Thursday, August 26, 2010

Direct Loans vs. Guaranteed Loans

Let's pretend for a moment that you're a bank.  You make money by loaning people money and them paying you back with interest.    So what stops you from loaning money to whomever wants it?  The risk is that the person won't be able to pay you back.  Let's say though, that some guy comes into your bank and asks for a loan, and tells you that his rich uncle will co-sign the loan.  You then do a credit-check of this uncle and find out that he has unlimited money.  That means no risk to you.  What a deal!  Just one question though, why doesn't that rich uncle just loan the guy the money?

That is my question when the government does so-called "Loan Guarantees".  Often when the fed wants to encourage a private enterprise they will guarantee their loans so that banks will lend them money.  The banks take the deal - there' is no risk to them after all.  The company then does their thing.  If they succeed the bank makes money and every body is happy - including the fed which owes no money.  If they fail, the bank is happy because they still get their money, but the tax payer is left with the bill.  If it's something worth doing, like researching a new technology, encouraging business in a poor area, or developing a natural resource, I don't mind risking government money on it for the greater good, but why give the banks a free ride?

If the congress thinks something is worth doing and banks won't loan the money, why not loan the federal money directly from our government?  Worse case scenario is that the enterprise fails and the fed is on the hook for the same amount as if it was a guaranteed loan, but if it succeeds, then the taxpayer can actually make money on the deal.  This seems like an obvious benefit to the fed and banks no longer get a free ride.

So why doesn't congress loan money directly?  My guess is that it's all about perceptions over the budget.  If congress guarantees a loan in 2010, it doesn't cost anything for the 2010 budget.  In fact, it may never show up on the budget if the enterprise is successful.  However, if the enterprise fails, it won't show up as a cost to the budget until years later.  Probably long after the president that approved it is out of office, the congressman that voted for it are now Senators, and the Senators that voted for it are dead or retired.  In other words, the people that agreed to guarantee it will be long gone by the time there's a default and it shows up on the U.S. budget.

So why not stop loan guarantees and start doing more direct lending.  There is a recent precedent where this was successful and the federal government came out ahead.  It was with student loans.  For a long time our government would guarantee student loans to get banks to loan to students for college.  The public benefit is obvious - a better educated work force is a more productive work force.  However, starting last year, the government quit guaranteeing those loans and started loaning directly to students.  Now, according to the non-partisan Congressional Budget Office, the fed is on its way towards saving billions of dollars a year thanks to this decision.

So, why not expand this to all services.  For the last month I've been reading about all sorts of programs where the government guarantees loans.  I think it's time for politicians to quit hiding our obligations in the short term, and save us some money in the long run.
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