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This concern led us to testify on coastal zone legislation before the Senate Subcommittee on Oceans and Atmosphere earlier this year. Copies of that testimony, which focuses on criteria by which to measure any proposal for federal credit assistance rather than endorsing any single method of financing, are enclosed and hereby submitted for the record.

Since the language pertaining to financing in the bills currently before your subcommittee is similar to that in the Senate bills, there is little we could add by a separate appearance. However, we would be delighted to answer questions or provide any assistance we can.

Respectfully,

Enclosures.

STEPHEN K. SMALL, Municipal Legislative Counsel.

STATEMENT BY THE INVESTMENT BANKERS ASSOCIATION OF AMERICA

I am Frank Smeal, Vice President and Treasurer of Morgan Guaranty Trust Company, New York City, and Vice President for Municipal Finance of the Investment Bankers Association of America. I am accompanied by Mr. John Petersen, Director of Municipal Finance, Investment Bankers Association of America.

We are authorized to testify on behalf of the more than 600 investment firms-both securities dealers and banks-who underwrite and make secondary markets for bonds of the 50 states and their political subdivisions. They have extensive experience and expertise in financing State and local government capital needs. Our member firms also underwrite and make markets in the securities of corporations and the Federal government, including its agencies. Because we serve as bankers and dealers in all debt instruments, we believe that we are objective in our appraisal of the effects of proposals to finance programs through the use of Federal credit assistance.

What we have to say deals with the way in which the capital expenditure portions of the Coastal Zone Management program might be financed. In particular, what should be the joint roles of State and local debt-financing and Federal aid in this effort? That is an important question because we believe that how this program to protect and to enhance our natural environment is financed has very great consequences for another environment which we all inhabit, our financial system. This system too has an “ecology", a complex relationship with balances and limitations. The original savings which our economy generates to preserve itself and to grow is a limited resource, capable of being exploited, overworked, and neglectfully taken for granted. In order that our selection of priorities be effective rather than empty, a continuing problem for public policy is the generation of ample savings and their employment in the most efficient manner. Alternative ways of financing Federal assistance must be examined in terms of meeting that larger problem as well as the program purpose immediately at hand.

In our testimony this morning we shall examine several aspects of the Ioan guarantee program as set forth in Section 307 of both S. 582 and S. 638. First, we shall briefly describe the technical content of this section and point out how it differs between the two measures. Secondly, we shall examine the overall growth and implications of Federal credit activities and indicate the fundamental policy questions that existing and proposed forms of Federal credit assistance raise. These we believe are especially important when such assistance is extended to State and local governments. Third, we shall review what we believe to be useful criteria that should be met in the design of such assistance programs, the most important of which we feel is the demonstration rather than the presumption of need. Last, we shall discuss what we think may be the preferable alternative methods of financing Federal assistance on both the current and capital accounts.

Before beginning our examination of the capital financing provisions set forth in S. 582 or S. 638, I want to stress that we have not come to judge the overall substance or desirability of either of these bills or their merits in comparison to other measures beyond that section of the program dealing with the mechanics of the credit assistance program. Thus, our assignment today is a very specific one. It is up to this Committee and this Congress to decide the relative priorities in this program, the intensity with which the needs are felt, and the degree

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to which the Federal government should commit its resources to meeting those needs. Our sole aim is to provide this Committee with what we believe to be an informed viewpoint on the alternative ways in which program objectives may be met, once the dimension and directions of those objectives have been determined.

If we do testify today with a special conviction and predilection, it is that the private capital market should be given every opportunity to continue to operate as fully and effectively as it has and it can in meeting the diverse credit needs of the 80,000 State and local governments. Beyond that, to the extent that particular needs are shown to exist, Federal credit assistance should be designed with those specific needs in mind and it should be implemented fairly and effficiently to meet that objective without penalizing or circumscribing unnecessarily the operation of that market.

CONTENTS OF SECTION 307

As now written, Section 307 of both S. 582 and S. 638 sets out broad powers of the Secretary of Commerce to “guarantee the bond issues and loans of coastal States for purposes of land acquisition or land and water development and restoration projects." The amount of the aggregate principal of outstanding guaranteed loans is limited to $140 million. The only difference between the two measures is that the terms and conditions of these guarantees are prescribed by the Secretary of Commerce in S. 582, whereas the Secretary of the Treasury has those prerogatives in S. 638.

In view of the brevity of Section 307, the terms and conditions specified by either the Secretary of Commerce or of the Treasury will be of overriding inportance in determining which and to what extent projects will be aided. The policy question arises whether these guarantees are intended to assist specific "hardship cases" for projects containing unusually high elements of risk or are intended to lower generally the costs of borrowing for the above purposes. Federal guarantees act to raise the credit standing of all borrowers to the highest level. Therefore, Federal guarantees are of greatest benefit to those projects that would otherwise pay the highest rates of interest. They contain the greatest element of subsidy when applied to such cases. However, if such guarantees are intended to assist all borrowings undertaken for Coastal Zone Management purposes, the authorized ceiling may well be insufficient to meet the demand, in which case the guarantees will have to be rationed among wouldbe claimants by the Secretary of Commerce. Therefore, the purpose of the guarantee and the probable scope of need should be clearly ascertained and the appropriate criteria for their dispersing should be incorporated into the legislation.

Secondly, Section 307 is silent on the point of what happens in the case of default. No specific authorization or other provision is made for the making good the amount of the guarantee in such an event.

Third, in S. 638 there is a division of responsibility for the guarantee program between the Secretary of Commerce and the Secretary of the Treasury. Since the former is charged with the execution of the program while the latter has the allimportant prerogatives of specifying the terms and conditions of such guarantees, there is the possibility of disagreements and, correspondingly, lapses in program implementation.

Aside from the need for a greater precision in setting out the objectives of this Section and for an explanation of the procedures to be followed in making guarantees, we would say that the bond guarantees envisaged in Section 307 have certain advantages over other methods of credit assistance that might be suggested. First, the Federally guaranteed security is familiar in our market, since this form of assistance has been used in other selected areas and similar instruments used for housing nd various other selected purposes are well known and widely traded. Furthermore, this form of assistance does utilize the existing market mechanism for its implementation and does not depend upon the creation of new credit institutions or banking procedures. Lastly, they are selective in the sense that they do give the greatest benefit to those projects with intrinsically the greatest risk and lowest investment quality.

The choice of how much and what kind of credit assistance is a very important one. This is not only because of the microeconomic implications of efficient funding for specific projects, but because the rapid expansion of all Federal credit assistance has important implications for the entire economy. Moreover, the

application of these programs to the State and local sector in particular raises important questions relating to the proper balance of autonomy and mutual responsibility among the major levels of our Federal system of government. Before examining the relative merits of alternative forms of such assistance, we should like to review some of the larger issues involved.

PROBLEMS WITH FEDERAL CREDIT ASSISTANCE

There is already a large army of Federal credit assistance programs that are growing at an exponential rate and dramatically changing the composition of credit flows in the economy. A key reason for this rapid growth has been that this form of financing permits the instatement of large new programs without the resulting expenditures being reflected directly in the budget.

Quite apart from the usefulness of the underlying purposes hereby financed, there are many problems with this method of program finance.

Before reviewing the ramifications of these, we should like to discuss the massive dimension of these programs. As the chart from the Special Analysis of the Budget indicates, total Federal credit assistance outstanding will have grown by 250 percent over the last 11 years, from $100 billion in 1960 to a contemplated $250 billion in 1972. While that part reflected in the budget will have grown hardly at all in the last four years (approximately $50 billion outstanding from fiscal 1968 through fiscal 1972), that part off the budget will shoot from $100 billion to over $200 billion, thereby doubling in four years. In fact, between fiscal 1971 and 1972, direct budgeted loans will increase by $2.7 billion, while off-the-budget loans will grow by $28.7 billion.

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Source: The Budget for Fiscal Year 1972: Special Analysis, Page 83.

NET FEDERALLY ASSISTED BORROWING FROM THE PUBLIC INCLUDING GOVERNMENT-SPONSORED AND GOVERNMENT-GUARANTEED AGENCIES

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Sources. Federal Reserve flow of funds. The budget for fiscal year 1972: Special Analysis, table C-8. Manufacturer's Hanover Trust Co., economic report, February 1971.

How does this $31 billion increase in Federally-assisted credit fit into the total credit flows of the economy? The accompanying table gives some indication of this by comparing net financial capital flows (funds raised) to that amount absorbed by new direct Federal and Federally-assisted borrowing. This fiscal year it appears that the Federal direct and assisted share of new capital raised will be over 30 percent. In fiscal year 1972, if the budget deficit requires $15 to $25 billion in public borrowing, as many observers think, and if Federally-assisted credit programs grow by approximately $30 billion, as is scheduled, then the combined total of Federally-assisted and direct borrowing will be $45 to $55 billion. This would represent approximately 40 percent of all net credit demands placed on the capital markets in the next fiscal year. By fiscal 1972, the combined $525 billion in publicly-held outstanding Federal direct and assisted obligations will equal about one-half of the GNP in that year.

Such a rapid explosion of Federal credit demands should be of paramount public concern, especially given the fact that the bulk of it is beyond the pale of budgetary review and control.

1. Federal credit assistance as a circumvention of the budget review and control Federal credit programs can distort the budget as a document for orderly choice among program priorities and as an instrument for economic control. The problem arises from the way in which the government has chosen to keep its books and a peculiar accounting convention that encourages the concealment of Federal credit activities.

The principal attraction is that large amounts of resources can be allocated without immediate budgetary impact. Guarantees are viewed as costless (except in the case of defaults or defaults that are only staved off by elaborate refunding or grants). Subsidized borrowing through agency borrowing or loan sale operations requires seemingly small apropriations to cover the debt-service subsidy. However, of course, these subsidies (and the attendant administrative costs) grow through time, and each fresh crop of new commitments brings higher future levels of outlays and contingent obligations. Thus, programs build in uncontrollable expenditures that snowball through time and reduce the latitude available to future Congresses and Administrations. And the budget-because these items are excluded-no longer shows the economic plan of the government or its pervasive influence over resource flows. This in itself is bad. But, when the fact is that putting expenditures outside of the budget has come to be a positive virtue, things are worse yet.

2. Federal credit programs often involve awkward, expensive, and discriminatory financing arrangements.

Much Federal credit assistance is awkward and expensive as a method of financing. In pact, this problem is a product of the multitude of programs and varieties of securities which the Federal government sponsors. Although explicitly or implicitly these all constitute Federal obligations, they command varying rates of interest as they compete with one another as well as other securities. For example, in 1971 Federally guaranteed loans typically carried gross yields of 91⁄2 percent (while borrowers, after subsidy, paid rates ranging from zero to 6 percent). Federal budget and nonbudget agencies that year borrowed at rates between 7 and 9 percent, while direct Federal lending generally commanded still lower interest rates.

Some programs are financed by sales of loan assets to private investors as 100 percent obligations which do not appear as budget items. This device may be used by agencies that have no lending or borrowing authority of their own; but a relatively small amount of seed capital placed in a revolving fund can be converted into a large-scale loan-brokering operation as the fund is turned over several times a year. All of the additional financing costs the absorbed by the Federal government, including the servicing of the loans, after they are sold. These programs are thus able to influence the flow of credit and allocation of resources outside the discipline of the budget. Moreover, this is done without taking advantage of the most efficient means of financing: direct Treasury borrowing.

A related problem is that some programs not only assist borrowers but may actually elevate them above the impact of both monetary and fiscal policy and reward them with unintended and unwarranted gains from inflation and credit stringency.

3. Federal credit programs are preemptive in their demand for credit and generate heightened competition for funds and higher interest rates.

In effect, Federal agency lending operations take would-be debtors that have been price-rationed out of the capital markets and reinject them as an Agency borrowing with Federal government backing. Since these programs do not increase the total supply of savings in the economy, their operation merely pushes the pressures along. Market rates of interest go up to create a new margin of hardship cases in some area that is not insulated.

It is patently incorrect to argue that a reshuffling of securities by Agencies lending operations, such as the proposed Environmental Financing Authority, in some fundamental way lessens the pressure for all credit markets by recycling the rationing process at the new, higher interest rates needed to ration the limited supply of credit. Carried to extremes, it will simply accentuate the overall financing problem for State and local governments and everyone else by driving up rates of interest.

4. Federal credit programs can be perverse in their impact on monetary and fiscal policy.

One of the ironies involved in proposals for credit assistance is that the greatest pressures for such assistance develop in times of restrictive credit and high interest rates. Yet at that very time, the infusion of an additional demand and a reducing of the interest sensitivity of greater amounts of borrowing exacerbates the problem of bringing the economy under control. At such times, when monetary policy is forced to work overtime to curb demands by squeezing out would-beborrowers, the injection of new, strongly-positioned demands by Federal agencies intensifies the restraint. Other borrowers-of lesser priority perhaps only because they are unknown or unrepresented-are forced out by a pocess which drives up all interest rates. Unless we give every worthy borrower a Federal subsidy or guarantee or Agency loan, we must come to realize that in times of credit stringency, capital market demands must be lessened, not intensified. This is done by encouraging savings and by financing out of current revenues. To the argument that such action requires raising taxes or making hard choices among expenditures, it must be replied that those who borrowed (or could not borrow) because of the recent high interest rates in effect did pay taxes. These taxes are collected in the form of higher debt service costs and fewer houses, public facilities, and other investment opportunities that are priced out of the market.

5. The ultimate influence of Federal credit programs on credit flows and resources is unclear and may be counterproductive.

Federal credit assistance is necessarily discriminatory and certainly stimulative of total credit demands. But our knowledge of the longer-term consequences-the details of restrictive credit and resource flows and their economic and political implications-remain hazy at best.

The answer that these credit programs merely rechannels existing credit flows misses the point.

As we and others have repeatedly pointed out, any rearranging of credit flows as a means of levering resources from one use to another always involves a loser who has been bid out of the market. Just as the budget does not reflect the beneficiaries of these programs, neither does it disclose the activity that no longer takes place. The net results may be completely counterproductive.

The ultimate alternative could be one of scrapping a free capital market and the substitution of blanket Federal credit support. The only borrowers then would be those with "priorities."

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