Legislative Analyst's Office, January 16, 1998

Rethinking the Cal-Vet Loan Program
Part I

Background

The California Veteran Farm and Home Purchase Program, known as the Cal-Vet loan program, has provided more than 400,000 California veterans of various wars the opportunity to buy a farm or home through state assistance.

The Cal-Vet loan program is currently not competitive with other private- and public-sector loan programs which now offer better interest rates and terms. Significant financial and operational problems have eroded the state's equity (assets less liabilities) in the Cal-Vet fund by $200 million. Recently, the Department of Veterans Affairs has undertaken an effort to fix the program's major problems and stem Cal-Vet's financial losses. Nonetheless, the total number of Cal-Vet loans is likely to continue to dwindle. Veterans do have other growing needs that are likely to create pressure for more General Fund spending.

In the short term, the Legislature should:

  • Strengthen internal and external oversight of the Cal-Vet program to ensure its proper management.
  • Restructure the program so that future Cal-Vet loans could be issued at an interest rate different, if necessary, from the rate established for previous Cal-Vet borrowers. Other short-term program improvements should also be encouraged.

In the long term, the Legislature should:

  • Amend state law to direct the orderly phase-out of issuance of new Cal-Vet loans by the year 2007. This recommendation reflects (1) the declining nature of the Cal-Vet loan portfolio due to federal restrictions on tax exempt state bonds (which fund the loan program) and the aging of the war veteran population and (2) the availability of loans through the private sector and other governmental programs.
  • Subject to voter approval, direct surplus Cal-Vet funds to programs that will benefit both aging war veterans and state taxpayers. This should be accomplished carefully by means that ensure that all obligations of the state to bondholders are met and that the program retains adequate reserves to meet the requirements of the program.

LAO Findings

LAO
Recommendations

Background

Legal Authority for the Program

Program Creation. The California Constitution (Article XVI, Section 6) authorizes the use of state money or credit to help war veterans acquire or pay for farms or homes. In 1921, the Legislature created the California Veteran Farm and Home Purchase Program, known as the Cal-Vet program, to provide such assistance to the veterans returning from World War I. The program currently operates under the authority of the Veterans Farm and Home Purchase Acts of 1943 and 1974 and various bond acts set forth in the state Military and Veterans Code.

Since its inception 77 years ago, the state has assisted more than 400,000 California veterans of World War I and World War II, as well as those serving on active duty during the Korean, Vietnam, and Persian Gulf conflicts. The vast majority of state assistance has been provided for the purchase of single-family homes, although some farm and mobilehome purchases have also been financed through the Cal-Vet program. California is one of five states to operate such a program. The others are Alaska, Oregon, Texas, and Wisconsin.

A Home Purchase Program

Contracts for Loans. Technically, the Department of Veterans Affairs (DVA) operates a home purchase rather than a home loan program. The DVA purchases new and existing homes, farms, and mobilehomes that have been selected by an eligible war veteran. The state then resells the 

property in accordance with a contract requiring installment payments by the veteran. Despite this technical distinction, the program operates very much like a conventional home loan program. In effect, Cal-Vet makes home loans similar to those of other lenders. War veterans participating in the program make monthly mortgage payments just like any typical borrower.

All loans are only for owner-occupied property. Moreover, Cal-Vet does not refinance loans on property a veteran already owns. However, a veteran who received a Cal-Vet loan and paid it off may apply for a subsequent loan.

Statutory Purpose. Notably, state law does not explicitly mandate that the Cal-Vet program provide loans at lower interest rates or with easier terms than could be obtained from other lenders. Rather, the statutorily defined mission of the Cal-Vet program is "to provide veterans with the opportunity to acquire farms and homes." Historically, however, war veterans have often been able to obtain Cal-Vet contracts with more favorable terms than they would otherwise have been able to receive from private-sector banks or savings and loans. The DVA has adopted a mission statement declaring the purpose of the program as providing "low-cost, low-interest financing" to eligible veterans "to recognize the sacrifice and service of our veterans in the armed forces."

Except for some older loans carrying an interest rate of 4.4 percent and some mobilehome loans set at 9 percent, most borrowers currently pay the equivalent of an 8 percent interest rate under the Cal-Vet program. In accordance with state law, this interest rate is subject to upward or downward revision throughout the life of the loan by the DVA. By law, Cal-Vet may provide up to 95 percent of the financing needed for most home purchases, with the veteran providing a 5 percent down payment.

During 1996-97, the Cal-Vet program provided $143 million in financing for 967 new property purchases, for an average of about $148,000 each. The Cal-Vet program also provided about $2.8 million for 242 home improvement loans averaging about $12,000 during the same fiscal year.

State law also authorizes the DVA to operate several insurance programs in conjunction with the Cal-Vet program. Veterans participating in the program are charged fees to pay for (1) fire and hazard insurance; (2) a disaster indemnity plan covering losses for floods, earthquakes, and other perils; and (3) insurance coverage providing for repayment of the Cal-Vet loan in the event a veteran dies or becomes disabled. However, conventional property mortgage insurance is not now required for Cal-Vet loans.

Program Financing

Bonds Are Funding Source. The Cal-Vet program has been funded over its life through the sale of more than $9 billion in general obligation bonds and revenue bonds. The current outstanding state debt, which amounts to about $3 billion, is being repaid from payments made by Cal-Vet borrowers and cash generated from other investments of Cal-Vet funds. As of last year, the interest rate on the outstanding debt of the Cal-Vet bonds ranged from about 3.5 percent to 11 percent.

Roughly 90 percent of the outstanding debt for the program consists of general obligation bonds, so-called because the full faith and credit of the state is pledged for repayment in the event that contract payments from veterans were ever insufficient to pay the debt service. (This situation has never occurred.) California voters have approved 25 such bond acts, most recently authorizing $400 million in additional debt through Proposition 206 on the November 1996 ballot.

The remaining 10 percent of debt for the program has originated from revenue bonds that lack full state backing, and which are secured instead by a pledge of the fund into which contract funds from participating veterans are deposited. The sale of mortgage revenue bonds commenced in 1980.

As can be seen in Figure 1, the overall level of debt in the Cal-Vet program peaked about the beginning of this decade and his been dropping steadily since that time.

Noncallable Bonds. About $900 million of the current outstanding Cal-Vet debt—roughly one-third of the debt total—originated from the sale of bonds that are deemed "noncallable." Noncallable bonds contain provisions that prohibit the Cal-Vet program from paying off the bonds ahead of schedule. In addition, about $575 million in bonds contained provisions that prohibited prepayment until the last five years of the life of the bonds. About $1.5 billionof the debt is subject to being "called" and can be paid off at any time.

The proceeds of both general obligation and revenue bonds are continuously appropriated by state law, and are specifically exempted from the regular state budget process.

At the time this analysis was prepared, the DVA was proceeding with a major refinancing of its existing bond debt as well as the issuance of additional bonds. The transaction, when completed by May 1998, will amount to $1.6 billion in new and refinanced debt. The main purposes of the transaction are to (1) replace some older, higher-cost bonds with new, lower-cost bonds; and (2) make new funds available to finance additional home purchases for veterans. We discuss and comment on the DVA's debt transaction later in this report.

Program Eligibility

General Rules. The eligibility of veterans for the Cal-Vet home purchase program is subject to various state and federal restrictions, including the period of a veteran's military service, the duration of the military service, the cost of the property to be purchased, and, in certain cases, the property location, the veteran's family income, and whether the veteran is a "first-time home buyer."

Until now, assistance has been limited to veterans who served on active duty for a statutorily defined wartime period—primarily World War I, World War II, and the conflicts in Korea, Vietnam, and the Persian Gulf—and who also received an honorable discharge. Under a new DVA-sponsored state law (Chapter 155, Statutes of 1997 [Knight,
SB 574]) which took effect on January 1, 1998, peacetime veterans who served outside of those defined wartime periods will be eligible for Cal-Vet home purchase assistance for the first time. Whether his or her military service was in wartime or peacetime, an applicant for Cal-Vet assistance generally must have served at least 90 consecutive days on active duty unless the veteran was discharged for a service-connected disability.

It is no longer necessary that a veteran be a California resident at the time he or she entered military service in order to qualify for a Cal-Vet loan. A 1992 California Supreme Court ruling (Del Monte v. Wilson) struck down such a Cal-Vet requirement as a violation of the federal constitutional right to equal protection of the laws.

Further restrictions apply to Cal-Vet applicants, depending on whether assistance is provided using the proceeds of general obligation bonds or revenue bonds. In both cases though, these restrictions apply to ensure that the bonds issued by the state are tax exempt for the purposes of federal tax law. The bonds' tax exempt status makes it possible for the state to sell them at a lower interest rate than would otherwise be possible.

The details regarding who may qualify for a Cal-Vet loan are discussed in the shaded box (see page 6).

Program Administration

Shift to Department in 1943. At the time of its creation, the Cal-Vet program was administered by the Veteran's Welfare Board. In 1943, the board was eliminated and its operational duties shifted to the DVA.

During 1996-97, the program operated ten California branch offices—eight full district offices and two satellites with minimal staffing—under the supervision of the central headquarters in Sacramento. The DVA is now realigning the office config-uration to provide five full district and five satellite offices. The location of each of the office sites under the new configuration is shown in Figure 2.

Of the 232 authorized positions associated with the Cal-Vet program, about 90 consist of personnel in either district or satellite offices, about 60 are program staff located at the Sacramento headquarters, 66 are administrative support functions (mainly data processing, personnel, accounting, and legal services) in Sacramento, and 16 are DVA managers.

The staffing and operating expenses of the Cal-Vet program amounted to $20.2 million during 1996-97. Of this amount, only about $1.2 million for administrative support was directly appropriated by the Legislature through the 1996-97 Budget Act, with the balance coming out of the off-budget Cal-Vet fund.

Applications for Cal-Vet loans have historically been marketed and processed exclusively through the program's network of branch offices. Although other government loan programs give private lenders the authority to place loans, that is not the case in the Cal-Vet program. Subsequent servicing of loans that have been funded, including such activities as billing, delinquent accounts, and repossession of defaulted property, has also been handled by DVA branch offices in the past. The Cal-Vet program is in the midst of a reorganization that we discuss later in this report that will consolidate key loan servicing operations in Sacramento while leaving most marketing and loan origination activities in the branch offices.

What Are the Cal-Vet Program Eligibility Rules?

Loans Financed With General Obligation Bonds. Cal-Vet loans financed with general obligation bonds may be provided only to veterans who served on active duty prior to
January 1, 1977, and who also were released from active duty within the last 30 years. The maximum loan on a single-family home purchase is $250,000, with a maximum of $300,000 for farm purchases and $70,000 for mobilehomes. There is no limit on the price of the home purchased through the program, and no limit on the income of the veteran, as long as general obligation bonds are the source of Cal-Vet assistance.

Loans Financed With Revenue Bonds. Cal-Vet participants who receive loans funded from revenue bonds are subject to different eligibility rules even though their loans carry the same interest rate and terms as those funded through general obligation bonds. For example, there is no requirement that the veteran had served on active duty before 1977 and no requirement that the veteran apply for benefits within 30 years of active military duty. Also, loans cannot be made to buy farms or for some mobilehome purchases.

Some nonveterans are eligible for revenue bond-supported loans. The surviving spouse of a veteran who was eligible for a Cal-Vet loan may also be eligible for a loan if the veteran died during the application process, if the veteran died from injuries received in the line of duty, or if the veteran was a prisoner of war or was declared missing in action. Spouses are not eligible for Cal-Vet loans supported by general obligation bonds.

A veteran who receives a revenue bond-funded loan must either be a "first-time home buyer" or live in a neighborhood "targeted" for assistance due to low incomes of residents or economic distress. A first-time home buyer is considered by law to be anyone who has not owned the home in which they have lived for the last three years.

Unlike loans funded through general obligation bonds, those funded with revenue bonds are subject to price limits. The price limits permit a larger amount of Cal-Vet assistance in targeted areas and a lower amount of assistance in nontargeted areas. For example, as of July 1996, a veteran receiving Cal-Vet assistance to purchase a new home in a targeted neighborhood in Los Angeles could buy a home costing up to $281,800. A veteran buying a home in a nontargeted Los Angeles neighborhood would be limited to a purchase of a home costing $230,563.

A veteran purchasing a home outside of a targeted area is also subject to family income limitations. For example, a family buying a home in a nontargeted Los Angeles neighborhood could have had an annual income of no more than $58,995 annually.

Veterans Board and Finance Committee. The California Veterans Board also plays a significant role in the operation of the Cal-Vet program. The panel is composed of six members, who are appointed by the Governor and confirmed by the Senate to terms of four years, and a seventh ex officio member, the Secretary of Veterans Affairs.

A 1946 state law provides that the board "shall determine the policies for all operations of the department," and a more recent measure (Chapter 1145, Statutes of 1996 [SB 1470, Johannessen]) mandates that the Secretary of the DVA not make policy changes to DVA programs, including Cal-Vet, without "fully briefing" the board. The board is also empowered to decide appeals of departmental decisions on applications for Cal-Vet program benefits.

The board is empowered to set the interest rate for Cal-Vet loans. A new state law (Chapter 197, Statutes of 1996 [SB 785, Johnson]) deletes a requirement that two-thirds of the board consent to that decision, leaving the matter to a board majority. A two-thirds vote would continue to be required only if the board sought to change the interest rate more than once within a calendar year.

Another panel, the Veterans Finance Committee of 1943, comprised of the Governor, the State Controller, the State Treasurer, the Director of Finance, and the Secretary of Veterans Affairs, or their representatives, also has responsibility for the Cal-Vet program. A majority of the finance committee must consent to any decision by the Veterans Board to change the Cal-Vet program interest rate.

Chapter 197 deleted the requirement that the finance committee, as well as the Veterans Board, review and take action on the Cal-Vet interest rate each year. Henceforth, the two panels need take no action at all if the DVA concludes that no change is needed in the Cal-Vet interest rate.

LAO Findings

Our review and analysis of the Cal-Vet program has led us to reach a number of conclusions regarding its benefit to veterans and the effectiveness of its operation. Our findings are discussed in detail below and are summarized in Figure 3.

Cal-Vet Program Not Competitive

In its present form, the Cal-Vet program is not competitive with other private- and public-sector loan programs. Creditworthy veterans can currently obtain better interest rates and terms from private lenders with the help of other federal and state agencies, including programs which specifically target veterans and low-income home buyers—Cal-Vet's customer base—for assistance. Cal-Vet lending activity has dropped off dramatically and many past participants in the program are paying off their loans early and borrowing from Cal-Vet's competitors because the private-sector mortgage market and other governmental mortgage assistance programs are meeting veterans' needs.

Cal-Vet Loans Attractive in Past

The DVA's stated goal is to provide eligible veterans with Cal-Vet loans on rates and terms that are better than can be found elsewhere. Throughout the 1970s and 1980s, the DVA accomplished that goal and provided substantial benefits to veterans. For example, when market interest rates on 30-year fixed-rate home loans peaked at above 17 percent during 1982-83, the rate for most Cal-Vet loans was less than half of that—8 percent. For a Cal-Vet veteran, that meant a savings in the hundreds of dollars on their monthly mortgage payment.

The fees and terms for Cal-Vet borrowers also have compared favorably with its competitors in the past. Unlike many private-sector borrowers, Cal-Vet loan recipients are not required to pay any "points" to obtain their loan, which sometimes can cost several thousand dollars; the loan origination fee is $50.

Moreover, unlike most private borrowers, Cal-Vet has not in the past required a borrower to obtain conventional property mortgage insurance whenever the amount borrowed exceeds 80 percent of the value of the purchased property. It is not unusual for the premiums for such insurance policies to cost a borrower in excess of $100 per month. Cal-Vet's fire, disaster, and life and disability insurance programs were low in cost and carried favorable terms with low deductibles, providing an additional incentive to a veteran to obtain a Cal-Vet loan instead of one from the private mortgage market.

Cal-Vet Not Competitive Now With Private Lenders

As can be seen in Figure 4, the Cal-Vet program has largely lost the competitive advantage it had long held over the private-sector loan market. While Cal-Vet's rates have remained level, the prevailing private-sector interest rates have dropped steadily since their peak in the early 1980s. In December 1997, at a time when most Cal-Vet loans carried an 8 percent interest rate, fixed-rate private-sector mortgages were available bearing about a 7 percent rate.

Cal-Vet's marketplace disadvantage is even more pronounced if Cal-Vet loans—which technically are variable- and not fixed-rate loans—are compared to variable-rate private-sector loans. In December 1997, 30-year adjustable-rate loans could be obtained at an initial rate of 5.5 percent.

Thus, Cal-Vet has been unable to compete with the private sector on the basis of interest rates in a highly price-sensitive mortgage market. This market disadvantage appears to have overwhelmed the benefits Cal-Vet borrowers would otherwise enjoy from lower fees and better insurance coverage.

Cal-Vet Faces Competition From Federal VA and Other Government Programs

Cal-Vet also appears at a severe disadvantage in competing effectively with the federal VA loan guarantee program.

Under the VA program, the federal government guarantees the repayment of a significant portion of a home loan if a private lender issues loans in accordance with federally established terms that are beneficial to veterans. Among VA's advantages over Cal-Vet:

Cal-Vet retains one significant marketplace advantage: its fees are significantly lower than those charged to borrowers under the VA loan guarantee program. However, that advantage is partly negated because the VA fees—which in some cases can exceed $1,000—can be financed through the loan and not paid up front. Cal-Vet and VA loans are similar in that no additional property mortgage insurance is required in order to obtain a VA loan even when the loan exceeds 80 percent of the value of the property being purchased.

Federal Housing Administration. The Federal Housing Administration (FHA) also competes with Cal-Vet in the California housing market through a loan guarantee program (the Section 203 [b] program). The program is focused on assisting lower-income home buyers and includes an element targeted specifically at assisting military veterans.

As is true for the VA program, FHA borrowers pay a prevailing market rate that may be less than Cal-Vet charges to borrowers. The FHA loans can cover up to 97 percent of the cost of purchasing a home, slightly more than the 95 percent allowable under the Cal-Vet program. A special 203 (b) program for veterans allows an even smaller down-payment.

Although FHA purchasers are subject to higher fees than under a Cal-Vet purchase, some of those costs need not be paid up front and can be added to the amount borrowed. However, the amount of an FHA-guaranteed loan is much smaller than one can obtain under the Cal-Vet program. As of 1997, the maximum loan in high-cost areas was about $155,000 compared to the $250,000 loan allowed under Cal-Vet. Lower FHA loan limits applied in other areas where living costs were lower.

California Housing Finance Agency. Some California veterans have also obtained single-family loans through the California Housing Finance Agency (CHFA). Unlike the Cal-Vet program, which markets its loans directly to customers, the CHFA makes advance commitments of funds to its network of private-sector lenders, who in turn lend the funds to loan applicants. The program focuses on assisting first-time home buyers and fostering home ownership in neighborhoods targeted for revitalization efforts.

Except for the lack of any requirement of prior military service, the eligibility rules for the CHFA loans are very similar to those established for the Cal-Vet revenue bond loan program. The CHFA loans, however, have a significantly lower interest rate than Cal-Vet loans. As of October 1997, at a time when the Cal-Vet interest rate was 8 percent, a 30-year fixed-rate CHFA loan carried a rate of between 6.5 percent to 6.75 percent depending on the location of the home purchase. At least 3,000 outstanding loans in the CHFA portfolio (the full number is not known) were made to veterans.

How Lack of Competitiveness
Has Affected Cal-Vet

Cal-Vet New Loans Declining. Figure 5 shows that the number of new loans issued each year by the Cal-Vet program has fallen sharply since the early 1980s. Loan activity in 1996 exemplifies this trend. The 1996-97 DVA business plan for the program anticipated that almost $170 million in new loans would be issued. About $146 million in loans were actually issued.

About five Cal-Vet loans were paid off and retired for every one new borrower during 199697. Some of the loans were retired on a normal pay-off schedule and others due to the death or delinquency of the borrower. About 68 percent were taken off of the Cal-Vet program's books because a home sale or a loan refinancing resulted in the early pay-off of the loan.

Certain demographic factors, which we discuss later in this report, appear to have contributed partially to the fall-off of new loan activity. We also believe the trend is related to the corresponding decline in market interest rates during the period in which these rates came in line with or dropped below the Cal-Vet program's rates.

Cal-Vet Portfolio Shrinking. This declining trend of new loans has sharply diminished the total number of loans in the Cal-Vet program portfolio, as seen in Figure 6. That portfolio dropped by 9 percent (about 4,200 loans) in 1995-96 and dropped another 9 percent (another 3,900 loans) in 1996-97. The 39,000 loans in the Cal-Vet portfolio as of June 30, 1997 is less than a third of the number the program had at the start of the 1980s.

Cal-Vet's Loan Market Share Disappearing. Cal-Vet's share of the California home mortgage market has always been small, but now has become even smaller. In 1990, about four-tenths of 1 percent of the $56 billion in home loans issued each year were issued by Cal-Vet. Now Cal-Vet has about a two-tenths of 1 percent share of a $59.6 billion loan market.

In addition, the number of loans made each year to California veterans under the VA, FHA, and CHFA loan programs dwarf the number issued by Cal-Vet. During federal fiscal year 199596, $4.6 billion in VA-backed loans were issued to 32,976 California veterans. The FHA, also active in the California market, assisted in financing almost 105,000 loans involving $11.2 billion during the 1995-96 federal fiscal year. (Of this total, 683 loans totaling $80 million were issued to California veterans.) Meanwhile, CHFA originated 6,166 loans amounting to $656 million during the overlapping 1995-96 state fiscal year. Cal-Vet issued only 984 new loans amounting to about $115 million during 1995-96.

After years of contending otherwise, the DVA now has recognized that its loan terms are no match for others in the private and public sector. Its pending $1.6 billion plan to restructure its debt is designed to lower the interest rate for most outstanding Cal-Vet loans to between 6.75 percent and 7 percent, and thus again make the program competitive with the private market. The new interest rate is expected to go into effect on April 1, 1998.

Even without these efforts by the DVA, however, the private-sector home mortgage market and other governmental mortgage assistance programs are meeting veterans' needs. Creditworthy veterans have many options for obtaining home purchase assistance in the current economic environment.

Mismanagement Eroded
State's Equity in Program

Significant financial and operational problems in the Cal-Vet home purchase program, some resulting from past mismanagement by the Department of Veterans Affairs and others not of its making, eroded the state's equity in the Cal-Vet fund. Almost every major element of the program—from bond sales, investment of cash, and handling of delinquent accounts to loan origination, insurance programs, and customer service operations—has suffered because longstanding problems were allowed to continue without corrective action and proper oversight for many years.

Financial Losses Suffered
Five Years in a Row

Audited financial statements indicate that Cal-Vet program expenses exceeded revenues by $22.5 million during 1996-97. As can be seen in Figure 7, this is the fifth year in a row that the program has recorded a financial loss. It is also the eighth year in the last eleven that a loss has been recorded.

These losses are not what administrators of the program had projected. A 1988 cash-flow projection prepared for the DVA suggested that Cal-Vet revenues would outpace expenses by $87 million during the five fiscal years ending in 1996-97. The actual result was a combined loss of about $125 million.

The cumulative effect of these successive annual losses has been an erosion of the state's equity in the program. By state equity, we mean the retained earnings that belong to the state after all liabilities, such as the outstanding bond debt, have been subtracted from the combined assets of the program, such as its cash and pool of purchase contracts. The equity essentially represents the financial return that has accrued over many years to state taxpayers for the billions of dollars they have invested in Cal-Vet mortgages for eligible veterans.

This equity, which was generated largely from the interest veterans paid on their loans and from other investments of the program's cash reserves, amounted to almost $458 million as of June 30, 1986. Because of the recurring losses over the last 11 years of operation of the Cal-Vet program, the state's equity has dropped to about $258 million as of June 30, 1997. That is a $200 million, or 44 percent, decline during that period. This downward trend is evident in Figure 8.

The long-term impact of these losses on the state's equity appears to be even more significant. Long-term cash-flow projections released by the DVA in 1991 indicated that, once all outstanding bonds had been retired and all Cal-Vet mortgages were paid off, the state's remaining equity in the program would exceed $1.6 billion. More recent projections indicate that the state's remaining equity at program's end would be less than $600 million—$1 billion less than the prior forecast. Part of the $1 billion differential is interest earnings that were foregone because of the unexpected decline in the Cal-Vet loan portfolio. Another part of the $1 billion differential is the long-term impact of past mismanagement of program finances and operations.

Forces outside of the DVA's managerial control, we note, have contributed to Cal-Vet's financial problems. These include statutory restrictions that were imposed on the program long ago that are not appropriate in the highly competitive loan market of the 1990s, major shifts in the California economy and interest rates, and constraints imposed through the federal tax code that have limited the program's potential market of eligible veterans.

On the other hand, other governmental loan programs, such as CHFA, faced their own set of constraints yet appear to have done a much better job of responding to changing conditions in the California mortgage market. While the Cal-Vet program was posting a $6.7 million loss in 199596, for example, the CHFA Home Mortgage Revenue Bond Program was experiencing a $21.5 million profit.

Program Remains Financially Secure    

We do not believe the recent losses pose any danger to the state's ability to pay off the bonds out of program revenues. Cal-Vet continues to have more than sufficient cash and other assets on hand to meet its obligations to borrowers and bondholders. A September 1997 status report on the program issued by the DVA stated that "cash reserves of the Farm and Home Fund are more than adequate for forecasted requirements." The Cal-Vet program balance sheet shows that the program held almost $1.2 billion in cash and other investments as of June 30, 1997.

Notably, program assets as of that date exceeded 108 percent of the liabilities shown on its balance sheet, in an enterprise where a 103 percent asset coverage ratio is considered to be financially secure by loan program experts. Assets in excess of 103 percent may be removed from the program and used for other purposes where (1) other specific reserve requirements required for insurance and bond issuance are met and (2) program revenues will meet expenses for the remaining life of the outstanding indebtedness.

Why Has the Program Lost Money For Five Years in a Row?

The main reasons for the program's losses are (1) a mismatch between interest earned by the program and interest paid out for bonds, (2) problems in Cal-Vet insurance programs, and (3) a wave of delinquencies and foreclosures on Cal-Vet properties. Underlying all of these problems was a history of weak program operations and management. We discuss these problems in more detail below.

The Interest Rate Gap. For many years, the Cal-Vet program borrowed money by selling bonds at relatively high interest rates and invested the proceeds at lower interest rates. The results were tens of millions of dollars in losses, known in the bond business as "negative arbitrage." In 1994-95 alone, for example, interest payments by the program exceeded interest earned by $15.6 million.

These losses occurred in part as a result of earlier decisions by program managers and the State Treasurer to issue noncallable bonds, thereby locking in for 25 years relatively high interest rates that the Cal-Vet program paid to bondholders. For example, during 1980 through 1984, at a time when interest rates were at their peak in modern times, the Cal-Vet program issued more than $1.5 billion in noncallable bonds at relatively high interest rates ranging between 7.8 percent and 11 percent. At the time, the sale of noncallable bonds lowered the program's borrowing costs by making them more attractive to prospective buyers. While issuance of noncallable bonds might have been to the Cal-Vet program's advantage had rates been at a low point, the decision program officials made was to lock in interest rates on bonds for 25 years at their peak in modern times.

In addition, other Cal-Vet cash was heavily invested in the State of California's Surplus Money Investment Fund (SMIF). In the early 1980s, SMIF earned as much as a 12 percent return and such an investment made sense. But, as can be seen in Figure 9, the interest rate earned for cash invested in the fund dropped steadily over the years and by 1994 was only about 4 percent. Cal-Vet officials were slow to withdraw cash from SMIF and shift it to higher-earning investments, resulting in financial losses to the state in the tens of millions of dollars.

The problem was magnified during the 1980s as more and more Cal-Vet borrowers paid off their loans early. Because such a large share of the Cal-Vet debt consisted of noncallable bonds, the DVA could not use the surge of incoming cash from the paid-off loans to pay off the high-interest bonds and lower its debt burden. Instead, it was required to set that cash aside to retire the noncallable bonds in installments over their 25-year life. In effect, the Cal-Vet program was compelled to amass a large amount of cash, which was invested at a substantial loss to the state.

Another critical factor in these losses is the single-interest rate structure of the program, which is established in statute and not subject to change by the DVA. During periods such as the early 1980s when it was costly for the Cal-Vet program to borrow money through bond issues, the DVA did not have the flexibility to charge a correspondingly higher rate to new Cal-Vet borrowers unless the interest rate was also increased for almost all other existing Cal-Vet loans. Had Cal-Vet been granted the authority to more closely match the interest rate it charges to veterans getting Cal-Vet loans with the interest rate it paid on the bonds used to fund those loans, the financial losses might have been minimized.

Life and Disability Insurance Program Problems. In its marketing efforts, Cal-Vet program officials have long stressed its low-cost, high-coverage, and low-deductible insurance coverages as an inducement to potential borrowers. However, the DVA's past failures to set aside adequate reserves, collect adequate premiums from borrowers, or to properly limit the program's financial risks have contributed significantly to the overall financial losses suffered by the Cal-Vet program in recent years.

Most of the losses since 1994 stem from the life and disability insurance program. A review of the program by the State Controller released in April 1996 found that insurance claim payments have generally exceeded premiums since 1983. This is occurring because the population of Cal-Vet loan recipients is aging and thus, not surprisingly, suffering more frequently from physical disabilities and filing claims against their coverage. The Controller concluded that, from 1984 through 1995, the life insurance program lost $29.6 million while the disability insurance component lost $18.4 million.

The statutes authorizing the Cal-Vet program make clear the Legislature's intent that the DVA maintain "appropriate and prudent" reserves for the life and disability insurance programs and that surplus funds are permitted to be used for the general purposes of the loan program.

It now seems clear that the DVA did not maintain adequate reserves to support the program in the long term. A 1993 actuarial analysis conducted by a DVA consultant found that the programs were underfunded by $38.4 million as of June 1992. The consultant concluded the programs had an unfunded liability due to, among other factors, (1) insufficient premium rates, (2) use of funds to subsidize a 1 percent cut in Cal-Vet interest rates from 1987 to 1989, and (3) transfers of funds to subsidize other Cal-Vet insurance programs. The Controller concluded in a 1996 review that "the financial instability of the program appears to have continued to deteriorate" since 1992.

In order to remedy the underfunding problem, the DVA is now implementing changes in life and disability coverage and premium levels, along with the transfer of the program to a private insurance firm. However, these actions are being challenged in a pending Los Angeles Superior Court lawsuit by Cal-Vet borrowers who contend that any changes in premiums and benefits should be overturned and that $71 million of the state's equity in the program should be placed in a special reserve for the two insurance programs.

Although the reserves set aside for the insurance programs were insufficient, it may well have been legally permissible for them to be operated in that fashion. Nonetheless, if the courts rule against the state on this issue, it could create further financial problems for the program.

Other Insurance Difficulties. The Cal-Vet program has in the past often operated without sufficient reserves in its other insurance programs. During some years, these other programs have suffered significant losses from fires, earthquakes, and floods that have contributed to the program's overall unprofitability.

A DVA consultant concluded that the programs have, at times, left the state vulnerable to even greater financial losses. The financial weakness in the programs was attributed to the insufficient premiums charged to Cal-Vet borrowers and the deductibles and other terms of coverage that have been much more generous than comparable commercial insurance policies. For example, the disaster indemnity plan provides only a $250 deductible for each claim—significantly less than commercial insurance policies requiring a deductible equal to 25 percent or more of the value of the insured property.

Delinquencies and Repossessions. The Cal-Vet program has suffered major financial losses in recent years as many borrowers became delinquent or defaulted on their loans. In addition to the lost mortgage payments, the program has lost substantial sums of money on the resale of the properties upon which it foreclosed for nonpayment. Also contributing to the program's losses were historically weak loan underwriting practices and poorly coordinated efforts and procedures for handling delinquent contracts and repossessions of property.

As of the end of 1995-96, about when the problem reached its peak, 2,317 Cal-Vet loans were delinquent but still active, another 326 Cal-Vet contracts had been canceled due to delinquency but not yet foreclosed upon by the program, and another 459 foreclosed-upon properties were in the Cal-Vet program's possession. Thus, 3,100 loans, or about 7.2 percent of the total Cal-Vet portfolio, consisted of troubled loans and foreclosures, compared with about 4.3 percent for private-sector lenders. Figure 10 shows the growth that occurred in the Cal-Vet inventory of repossessed property in 1995 and 1996. At one point, the value of the repossessed property on the Cal-Vet program's books was estimated to be more than $75 million.

The cost of a loan foreclosure to the Cal-Vet program can be high. During the recent surge of foreclosures, each Cal-Vet property that had to be foreclosed upon and resold typically resulted in lost interest payments of $5,900. Cal-Vet also typically lost $26,100 on the resale of a foreclosed-upon home. The program usually lost an average of 27 percent of its investment in a resold property. This is a significant change from the past, when Cal-Vet usually was able to resell repossessed property at a small profit.

Thus, repossessions have taken an increasing toll on the Cal-Vet program's bottom line, as can be seen in Figure 11. The program recorded an $8.3 million loss in 1996-97 on the disposal of repossessed property for that year. Financial statements provided by the DVA also indicated that program officials had reduced the value of the real estate assets on its books by $18 million to account for projected future losses on repossessed property.

Even larger losses are reflected on Cal-Vet's financial statements to account for the failure of veterans to make payments on delinquent loans. The statements indicate that $22.7 million in bad debts were written off by the program during 1996-97.

For many years, Cal-Vet underwriting standards were lax compared to those applied by commercial lenders and other governmental loan programs. For example, incomplete credit reports were sometimes used to determine the eligibility of applicants, and loans were sometimes granted to individuals with prior bankruptcies and foreclosures or an excessive amount of other debt that would have automatically disqualified them with other lenders. These Cal-Vet practices may have helped the program to compete for a greater share of the lending market in the short run, but proved costly to the state in the long run.

The failure of program managers to require property mortgage insurance for Cal-Vet loans involving a low down payment also led to sizable financial losses for the program. When California's severe recession early in the 1990s depressed housing prices—in some cases by as much as 40 percent—a number of veterans found that their houses were worth less than what they owed Cal-Vet and walked away from the properties. Because the loans were not backed up with property mortgage insurance policies, the millions of dollars in losses that resulted fell entirely on the Cal-Vet program.

Cal-Vet often failed to intervene early, when a veteran first missed a payment, to provide financial counseling or assistance that could prevent a default from occurring. When a wave of foreclosures did hit the Cal-Vet program, district offices appeared ill-prepared for the task of taking legal steps to reacquire control of the property, bringing it to marketable condition, and marketing it aggressively for resale.

The DVA's initial sluggishness in coping with the surge of defaulted loans results from a number of factors, including inadequate training of Cal-Vet personnel, the lower priority given repossessions by some district offices, excessive paperwork, and inadequate case-tracking systems. Some district offices were aggressive about fixing up repossessed property for resale, while others were reluctant to fix even minor cosmetic problems that could drive away potential buyers.

It should be noted that some delays in processing of foreclosures were due to factors outside of the program's control, such as backlogs in the processing of necessary documents by county recorders and filings for personal bankruptcies by Cal-Vet borrowers. In the latter case, such filings automatically stay the repossession of a veteran's property.

Weak Management and Operations

In the past, the DVA has mismanaged Cal-Vet program operations, historically overstaffing field offices and understaffing critical cash and debt management operations in ways that have contributed to its financial losses and the $200 million loss in the state's equity. A lack of effective internal and external checks-and-balances over the DVA's decision making is also an underlying factor. For example:

The lack of external or internal systems to hold the DVA accountable has hidden the overstaffing and other problems in the Cal-Vet program from public view.

Because it is engaged in an entrepreneurial and competitive activity, the Cal-Vet program is off-budget and its appropriations have not been subject to the review normally provided by the Legislature in annual budget hearings. The California Veterans Board's part-time status, advocacy role for veterans, and lack of an independent staff mean that few decisions by Cal-Vet program administrators are challenged or publicly debated by board members.

The "Reengineering" of Cal-Vet

The Department of Veterans Affairs has undertaken a process to "reengineer" the Cal-Vet home purchase program, curtail its financial losses, and again make the program beneficial to veterans.

Reform Process Under Way. In 1996, in response to growing concern over mounting annual losses in the Cal-Vet program, the DVA embarked on an effort to reexamine its operations.

First, the department retained an outside consultant and assigned the firm to conduct a "baseline review" to assess its performance. That review focused on (1) the processing and servicing of loans, (2) insurance program and tax collection issues, (3) financing of the program, (4) the computerized communications "infrastructure" of the program, and (5) statutes and regulations governing Cal-Vet operations. The consulting firm completed a comprehensive report by mid-1996 calling for a major overhaul of almost every facet of Cal-Vet's operations.

The DVA next initiated what it has termed a "business process reengineering" program to assess the findings of the consultants and to determine specifically how those findings deemed to be worthwhile could be implemented. The DVA created ten internal teams with direction to return within a few months with recommendations for program changes. The DVA's managers subsequently reviewed the team recommendations, in some cases rejecting team proposals but in many other cases issuing orders for specific program changes that they proposed. Some have already been implemented, while other more complex tasks will take longer to carry out.

Among the changes being made as a result of the DVA reengineering process:

The DVA has established a tracking system to ensure that the changes in the Cal-Vet program directed by management are carried out in a timely manner. A new program manager was also named and given direction to implement the proposed reforms.

Financial Restructuring. In an effort to restore the competitiveness of Cal-Vet loans, the DVA has undertaken a $1.6 billion financial restructuring of the program. The key elements of the proposal, as announced in September 1997, are as follows:

A Model Process. We believe the program that the DVA has developed is more likely to be successful because of the Total Quality Management (TQM) process the department employed in its development.

The TQM is a formal process by which an organization can successfully initiate and manage major changes in its operations. It is characterized by a customer-service orientation, a focus on delivering quality products or services, the involvement of both employees and managers, the use of "benchmarking" of the practices of competitors to assess past performance, and the development of measurable standards to judge future performance.


Continue to Rethinking the Cal-Vet Loan Program Part II

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