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entitled 'Small Business Administration: Accounting Anomalies and 
Limited Operational Data Make Results of Loan Sales Uncertain' which 
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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:



GAO Highlights:



Highlights of GAO-03-87, a report to the

Ranking Minority Member, Committee on

Small Business and Entrepreneurship,

U.S. Senate





Why GAO Did This Study:



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.



What GAO Found:



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.



What GAO Recommends:



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.



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) 512-8678.



Letter:



Results in Brief:



Background:



SBA’s Sales Process Is Designed to Satisfy Investor Demands:



Lenders Expressed Satisfaction with SBA’s Loan Sales, but SBA’s Data on 

Borrowers’ Reactions Was Incomplete:



SBA’s Accounting for Loan Sales and the Remaining Portfolio Was Flawed:



Loan Sales Have Reduced SBA’s Loan Servicing Volume, but Other 

Operational Benefits May Be Overstated:



Conclusions:



Recommendations:



Agency Comments:



Appendixes:



Appendix I: Scope and Methodology:



SBA Field Locations We Visited:



Appendix II: types of Borrower Inquiries and Complaints Received by

SBA:



Appendix III: Comments from the Samll Business Administration:



Appendix IV: Comments from the Inspector General of the Small

Business Administration:



Appendix V: Comments from Cotton and Company:



Appendix VI: GAO Contacts and Acknowledgements:



Contacts:



Acknowledgments:



Glossary:



Tables:



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



Table 2: Loan Receivable Balances of SBA’s Disaster Loan Program:



Figures:



Figure 1: Time Line of a Loan Sale:



Figure 2: Total Balance of Loans Sold:



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

about Loan Sales:



Figure 4: Gain / Loss Calculation on Previously Defaulted Sold 

Guaranteed Loans:



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

Commercial Loan Servicing Centers:



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

Servicing Centers:



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.[Footnote 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.



In determining whether or not to sell these loans, SBA estimated the 

current value to the government, also known as the hold value,[Footnote 

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.[Footnote 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.



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.[Footnote 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 

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,[Footnote 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.[Footnote 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.[Footnote 7] 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 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,[Footnote 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.[Footnote 

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 guaranteeing loans through its 7(a) and 504 programs.[Footnote 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.[Footnote 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.[Footnote 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:



between credit and noncredit programs.[Footnote 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.[Footnote 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.[Footnote 15] The subsidy cost is the present value of 

disbursements[Footnote 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 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.[Footnote 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 Designed to Satisfy Investor Demands:



SBA officials told us that the loan asset sale process is designed to 

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 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. 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.[Footnote 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 Planning and an Investment of Resources:



SBA’s asset sales team, which manages the loan asset sale program at 

SBA headquarters, coordinates the efforts of contractors, SBA field 

offices, and lending partners to execute a loan sale (fig. 1). Two 

financial advisers and a due diligence contractor are involved in each 

sale.[Footnote 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.



Figure 1: Time Line of a Loan Sale:



[See PDF for image]



[End of figure]



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,[Footnote 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,[Footnote 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 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.[Footnote 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.



Sales Results and Investor Interest Depended in Part on the Loan Pools’ 

Characteristics:



For each sale, SBA received proceeds from loans sold that exceeded the 

estimated value to the government of the loans, as calculated by SBA’s 

hold model. SBA’s proceeds as a percentage of the unpaid balances of 

the loans 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.[Footnote 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.



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



Dollars in millions.



Unpaid principal balance; Sale 1: $332.1;  

in millions: Sale 2: $1,200.7; Sale 3: $1,105.1; 

 in millions: Sale 4: $1,186.1; Sale 5: 

$600.6.



Gross proceeds; Sale 1: $195.1; 

Sale 2: $530.0; Sale 3: $662.5;  

Sale 4: $873.3; Sale 5: $402.8.



Gross proceeds/Unpaid principal balance; Sale 1: 

59%; Sale 2: 44%; Sale 3: 

60%; Sale 4: 74%; Sale 5: 

67%.



Estimated percentage of disaster loans secured; 

Sale 1: n. a.; Sale 2: 88%; 

Sale 3: 95%; Sale 4: 99%; 

Sale 5: 76%.



Estimated percentage of disaster loans performing; 

Sale 1: n. a.; Sale 2: 78%; 

Sale 3: 82%; Sale 4: 89%; 

Sale 5: 88%.



Estimated percentage of business loans secured; 

Sale 1: 88%; Sale 2: 84%; 

Sale 3: 94%; Sale 4: 84%; 

Sale 5: 81%.



Estimated percentage of business loans performing; 

Sale 1: 61%; Sale 2: 37%; 

Sale 3: 32%; Sale 4: 36%; 

Sale 5: 10%.



n. a. = not applicable:



Source: SBA.



[End of table]



Figure 2: Total Balance of Loans Sold:



[See PDF for image]



[End of figure]



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 Feedback to Shape and Improve the Sales Process:



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

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

attracting 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 lessons-learned 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.[Footnote 

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.



Lenders Expressed Satisfaction with SBA’s Loan Sales, but SBA’s Data on 

Borrowers’ Reactions Was Incomplete:



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

Although 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 difficult to measure. An important factor in 

the reactions of both groups is that lenders’ involvement is voluntary 

but borrowers’ is not. Lenders must 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 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 Whom We Spoke Are Satisfied with the Loan Sales:



Lenders who participate in SBA’s 7(a) loan guaranty program have an 

interest in the outcome of the sales, because they still have a stake 

in the 7(a) loans for sale. When a 7(a) loan defaults, SBA honors its 

loan guaranty, 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 Experience with Prior Sales Drive Lender 

Participation:



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

we identified two primary factors that drive lender participation in 

the sales: 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 Protections Addressing Loan Servicing and Disaster 

Assistance:



Unlike lenders, SBA’s borrowers have little control over what happens 

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

some safeguards to protect the integrity of the programs that provided 

the loans. 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 Is Incomplete Because SBA’s Process for 

Documenting and Tracking Borrower Inquiries and Complaints Has 

Weaknesses:



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

the loan sales, because SBA could not provide a reliable estimate or 

information on the number of borrowers who had contacted them about 

their sold loans. Complete and reliable information on borrower 

complaints is important, because SBA officials told us that they 

contacted purchasers when a borrower complained about a servicing 

action to collect 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:



[See PDF for image]



[End of figure]



In August 2001, SBA began providing a toll-free number for borrowers to 

call with questions or complaints about loan sales.[Footnote 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 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 Loan Sales and the Remaining Portfolio Was Flawed:



SBA sold almost 110,000 loans with an unpaid principal balance of about 

$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 

errors that could significantly affect the reported results in the 

budget and 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 Losses on Loan Sales:



Accounting records related to loan sales indicated that losses exceeded 

$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)[Footnote 26] of the loans sold and 

the net sale:



proceeds.[Footnote 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 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:



[See PDF for image]



[End of figure]



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 Are Unreliable:



SBA did not conduct key analyses of either the loans sold or its 

remaining 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.[Footnote 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 Account Was Misstated:



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

subsidy allowance account for the disaster loan program had an 

unusually 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.



Loans receivable outstanding; Fiscal year 1998: 

$5,634; Fiscal year 1999: $5,659; Fiscal year 2000: $5,305; Fiscal year 

2001: $3,293.



Less / (plus): Subsidy allowance balance; Fiscal 

year 1998: $1,230; Fiscal year 1999: $929;  

Fiscal year 2000: $505; Fiscal year 2001: ($77).



Net book value; Fiscal year 1998: $4,404;  

Fiscal year 1999: $4,730; Fiscal year 

2000: $4,800; Fiscal year 2001: $3,370.



Subsidy allowance as a percentage of loans receivable balance;  

 Fiscal year 1998: 21.8%; Fiscal year 

1999: 16.4%; Fiscal year 2000: 9.5%; 

Fiscal year 2001: (2.3%).



Source: SBA.



[End of table]



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.[Footnote 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.[Footnote 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 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.[Footnote 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 Reduced SBA’s Loan Servicing Volume, but Other 

Operational Benefits May Be Overstated:



SBA reported that loan asset sales had benefited the agency’s 

operations by reducing loan servicing, and that this reduction in loan 

servicing volume should help allocate resources to other areas 

necessary to achieving SBA’s mission and help the agency to manage its 

loan portfolio more effectively. Though we found that loan servicing 

volume had declined for SBA disaster home loan centers, the effect on 

regular business loans was less clear. Furthermore, despite these 

reductions in loans servicing volumes, SBA had 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 

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 Servicing Volumes Have Been Greatest for Disaster 

Loans:



The loan asset sales have reduced SBA’s servicing and liquidation 

workload for disaster loans at the disaster home loan servicing 

centers, but they have had little impact on regular business loans, 

such as 7(a) loans, at the 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.[Footnote 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 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:



[See PDF for image]



[End of figure]



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:



[See PDF for image]



[End of figure]



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 Workforce Realignment Have Been Mixed:



The role of loan asset sales in facilitating SBA’s workforce 

realignment may be smaller than was initially expected. SBA had 

reported that loan asset 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 the Ways in Which SBA Manages Its Loan 

Portfolio, but So Have Other Factors:



According to SBA officials, the process of selling loans, particularly 

the intensive due diligence process and the field office review of 

loans selected for the sales, makes loan servicing more timely and 

consistent across the 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:



Signed by Davi M. D’Agostino



Linda M. Calbom, Director

Financial Management and Assurance:



Signed by Linda M. Calbom



[End of section]



Appendix 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,[Footnote 

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 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 We Visited:



District Offices:



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):



[End of section]



Appendix II: Types of Borrower Inquiries and Complaints 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.[Footnote 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,[Footnote 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.



[End of section]



Appendix III Comments from the Small Business Administration:



U.S. SMALL BUSINESS ADMINISTRATION WASHINGTON, D.C. 20416:



December 13, 2002:



Ms. Davi M. D’Agostino Director:



Financial Markets and Community Investment U.S. General Accounting 

Office:



441 G Street, N.W. Washington, DC 20548:



Ms. Linda M. Calbom Director:



Financial Management and Assurance U.S. General Accounting Office:



441 G Street, N.W. Washington, DC 20548:



Dear Ms. D’Agostino and Ms. Calbom:



The purpose of this letter is to provide SBA’s comments on the draft 

GAO report titled, “Accounting Anomalies and Limited Operational Data 

Make Results of Loan Sales Uncertain” (Report). The Report identifies a 

range of complex accounting and budgeting issues associated with SBA’s 

Loan Sales Program. While we generally concur with the GAO’s findings 

and recommendations, especially the need to better assess the financial 

impact of SBA’s Loan Sales Program, we wish to point out that current 

senior SBA management (including the new Chief Financial Officer (CFO) 

team that the current SBA Administrator has put in place) became aware 

of these issues and were working to solve them prior to learning of the 

findings of the GAO audit. We are making every effort to resolve these 

issues by the end of March 2003; therefore, we respectfully request 

that GAO not finalize the Report until SBA completes this process. 

Given that GAO itself could not identify the cause of the accounting 

and budget anomalies, but instead suggested that additional analysis is 

needed, we are concerned that readers may reach potentially premature 

and inaccurate conclusions regarding these issues. In addition, we 

believe the Report should clearly state that there is no indication 

that SBA intentionally misrepresented the loan sale results on its 

financial statements.



GAO recommendations regarding financial and budgetary issues:



The Report identifies apparent inconsistencies between the results 

produced by the financial models used in connection with SBA’s Disaster 

Loan Program and its Loan Sales Program. The former management of the 

Office of the CFO was aware of these seeming inconsistencies but was 

unable to resolve them. SBA’s fiscal year 2000 and

2001 financial statements included footnotes disclosing the book losses 

and discussing the Loan Sales Program. In the Spring of 2002, the 

current Administrator replaced the management team in the Office of the 

CFO. The new management team was given clear direction to review and 

modify operations, including to assess the financial and budgetary 

impact of the Loan Sales Program. The Administrator directed the new 

management team to ensure that the Office of the CFO consistently 

produce timely, thorough, and accurate financial information that can 

reliably be used to support the Agency’s programs and decision-making.



Shortly after coming onboard, the new CFO team recognized the 

importance of the loan sales budgeting and accounting issues, including 

the potential impact of the sales on the subsidy rate for the Disaster 

Loan Program. Under the CFO team’s direction, SBA has undertaken a 

rigorous review of all aspects of the issues, including those raised in 

the Report. Specifically, we are looking at the methodology and 

assumptions in the disaster loan subsidy model and hold model, the 

characteristics (including performance) of the loans sold versus those 

remaining in the portfolio, the value of the remaining portfolio, and 

the detailed accounting transactions that have been recorded for each 

cohort. This is a top priority of the Agency and we are devoting much 

of our internal staff’s time to ensuring that the issues are 

satisfactorily resolved. In addition, we are engaging a contractor with 

the expertise necessary to advise us regarding these complex matters. 

We have also worked extensively with our independent auditor over the 

past few months to analyze the potential causes of the inconsistencies 

and to identify options for resolving the situation.



We are concerned that the Report fails to take into account or 

appreciate the complex and unique problems faced and solved in 

implementing the Loan Sales Program. These include the diverse nature 

of the SBA loan portfolio that did not lend itself well to traditional 

sale methods, the need to create a market for the portfolio, as well as 

a host of attendant legal problems. It should also be noted that the 

loan sales process begins between nine months to a year prior to the 

actual bid date for each sale.



The following provides some background and context that we believe is 

relevant but not included in the Report and also details SBA’s past 

efforts to resolve the issues identified in the Report. SBA has been a 

government-wide leader in asset sales, as one of the few credit 

agencies to conduct them under the credit reform guidelines. The SBA 

Loan Sales Program presents unique challenges because of the diversity 

of types of loans that are sold and the large number of loans that have 

been sold in each of the sales. As GAO noted in its exit meeting with 

SBA, this is not an area where extensive official implementation 

guidance has been developed. The guidance that exists from the Office 

of Management and Budget (OMB), the Federal Accounting Standards Board 

(FASB), and others is general in nature and requires interpretation for 

specific application and implementation.



SBA repeatedly sought the assistance of reputable outside experts to 

interpret and apply the available guidance. SBA’s loan sales process, 

including the budgeting and accounting components, was developed with 

the support and guidance of well qualified and recognized outside 

contractors. The contractors who worked on various aspects of the 

process included KPMG Consulting, Ernst & Young, Cushman & Wakefield, 

Merrill Lynch, and others. In addition, OMB and GAO have been involved 

in various aspects of the Loan Sales Program. Throughout the history of 

the Program, it appears that SBA has followed all the guidance that was 

available.



Indeed, such guidance and the available expertise have not been able to 

resolve the unique problems presented by the Loan Sales Program. For 

example, SBA retained PricewaterhouseCoopers, an independent 

accounting firm, to look at the accounting and budgeting issues 

relating to the Loan Sales Program. Officials from OMB were also 

engaged to assess these issues. The results of the reviews were 

inconclusive -the hold model, subsidy model, and accounting procedures 

were found to be sound individually, but the inconsistencies between 

them remained.



As stated above, the Agency’s current management is working diligently 

to resolve these inconsistencies and the other issues noted in the 

Report that were left unresolved in the past.



GAO recommendation regarding programmatic issues:



The Report recommends that SBA develop a comprehensive process for 

documenting and tracking borrower inquiries and complaints in order to 

guide SBA field personnel, to enforce borrower protections in the loan 

sale agreement, and to report accurately to Congress. SBA has already 

taken a number of steps to improve this process and the Report should 

reflect the fact that SBA has responded in writing to every written 

complaint or inquiry submitted by a borrower, lender or member of 

Congress.



Often these complaints and inquiries arise when a borrower requests an 

accommodation from the purchaser that is outside the terms of the 

underlying loan documentation. When a loan is sold, the borrower and 

guarantors retain all the rights and obligations that they had when SBA 

and the participating lender owned and serviced the loan. The purchaser 

does not have any power to change the terms of the loan without the 

borrower’s consent. SBA cannot enforce these rights and protections on 

behalf of the debtor, any more than SBA can collect the loan on behalf 

of the purchaser. What SBA can do (and does) is ensure that the 

purchasers can adhere to the servicing standards in each loan sale 

agreement. In order to accomplish this, SBA accepts bids only from 

entities that have demonstrated experience in the servicing of the 

types of loans SBA sells and that follow standard commercial loan 

servicing practices. In addition, when our assistance is requested, SBA 

attempts to work with the parties to reach a resolution.



Furthermore, the Agency currently is preparing a Procedural Notice for 

distribution to all Field Offices, Servicing Centers and Disaster Area 

Loan Offices that will clarify how borrower inquiries and/or complaints 

are to be handled so that a uniform process is utilized. This Notice 

will also describe the (800) customer information line in the Santa Ana 

Commercial Loan Servicing Center. It will explain the purpose of the 

line, information available and types of borrowers that should be 

transferred to that number.



In addition to the Procedural Notice, SBA is:



*Establishing a designated electronic mail account for use by all SBA 

employees to record borrower comments and forward them to the Asset 

Sales Team in Headquarters for documentation, tracking and possible 

response.



*Developing a relational database maintained by the Asset Sales Team at 

Headquarters to track borrower complaints, borrower inquiries, 

Congressional inquiries, Freedom of Information Act requests or any 

other inquiries generated due to the sale of loans.



*Implementing additional enhancements to the Santa Ana Disaster Home 

Loan Customer Inquiry tracking system for recording borrower complaints 

and inquiries.



Conclusion:



As you are aware from your own experience in reviewing the Loan Sales 

Program, the causes of the budgetary and accounting issues raised in 

the Report have proven to be difficult not only to identify but also to 

resolve. As we noted above, we are hopeful of resolving these issues in 

the next few months. Accordingly, we reiterate our request that you 

withhold publication of a final version of the Report until we have 

concluded our review and have provided you with our methodology for 

resolving these issues.



We appreciate the opportunity to comment on the Report. We look forward 

to providing you more information on the resolution of the issues 

raised in the Report as soon as possible.



Sincerely,



Thomas A. Dumaresq Chief Financial Officer:



Signed by Thomas A. Dumaresq



[End of section]



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

Administration:



U.S. Small Business Administration Washington, D.C. 20416:



OFFICE OF INSPECTOR GENERAL:



December 13, 2002:



Ms. Davi M. D’Agostino Director:



Financial Markets and Community Investment U. S. General Accounting 

Office:



441 G Street, N. W. Washington, DC 20548:



Ms. Linda M. Calbom, Director:



Financial Management and Assurance U.S. General Accounting Office:



441 G Street, N. W. Washington, DC 20548:



Dear Ms. D’Agostino and Ms. Calbom:



We have reviewed the General Accounting Office’s (GAO) draft report 

GAO-03-87, “Accounting Anomalies and Limited Operational Data Make 

Results of Loan Sales Uncertain. “ GAO’s report identified significant 

errors in the Small Business Administration’s (SBA’s) accounting and 

budgeting for loan sales which may have affected the fair presentation 

of its Fiscal Year (FY) 2000 and 2001 financial statements. 

Accordingly, GAO recommended 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 FY 2000 and 2001 need to be 

revised. Further, GAO made several recommendations to SBA’s 

Administrator to provide accurate and reliable information about how 

the sales affect SBA’s financial statements, budget, and operations.



We agree with both the recommendation addressed to our office as well 

as those recommendations addressed to the Administrator. With respect 

to the recommendation addressed to our office, we are continuing to 

work with Cotton and Company LLP (Cotton) and SBA management to 

determine the magnitude of the errors in SBA’s FY 2000 and 2001 

financial statements and resulting impacts of those errors. 

Additionally, Cotton has informed our office that the opinions on the 

FY 2000 and 2001 financial statements should no longer be relied upon 

as these statements may be materially incorrect due to the errors noted 

in your report. Accordingly, Cotton plans to withdraw their unqualified 

opinions on those financial statements and issue disclaimers of 

opinion.



Federal Recycling ProgramPrinted on Recycled Paper:



Our office is working with Cotton and SBA to ensure affected parties 

are notified and appropriate actions are taken.



We recognize that the recommendations addressed to the Administrator 

are necessary to ensure that the issues noted in your report do not 

continue to have a detrimental effect on SBA’s loan sale program. As 

acknowledged in the subject report, many of the errors GAO identified 

need further analysis to determine the impact on the accuracy of the 

financial statements. SBA and Cotton have been attempting to evaluate 

the magnitude of these errors, but have yet to determine the extent of 

any material misstatements in the FY 2000 and 2001 financial 

statements. We will work with the Administrator to ensure these errors 

are quantified and the underlying problems are adequately addressed.



Should you or your staff have any questions, please contact Robert G. 

Seabrooks, Assistant Inspector General for Auditing, at (202) 205-7203.



Sincerely,



Signed by David R. Gray for:



Peter L. McClintock Acting Inspector General:



cc: Hector Barreto, Administrator:



Lloyd Blanchard, Chief Operating Officer Thomas Dumaresq, Chief 

Financial Officer Ronald Bew, Associate Deputy Administrator for 

Capital Access Herbert Mitchell, Associate Administrator for Disaster 

Assistance Charles Hayward, Partner, Cotton and Company LLP:



[End of section]



Appendix V: Comments from Cotton and Company:



COTTON & COMPANY LLP:



December 13, 2002:



Ms. Linda Calbom Director:



Financial Management and Assurance U.S. General Accounting Office:



441 G Street, NW Washington, DC 20548:



Subject: GAO-03-87, Accounting Anomalies and Limited Operational Data 

Make Results of Loan Sales Uncertain:



Dear Ms. Calbom:



We have reviewed the draft report cited above. We wish to comment on 

the text under the caption SBA’s Accounting for Loan Sales and the 

Remaining Portfolio Was Flawed and on related material elsewhere in the 

draft report. Among other things, these portions of GAO’s report state 

that SBA made errors in budgeting and accounting for loan sales that 

could have significantly affected reported results in its budget and 

financial statements. GAO’s report also conveys that Cotton & Company 

as SBA’s auditor gave unqualified audit opinions on SBA’s Fiscal Years 

(FY) 2000 and 2001 financial statements, and that we are reevaluating 

those opinions.



We agree with these statements. GAO’s report will, however, provide a 

more fair and balanced presentation of the facts and have a more 

positive effect if it also explains the:



Need for and inherent risk associated with accounting estimates.



Inherent complexities in making credit reform estimates, particularly 

loan sale cost estimates.



Lack of comprehensive implementation guidance provided to agencies in 

these complex areas.



The need to strengthen authoritative implementation guidance is equal 

in importance to issues noted in the draft GAO report.Further, the 

importance of these points is illustrated by the fact that many 

organizations and experts, including GAO, previously reviewed SBA’s 

estimation procedures year after year and did not identify an important 

weakness in SBA’s disaster loan model. That weakness made the output of 

that model unreliable when substantial loan sales were undertaken and 

contributed substantially to issues raised in the draft report. These 

matters are addressed in more detail in the balance of this letter.



GAO’s report should also make clear that no evidence exists that the 

financial statements were intentionally misstated.



Accounting Estimates, While Necessary, Are Inherently Uncertain:



The auditing profession, through its guidance, has long recognized that 

accounting estimates are both necessary and carry a higher degree of 

risk than accounting information that consists solely of factual data. 

Credit reform requires program managers to estimate the cost of loans 

based on assumptions about loan performance. In this instance, SBA is 

required to make assumptions about both the terms of loans that will be 

made to individuals and businesses that have suffered losses from 

natural disasters and about performance of these loans over time.



Such estimates could be made in many ways. OMB circulars and FASAB 

accounting standards provide broad standards and principles stated in 

conceptual terms. Auditors must, however, judge the reasonableness of 

credit-reform estimates underlying financial statements in a context 

where little or no practical guidance exists to help agencies make 

them.



In the absence of published guidance, SBA, in consultation with others, 

made a determination about specific requirements for a cash flow model 

and developed one based largely on historical data. SBA’s model, once 

developed, subsequently was critically evaluated at various times as 

follows:



SBA contracted with a number of reputable outside experts to provide 

independent validations of the models. Those experts provided reports 

of their results (which we evaluated without exception) that did not 

mention the issues GAO now notes.



OMB staff annually reviewed and approved the models prior to each 

year’s budget submission.



GAO reviewed our work papers and the models and gave us advice on 

testing the models (which we adopted).



Cotton & Company, as part of the financial statement audit, reviewed 

the models according to auditing standards for accounting estimates.



How the Accounting Estimates Were Audited:



Recognizing the necessity and inherent uncertainty in accounting 

estimates, we performed substantial evaluations of SBA’s estimating 

methods and tested their results. In the audit for FY 2000, we found 

that book value losses on disaster loan sales were not included in the 

disaster loan subsidy:



reestimates. To account for this cost, we recommended that the 

financial statements include an imputed subsidy reestimate of $468 

million, which was the estimated amount needed to cover these losses as 

SBA had computed them. SBA accepted this recommendation and recorded an 

adjustment within its financial statements.



In FY 2001 audit, we found that cash flow estimates included, for the 

first time, effects of loan sales, but that these reestimates were 

substantially smaller than expected based on previous work. To resolve 

this apparent inconsistency and determine if it had caused the debit 

balance in the allowance for subsidy cost, we requested that SBA 

perform additional analysis of its subsidy estimates. That additional 

analysis generally confirmed that the subsidy estimates were consistent 

with balances in the financing account.



We believe that our audit work met professional auditing standards. 

Indeed, GAO itself reviewed our work in these areas and, prior to the 

subject report, did not bring this matter to our attention. Moreover, 

GAO’s draft report states that Cotton & Company, during its audit of 

SBA’s FY 2001 financial statements:



... 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.



The procedures GAO cites constitute the principal auditing procedures 

required for auditing accounting estimates.



Post-Audit Discovery of Limitations in the Accounting Estimates:



We realize now that the methods used to estimate the disaster loan cash 

flows have an important limitation. A key premise of the cash flow 

model is that one illustrative loan can serve as an effective proxy for 

all loans made to individuals, and another illustrative loan can do the 

same for businesses. At the time that the single proxy premise was 

adopted, loan sales were not anticipated. The effect of loan sales on 

this premise was not considered until recently, even though OMB, GAO, 

outside consultants, and Cotton & Company reviewed and thoroughly 

evaluated the cash flow model.



General agreement now exists that the premise became inadequate when 

substantial loan sales began. It did so because a single proxy loan 

cannot produce realistic cash flows when the:



Portfolio is diverse.



Cost of any loan increases with the loan term (terms vary from 1 to 30 

years). Average term of loans sold is several years longer than that of 

the original portfolio.



Moreover, a single proxy cannot simultaneously represent loans sold and 

loans kept. This led to imprecise estimates in both categories and 

contributed substantially to the issues noted in the GAO report. Until 

SBA revises its model, the effect of imprecise estimates on the 

financial statements cannot be measured. As a result, we cannot 

determine if they have a material effect on the financial statements.



Because of the subsequent discovery that SBA’s estimates in the FYs 

2000 and 2001 financial statements may not be materially correct, we 

have concluded that our unqualified opinions on those financial 

statements should no longer be relied upon. We are taking steps in 

conformance with auditing standards and with SBA’s assistance to 

withdraw those opinions and issue disclaimers of opinion on those 

financial statements.



Recommendations:



The fact that extensive reviews took place without disclosing this 

problem suggests that there is insufficient information about how the 

concepts related to loan sales should be applied in practice. The main 

sources of guidance are OMB Circular A-11 and the FASAB accounting 

standards (SFFAS Nos. 2 and 18 and Federal Financial Accounting and 

Auditing Technical Release No. 3). These documents focus on broad 

budgetary and accounting concepts and do not discuss implementation 

issues in a systematic way. Technical Release 3, which provides 

substantial and practical guidance in many areas, does not include 

guidance regarding standards for cash flow estimates involving loan 

sales or the treatment of loan sales generally.



Among other things, additional guidance is needed regarding:



How the book value of loans should be determined when cash flow 

estimates are not made on a loan-by-loan basis (which is the most 

common case).



Minimum requirements of cash flow estimates to meet loan sale 

requirements.



The relationship between the calculation of a hold value for loan sales 

and routine subsidy calculations for other purposes.



These are important topics, and they are central to the measurement of 

the cost of federal credit programs in general and the cost of loan 

sales in particular. We encourage further discussion of this subject 

and will welcome the opportunity to make specific suggestions.



Looking forward, three things need to be done:



In the short term, agencies should be advised to determine if cash flow 

models they used for initial subsidy estimates are adequate for 

estimating the cost of loan sales. Such an advisory may help other 

agencies avoid the problems identified in your report.



OMB and FASAB need to provide guidance on how the concepts laid out in 

OMB circulars and FASAB accounting standards should be applied in 

practice.



SBA needs to improve the cash flow model for disaster loans.



We commend GAO’s effort in evaluating these complex and cutting-edge 

issues. Actions taken as a result of this evaluation and report will be 

valuable to other agencies and should improve the overall usefulness of 

federal financial statements. Thank you for the opportunity to review 

the report and provide our views.



Very truly yours,



By:



Charles Hayward, CPA, CFE, CGFM, CISA



Signed by Charles Hayward



[End of section]



Appendix 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.



[End of section]



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.



FOOTNOTES



[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.



[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.



[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.



[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.



[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, § 31001, 110 Stat.1321-358 

(1996).



[10] The 7(a) program is established under section 7(a) of the Small 

Business Act, 15 U.S.C. § 636 (2000 § Supp. 2002). The 504 program is 

established under Title V of the Small Business Investment Act of 1958. 

See 15 U.S.C. § 696 et seq. (2000 § 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.



[13] Federal Credit Reform Act of 1990, Pub. L. No. 101-508 § 13201 

(1990), 2 U.S.C. § 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.



[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.



[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.



[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.



[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.



[23] Similar loans refer to loans with comparable maturities, 

prepayment risks, and default risks.



[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.



[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. § 2605 (b), (c) (2000 § Supp. 2002). The 

act does not specify how long the toll-free number should be 

operational following the transfer of servicing.



[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.



[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.



[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.



[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.



[31] Statements on Auditing Standards, AU §508, paragraphs 22 and 23.



[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.



[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.



[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.



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