|Credit enhancement hiding in plain sight
I remember reading the piece by Curley and Haislip in 2014 that covered the innovative use of a credit enhancement. It began, “On August 13, 2013, the state of New York set an important legal precedent that could help to retard climate change and reduce greenhouse gas (GHG) emissions in the United States.” Enraptured, I digested the anatomy of how a bond issued by the New York State Energy Research and Development Authority (NYSERDA) was secured by a financial guarantee provided by the New York Clean Water State Revolving Fund. The transaction that funded residential energy efficiency measures was such a milestone that it was recognized as the National Deal of the Year by the Bond Buyer, the authoritative publication in the public finance industry. The transaction was lauded for its significant reduction of the bond debt service and establishment of a nationally replicable model. I was convinced that it would indeed be replicated across the country. Not the case.
CWSRF is a federally supported and state-run financial assistance program overseen by the EPA that supports water quality improvement projects in this country. SRFs have been capitalized from federal appropriations and 20% state matching contributions and retained earnings since inception. With a total capitalization of approximately $51 billion through 2018, CWSRFs are are authorized to provide financial assistance by making loans, purchasing debt obligations, securitizing financings, and providing financial guarantees. Non-point source projects are eligible under the CWSRF program. Under federal authority, eligible recipients include municipalities, farmers, non-profit organizations, individual home owners, commercial businesses, and many more. Eligible projects include those that deliver ecosystem services, including source water protection, water conservation, and projects or programs that mitigate the emission of air pollutants such as mercury and nitrogen that impair water quality.
Over 96% of the financial assistance has gone to sewage treatment plants. The remaining 4% has gone almost exclusively for agricultural non-point source water pollution reduction projects. Under Title VI of the Water Quality Act of 1987, states are given several options to finance clean water projects. For example, §603(d)(1) provides that they can make direct loans for terms of up to 30 years. Paragraph (2) authorizes SRFs “to buy or refinance the debt obligation of municipalities and inter-municipal and interstate agencies within the State.” And, Paragraph (3), which is the most important and yet underutilized provision, authorizes SRFs “to guarantee, or purchase insurance for, local obligations where such action would improve credit market access or reduce interest rates.”
Generally speaking, available resources, provided from new appropriations and dollars recycled from prior project commitments are encumbered by new projects. This fuels the common perception that such encumbrances leave no resources that can be dedicated to expanding SRF product offerings to additional forms of financial assistance such as financial guarantees.
However, future project encumbrances are not a limitation on increased SRF utilization. Often there are sufficient SRF resources that could be pledged to support guarantees that would qualify for triple-A claims-paying designation. Most SRFs have pledged cashflows supporting triple-A ratings for their pooled bond indentures that are in excess of that needed to support such ratings given required rating agency stressed loss assumptions. An SRF guarantee product can be positioned as a pledge relying on a subordinate lien on the equity turnover from the bond indenture. Repayments of direct loans held on the SRF balance sheet could also be added to the credit assessment which would only deepen guarantee capacity. For most if not all programs in the country, the assumed net of loss cashflows required to establish lending program triple-A credit support plus the pledge of available equity balances should provide ample resources to support a top rated SRF guarantee product that could serve market-based solutions for cost effective investment in water quality protection and nutrient mitigation.
I am convinced there is an opportunity to access the credit enhancement in a ground breaking manner to support natural climate solutions in this country while positively impacting water quality and quantity. In 2014, the EPA Financial Advisory Board (Board) produced a report that analyzed the potential of CWSRFs to provide credit guarantees to support projects not traditionally targeted by the lending program, given priority considerations. Specifically, the report evaluated the prospects for tapping the federal authority granted by Title VI, Section 603(d) of the Act to support such projects by providing financial assistance in the form of credit guarantees for Green Infrastructure projects. The goal was to identify a mechanism by which states could expand overall financial assistance capacity that would further national clean water goals.
The conclusion of the Board’s report was clear. They found that CWSRFs have the capacity to offer credit triple-A rated guarantees. They determined that for each dollar of recycled CWSRF program equity, $3 to $14 of CWSRF guarantee capacity could be provided to fund projects in addition to current project funding levels. The Report concluded that leveraging recycled dollars in this manner could support as much as $50 billion in guarantee capacity if all programs took advantage of it nationwide.
The central premise to this finding is that the current strength of SRF balance sheets can enable SRF administrators to use the guarantee to meaningfully expand funding capacity without reducing current levels of lending activity. On behalf of one of our clients, American Forest Foundation, we are actively exploring how to structure just such a guarantee to support their Family Forest Carbon Program.
The prospect that SRFs could offer guarantee products to provide financial assistance to underserved project categories without diluting the capacity of the established below-market lending program is significant. It is a powerful credit enhancement tool hiding in plain sight.