loans sold since
sale two have been nonperforming, and many were sold in smaller pools that
small investors can bid on, according to SBA officials. Two small
investors

with whom we spoke have purchased these loans to try to return them to
performing status and resell them at a profit.

SBA Used Investor From the outset of the loan asset sales program, SBA
used feedback from

Feedback to Shape and investors to shape and improve the sales process,
with the aim of attracting

Improve the Sales Process as many investors as possible and obtaining
quality bids on loan pools. As

part of presale marketing, the transaction financial adviser consults with
potential investors to determine which loan offerings, loan data, and sale
procedures will yield the greatest interest. Investors are also surveyed
after

the sales to obtain feedback to consider in planning future sales. SBA
officials told us that these surveys are an integral part of the
lessonslearned process that SBA established for the close of each sale, to
help the agency target and address problems. According to SBA officials,
analyzing SBA*s processes and applying lessons learned have made SBA more
efficient in activities such as removing loans that do not meet sale
criteria. According to SBA officials, this process has reduced the number
of loans that investors have sold back to SBA for not meeting the
conditions of the agency*s representations and warranties. 24 SBA
officials also spoke with investors to identify common concerns that may
have been leading them to

discount their bids. According to SBA, after the early sales, many
investors reported that they wanted SBA to provide additional data, such
as borrower credit scores and lien information. SBA responded by adding
information to its database, including credit scores and lien information,
to

reduce investor uncertainty about the quality of loans for sale. The six
investors with whom we spoke and most of the 42 survey responses for sales
four and five positively assessed SBA*s loan sale process. Most investors
stated that the loan pools are well organized and that SBA provides the
data they need to make informed bids. Furthermore, our review of the
information provided to investors found minimal problems with the
completeness of the data. The investors with whom we spoke indicated that
they will continue to bid on sales. Other investors interviewed by the
transaction financial adviser* including those who have not bid in past
sales* reported that they are interested in participating in future sales.
SBA officials believe that the refinement process and provision of better
data to investors has yielded higher bids.

24 Representations and warranties are a set of legally binding statements
by the seller that are intended to assure buyers that the assets being
sold meet certain qualitative expectations. Representations and warranties
are accompanied by obligations to *cure* conditions that are breaches of
the original representations, as well as by remedies available to the
investor if the condition cannot be cured. Such remedies may require a
repurchase or substitution of an obligation.

Lenders Expressed Lenders and borrowers also play a role in the loan sale
process. Although

Satisfaction with SBA*s many 7( a) lenders that participated in SBA*s loan
sales reported satisfaction with the way in which the sales were
conducted, borrowers* reactions were

Loan Sales, but SBA*s difficult to measure. An important factor in the
reactions of both groups is

Data on Borrowers* that lenders* involvement is voluntary but borrowers*
is not. Lenders must

Reactions Was consent before SBA can sell business loans they made, while
borrowers

have no choice. Most of the 7( a) lenders with whom we spoke said they are
Incomplete

satisfied with the loan sale process and the proceeds they are receiving
on loans they consented to sell. However, lenders* participation in sales
is limited and driven by a practical decision: whether greater net returns
will result from selling the loan or from liquidating it. The reaction of
borrowers was difficult to assess because of weaknesses in SBA*s system
for collecting and following up on inquiries and complaints* its primary

method of ensuring that borrowers whose loans are sold are protected. Most
7( a) Lenders with

Lenders who participate in SBA*s 7( a) loan guaranty program have an Whom
We Spoke Are interest in the outcome of the sales, because they still have
a stake in the

Satisfied with the Loan 7( a) loans for sale. When a 7( a) loan defaults,
SBA honors its loan guaranty,

Sales paying the lender 75 to 85 percent of the unpaid principal balance.

Thereafter, the lender and SBA share any loan payments according to the
percentage set out in the guaranty. Therefore, SBA must obtain consent
from the lender before selling a defaulted 7( a) loan. We spoke with 12 7(
a) lenders who have all participated in more than one SBA loan sale, and
10 said that they had used the loan sales as an additional portfolio
management tool for nonperforming loans. According to 8 of the lenders

whom we interviewed, proceeds from the sales they participated in were
satisfactory; 2 lenders stated that SBA is obtaining market value for
nonperforming 7( a) loans. One lender stated that SBA sales have tapped a
market for nonperforming loans that his company would not otherwise be
able to access.

According to SBA, following the early sales lenders raised two concerns,
which the agency has since addressed. First, in the first four sales,
lenders did not know how to estimate the proceeds they would receive by
selling loans. And second, when some lenders received their shares of
sales proceeds, SBA did not clearly identify the price paid for each loan.
These practices resulted in accounting problems for the lenders. Beginning
with

the fourth sale, SBA sent lenders one check and a list of the earnings
from each loan sold. Beginning with the fifth sale, SBA also began
providing information on returns from past sales to help lenders decide
whether to

consent to sell loans. Four lenders we spoke with specifically noted that
SBA had made improvements to its loan sale process in areas such as
distributing sale proceeds and seeking consent to sell loans.

Expected Returns and Based on our discussions with 7( a) lenders and SBA
district officials, we

Experience with Prior Sales identified two primary factors that drive
lender participation in the sales:

Drive Lender Participation whether the net returns from the sale are
likely to exceed those from liquidation, and whether proceeds from a
previous sale met expectations.

Lenders* consent to sell 7( a) loans must be given voluntarily, and most
lenders sell these loans only after trying to liquidate them. Three SBA
district officials and two lenders said that in the early sales, SBA
lenders did not have all the information they wanted about expected
returns from selling loans and therefore preferred not to sell them. A
lack of control over the loan sale process, timing of the sales, and
distribution of the proceeds can influence lenders* expectations of net
returns from selling loans rather

than liquidating. Lenders have no role in determining in which pools their
loans will be sold or whether bids are acceptable. Also, lenders must wait
until SBA*s bid day to sell loans, and the value of non* real estate
collateral generally declines as time passes. Finally, proceeds from SBA
sales do not arrive until almost 2 months after the sale, giving lenders
greater incentives to begin loan liquidation in order to try to recover
money more quickly.

Lenders who have already begun investing resources in liquidation believe
they will maximize returns by continuing with their liquidation strategy.
Lenders are prepared to sell loans when they believe that their net
returns from investing resources in liquidation will no longer provide
satisfactory returns in comparison with selling loans. SBA officials
confirmed that most 7( a) loans that lenders agree to sell have little
value left in them.

According to SBA district office officials, some lenders have stopped
participating in loan sales because the proceeds from a previous sale did
not meet their expectations, and we spoke with one lender who confirmed
this statement. We also learned that some lenders who had stopped
participating in sales had not completed loan collection actions, such as
seizing collateral. Another disappointed lender we interviewed decided to
return to SBA loan sales, but only to sell loans after completing
collection efforts.

SBA Created Borrower Unlike lenders, SBA*s borrowers have little control
over what happens to

Protections Addressing their loans if SBA decides to sell them. However,
SBA has built in some

Loan Servicing and Disaster safeguards to protect the integrity of the
programs that provided the loans.

Assistance SBA*s loan programs, including loan servicing, are designed to
help the borrower stay in business or recover financially from a disaster.
To protect

the public policy goals associated with these programs, SBA*s loan sales
agreements with purchasers require certification that the investors are
qualified to purchase and service the loans and will follow prudent loan

servicing practices. The loan sales agreement also prevents purchasers
from unilaterally changing the terms and conditions of the loans.

SBA made additional policy decisions concerning disaster loans. The agency
does not sell some disaster loans, including those issued to borrowers
currently residing in a federally declared disaster area and those that
are less than 2 years old. SBA decided it would sell disaster loans only
if they were more than 2 years old, because disaster loans typically
require more servicing in the first 2 years and sometimes must be
increased to cover exigencies, such as occurs with revised physical damage
estimates.

Information on Borrowers We were unable to validate the way in which
borrowers have reacted to the

Is Incomplete Because loan sales, because SBA could not provide a reliable
estimate or

SBA*s Process for information on the number of borrowers who had contacted
them about

Documenting and Tracking their sold loans. Complete and reliable
information on borrower

complaints is important, because SBA officials told us that they contacted
Borrower Inquiries and

purchasers when a borrower complained about a servicing action to collect
Complaints Has Weaknesses additional information and determine whether a
purchaser was breaching the borrower protections. For example, in one case
in which SBA was receiving many complaints about one particular purchaser,
SBA found some evidence to suggest that the purchaser*s servicing
employees were overly aggressive or rude with some borrowers. In response,
SBA

forwarded the specific complaints to the purchaser and requested that the
purchaser improve its handling of new loans.

One reason why SBA*s tracking system is ineffective is that borrowers with
questions or complaints can call or write to several different SBA
offices, or to a representative from Congress (fig. 3). Some SBA field
office officials told us that SBA does not provide them with clear
guidance on how to respond to or document such complaints. Officials from
seven district offices, three servicing centers, and two disaster area
offices told us that they had received calls and letters from borrowers
who had concerns about

loans that had been sold. But the methods of documenting inquiries and
complaints varied across offices, except for congressional letters, which
were consistently forwarded to SBA headquarters.

Figure 3: Outlets That SBA Borrowers Use for Inquiries and Complaints
about Loan Sales

Servicing center

Disaster SBA area

toll- free office

number Headquarters Congress District

office SBA headquarters

Source: GAO.

In August 2001, SBA began providing a toll- free number for borrowers to
call with questions or complaints about loan sales. 25 Borrowers were
informed about the toll- free number in a letter telling them how to
contact

the new owner of their loan. However, field office staff did not receive
any guidance regarding the purpose and use of the toll- free number. Santa
Ana

25 The Real Estate Settlement Procedures Act (RESPA) requires that loan
servicers provide either a toll- free or collect call number for home loan
borrowers to call about servicing problems before and after the loan is
sold. 12 U. S. C. S: 2605 (b), (c) (2000 S: Supp. 2002). The act does not
specify how long the toll- free number should be operational following the
transfer of servicing.

liquidation and loan servicing center staff who answer calls to the toll-
free number told us that initially they thought the number was only
provided for answering borrowers* questions, and therefore they did not
record inquiries or complaints called in to this number. Therefore, we
were unable

to collect a reliable sample of inquiries and complaints from this source.
We also could not validate the number of inquiries and complaints received
at headquarters. SBA officials at headquarters told us that, overall, SBA
had received about 300 inquiries or complaints from borrowers. However,
when we were provided with a database of these inquiries and complaints,
there were only 155. When we asked how SBA came up with the number 300,
officials told us that it was an estimate.

We also reviewed 50 complaints from a servicing center, the only field
office with whom we talked that could provide a record of phone calls and
letters from borrowers whose loans had been sold, to compare them with the
inquiries and complaints at headquarters. Forty- five complaints involved
problems with purchasers during the servicing transfer period* for
instance, some borrowers said that payment had not been posted, and others
had difficulty in modifying the terms of their loans. However, we found
that only 3 of the borrowers listed in 50 complaints from the servicing
center were reflected in the 155 borrower inquiries or complaints we
reviewed at SBA headquarters. An SBA official at headquarters told us that
the office had received some of the complaints from the center, but
acknowledged that they had not included these complaints in the files we
had reviewed.

Though we were unable to determine how many borrowers have contacted SBA
about their sold loans, we reviewed 133 of the 155 written inquiries and
complaints documented at headquarters, along with SBA*s written responses,
to identify the types of questions and problems borrowers may

have when their loans are sold. Our analysis showed that almost half (65)
were inquiries and concerns about their loans being sold, requests to buy
their own loans, or pleas to not have their loans sold. However, 47 of the
borrowers complained about a purchaser*s servicing action. SBA responded
in writing to the written inquiries and complaints we reviewed at
headquarters. More information on our review of these inquiries and
complaints is presented in appendix II.

SBA*s Accounting for SBA sold almost 110,000 loans with an unpaid
principal balance of about

Loan Sales and the $4.4 billion in five loan sales from August 1999
through January 2002. We reviewed the budgeting and accounting for these
loan sales and found

Remaining Portfolio errors that could significantly affect the reported
results in the budget and

Was Flawed financial statements. Specifically, SBA (1) incorrectly
calculated loan sales

losses reported in the footnotes to its financial statements; (2) did not
appropriately consider the effect of loan sales on its estimates of the
cost of the remaining portfolio, which could significantly affect its
budget and financial statement reporting; and (3) had significant
unexplained declines in its subsidy allowance for the disaster loan
program. Despite these errors and uncertainties, SBA*s auditor gave
unqualified audit opinions on SBA*s fiscal year 2000 and 2001 financial
statements. We discussed these issues with SBA*s auditors, who indicated
that they are currently assessing the cause of the unusual balance in the
subsidy allowance account and, if

necessary, plan to reevaluate their audit opinions on the fiscal years
2000 and 2001 financial statements. Until SBA performs further analyses to
determine the full impact of these errors and uncertainties, the financial
effect of its loan sales and the reliability of current and future subsidy
rates

will remain unknown. SBA Improperly Calculated

Accounting records related to loan sales indicated that losses exceeded
Losses on Loan Sales

$1.5 billion. However, this amount is overstated because of errors in the
way that SBA calculated the losses. Because of the lack of reliable
financial data available, we were unable to determine the financial effect
of loan sales on SBA*s budget and financial statements. These errors raise
serious concerns about the information related to the results of loan
sales included in the footnotes to the annual financial statements
provided to OMB and the Congress for decisionmaking purposes. For
accounting purposes, the gain or loss on a loan sale represents the

difference between the net book value (the outstanding loans receivable
balance less the subsidy allowance) 26 of the loans sold and the net sale

26 The subsidy allowance account represents the subsidized portion of
direct loans and defaulted guaranteed loans assumed by the federal
government. It is subtracted from the loans receivable balance on the
balance sheet to arrive at the net loan amount expected to be repaid.

proceeds. 27 The accounting gain or loss differs from the hold value
calculation, discussed earlier, which indicates that the sales resulted in
a benefit to the government of about $606 million. This difference exists
because the benefit calculation* the difference between the hold value and
the net sales proceeds* is not designed to take into consideration changes
in interest rates from the time the loans were disbursed to the date of
the sale, while the accounting gain or loss, if properly computed, does
take these changes into account. The footnotes to SBA*s fiscal years 1999
and 2000 financial statements reported accounting losses of $75 million
and $600 million, respectively, on its loan sales. SBA did not separately
disclose in its financial statements the losses calculated on the two loan
sales that took place during fiscal year 2001. According to SBA*s
accounting records,

the first five sales have resulted in total losses of more than $1.5
billion. We reviewed the methodology SBA used to calculate the results of
its loan sales for accounting purposes and found significant errors that
caused SBA to overstate losses. When calculating whether loans are sold at
a gain or at a loss, agencies must estimate the portion of the subsidy
allowance to allocate to each loan sold in order to calculate the net book
value for those loans. Since SBA*s calculation of the net book value of
the sold loans exceeded the net proceeds from the sales, losses were
calculated. Our review of these calculations found that SBA*s estimates
did not consider all

the appropriate cash flows when allocating the subsidy allowance to the
sold loans. For example, when calculating the gains or losses for the
disaster loan program, SBA failed to allocate a portion of the subsidy

allowance for financing costs associated with lending to borrowers at
below- market interest rates. In addition, SBA incorrectly allocated the
subsidy allowance for the previously defaulted 7( a) and 504 loan
guarantees. SBA used its estimated net default cost, which considers first
the probability of default and then the estimated recovery rate after
default. For example, if a $10,000 guaranteed loan has an estimated
default rate of 10 percent and an

estimated recovery rate of 50 percent, the subsidy allowance allocated by
SBA would be $500 ([$ 10,000 x .10] x .50). However, since sold guaranteed
loans have already defaulted, SBA should have used only the estimated

27 OMB Circular A- 11 defines net sales proceeds in the context of loan
sales as the amounts paid by purchasers less all seller transaction costs
(such as underwriting, rating agency, legal, financial advisory, and due
diligence fees) that are paid out of the gross sales proceeds rather than
paid as direct obligations by the agency.

recovery rate for these loans, meaning that the subsidy allowance
allocated would be $5,000 ($ 10,000 x .50). Figure 4 illustrates the
difference in the calculated gain or loss resulting from this error. The
left column, based on SBA*s methodology, shows that the loan was sold for
a $3,000 loss, while the right column appropriately allocates the
allowance based on expected recoveries and results in a $1, 500 gain.

Figure 4: Gain / Loss Calculation on Previously Defaulted Sold Guaranteed
Loans

Dollars

SBA's method Correct method

Previously defaulted loan guarantee $10,000 Previously defaulted loan
guarantee $10,000

Less allowance based on net defaults 500 Less allowance based on portion
5,000

(defaults less recoveries) not expected to be recovered

Net book value 9,500 Net book value 5,000

Net sale proceeds 6,500 Net sale proceeds 6,500

Loss ($ 3,000) Gain $1,500

Source: GAO analysis.

SBA*s errors in calculating the losses on disaster loans and on previously
defaulted sold guaranteed loans, both resulted in overestimates of the net
book value of the sold loans and the losses that SBA reported in the
footnotes to its fiscal years 1999 and 2000 financial statements. Because
of the way in which the results of loan sales are incorporated into the
budget and the financial statements, the reestimates, if done properly,
should have corrected the effect from these errors. However, as discussed
below, we found that the reestimates were not reliable.

Subsidy Cost Reestimates SBA did not conduct key analyses of either the
loans sold or its remaining

Are Unreliable loan portfolio in order to determine the impact of the
sales on its

reestimates of program costs for its remaining loans. OMB*s budget
guidance directs agencies to make reestimates for all changes in cash flow
assumptions in order to adjust the subsidy estimate for differences
between the original estimated cash flows and the actual cash flows. SBA
officials acknowledged that analyses of the impact of loan sales on its
historical averages should be done. However, according to SBA officials,
the agency has lacked the appropriate historical data and resources to do
these necessary analyses. Because SBA did not assess the effect that loan

sales would have on its historical averages of loan performance, such as
when loans default or prepay, the agency does not know whether these
averages, which can significantly affect the estimated cost of a loan
program, reasonably predict future loan performance. As a result,
information in both the budget and financial statements related to the
reestimated cost of SBA*s loan programs cannot be relied upon.

SBA is generally required to update or *reestimate* loan program costs
annually. OMB Circular A- 11 directs agencies to do reestimates for all
changes in cash flow assumptions. Thus, reestimates should include all
aspects of the original cost estimate, including prepayments, defaults,
delinquencies, and recoveries. These reestimates are done to adjust the
subsidy cost estimate for differences between the original cash flow
projections and the amount and timing of cash flows that are expected

based on actual experience, new forecasts about future economic
conditions, and other events that affect the cash flows.

Even after selling about $4.4 billion of loans, nearly half of its loan
portfolio, SBA has not analyzed the effect of loan sales on the estimated
cost of the remaining loans in its portfolio. SBA officials told us that
loans are selected for sale based on certain criteria, such as where the
loan is located or serviced, the type of collateral, or whether the loan
is performing. Since the loan selection process is not random* that is,
all

loans do not have an equal chance of being selected* it is likely that the
loans sold will have different characteristics from those of the
portfolio*s historical averages prior to sales. Consequently, the
characteristics of the

remaining loans may also differ substantially from the portfolio
historical averages prior to the sales. For example, during our analysis
of the loans that were sold, we determined that 84 percent of the $3.8
billion of disaster loans sold were performing* meaning that payments were
not more than 30 days delinquent. Selling mostly performing loans could
conceivably leave a disproportionate level of nonperforming loans in SBA*s
portfolio. Because SBA has not analyzed the effect of loan sales on its
reestimates of the remaining portfolio, it does not know if the
percentages of remaining performing and nonperforming loans are different
from the historical averages prior to the sales. A change in these
percentages could indicate that expected defaults in the remaining
portfolio could be higher or lower

than current assumptions, based on historical data, suggest. Another
important loan characteristic is the average stated loan term. This term
is the contractual amount of time the borrower has to repay the loan.
SBA*s estimated costs of the disaster loan program are based on historical

average loan term assumptions of 16 years for business disaster loans and
17 years for home disaster loans. Based on our review of the disaster
loans sold in the first five sales, the average loan term was about 25
years. However, SBA continued to use the average loan term assumptions of
16

and 17 years in its reestimates without doing the appropriate analysis to
determine whether these assumptions were still valid. Because of the large
number of loans sold, it is unlikely that the average loan terms for the
remaining loans are still 16 and 17 years, if in fact these are valid
estimates of the overall presale averages. Assuming that these assumptions
are valid, by selling longer- term loans, the average loan terms for the
remaining portfolio would be shorter. As a result, if there are no changes
in any other assumptions, the reestimated cost of the disaster loan
program would be less, since SBA would be subsidizing below- market rate
loans for a shorter period of time. 28 Given the significant volume of
loans sold since 1999, it is important that SBA assess whether the
characteristics of the remaining portfolio are similar to the
characteristics of the loans used to calculate the

averages used in the credit subsidy estimates. Relatively minor changes in
some cash flow assumptions* such as higher or lower default and recovery
rates, or changes in loan terms* can significantly affect the estimated
cost of the loan program and, therefore, the program*s budget.

We attempted to determine the effect of loan sales on the cost estimates
of the remaining portfolio. However, SBA could not provide us with timely,
basic information about the composition of its loan portfolio before and
after each sale, including the amount of loans that were current on
payments, delinquent, or in default. According to SBA, this information
was

not readily available because of systems limitations and reconciliation
problems. Shortly before we concluded our work, SBA provided some
information about the quality of its portfolio before and after some of
the loan sales. However, because a gap of several months occurred between
the pre- and post- loan sales analyses, the data could not be reliably
used to determine the effect that loan sales were having on the quality of
the remaining portfolio.

The Subsidy Allowance During our review of the accounting for loan sales,
we noted that the

Account Was Misstated subsidy allowance account for the disaster loan
program had an unusually

28 The fact that the average loan term of the loans sold to date, which
represents over half the loan portfolio, is 25 years could also mean that
the 16- and 17- year assumptions of the average loan term were too short.

low balance. For a subsidized loan program, the subsidy allowance account
is generally the amount of expected losses on a group of loans related to
estimated defaults and financing costs from making below* market rate
loans. In effect, the subsidy allowance is the cost associated with the
loans

that SBA does not expect to recover from borrowers. For financial
reporting purposes, the subsidy allowance reduces the outstanding loans
receivable balance to determine the amount that SBA expects to collect
from borrowers, known as the net loans receivable balance (or net book
value), which is shown on the balance sheet. Table 2 summarizes the
disaster loan program*s reported outstanding loans

receivable balance, the subsidy allowance balance, the net book value, and
the subsidy allowance as a percentage of the loans receivable balance for
fiscal years 1998 through 2001. The subsidy allowance compared with the
loans receivable balance decreased significantly in fiscal years 2000 and
2001, to the point of showing that the remaining portfolio of the disaster

program was expected to generate a profit. SBA could not provide support
for the balance or explain the reason for this anomaly. Table 2: Loan
Receivable Balances of SBA*s Disaster Loan Program

Dollars in millions

Fiscal year Fiscal year

Fiscal year Fiscal year

Disaster loan program 1998 1999 2000 2001

Loans receivable $5,634 $5, 659 $5,305 $3, 293

outstanding Less / (plus): Subsidy $1,230 $929 $505 ($ 77) allowance
balance Net book value $4,404 $4, 730 $4,800 $3, 370

Subsidy allowance as a 21. 8% 16.4% 9. 5% (2.3%) percentage of loans
receivable balance

Source: SBA.

While Table 2 shows a rapid decrease in the subsidy allowance over the 2-
year period between fiscal years 2000 and 2001, most of the decrease
actually occurred in fiscal year 2000, but was masked by an adjustment
made during the fiscal year 2000 financial statement audit. Before SBA had
made the audit adjustment, discussed below, the subsidy allowance for the
disaster program was about $91 million for fiscal year 2000. This balance
was $838 million, or about 90 percent, less than the $929 million balance
for

fiscal year 1999, while loans receivable outstanding decreased by only
$354 million, or about 6 percent. SBA could not explain why the subsidy
allowance reduction occurred. In order to restore the subsidy allowance to
a more reasonable balance at

the end of fiscal year 2000, in agreement with its auditors, SBA increased
the subsidy allowance balance by recording an audit adjustment that was
essentially meant to reflect the expected impact of loan sales on the
reestimates prepared in fiscal year 2000, which did not factor in the
effects of loan sales. 29 This increased the reported cost of the disaster
loan program by $414 million. Since the amount of the adjustment was based
on SBA*s erroneous calculations of loan sales losses, previously
discussed, the amount of the adjustment was incorrect. During fiscal year
2001, SBA reversed the audit adjustment and revised its reestimates to
include cash flows related to loan sales. Our review of the fiscal year
2001 disaster loan program reestimates indicated that loan sales increased
the reported cost of the program by about $292 million. 30 However, this
amount is also likely misstated because, as previously mentioned, the
reestimates did not consider the specific characteristics of the loans
sold or the loans remaining in the portfolio.

The unexplained decline in the subsidy allowance continued in the fiscal
year 2001 financial statements, where SBA reported a negative balance in
the subsidy allowance for the disaster loan program. As illustrated in
table

2, this balance no longer reduced the amount SBA expected borrowers to
repay* it actually increased the expected repayments from borrowers and
indicated that the loan program was profitable. However, because the
program is subsidized, with estimated default and financing costs
exceeding the amount of interest borrowers are expected to pay, it should
not be showing an expected profit. Based on SBA*s most recent reestimates,
the subsidy cost of this program ranges from 17 percent to 33 percent, and
thus the balance for the subsidy allowance account appears to be
significantly misstated. As in the prior year, SBA could not explain the

29 Theoretically, had the reestimates factored in the loan sales, the
subsidy allowance account would have been appropriately adjusted,
regardless of any errors made in recording the calculated accounting
losses.

30 The effects of loan sales on the reestimated cost of a loan program
differs from the results of loan sales based on the hold value because the
reestimates, similar to the accounting gains or losses of a loan sale, are
influenced by changes in interest rates from the time the loans were
disbursed to the date of the sale.

unusual balance. SBA officials told us they were currently working with
their auditors to determine the cause of these unusual balances.

While neither we nor SBA could determine the specific cause of this
unusual balance, several possibilities exist. As previously mentioned, a
failure to consider the characteristics of the loans sold or of those
remaining in SBA*s portfolio could contribute to the unusual balance.
Another possibility is that SBA could have incorrectly reduced its subsidy

allowance account balance by writing off loan amounts that are still
collectible. This would mean that both the loans receivable outstanding
balance and the subsidy allowance account would be misstated, but not the
net book value. Yet another possibility is that SBA may have
underestimated the cost of its disaster loan program because the cash flow
assumptions used to estimate the subsidy cost did not reflect the true
characteristics or performance of its loan portfolio. If SBA had
underestimated its losses on disaster loans, it would not have put enough
into the subsidy allowance account to cover these losses, and the subsidy

allowance would be depleted as loans were written off against it until
there was a negative balance. This could mean that SBA did not request an
appropriation large enough to cover the cost of the loan program, and that
the difference would be made up through the reestimates, which are covered
by permanent indefinite budget authority. It is also possible that a
combination of these and other errors may have occurred. Regardless of the
reason, because SBA does not currently know why the anomalies are
occurring, the disaster loan program*s subsidy estimates for the budget
and financial statements cannot be relied on.

Despite the significant, unexplained decline in the subsidy allowance and
the errors in calculating the losses on loan sales, SBA received an
unqualified or *clean* audit opinion on its fiscal years 2000 and 2001
financial statements. An unqualified audit opinion indicates that the

balances in the financial statements are free of significant errors, known
as material misstatements. As previously mentioned, SBA*s auditor
attempted to adjust the anomalies in the subsidy allowance during the
fiscal year 2000 financial statement audit. However, the adjustment was
based on the previously described erroneous loss calculation. For the
fiscal year 2001 audit, SBA*s auditor performed a number of audit
procedures related to the disaster loan program subsidy allowance account.
For example, the auditor evaluated the methodology and formulas used to
calculate reestimates, assessed data used to calculate key cash flow
assumptions, and reviewed various internal controls over the subsidy
estimation process. However, this work did not appear to focus on
determining the cause of the unusual

negative balance of the account, which, contrary to the fact that this is
a subsidized loan program, would indicate that these loans were expected
to generate a profit. The auditor*s workpapers indicated that the auditor
had agreed, in discussions with SBA management, that if the *methodology
and data were materially correct, we [the auditor] would conclude that the
resulting subsidy reserve [allowance] would be materially correct for
financial statement reporting purposes.* The workpapers also indicated
that, *whatever the results of the reestimates are, as long as the

methodology is sound and supportable, we [the auditor] would not consider
the balance [of the subsidy allowance] anything other than *natural. **

Although SBA*s auditor may have recognized some of the errors we
identified, it did not determine the cause of the unusual balance and
propose the necessary audit adjustments, nor did it modify its audit
report as appropriate. In such situations, when auditors cannot determine
whether a balance is fairly stated because sufficient reliable supporting
documentation is not available, audit standards call for auditors to
qualify their opinion or issue a disclaimer of opinion. 31 We discussed
these issues with SBA*s auditors and they indicated that they are
currently assessing the cause of the unusual balance in the subsidy
allowance account and, if necessary, plan to reevaluate their audit
opinions on the fiscal years 2000 and 2001 financial statements.

Loan Sales Have SBA reported that loan asset sales had benefited the
agency*s operations by

Reduced SBA*s Loan reducing loan servicing, and that this reduction in
loan servicing volume

should help allocate resources to other areas necessary to achieving SBA*s
Servicing Volume, but

mission and help the agency to manage its loan portfolio more effectively.
Other Operational Though we found that loan servicing volume had declined
for SBA disaster

Benefits May Be home loan centers, the effect on regular business loans
was less clear.

Furthermore, despite these reductions in loans servicing volumes, SBA had
Overstated

not yet redeployed staff to more mission- critical activities, such as
lender oversight and business outreach. SBA has also reported that the
loan sales have prompted borrowers to pay their loans in full, revealed
inconsistencies in the application of the agency*s servicing procedures,
and highlighted weaknesses in its information system. We found some
support to show that the loan sales had produced portfolio management

31 Statements on Auditing Standards, AU S:508, paragraphs 22 and 23.

efficiencies. But we also found that some of the benefits SBA had reported
began before the loan sales program, or could have been caused by other
factors.

Reductions in Loan The loan asset sales have reduced SBA*s servicing and
liquidation workload

Servicing Volumes Have for disaster loans at the disaster home loan
servicing centers, but they have

Been Greatest for Disaster had little impact on regular business loans,
such as 7( a) loans, at the

Loans commercial servicing centers and district offices. SBA had stated
that reductions in loan servicing and liquidation workloads would be one
of the

loan sales program*s most significant benefits, as the growth in loan
volume and the continuing decline in staff had compromised its ability to
adequately service a growing portfolio. During the 1990s, SBA*s portfolio
of

7( a) business and disaster loans grew dramatically. For example, from
1990 through 1996, SBA*s annual volume of 7( a) loan approvals increased
from 19, 907 to 52, 729. Disaster assistance loan approvals varied from
year to year, depending on the number and severity of disasters. However,
in 1994 SBA*s loan approvals for disaster assistance loans increased to
over 125,000, primarily because of the Northridge earthquake in
California* a significant jump from the levels of the previous 4 years,
when loan approvals ranged from about 12,000 to 59,000. Servicing and
liquidating loans account for large operating expenses for SBA, reaching
approximately $85 million a year, according to SBA*s fiscal year 2001

Accountability and Performance report. Servicing and liquidating loans
currently involve approximately 186 employees at six servicing centers and
employees at 70 district offices, who also perform other loan management
functions. 32

SBA*s disaster home loan servicing centers have seen a much greater
reduction in the number of loans they service than have the commercial
loan servicing centers. According to SBA*s limited analysis, the number of

loans serviced at SBA*s disaster home loan servicing centers decreased by
17 percent from January 1999 through March 2002 (fig. 5), and SBA*s
analysis of the servicing centers shows that if more loans are sold, SBA
may be able to reduce and consolidate its loan servicing resources for

32 SBA has four disaster home loan servicing centers, located in New York
City, New York; Birmingham, Alabama; El Paso, Texas; and Santa Ana,
California, which service only disaster home loans. SBA also has two
commercial loan servicing centers, located in Little

Rock, Arkansas, and Fresno, California, which service 7( a) and
development company loans as well as disaster business loans.

disaster home loans. However, SBA*s analysis also shows that the number of
loans at SBA*s commercial loan servicing centers fell by less than 0.5
percent over the same time period. Though the sales have reduced the
number of disaster business loans, most of the loans in the commercial
loan servicing centers are from the 7( a) program and are not put up for
sale until they default. SBA officials told us that lenders do not always
consent to sell the 7( a) loans that SBA would like to sell. Moreover, one
commercial loan director explained that servicing performing loans can
require as

much if not more work than can nonperforming loans, as businesses
frequently seek additional financing and therefore want to modify the
terms of their loans. For this reason, the growth of the 7( a) program has
offset the number of loans sold in the commercial loan centers.

Figure 5: Change in Loan Servicing Volume at the Disaster Home Loan and
Commercial Loan Servicing Centers 110

Percent relative to Jan. 1999 (index 1999= 100) 99.6 100

90 83.1 80

Jan. June

Sept. Dec.

Jan. June

Sept. Dec.

Jan. June

Sept. Dec.

Mar. 1999

1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 Commercial
loans Disaster home loans Source: SBA.

Since the loan sales began, SBA has been able to reduce the number of
employees at the servicing centers (fig. 6). However, one of the problems
SBA hoped to address with loan asset sales was to reduce its loan
servicing volume to a level that matches its staffing capacity. Since the
implementation of the loan sales, the number of loan servicing staff has

fallen faster than have loan volumes for most of SBA*s loan servicing
centers. According to SBA officials, the reduction in employees at SBA is
driven more by employee departures, retirements, and the hiring freeze
than by reductions in servicing volumes form the loan sales. As a result,
the number of loans serviced per employee increased on average by 14
percent at the disaster home loan centers and by 23 percent at the
commercial centers (fig. 6). Only one of the disaster home loan servicing
centers has experienced a reduction in the number of loans serviced per
employee. The disparity between staff attrition and loan volumes is
especially problematic at SBA*s commercial loan servicing centers, where
the number of loan servicing employees has fallen by 19 percent and loan
volumes have remained unchanged. The analysis we reviewed did not address
how these employee reductions or any other operational effects may
translate into cost savings.

Figure 6: Changes in Number of Employees and Workload per Employee at
Servicing Centers 110

Percent relative to Jan. 1999 Center employees 100

90

81.1%

80

72.9%

70 Jan.

June Sept.

Dec. Jan.

June Sept.

Dec. Jan.

June Sept.

Dec. Mar.

1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 125

Percent relative to Jan. 1999 Workload per center employee

123

120 115

114

110 105 100

Jan. June

Sept. Dec.

Jan. June

Sept. Dec.

Jan. June

Sept. Dec.

Mar. 1999

1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 Commercial
loan servicing center Disaster home loan servicing center Source: SBA.

Officials from most of the seven district offices that we visited had
mixed views about the effect of the loan sales on their own loan servicing
portfolios. Some district office officials told us that the first two
sales had

significantly reduced their portfolios, and that subsequent sales continue
to reduce the number of disaster loans they have to liquidate. When a
disaster loan is more than 90 to 150 days delinquent, the servicing center
can forward it to the appropriate district office for possible
liquidation. District

offices may also liquidate defaulted 7( a) and development company loans,
or may assist lenders in doing so. However, loan sales have had a much
smaller effect on the SBA*s 7( a) portfolio at the district offices we
visited.

District office officials with whom we spoke said that they have had to
continue assisting lenders with liquidation or liquidate loans themselves,
in addition to reviewing loans for possible sale. The data we reviewed on
the district offices* portfolio of loans in liquidation status for the
most part supported what the district officials had told us. For example,
the South Florida district office portfolio of disaster assistance loans
shrank from 768 loans in September 1997 to 92 loans in August 2002. But
all of the district offices we included in our review had experienced
growth in the number of defaulted 7( a) loans that they were helping
lenders to service or liquidate, or that they were monitoring.

The Effects of Loan Sales on The role of loan asset sales in facilitating
SBA*s workforce realignment may

Workforce Realignment be smaller than was initially expected. SBA had
reported that loan asset

Have Been Mixed sales would help the agency move employees out of loan
servicing

positions to more mission- critical positions, such as lender oversight
and outreach to small businesses. But since most of the loans sold have
been from the disaster home loan servicing centers, the overall reduction
in loan volume has not translated into job reassignments for district
office staff. Officials from two district offices wondered how they would
benefit from

the reduction in workloads at the disaster home loan servicing centers,
since the center employees are funded by appropriations for disaster
assistance, and most of the district offices are funded by appropriations
for business loan programs. Most officials from the district offices and
servicing centers told us that they have not been able to reassign
servicing and liquidation staff to nonservicing activities such as lender
oversight or outreach to small businesses. Moreover, training
opportunities to prepare for reassignment have been limited, with only the
South Florida district office telling us that they have participated in
such training.

However, loan sales may facilitate SBA*s long- term efforts to consolidate
its loan servicing and liquidation functions into fewer service centers.
SBA

recently reported in its draft 5- year workforce transformation plan that
it would consolidate its loan servicing and liquidation functions into
fewer service centers. This plan also stated that SBA intends to continue
its loan asset sales program, to reduce the agency*s overall loan
portfolio and workload at some locations.

Loan Sales Have Affected According to SBA officials, the process of
selling loans, particularly the

the Ways in Which SBA intensive due diligence process and the field office
review of loans selected

Manages Its Loan Portfolio, for the sales, makes loan servicing more
timely and consistent across the

but So Have Other Factors agency. For example, when defaulted loans are
selected for sale, agency staff must determine whether anything
collectible remains on the loan. If

not, the loan is charged off. In these cases, SBA recognizes a loss on the
loan and removes it from the receivable accounts. And if SBA is in the
process of working out a compromise with a borrower on a loan that is
selected for sale, the impending sale prompts agency staff and borrowers
to complete the compromise before the sale date. The process of reviewing
loans before they are sold undoubtedly provides some benefit to the agency
in terms of bringing inconsistencies to light and forcing decisions on
some loans. However, we also found that the loan sales alone were probably
not responsible for all the benefits SBA reported.

In May 2002, SBA testified that of the loans selected for the first four
sales, over 9,880 loans totaling about $382 million had been paid in full,
702 loans totaling $107 million had entered into compromise agreements,
and 7,549 loans totaling about $632 million had been charged off. SBA
provided data to us showing that since the loan sales began in 1999, the
percentage of

loans paid in full ranged from 10.35 to 11.30 percent, and that the
percentage of loans written off had ranged from 4.97 to 5.98 percent.
However, SBA data also showed that before the loan asset sales* from
fiscal year 1997 through fiscal year 1998* the rate of loans paid in full
and charged off had already been increasing. For example, the percentage
of loans paid in full increased from 8.8 percent in fiscal year 1997 to
10. 46

percent in fiscal year 1998. Thus, some of the positive effects of the
loan sales reported by SBA could have been caused by other factors,
including changes in the economy such as lower interest rates, which would
prompt people to refinance their mortgages. Officials at SBA*s Birmingham
disaster home loan servicing center told us that borrowers who refinanced
their mortgages often consolidated their loans and paid off their disaster
loans, even though their disaster loans had low interest rates.

Other benefits of the sales cited in SBA*s official statements or by SBA
officials included the highlighting of inconsistencies in the ways that
field staff applied SBA*s servicing procedures, and the identifying of
weaknesses in the agency*s information systems. For example, SBA officials
at headquarters told us that as a result of inconsistencies found in the
loan files during preparations for the sales, SBA had held a meeting of
all the servicing center managers to discuss the inconsistencies and to
clarify policies and procedures for loan servicing. Though field office
staff told us that they had not substantially changed the ways in which
they serviced loans because of problems uncovered by the sales, some
employees

provided examples of how they had modified some of their work processes.
For example, officials at one servicing center told us that they had begun
to check the accuracy of certain items, such as maturity date, when a new
loan file arrived.

Similarly, SBA officials told us that the due diligence process for the
loan sales had revealed that the agency*s information management system
for its loan portfolio did not include data that investors value, such as
updated information on types of collateral and lien positions. These
variables were being included in plans to upgrade the agency*s information
systems. However, field office employees at one of the servicing centers
told us that

they had complained about the fact that these items were not included in
SBA*s information systems long before the loan sales began. Whether the
loan sales will have an actual impact on improving SBA*s information
systems is still unclear. At the time of our review, SBA was still having
its field offices and due diligence contractor compile information on the
loans from the paper files and had not yet upgraded its information
systems to capture information such as the current status of collateral
and lien positions.

Conclusions SBA had never sold loans in bulk loan sales before undertaking
the current program. SBA*s loan sales are being closely watched, because
OMB plans to expand similar sales to other federal credit programs, such
as those

provided by the Departments of Agriculture and Education. The impact of
SBA*s sales on the agency and the scope of the benefits they provide to
the government can help OMB in providing guidance on similar sales
programs

in the future. The sales have had some success in attracting investors,
giving lenders a choice in disposing of defaulted loans, and reducing
SBA*s servicing workload for disaster assistance loans. But other effects
are difficult to measure, because SBA lacks a comprehensive system to

document and track all borrower inquiries and complaints after loans are

sold; faulty accounting and reporting methods obscure the actual financial
and budgetary impact of the loan sales; and a thorough analysis of
benefits and other effects on agency operations has not been done.

The lack of a comprehensive process for identifying borrower inquiries and
complaints suggests that SBA may be unable to adequately enforce borrower
protections. From the limited inquiries and complaints we were able to
review, some borrowers had clearly experienced servicing problems after
SBA sold loans to investors. While SBA did track and follow up on some
inquiries and complaints, it did not have a comprehensive process to
collect and document the complaints received at the field offices. As a
result, the agency may not know how many complaints have actually been
registered or whether some private lenders* actions are in conflict with
SBA*s public policy goals.

Since SBA incorrectly calculated the losses on its loan sales and lacks
reliable financial data, we were unable to determine the financial impact
of SBA*s loan sales on its budget and financial statements. Further,
because SBA did not analyze the effect of loan sales on its remaining
portfolio, its reestimates of loan program costs for the budget and
financial statements may contain significant errors. Until SBA corrects
these errors and determines the cause of the precipitous decline in the
subsidy allowance account, SBA*s financial statements will likely be
misstated, and the audit opinion on past financial statements may be
incorrect. Further, the reliability of the current and future subsidy cost
estimates will remain unknown. These errors and the lack of key analyses
also mean that congressional decisionmakers are not receiving accurate
financial data to make informed decisions about SBA*s budget and the level
of appropriations the agency should receive.

Finally, some of the operational benefits of the loan sales have not yet
been realized, or may be overstated. Most of the reductions in loan
servicing volume have occurred at SBA*s disaster home loan servicing
centers. SBA*s commercial servicing centers and district offices that
primarily serve small businesses are still involved in servicing loans,
primarily because SBA has not been able to sell as many defaulted 7( a)
loans, because lenders do not always consent to sell these loans and SBA
employees continue to assist lenders or take over the servicing from
lenders when a loan becomes delinquent. As a result, SBA has not been able
to free up the resources it had hoped to reallocate to mission- critical
areas, such as outreach to small businesses. Though SBA has conducted
limited analysis on the impact of loan sales on its servicing centers and
portfolio activity, a more thorough

evaluation is needed to determine the agencywide effects of the loan sales
and the cost savings to the agency.

It would be imprudent to continue SBA loan asset sales in the absence of
reliable and complete information on the accounting and budgetary effects
of the sales. A successful loan sales program is not solely about
maximizing proceeds and attracting investors: it is also a means of
improving an agency*s ability to achieve its mission and to best serve the
American people. Moreover, as OMB continues to encourage loan asset sales,
it is

important that agencies embarking on new loan asset sales programs have
the capability to properly carry out and account for these activities.

Recommendations We make several recommendations to the Administrator of
the Small Business Administration, in order to provide accurate and
reliable

information about how the sales affect SBA*s borrowers, financial
statements, budget, and operations.

To ensure that SBA has complete information to enforce borrower
protections in its loan sale agreements and has reliable information to
report to Congress on how borrowers are reacting to the sales, we
recommend that the Administrator develop procedures for documenting

and processing inquiries and complaints from borrowers, and provide
guidance to the field offices about implementing them.

To address the errors and weaknesses in SBA*s accounting and budget
reporting, we recommend that the Administrator take the following actions
before conducting additional loan asset sales:

 Correct the errors in SBA*s loss calculations for loan sales one through
five, and adjust the fiscal years 2000 and 2001 financial statements.

 Perform the necessary analyses to assess the effect of loan sales on the
reestimates, to determine whether the cash flow assumptions in SBA*s model
reasonably predict future loan performance.  Perform the necessary
analyses to determine and correct the cause of

the unexplained decline in the subsidy allowance account, and make the
relevant adjustments to the fiscal years 2000 and 2001 financial
statements, as appropriate.

We also recommend that the Inspector General, in conjunction with SBA*s
financial statement auditors, assess the impact of any identified errors
in the financial statements and determine whether previously issued audit
opinions for the fiscal years 2000 and 2001 financial statements need to
be revised.

Finally, to provide Congress and SBA with a better understanding of the
impact of loan sales on SBA*s operations, we also recommend that the
Administrator conduct a more comprehensive evaluation of the loan sales*
impact on the agency and the cost savings from the sales.

Agency Comments We requested comments from SBA, SBA*s Inspector General,
and Cotton and Company, SBA*s independent financial statement auditor, on
a draft of

this report. The Chief Financial Officer for SBA, the Acting Inspector
General, and Cotton and Company provided their comments in writing, which
are presented in their entirety in appendixes III, IV, and V,
respectively.

SBA generally agreed in its comments with the overall findings and
recommendations in this report. In response to our recommendation on
tracking borrower inquiries and complaints, SBA stated that the agency is
preparing guidance for distribution to all field offices that will clarify
how borrower inquiries and complaints are to be handled. This guidance
will include information on SBA*s toll- free number. In addition, SBA
stated that

it is establishing a designated electronic mail account for use by all SBA
employees, to record borrower comments and forward them to headquarters;
developing a database to track borrower inquiries and complaints and any
other inquiries generated by the sale of loans; and improving the
documentation and tracking of inquiries and complaints made through its
toll- free number.

In its comments regarding our findings and recommendations on the
accounting and budgetary anomalies, SBA stated that it is actively
engaging a contractor to help resolve these issues and has worked
extensively with

its independent auditor to identify causes and options for resolving the
issues we identified. Additionally, SBA stated that the accounting and
budgetary guidance is general in nature and requires interpretation.

SBA did not respond specifically to our recommendation to conduct a more
thorough analysis of the impact of loan sales on agency operations.

SBA requested that we delay issuance of the report until March 2003. By
then, it hoped to have determined the causes of the accounting and
budgetary problems, and to be able to propose an appropriate methodology
for resolving them. Though we appreciate the desire to provide a plan of
action for addressing these problems in our final report, it is not our
policy

to delay issuance of our reports until problems we have identified are
resolved. SBA also stated that the report did not portray the complexity
and unique problems faced in implementing the loan sales program. We agree
that SBA faced a complex and difficult endeavor when it

implemented the loan sales program. In the introduction to the report, we
stated that SBA had never before conducted bulk loan sales. Furthermore,
the first section of our report is intended to reflect the complexity of
the loan sales process and includes a detailed discussion of what is
involved in conducting a sale, including a time line that shows that the
process can take almost a year to complete. This section and the
background section

also describe the variety and number of loans sold. SBA also noted that
the report did not reflect the fact that SBA responds in writing to all
written inquiries and complaints from borrowers; therefore, we added a
statement in the report reflecting the fact that SBA had responded in
writing to the written inquiries and complaints we reviewed at
headquarters.

The Inspector General also agreed with our recommendations and is working
with Cotton and Company and SBA management to determine the magnitude of
the errors in SBA*s fiscal years 2000 and 2001 financial statements. The
Inspector General stated that Cotton and Company has informed the IG*s
office that the audit opinion on the fiscal years 2000 and 2001 financial
statements should no longer be relied upon, as they may be materially
incorrect because of the errors identified in this report. The comments
also stated that Cotton and Company plans to withdraw its

unqualified audit opinion on those financial statements, and to issue
disclaimers of opinion. Cotton and Company, SBA*s independent financial
statement auditor, agreed with our findings and did not specifically
comment on our

recommendations. However, Cotton and Company also stated that the report
would be more fair and balanced if we further elaborated on the inherent
risks and complexities associated with accounting estimates and loan
sales. Cotton and Company also stated that it believes there is a lack of
comprehensive implementation guidance on credit subsidy and loan sale

cost estimates. Additionally, Cotton and Company stated that (1) our prior
reviews of its work did not identify the problems discussed in this
report,

and (2) we did not determine the specific causes of these errors. Further,
Cotton and Company elaborated on some of the audit work it had done. We
agree with Cotton and Company*s and SBA*s statements that accounting for
and auditing estimates of loan program costs and loan sales are complex,
and we describe these complexities in the background section of this
report.

Regarding the adequacy of existing guidance on preparing and auditing
credit subsidy estimates and loan sales, we used guidance that currently
exists in OMB Circular A- 11, Preparation, Submission, and Execution of

the Budget; SFFAS No. 2, Accounting for Direct Loans and Loan Guarantees
(effective fiscal year 1994); Technical Release 3, Preparing and Auditing
Direct Loan and Loan Guarantee Subsidies under the Federal Credit Reform
Act (issued July 31, 1999; and Statement of Auditing Standard 57, Auditing
Accounting Estimates (effective January 1989), in

performing our assessment of SBA*s accounting for loan sales and the
credit subsidy estimates. These documents provide considerable guidance to
agencies while still providing the flexibility necessary to be applicable
to a wide variety of credit programs. For example, Appendix B to SFFAS No.
2 contains technical explanations and illustrations related to estimating
loan program costs and loan sales* including guidance for calculating
changes in a loan*s book value, guidance for calculating the gain or loss,
and the impact that loan sales have on various financial statement
accounts, such as the allowance for subsidy. Further, Technical Release 3
provides guidance on auditing estimates of loan program costs, including
assessing internal controls and inherent risks, as well as suggested audit
steps and analytical review procedures.

While further elaboration may be helpful, the errors we identified in the
financial statements and the related footnotes were primarily related to
fundamental flaws in the application of existing guidance rather than to
insufficient guidance. In addition, the anomalies in the disaster loan

subsidy allowance account were known to Cotton and Company, and SBA
provided no viable explanation for these anomalies. Regarding prior GAO
reviews of Cotton and Company*s related audit work, these reviews were
part of our governmentwide consolidated financial

statement audit and were designed to focus on issues that could be
significant to the consolidated financial statements of the federal
government. Because the materiality of the consolidated financial
statements far exceeds the level of what is material to SBA, these reviews

were far less detailed than what was conducted for this report. Further,
loan sales were not significant to the governmentwide financial statements
and, therefore, were excluded from the scope of the prior GAO reviews.
However, it should be noted that prior GAO reviews of Cotton and Company
audit work at SBA going as far back as 1997 raised concerns about its
audit scope and methodology in the credit subsidy area, and offered
suggestions for improvement on both a formal and an informal

basis. Although we did identify specific errors in the calculation of the
loss on loan sales reported in the financial statements, we agree that we
did not identify the cause of the negative balance in the disaster loan
subsidy allowance account. We were unable to identify the cause because
SBA lacked some of the fundamental information necessary to enable us to
do so. This missing information, which should have been made available for
the financial statement audit, included an aging of the delinquent and
defaulted loans by year of loan commitment, detailed reconciliations of
the allowance for subsidy, and an analysis of the impact that loan sales
had on the estimated performance of the remaining loan portfolio. Because
this type of information was not available at the time of our review or of
Cotton and Company*s audit, it was not possible either for us, Cotton and
Company, or the SBA to determine the cause of the anomalies in the

disaster loan subsidy allowance account. We understand that SBA is now
working on preparing this information.

Regarding the elaboration of audit work that Cotton and Company provided,
we saw this work when we reviewed the auditor*s workpapers, and we
provided a summary of this work in the body of the report.

Unless you publicly announce its contents earlier, we plan no further
distribution until 30 days after the date of this report. At that time, we
will send copies of the report to the Chairman of the Senate Committee on
Small Business and Entrepreneurship, the Chairman and Ranking Minority
Member of the House Committee on Small Business, other interested
congressional committees, the Administrator of the Small Business
Administration, and the Director of the Office of Management and Budget.
We will make copies available to others on request. This report will also
be

available at no charge on the GAO Web site at http:// www. gao. gov.

Please contact us at (202) 512- 8678 if you or your staff have any
questions. Additional contacts and staff acknowledgments are listed in
appendix VI.

Sincerely yours, Davi M. D*Agostino, Director Financial Markets and

Community Investment Linda M. Calbom, Director Financial Management and

Assurance

Appendi Appendi xes x I

Scope and Methodology In preparing this report, we focused on the first
five of SBA*s six loan asset sales. The unpaid principal balance of the
loans sold in these sales represents about 87 percent of all the loans SBA
sold from August 1999 through August 2002. The sixth sale was not
completed in time to be

included in our analysis because purchasers do not begin servicing the
loans and accounting adjustments are not complete until several weeks
after the sale date.

To describe SBA*s loan sale process, we reviewed a variety of documents
related to planning and conducting a loan sale, including strategic plans,
guidance, and procedures. We also collected data on the types of loans
sold and the proceeds that SBA received from the sales, and we interviewed
SBA officials and contractors. Our interviews with SBA officials took
place at headquarters and at several SBA field offices that participate in
the loan sales process, including two disaster home loan servicing
centers, one commercial loan servicing center, and seven district offices.
We selected a mix of large and small field offices around the country,
based on the size of the loan portfolio and the number of loans sold. An
additional consideration for three of the district offices we selected was
their proximity to the finance center and the three servicing centers we
visited. We also interviewed the financial adviser who advises SBA on its
overall strategy for selling loans; the financial advisers hired to
conduct the first, third, and fifth sales; and the due diligence
contractor for the first four sales. To confirm that SBA*s loan sale
process was working as described, we

reviewed the loan information in the bidder information packages and
interviewed investors. To confirm that SBA was providing relatively
complete data to investors, we evaluated the loan data provided to
potential investors in the bidder information packages. Specifically, we
tested the data*s completeness for several key fields, such as interest
rate, outstanding balance, and maturity date. For investor feedback about
the loan sale process, we interviewed six investors and reviewed 42
responses

to surveys conducted by SBA*s Transaction Financial Advisers of investors
who had participated in sales four and five. We selected a mix of large
and small investors with a variety of experiences with the sales,
including investors who had won, lost, or just requested information but
declined to bid. In our interviews we asked investors to evaluate aspects
of SBA loan sales, including data they had received about loans for sale,
communications they had had with SBA and its contractors, the loan sales
process, and the organization of loan pools. We also asked whether the
investors planned to participate in future sales. Although we attempted to

contact a cross section of investors, the comments we received cannot be
generalized to a larger group. To determine how SBA loan asset sales
affect 7( a) lenders, we reviewed the lenders* role in the loan sale
process and interviewed officials representing lenders that had
participated in at least one sale. We selected a mix of 12 small and large
lenders based on 7( a) lending volume, asset size, and location. In our
interviews we asked lenders to evaluate their experience with SBA*s loan
sale process, describe how they made the decision to

participate in the sales, and discuss their level of satisfaction with the
proceeds. Although we attempted to contact a cross section of lenders,
their comments cannot be generalized to a larger group. We did not
interview any certified development companies that make 504 loans, because
the only 504 loans that were sold did not require consent from the lender.
To obtain additional feedback on SBA*s loan sale process, we spoke with
officials representing the National Association of Government Guaranteed
Lenders and the National Association of Development Companies, which
represent SBA 7( a) lenders and certified development companies that make
504 loans, respectively.

To determine how borrowers reacted when their loans were sold, we reviewed
borrower inquiries and complaints documented by SBA and the process for
documenting and processing these inquiries and complaints. To determine
the types of inquiries and complaints borrowers have, we

reviewed 133 of 155 borrower inquiry and complaint letters filed at
headquarters since the first loan sale in August 1999. We collected
information that included the date and type of inquiry or complaint (for

example, questions about a loan sale or complaints about a servicing
action by a purchaser) and the name of the purchaser (if available). We
prepared a summary of SBA*s written response. We also interviewed SBA
officials at headquarters and field offices (three servicing centers,
seven district offices, and two disaster area offices) about the types of
inquiries and complaints they receive from borrowers and about SBA*s
process for handling these complaints. In addition, we asked staff at
field offices whether they had forwarded borrower complaints to
headquarters or documented the complaints. We reviewed a nonstatistical
sample of complaints from the third, fourth, and fifth sales drawn for us
by staff at one of the disaster home loan servicing centers to determine
whether the information in borrower complaints received at field offices
was accurately represented in headquarters records. Specifically, we
compared the names on the complaints we received from the disaster home
loan servicing center with the names on the complaints at headquarters. We
also reviewed

the complaints logged through the toll- free number, but these data were
limited because SBA staff did not begin logging the complaints from this
number until April 2002.

To evaluate SBA*s budgeting and accounting for loan sales, we assessed
SBA*s compliance with various budget and accounting guidance, including
OMB Circular A- 11, Preparation, Submission, and Execution of the Budget;
Statement of Federal Financial Accounting Standard Statement No. 2,
Accounting for Direct Loans and Loan Guarantees; and U. S. Government
Standard General Ledger, Account Transactions. Specifically, we analyzed
SBA*s cash flow models to reestimate subsidy costs for the disaster loan
program and the 7( a) and 504 loan guarantee programs, in order to
determine the effect of loan sales on the cost of each program for the
budget. We evaluated characteristics of loans sold as compared with cash
flow assumptions used to reestimate the costs of SBA*s loan programs. To
assess SBA*s estimates of hold values for loans sold, we reviewed an
external validation of the hold model used for sales one through three
that was prepared by an SBA contractor, who concluded that the
calculations were accurate and reasonable. Since SBA changed to a more
sophisticated

hold model after sale three, 33 we also reviewed the methodology and
assumptions in SBA's revised model used to estimate hold values for loans
sold in sales four and five, and we found the approach to be reasonable.
However, we did not audit the data used to calculate the hold values for
each sale, and therefore did not conclude on the reasonableness of the
hold values for any of the sales. We reviewed SBA*s accounting related to
the balances of the loans sold, proceeds and costs of the sales, and
calculations of gains or losses on sales to determine whether SBA
considered all appropriate cash flows in these calculations. We discussed
SBA*s budgeting and accounting procedures for loan sales with SBA and OMB
officials, Federal Accounting Standards Advisory Board staff, and SBA*s
independent auditors. We also reviewed SBA*s audited financial statements
for fiscal years 1999 through 2001 and examined workpapers from SBA*s
auditor for fiscal years 2000 and 2001.

Finally, to assess the ways in which SBA benefited from loan sales, we
reviewed official statements, including testimony, press releases, and
other

33 SBA*s revised hold model was first used to estimate hold values for
sale four. Hold values from this more sophisticated model were calculated
at the loan level rather than based on a loan pool approach or averages.
The revised model*s calculations were based on actual data from all loans
selected for sale rather than on a sample of data from the loans selected
for

sale.

documents that cited benefits related to loan servicing reductions, staff
realignment, and loan portfolio management efficiencies. To confirm these
benefits, we reviewed and analyzed trend data on SBA*s loan servicing
workloads to determine how the loan sales had affected SBA*s loan
servicing workloads and staffing. We reviewed and analyzed data on loan
activity, including prepayments and charge- offs, before and after the
loan asset sales began. We also interviewed SBA officials at headquarters
and field offices to obtain their views on how SBA has benefited from the
sales. We did not independently verify the accuracy of the loan servicing
and loan portfolio data provided by SBA, because we were interested only
in the trends before and after the loan sales began.

We performed our review from January 2002 through October 2002 in
Washington, D. C., and several other locations across the country, listed
below, in accordance with generally accepted government auditing
standards.

SBA Field Locations

District Offices

We Visited Birmingham, Alabama

Little Rock, Arkansas Santa Ana, California Los Angeles, California
Denver, Colorado Miami, Florida (telephone interview) Philadelphia,
Pennsylvania

Loan Servicing Centers

Birmingham, Alabama (disaster home loan servicing) Santa Ana, California
(disaster home loan servicing and liquidation) Little Rock, Arkansas
(commercial loan servicing)

Denver Finance Center Denver, Colorado

Disaster Area Offices

Niagara Falls, New York (telephone interview) Fort Worth, Texas (telephone
interview)

Types of Borrower Inquiries and Complaints

Appendi x II

Received by SBA We reviewed 133 of the 155 inquiries or complaints SBA had
documented from August 1999 through April 2002, to identify the types of
concerns and problems borrowers faced when their loans were sold. 34 From
our review, we determined that borrowers generally contact SBA about loans
that have been sold for one of two reasons:

 they have a question or concern about why SBA is selling their loan, or
they want to purchase their loan rather than have SBA sell it to the
private sector; or

 they want to modify their loan and have a complaint about the
purchaser*s procedures or treatment. Almost half (65) of the 133 letters
from borrowers that we reviewed at

headquarters involved questions about why loans were being sold, requests
to buy a loan discounted lower than the unpaid principal balance, or pleas
that the loan not be sold. Forty- seven letters referred to purchasers*
servicing actions. Twenty- three of these letters involved disagreements
or frustration with servicing decisions the new purchaser had made, such
as

refusing to subordinate or release collateral, 35 or imposing a fee to
complete a servicing action such as subordination. Another 18 letters came
from borrowers who wanted to defer payments or change the amount of their
monthly payment because of financial problems, and felt they were not
getting appropriate treatment from the purchaser of their loan. Six of the
letters complained about problems that occurred while SBA was transferring
the loan to the purchaser. For example, some borrowers found that
purchasers had not properly applied their loan payments during the
servicing- transfer period. Nineteen of the remaining 21 letters came from
borrowers who wanted SBA to subordinate, release collateral, or compromise
on a loan*s payment or terms, and who were told that SBA had sold the loan
and thus could no longer service it.

34 We tried to review all of the inquiries and complaints documented at
headquarters and stored in two binders. However, we did not include in our
review additional follow- up letters from the same borrowers. Furthermore,
the database that SBA created after our review included inquiries and
complaints after April 2002, when we had reviewed the inquiries and
complaints at headquarters. Therefore, our 133 complaints did not match
exactly the 155 complaints in SBA*s database.

35 *Subordination* occurs when a lender allows a new or existing loan to
take a superior lien to another loan. For example, a borrower with an SBA
disaster home loan may want SBA or a lender to subordinate the disaster
loan to a new or refinanced home mortgage.

Comments from the Small Business

Appendi x III Administration

Comments from the Inspector General of the

Appendi x IV Small Business Administration

Appendi x V Comments from Cotton and Company

Appendi x VI

GAO Contacts and Acknowledgments Contacts For questions regarding this
report, please contact Davi D*Agostino at (202) 512- 8678 or Linda Calbom
at (202) 512- 9508. Acknowledgments Additional staff making major
contributions to this report were Dan Blair, Marcia Carlsen, Jay Cherlow,
Heather Dunahoo, David Eisenstadt, Edda

Emmanuelli- Perez, Katie Harris, DuEwa Kamara, Kay Kuhlman, and Paul
Thompson.

Glossary The following is a group of terms commonly used in credit
budgeting and accounting. The definitions for many of these terms are
equally applicable to direct loans and loan guarantees.

Cash flows Payments or estimates of payments to or from the government
over the life of a loan or group of loans. For direct loans, these may
include loan disbursements, repayments of principal, payments of interest,
prepayments, fees, penalties, defaults, and recoveries on defaulted loans.

Cash flow assumptions All known and forecasted information about the
characteristics and performance of a loan or group of loans used to
estimate future loan performance. Examples include estimates of loan
maturity, borrower interest rates, default and delinquency rates, and the
timing of cash flow events, such as defaults and collections on defaulted
loans.

Credit reform Refers to the collective requirements as set forth in (1)
the Federal Credit Reform Act of 1990, which generally requires that
agencies calculate and record the net present value cost of credit
programs to the government

included in the budget, (2) the Statement of Federal Financial Accounting
Standard No. 2, Accounting for Direct Loans and Loan Guarantees, and (3)
OMB Circular A- 11, Preparation, Submission, and Execution of the Budget.

Gross proceeds Total amount received from investors as a result of the
loan sales. Hold value The estimated value of loans to the government if
held to maturity or

resolution, stated on a net present value basis and discounted with
interest rates from the most recent President*s budget at the time the
estimate is prepared. The hold value is a more detailed loan value
analysis than the credit subsidy estimate, because it specifically
considers the cash flows

and characteristics of the loans for sale and is calculated on a loan- by-
loan basis.

Market value estimate An estimate of the anticipated proceeds from
investors on loans for sale based on current market trends and conditions,
and the characteristics of

the loans being sold. A contractor who assists SBA with the loan sales
prepares the estimate.

Net book value An amount calculated by subtracting the subsidy allowance
from the outstanding loans receivable balance for a loan or group of
loans. Net proceeds Gross proceeds received from a loan sale less seller
transaction costs

associated with conducting the sale (such as fees for underwriting, rating
agency work, legal advice, financial advice, and due diligence) that are
paid out of the gross sales proceeds rather than paid as direct
obligations by the agency.

Present value The worth of the future stream of returns or costs in terms
of money paid immediately. In calculating present value, prevailing
interest rates provide the basis for converting future amounts into their
*money now* equivalents.

Reestimates Revisions of the subsidy cost estimate based on information
about the actual performance of loans or other estimated changes in future
cash

flows resulting from changes in economic conditions, other events, and
improvements in the methods used to estimate future cash flows.

Subsidy allowance Financial statement reporting account used to recognize
the costs of a loan program that are not expected to be recovered from
borrowers, including

default costs and financing costs arising from subsidizing below- market
rate loans.

Subsidy cost The estimated long- term cost to the government of direct
loans or loan guarantees, calculated on a net present value basis,
excluding administrative costs. The subsidy cost is the present value of
disbursements by the government (loan disbursements and other payments)
minus estimated payments to the government (repayments of

principal, payments of interest, other recoveries, and other payments)
over the life of the loan.

Unpaid principal balance Amount of outstanding loan principal owed by
borrowers (also known as the loans receivable balance).

Unqualified opinion An auditor*s opinion that states that the financial
statements present fairly, in all material respects, the financial
position, results of operations, and

cash flows of the entity, in conformity with generally accepted accounting
principles.

(250059)

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a

GAO United States General Accounting Office

From August 1999 through January 2002, SBA held five loan asset sales,
disposing of a total of $4.4 billion in disaster assistance home and
business loans (85 percent) and regular business loans (15 percent). SBA
created a sales process that has attracted investors and responded to
their concerns. Lenders who participate in the 7( a) business loan
guaranty program were also satisfied with the sales as an option for
disposing of their defaulted

loans. SBA relies on borrower inquiries and complaints to determine
whether purchasers of the loans are using prudent loan servicing
practices, as required in the loan sale agreements. However, information
on borrowers* reactions to loan sales is incomplete, because SBA does not
have a comprehensive process to capture the inquiries and complaints it
receives.

SBA incorrectly calculated the accounting losses on the loan sales and
lacked reliable financial data to determine the overall financial impact
of the sales. Further, because SBA did not analyze the effect of loan
sales on its remaining portfolio, its reestimates of loan program costs
for the budget and

financial statements may contain significant errors. In addition, SBA
could not explain significant declines in its loss allowance account for
disaster loans. Until SBA corrects these errors and determines the cause
of the precipitous decline in the loss allowance account, SBA*s financial
statements will likely be misstated, and the audit opinion on past
financial statements may be incorrect. Further, the reliability of current
and future subsidy cost estimates will remain unknown. These errors and
the lack of key analyses also mean that congressional decisionmakers are
not receiving accurate financial data to make informed decisions about
SBA*s budget and the level of appropriations the agency should receive.
Our analysis of the operational benefits from loan sales suggests that
some

benefits that SBA reported either have not yet materialized or were
overstated. SBA conducted a limited analysis of the impact of loan sales
on its loan servicing centers, showing that loan servicing volume had been
reduced. However, loan sales had a much greater impact on disaster loan
servicing than on business loan servicing. Therefore, how the sales will
help SBA realign its workforce in the small business programs remains
unclear.

It would be imprudent to continue SBA loan asset sales in the absence of
reliable and complete information on the accounting and budgetary effects.
A successful loan sales program is not solely about maximizing proceeds
and

attracting investors: it is also a means of improving an agency*s ability
to achieve its mission and to best serve the American people. Moreover, as
OMB continues to encourage loan asset sales, it is important that agencies
embarking on new loan asset sales programs have the capability to properly
carry out and account for these activities.

SMALL BUSINESS ADMINISTRATION

Accounting Anomalies and Limited Operational Data Make Results of Loan
Sales Uncertain

www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 87. To view the full report,
including the scope and methodology, click on the link above. For more
information, contact Davi M. D*Agostino or Linda M. Calbom, (202) 5128678.
Highlights of GAO- 03- 87, a report to the

Ranking Minority Member, Committee on Small Business and Entrepreneurship,
U. S. Senate

January 2003

SBA*s loan asset sales are being closely watched because similar sales are
projected for other government agencies as a means of reducing loan assets
and servicing costs. To assess the progress and effects of SBA*s loan
sales, GAO undertook this study to (1) describe the process for selling
loans, (2) identify how lenders and

borrowers have reacted to loan sales, (3) determine whether SBA is
properly accounting for its loan sales and their subsequent impact

on credit subsidy estimates, and (4) assess whether loan sales generated
operational benefits for the agency. GAO did not determine whether SBA
maximized proceeds from the loan sales.

We recommend that, before doing more loan asset sales, SBA correct the
accounting and budgeting errors and misstatements. Also, the Inspector
General, with SBA*s independent auditors, should assess the impact of
identified errors in the financial statements and determine whether audit
opinions for fiscal years 2000 and

2001 financial statements need to be revised. We also recommend that SBA
improve its tracking of borrower inquiries and complaints and analyze the
benefits and other effects on agency operations of the sales. SBA
generally agreed with

our findings and recommendations but did not respond to the recommendation
to analyze the operational effects of loan sales.

Page i GAO- 03- 87 SBA Loan Sales

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Appendix I

Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix II

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Appendix III

Appendix III Comments from the Small Business Administration

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Appendix III Comments from the Small Business Administration

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Appendix III Comments from the Small Business Administration

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Appendix IV

Appendix IV Comments from the Inspector General of the Small Business
Administration

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Appendix V

Appendix V Comments from Cotton and Company

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Appendix V Comments from Cotton and Company

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Appendix V Comments from Cotton and Company

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Appendix VI

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United States General Accounting Office Washington, D. C. 20548- 0001

Official Business Penalty for Private Use $300

Address Service Requested Presorted Standard

Postage & Fees Paid GAO Permit No. GI00
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