everyone loves reading about loan guarantees

I had a little bit of back and forth with Tim on Twitter about Solyndra and loan guarantees. When I first came to Sunlight I worked on Subsidyscope, and while I wouldn’t want to claim deep expertise on the subject, it’s certainly the case that I used the phrase “loan guarantee” several thousand times more frequently than the average pre-Solyndra American. I have no interest in defending Solyndra or the specific decision to subsidize their work, but I think at least some of the interest in this issue is driven by genuine confusion about this subsidy type and not cynical partisan scandal-seeking.

Subsidyscope has a great explanation of how loan guarantees work; you should have a look at it. But wouldn’t it be wonderful if there was a metaphorical version available that was full of folksy nonsense? I thought so, too.

So let’s say the government needs some dynamite. Maybe Capitol Hill has some stumps to clear; maybe the Vice President is going fishing. Whatever the reason, there’s a problem: the market isn’t supplying enough dynamite for what they have in mind. In fact, a 22 year-old intern at GAO has recently estimated that we will need the output of fully three more dynamite factories to reach the necessary supply level (though he is also quick to point out that all of his input data is of terrible quality; that dynamite experts express varying opinions; that more research is necessary; and, of course, that Challenges Remain. His report does have a rather nice introduction about the history of governmental involvement in the explosives industry, though).

Fine, maybe we ought to build some dynamite factories. Not so fast! Each factory costs $1 million, which also happens to be the entire amount available at current GSA fishing trip reimbursement rates. That won’t get the job done!

Luckily, the market can help us out. It turns out that there are businessmen interested in building dynamite factories. The problem, as any dynamite entrepreneur will tell you, is that any such a factory has a 25% chance of blowing up shortly after the ribbon-cutting ceremony. Unfortunately, the current state of the market makes this an unacceptable risk, what with all the regulatory uncertainty and undocumented workers and job-killing health care bills and whatnot. The businessmen wish they could help, but right now there’s simply no way they can justify building those factories. If a factory exploded, its owners would be ruined.

“Aha!” says the government. “I know what we can do! We’ll just pick the four most promising dynamite factory proposals and tell their authors that if they go ahead with building, we’ll promise to cover the cost of their investment if their factory explodes.”

With this guarantee in hand, the businessmen proceed. They build four factories. One explodes. Whoops! Don’t worry, no one was hurt and it looked pretty rad. Uncle Sam cuts a check and everyone’s happy. The government has now spent a million dollars and gotten the three factories it needed. Nice! If they had tried to build a factory themselves, they could have only afforded one — really, three-quarters of one, since it might have blown up (some say government-built dynamite factories are even more prone to this defect that those of the private sector).

So this is the idea: that the government can offer guarantees that tip unacceptably risky — but not totally foolhardy! — economic activity over into the realm of realization. The government is using its unique powers to shift risk instead of shifting resources directly. Sometimes shifting risk can allow money to flow through the economy in new and desirable ways. And it’s often dramatically cheaper than spending funds directly to achieve the same result.

In some ways this is a very efficient way to spend subsidy dollars. In others, not so much: you’re picking winners, you’re shoving money into the finance system where some will be skimmed off, you’re relying on risk estimates which sometimes just aren’t that good. CFDA.gov lists 68 such programs right now; here’s one that helps build ships and shipyards. Here’s one that subsidizes the purchase of Boeing aircraft (note that in this case the default costs are balanced by gains from interest on successful transactions).

I haven’t followed the Solyndra story very closely, but my understanding is that changing market conditions overtook their business very rapidly. The financing pipeline supporting them should have noticed this and shut down but didn’t, either because of bureaucratic inertia or special favors or both. That’s unfortunate. Luckily, the government’s total exposure is likely to be much less than the $500 million face value that’s being widely cited, and the final cost of the program that administered the loan guarantee is likely to be a small fraction of the face value of the lending it enabled.

All of this is a separate question from whether the government should be intervening in the economy in this manner. I think that’s a conversation worth having. But it should be a conversation about programs, not transactions. To focus on one failed loan is a bit like pointing to a lottery winner and saying, “That’s how they think we’re going to pay for our schools — by handing out checks? What a bunch of dopes!” But of course this ignores the bigger picture. Perhaps there is a problem with that lotto payout, but that’s a different and frankly less important issue than whether it’s wise for the government to run a lottery. This is why the intense focus on Solyndra strikes me and many others as a transparently partisan feeding frenzy rather than a considered discussion of energy policy.

15 Responses to “everyone loves reading about loan guarantees”

  1. Megan McArdle

    This assumes that the capital markets won’t support risky ventures, which isn’t true. The financial structure won’t be the same as a conventional low price bank loan, but the capital’s there–if it weren’t, MCI and Sprint would never have been able to build out their backbones.

  2. Tom

    No, it just assumes that there are some ventures that are too risky to find affordable financing (it’s simplest to imagine that loans are available for any amount of risk, at correspondingly increasing cost — reality is probably not this continuous). These ventures are close to but not quite at the margin of feasibility. If government drains away some risk, they can find financing that’s cheap enough for them to make money if they succeed. That’s the idea behind loan guarantees.

    Obviously Solyndra wasn’t all one or the other, as it had found some money prior to DOE’s involvement. The situation may be more complicated in their case — as I said, I haven’t followed it closely enough to say.

  3. Megan McArdle

    When loan financing is too expensive, you do equity financing (which is what they did prior to the loan; their private finance was ultimately about twice the value of the loan). It’s certainly true that you can’t get bank loans for things with a high likelihood of melting down, but the capital markets can definitely handle a $500 million capital raise for a promising company, or even a portfolio of promising companies. The point at which the delta between a guaranteed and an un-guaranteed loan rate is the difference between success and failure in a new venture is the point where either you’re taking on way too much debt, or your venture is fairly unlikely to succeed.

    It’s totally true that loan guarantees are an excellent way for the government to leverage money that it wants to spend on, say, building solar power manufacturing plants. But that is not proof that the government needs to spend this money because without it, excellent projects will languish. If people want to buy solar panels at a price commensurate with their manufacturing price, capital will be expended to build plants to make them.

    If you think that people will not wish to purchase the output, and that this is a bad outcome, then we should subsidize the output. That way, we still mobilize lots of private capital, which gets invested to meet demand, but we’re not picking corporate winners–and more importantly, that way, we’re ensuring that the outcome is the actual one we want, which is more installed solar panels. With Solyndra, we got an empty building (which burned carbon and resources in construction) and a big stack of solar panels sitting in a warehouse that are apparently now hard to sell because there’s no company to guarantee their lifespan.

    I’d argue that loan guarantees only look sensible because of government accounting, not from an economic perspective. I can certainly buy the argument that if it’s politically infeasible to tax carbon, subsidies may be a necessary second-best. But I don’t think that loan guarantees are the way to structure that subsidy.

  4. Tom

    Well, again, I’m disinclined to debate the merits of the Solyndra case, both because I haven’t been following it closely and because I think it’s beside the point.

    You’re of course right that there are various types of financing available. But like everything else they exist in equilibria of costs and benefits. I don’t really want to get into a debate about which financing mechanism is appropriate in which circumstance — I’m not qualified to say — but it seems obvious that the choice depends on the situation.

    I take it you feel that if something is worthwhile, the market will find a way to finance it. This is a coherent line of thought in a post-hoc analysis, where everything is a good or a bad idea, and should have been funded or not. But it ignores the role of uncertainty, and the difficulty of precisely quantifying risk — which of course is the whole point. There’s a reason that the literature classifies loan guarantees as a form of “risk transfer.” You are essentially arguing that the existence of other forms of financing mean that a marginal business loan does not exist. I just don’t buy that.

    I agree with you that loan guarantees are as prevalent as they are because they are politically palatable, and that this is not ideal. Given our structural deficit, negative subsidies should pretty obviously be our first-line approach to jiggering with the economy over the long run. Still, I’m not sure that I agree that LGs are an accounting trick. The long-run viability of entities like Ex-Im argue against that idea. Certainly I think they’re not benefiting from any such illusory advantage right now, with every media outlet in the country gleefully quoting the Solyndra loan’s face value in a misleading way.

  5. bill shoe

    Author assumes dynamite shortage without realizing he is assuming shortage. This implies lack of understanding regarding difference between scarcity and shortage. Why is author’s hypothetical market not able to supply dynamite at market clearing prices? Must begin to address this basic issue before considering other things.

  6. Tom

    bill: as I tried to jokingly make clear through the allusions to the fictional GAO report’s shortcomings, I am starting from a posited desire by the government to induce some particular economic activity. They have decided they want more dynamite factories/solar panels/green jobs/whatever. Now: how do you spend money to make that happen? That’s all I was suggesting. In reality I am sure the dynamite market is perfectly able to keep up with Mr. Biden’s needs.

  7. bill shoe

    If the market is able to keep up with Mr. Biden’s needs then you assume normal scarcity. This means any government loan subsidies will necessarily create a dynamite surplus.

    I don’t want to ponder the best way for the government to create a dynamite surplus. I want you to explain why the government should create a dynamite surplus in the first place.

    It’s true you make the initial assumptions a bit tongue-in-cheek, but you follow them to conclude seriously (I think) that the government should output money by creating surpluses. I think this means the assumption and its context are valid considerations.

    If the government wants to output money through inefficiencies such as a surpluses then many approaches, including loan subsidies, will “successfully” accomplish it. You’ve simply defined success down until it matches actual results.

  8. Solyndra and the Dubious Benefits of Loan Guarantees | Bad Credit Loan Bank

    […] to expand upon Friday’s post a bit, because I had a blog conversation with the excellent Tom at Manifest Density which bears on the subject. All of this is a separate question from whether the government should […]

  9. Tom

    bill: I’ve specifically refrained from making a judgment about whether subsidizing solar energy production/dynamite is a wise idea. That’s not the point of the post.

    I understand what you’re saying, but bear in mind that literally everything the government does distorts the economy in one way or another. Even a nightwatchman state will be subsidizing markets for guns, badges and silly-looking hats. You can have this conversation about everything the government does. I bet you and I have different opinions about what the government should be doing, but I’m not really interested in getting into the specifics of all that.

  10. Kristo Miettinen

    Tom,

    Providing illustrations (more allegory than metaphor, I think) is valuable – keep it up. But I think that your dynamite-factory example needs work.

    There is a key difference between course of action A (guarantee four loans) and course of action B (build a dynamite factory) besides the three – vs – one (or ¾) issue that you focus on. The other difference, and this is a whopper, is that under COA B the government owns the factory. Under COA A the factories needed to satisfy the government’s appetite for dynamite are built, but the government has no claim on their output. Under COA B the government can satisfy only 1/3 of its need, but at least it can do that much.

    Given efficient pricing, the total cost to the government of securing the dynamite it needs will be the same regardless of how the government goes about doing it – guaranteeing the loans and then buying the output of the new factories, or building and operating factories for itself. The question of whether to do it one way or the other turns on presumed inefficiency of pricing: does the government have inside information that lets it price some item of risk, or investment, or spending, differently than the market? If so, then the government should act so as to secure for itself the benefit of the price difference, thereby incidentally sharing its inside information (i.e. affecting market prices).

    If nobody has any inside information, then there is no reason for preferring one COA over another. But what kinds of inside information might exist that would allow the government to benefit from a pricing inefficiency? The most obvious inside information that the government has is information about its appetite for dynamite in the first place. This inside information has nothing to do with the probability of a dynamite factory blowing up, and therefore shouldn’t affect the price of risk associated with a loan guarantee, but it does affect anticipated future pricing of dynamite – a new substantial consumer is known to the government to be about to enter the market. Under these circumstances, the smart money (in this case the government) would benefit from positioning itself as a dynamite supplier before the market learns of the government’s intentions and the prices of dynamite precursor chemicals and dynamite factory components rise.

    On the other hand, it is also possible for the existing dynamite industry to have inside information. For instance, perhaps only dynamite companies have the technical expertise to realize that because of new EPA regulations banning explosive-stabilizing additives, newer “green” dynamite factories are going to be more likely than legacy factories to blow up, perhaps 1 in 3 instead of 1 in 4. Under these circumstances, the government will mis-assess the expected cost of loan guarantees, and the dynamite companies can secure financial advantage by suckering the government into such guarantees based on analysis of historical but misleading loss rates.

    So what is government to do in the general case? In general, sound investments are distinguished by the most knowledgeable parties being willing to accept the greatest risks (in return for a favorable negotiated share of expected returns), and having the smart money shun risk in a shared investment is a sign that the whole enterprise is probably a negative NPV proposition. So the government should use loan guarantees when it thinks it knows the risks better than the investors it is dealing with, but shun them otherwise. Government information superiority will rarely be the case when loaning money to specific companies like Solyndra, which are too small for the government to have any special knowledge about them at all.

  11. Tom

    I think you missed the point of my example, Kristo. The need for dynamite is just a narrative device. The result that the government is trying to produce/induce is the creation of the factories. That is the limit of the example’s relevance vis a vis loan guarantees. “Congressman X has decided 3 factories need to be built” would be equally correct, though a bit less amusing.

  12. Kristo Miettinen

    No, I think I got it – unless you really mean that the government wants to induce the creation of factories without wanting the output thereof. But I don’t think that’s what you mean. The factories are just a means, the dynamite is the end. Right? You begin the problem statement with “So let’s say the government needs some dynamite…”

    My point then is that in a fictitious world of perfect shared information (i.e. a world where market prices are efficient) the total cost to the government of the dynamite is the same regardless of how the government procures it – by subsidizing the risk of building new plants, by building its own plants, etc. Your example doesn’t recognize this because you don’t add up all the costs of procuring the dynamite. Under COA A you consider the cost to the government of one strategy for supporting the building of factories, but the government is still left needing to pay additional money to buy the dynamite itself. Under COA B you consider the cost to the government of a strategy for building a fraction of the capacity it needs, but not the full capacity, and not the costs of operating the plant(s). In each case the total costs to the government will be the same once you carry the analysis to the end (to dynamite in hand), unless there are information inequalities (which there always are).

    Given information inequalities, the relative imbalances in knowledge determine the proper risk acceptance postures of the relevant players (government and industrialists).

  13. Tom

    Actually yes, for purposes of this example it’s perfectly fine to say that the government decides it doesn’t want any dynamite after all. Someone decided that more dynamite factories is a desirable policy goal, so they pushed for it. This is a situation more closely analogous to Solyndra, anyway — the LG wasn’t made to lower the price of solar for government purchases.

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  15. Kaleberg

    Even if the full risk was $500,000,000, why is everyone making such a fuss? You can barely hire a hedge fund manager for a full year on that. Let’s talk about real money.

    P.S. We’d still do better with a failed solar company than a hedge fund manager. When a tech company fails, you get scads of engineers who learned a lot of valuable lessons both about how to do things and how not to. Tech recruiters call this scar tissue, and serious tech firms want engineers with scar tissue. The space wasters, like Dilbert’s home company, go for spec matching. It’s this non-book learning that pushes things in a way that tech transfer from universities to the field cannot. A good example was Henry Ford, who worked on electric cars at Detroit Power, then decided to make Otto cycle driver automobiles having learned the business at DP’s expense.

    P.P.S. Don’t overrate the risk taking abilities of the capital market. Private companies, even venture capital firms, are amazingly risk averse. EVERY major new technology has required government backing. Who else but the government would have come up with the idea of burying perfectly good food in the dirt and found agriculture?

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