The Downside of Washington's Leverage Game

Commenter No_Rush makes an important point about using loan guarantees as a way to make your government spending go further by "leveraging" private sector investment.  Which is that loan guarantees are, in fact, increasing the leverage of your program.  As with all leveraged investments, your upside increases--but so does your potential downside.

Suppose that the DOE has $1bn that it's happy to risk in order to subsidize alternative energy. It could simply grant that $1bn in $50m pieces to twenty companies. Using loan guarantees, however, it can leverage that $1bn to much greater effect. Assuming that the DOE thinks that 10% of these businesses will fail, it can guarantee $10bn worth of loans to the same 20 companies, so that each gets $500m. Assuming that it's right about the 9-to-1 repayment to default ratio, it will still be out $1bn once the loans are satisfied (or defaulted upon). (I've used round numbers for simplicity, these aren't even close to real ratios.)

Now, say that one of the companies--we'll call it Hypolyndra--fails and defaults on its loan relatively early. There are two ways of looking at this: first, that only 5% of the DOE's total exposure to the market has defaulted. This is the way that it appears, from your comments above, that you're looking at it: there's only been one default, and everything else is doing "okay for now." The other way of looking at it is that 50% of the expected losses have now occurred, and two more defaults will make the program considerably bigger than anticipated. While six defaults would only represent a total of 15% of the DOE's total market exposure, that wouldn't be a phenomenal success, it would be a program that's 300% of its forecast budget.