environmental financial advisory board report relative benefits of direct and leveraged loans in...

Environmental FinancialAdvisory Board Report

Relative Benefits of Direct and Leveraged Loans in State Revolving

Loan Fund (SRF) Programs

State/EPA WorkgroupOctober 21, 2008

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Questions Posed To EFAB In Light of the Growing Needs Gap• In August 2006, EFAB initiated a review of the

leveraging financing technique, including:– Whether States that use leveraging tend to

have higher rates of loans as a percentage of their capitalization grants.

– Whether leveraging could improve the sustainability of the SRFs .

– Whether the Board ought to recommend that EPA do more to promote the use of leveraging.

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EFAB Leveraging Workgroup

George Butcher (Chair)*

Staff Lead: Vera HanniganTerry Agriss*

Michael CurleySteve GrossmanSteve Mahfood

Andrew SawyersJim Smith*

Greg Swartz*Sonia ToledoScott HaskinsJustin Wilson

Jim Gebhardt *Dave Miller (EW)

Heather Himmelberger (EW)Jeff Hughes (EW)

Program Contacts:Kit Farber-CW

Howard Rubin-DWStan Meiburg - DFO

CW – Clean Water program contactDW – Drinking Water program contactEW – Expert Witness (non-EFAB member)DFO – Designated Federal Official

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Categories of SRF Structures• Direct loan – 100% funded with SRF equity • Leveraged Low – up to 33.33% of loans funded with bond

proceeds• Leveraged Medium – between 33.33% and 66.67% of loans

funded with bond proceeds• Leveraged High – more than 66.67% of loans funded with

bond proceeds

Number of States by Lending Structure

SRF Program

Direct Loan

Leveraged Low

Leveraged Medium

Leveraged High

Clean Water 24 9 9 9

Drinking Water 31 4 6 10

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Population Served By SRF Category

Populations Served (millions)

SRF Program

Direct Loan

Leverage Low

Leveraged Medium

Leveraged High

Clean Water 87.0 83.7 66.5 61.7Drinking Water 182.1 15.5 34.3 66.9

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Grants And Loans by SRF Category

SRF Capitalization and Loans – As of June 30, 2007 (Billions)

Lending Structure

CWSRF Capitalization

Grants

CWSRF Loans

Executed

DWSRF Capitalization

Grants

DWSRF Loans

Executed

Direct Loan $7.398 $12.833 $3.501 $4.412

Leveraged Low

$5.658 $11.814 $0.520 $0.771

Leveraged Medium

$5.768 $15.968 $0.888 $2.084

Leveraged High

$7.197 $23.333 $1.612 $4.683

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Leveraging Factor By SRF Category

Leveraging factor is the ratio of loans made to capitalization grants.

SRF Leveraging Factor– As of June 30, 2007

`Lending Structure CWSRF DWSRFDirect Loan 1.73 1.26

Leveraged Low 2.09 1.48Leveraged Medium 2.77 2.35

Leveraged High 3.24 2.91

Both direct and leveraged SRF programs have made loans with a significantly greater value than their federal capitalization grants.

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Key Attributes Of SRF Structures

• In both direct loan and leveraged SRFs, the subsidy is provided by using or forgoing earnings that could otherwise have been earned on program equity and retained to grow program equity.

• If states are making loans at identical interest rates (above 0%), leveraged loan states use less equity. So, with the same amount of equity, a leveraged loan state can fund more projects.

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Sustainability Is A Key Objective• An SRF will become sustainable when on an

annual basis, its recycled federal and state capitalization grants and retained earnings are sufficient to continue its existing level of project funding in inflation-adjusted dollars.

• Although the primary goal of any SRF is to make loans, another important goal is to ensure that over time the program is sustainable.

• If federal capitalization grants decline as was anticipated at the initiation of the SRF programs, the SRFs will have to depend more on growth of retained earnings to sustain their programs.

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Retained Earnings For CWF SRFsCWSRF Retained Earnings as % of SRF Equity

Grouping of States By Retained Earnings Top ThirdMiddle Third

Bottom Third

Average Retained Earnings as % of Equity 25.95% 16.97% 7.68%

Direct Loan (24 States) 12 7 5

Leveraged Low (9 States) 2 7 0

Leveraged Medium (9 States) 2 2 5

Leveraged High (9 States) 1 1 7

Average Loan Rates (Overall Average is 2.10%) 2.14% 2.42% 2.01%

Borrowed State Match as % of Total Match 9.31% 15.96% 41.65%

Loan Disbursements as % of Loans 79.31% 87.51% 91.11%

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Retained Earnings For DWF SRFsDWSRF Retained Earnings as % of SRF Equity

Grouping of States By Retained EarningsTop ThirdMiddle Third

Bottom Third

Average Retained Earnings as % of Equity 14.90% 6.34% 3.10%

Direct Loan (31States) 9 11 11

Leveraged Low (4 States) 0 4 0

Leveraged Medium (6 States) 3 1 2

Leveraged High (10 States) 5 1 4

Average Loan Rates (Overall Average is 2.20%) 2.38% 2.08% 2.16%

Borrowed State Match as % of Total Match 16.37% 13.65% 34.64%

Loan Disbursements as % of Loans 79.55% 80.39% 77.30%

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The Opportunity Cost For Equity Used To Make Loans Affects Sustainability

• The “opportunity cost” of an SRF loan is the difference between (a) how much the SRF earns on the equity used to make or support the loan, and (b) the investment return that the SRF could otherwise earn on the equity.

• The higher the opportunity cost to an SRF of funding its loans, the less sustainable its program will be.

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Equity Used To Make Direct Loan Is In Effect Yield Restricted

• If a state makes a direct loan with a 50% interest rate subsidy versus the borrower’s normal 4% borrowing cost, the SRF’s return on equity has two components:– First, the interest rate paid by the borrower on its loan – in

this case 2%, and – Second, the interest subsidy provided to the borrower, which

is the difference between the rate the borrower would otherwise pay (4%) and the actual rate (2%).

The SRF’s return on its equity is 4%, the borrower’s tax-exempt borrowing cost.

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Direct Loan SRFs Can Leverage to Grow Earnings By Reducing Their Opportunity Cost

• If a state makes a $100 direct loan and provides a 50% interest rate subsidy versus the borrower’s normal 4% tax-exempt borrowing cost, the SRF’s retained earnings would be 2% on the $100, or $2.00.

• If the state issued bonds to fund the $100 loan, it could use $50 of equity to support the loan and invest the remaining $50 of equity at a taxable market rate of about 4.5% on the invested $50, or $2.25, a 12.5% better return.

The key is to use separate portions of the SRF’s equity to provide subsidies and to grow earnings.

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EPA Can Take Administrative Steps To Enhance SRFs Ability to Grow Earnings

• First, EPA could allow states to elect an approach that would eliminate the connection between federal capitalization grant draws by the state and the construction pace of SRF funded projects. – A perceived nexus between the capitalization

grant draws and the expenditure of bond proceeds has caused bond counsel to subject the SRF equity to arbitrage restrictions, even if it is solely invested to grow earnings.

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EPA Can Take Administrative Steps To Enhance SRFs Ability to Grow Earnings

• Second, EPA could interpret the “perpetuity rule” by measuring compliance based on expected earnings over time, rather than current year-end results.– The static test has been viewed to restrict the

use of retained earnings to fund interest subsidies. By using both the principal and interest on retained earnings to fund subsidies the amount subjected to restriction can be reduced.

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EFAB Conclusions

• SRF programs have been very successful in financing clean water and drinking water projects, regardless of program design.

• State programs that have leveraged their SRF funds have provided greater assistance as a percentage of their capitalization grants than those that have not leveraged.

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EFAB Conclusions (cont.)

• In both direct and leveraged programs, the subsidy is by using earnings that could otherwise be used to grow equity.

• If capitalization grants decline in the future, SRFs will depend more on growth in retained earnings to sustain their programs.

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EFAB Conclusions (cont.)

• Leveraged programs make it possible to meet greater loan demand by using earnings to provide loan subsidies on a larger amount of loans.

• Direct loans have been used by SRFs that have less loan demand or that place more emphasis on growing retained earnings for future use.

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EFAB Conclusions (cont.)

• States can increase retained earnings growth by utilizing innovative financing concepts that are now being applied in some states.

• Direct loan states can use leveraging to fund the same amount of loans and increase the growth of retained earnings.

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EFAB Recommendations• EPA should encourage direct loan states to

improve SRF sustainability by showing the states how leveraging can be used to increase their retained earnings.

• EPA should assist states to develop sustainable SRFs by administratively allowing states to accelerate draws of capitalization grants, modifying its interpretation of the perpetuity rule and by advocating for arbitrage.

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EFAB Recommendations (cont.)

• EFAB should explore the benefits of developing more aggressive parameters for SRF equity investments and recommend appropriate program changes to EPA.

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Overall, There Is A Tradeoff Between Retained Earnings and Loans

CWSRF Data by Lending Structure as of June 30, 2007 (millions)

SRF Category SRF EquityRetained Earnings

as % of Equity

Leveraged Bonds as % of Loans

Executed

Loans as % of Capitalization

Grants

Leveraged High $ 8,477 10.6% 85.6% 343.6%

Leveraged Medium $ 7,311 16.4% 45.2% 304.0%

Leveraged Low $ 7,442 18.9% 11.7% 229.5%

Direct Loan $ 9,667 20.3% 0.0% 193.0%

United States $ 32,899 16.6% 44.0% 267.3%

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Overall, There Is A Tradeoff Between Retained Earnings and Loans (cont.)

DWSRF Data by Lending Structure as of June 30, 2007 (millions)

SRF Category SRF EquityRetained Earnings

as % of Equity

Leveraged Bonds as % of Loans

Executed

Loans as % of Capitalization

Grants

Leveraged High $ 2,465 11.5% 78.7% 290.6%

Leveraged Medium $ 1,269 12.9% 47.2% 234.7%

Leveraged Low $ 679 5.8% 24.2% 147.5%

Direct Loan $ 4,797 6.6% 0.0% 125.7%

United States $ 9,212 8.7% 40.6% 182.9%

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The Leveraged Approaches Achieve A Higher Leverage Factor

CWSRF Leverage Factor and Lending Structure

Lending Structure

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third Leveraging

Factor

Leveraged High 7 2 0

Leveraged Medium 7 1 1

Leveraged Low 2 5 2

Direct Loan 1 9 14

Total States 17 17 17

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The Leveraged Approaches Achieve A Higher Leverage Factor (cont.)

DWSRF Leverage Factor and Lending Structure

Lending Structure

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third Leveraging

Factor

Leveraged High 8 2 0

Leveraged Medium 5 1 0

Leveraged Low 0 3 1

Direct Loan 4 11 16

Total States 17 17 17

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Role Of Financing Agency In Day-T0-Day Management

• Lead Role – Lead contact and manages all aspects of SRF from generating Intended Use Plan to servicing loans

• Significant Role – Manages some, but not all, aspects of SRF including programmatic and financial aspects

• Minor Role – May service loans and may issue state match or leveraged bonds

• No Role – No finance agency involvement

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Role Of Financing Agency In Day-T0-Day Management (cont.)

CWSRF Financing

Agency Role

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third

Leveraging Factor

Lead Role 11 5 3

Significant Role

4 2 3

Minor Role 2 5 5

No Role 0 5 6

Total States 17 17 17

CWSRF Leveraging Factor and Finance Agency Role

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Role Of Financing Agency In Day-T0-Day Management (cont.)

DWSRF Financing

Agency Role

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third

Leveraging Factor

Lead Role 10 3 3

Significant Role

3 4 3

Minor Role 1 5 2

No Role 3 5 9

Total States 17 17 17

DWSRF Leveraging Factor and Finance Agency Role

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Averages For Five Program Measures By Leveraging Factor Rankings

CWSRF Leveraging Factor and Program Measures

Program Measure

CWSRF National Average

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third

Leveraging Factor

Average Interest Rate 2.10% 2.32% 2.28% 1.96%

Loans Funded with Bonds as % of Total Loans 44.1% 62.4% 29.5% 4.9%

Match Bonds as % of Total State Match 24.1% 37.2% 14.6% 13.8%

Disadvantaged Assistance as % of Total Assistance 10.9% 10.1% 5.4% 21.2%

Retained Earnings as % of Equity 16.6% 13.5% 20.1% 16.7%

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Averages For Five Program Measures By Leveraging Factor Rankings (cont.)

DWSRF Leveraging Factor and Program Measures

Program Measure

DWSRF National Average

Top Third Leveraging

Factor

Middle Third Leveraging

Factor

Bottom Third

Leveraging Factor

Average Interest Rate 2.20% 2.47% 2.36% 1.79%

Loans Funded with Bonds as % of Total Loans 40.6% 62.8% 25.3% 0.34%

Match Bonds as % of Total State Match 21.5% 24.4% 18.8% 19.9%

Disadvantaged Assistance as % of Total Assistance 32.3% 42.2% 31.3% 21.3%

Retained Earnings as % of Equity 8.7% 13.2% 7.2% 4.8%