By John Ryan
In its 2020 annual report, the U.S. Environmental Protection Agency’s Water Infrastructure Finance and Innovation Act (WIFIA) loan program describes itself as a “government bank with unique flexibilities.” Can those flexibilities be useful for Clean and Drinking Water State Revolving Funds (SRFs) considering leverage to expand their capacity for loans?
WIFIA is a popular and successful water infrastructure loan program. Since operations began in 2017, the program has closed a total of more than 40 loans aggregating more than $9 billion to date with an additional $10 billion currently in process. The program’s borrowers are primarily public water systems with high credit ratings that are financing large-scale water infrastructure projects.
WIFIA also lends to SRFs to leverage their equity bases and expand their loan volume capacity. In 2018, WIFIA implemented the SWIFIA Act, which is legislation specifically designed to encourage and expedite lending to SRFs. The program completed its first SRF loan to Indiana Finance Authority in late 2019. Since then, WIFIA received and selected applications from SRFs in four states: New Jersey, California, Rhode Island and Iowa. More generally, the program has indicated that increased lending to SRFs is one of its most important objectives.
It’s also a challenging objective.
Nearly half of SRFs do not utilize any leverage, and of those that do, only a few utilize it extensively. SRF applications to WIFIA so far are exclusively from this latter group. Loans to already optimally leveraged SRFs will of course establish useful transactional precedents. But the ability to incentivize currently unleveraged and under-leveraged SRFs to consider and apply for a WIFIA loan would be a far more impactful policy outcome. One approach to realize that goal is to explore how the current features of a WIFIA loan that are particularly useful to borrowers could be used by SRFs in innovative ways to overcome their concerns with leverage.
WIFIA Encourages the Innovative Use of Features
The vast majority of WIFIA’s non-SRF borrowers are highly rated public water systems that can access very cost-effective tax-exempt financing in the municipal revenue bond market. Interest rates in this market are typically near or even below the U.S. Treasury rates offered by WIFIA. A U.S. Treasury interest rate in itself is therefore not necessarily a determinative factor in a public system’s decision to apply for a WIFIA loan. Instead, many applicants focus on a WIFIA loan feature that has unique and intrinsic value, a costless interest rate hedge, or the ‘rate lock.’ The rate lock allows flexible loan drawdowns and capitalized interest accrual during the project’s construction period at a single WIFIA loan rate fixed at closing. Since the full loan may be drawn in a single funding for up to one year after construction completion, the rate lock can be (and often is) efficiently used as an interest rate option for WIFIA permanent financing.
The rate lock feature also adds value to another WIFIA loan feature, the ability to defer WIFIA loan debt service for up to five years after project completion. Like capitalized interest during construction, deferred interest during this period will simply accrue at the original WIFIA loan rate without the need for hedging. The deferral option requires approval by the program at loan closing, but this is routinely granted.
The rate lock feature was not specifically designed for the WIFIA loan program. It was inherited from the Transportation Infrastructure Finance and Innovation Act (TIFIA) loan program, on which WIFIA was closely modeled. At TIFIA, the rate lock was intended to assist new and cash-strapped project financings where interest rate hedging during construction would be expensive or not available at all. In contrast, WIFIA’s highly rated borrowers have access to standard and relatively cost-effective hedging products. However, these borrowers quickly determined that WIFIA’s rate lock feature would also be a uniquely effective and valuable tool in the context of long-term liability management. Its innovative use as an interest rate option noted above is an example.
Importantly, WIFIA has been actively and positively responsive to this innovative use of a WIFIA loan feature. In its 2020 Annual Report, two new Program capabilities are highlighted in the first page. The first, the program’s increased flexibility on Master Agreement financings, will expand the scope and time horizon in which a rate lock can be used, adding significantly to its value. The second, loan re-execution, directly improves the value of a rate lock by resetting the loan rate on a previously executed (but undrawn) WIFIA loan to reflect a new, lower U.S. Treasury rate. Of course, both capabilities are completely consistent with the Program’s current legislative framework and federal oversight protocols, but their development was not required. Instead, WIFIA took a proactive and accommodative approach to helping their borrowers maximize the value of WIFIA loan features in innovative ways that were not originally contemplated when the program was enacted.
Innovation for SRF Leverage
Obviously, SRFs making loans and public water systems building infrastructure are different in fundamental ways. But with respect to borrowing from WIFIA, there are two important similarities. The first is that SRFs are almost universally highly rated public-sector entities which (like highly rated water systems) can access very cost-effective tax-exempt bond financing. As noted above, this means that the U.S. Treasury rate offered by WIFIA may not be especially compelling for SRFs. More specifically, to the extent that SRFs generally offer discounted or below-market rates to their borrowers, almost any market-determined rate on their portfolio leverage (even when federally subsidized, as with tax-exempt bonds or WIFIA’s spread-less U.S. Treasury rate) may be a limiting factor. This is because the debt service cash flow from a below-market loan portfolio may be uncomfortably close to the debt service cash requirements of at-market leverage. The original version of the SWIFIA legislation appeared to recognize this constraint by proposing that WIFIA offer below-market loan rates, at 80 percent of U.S. Treasury yields. This part of the legislation did not pass, however, since it would have required a dramatic increase in appropriations for the WIFIA program. From a policy perspective too, lending at rates below U.S. Treasury cost is in effect a hidden grant program. This would violate one of WIFIA’s core principles — that federal taxpayers are paying only for the program’s expected credit losses and administration (both extremely small) since the Treasury’s loan funding costs are expected to be fully recovered from the borrower.
The vast majority of WIFIA’s non-SRF borrowers are highly rated public water systems that can access very cost-effective, tax-exempt financing in the municipal revenue market.
The second similarity between SRF leverage and water system infrastructure financing involves liability management. A water system planning a large financing for an infrastructure project needs to consider how debt service cash flow requirements will be matched to future water rates, and how changing interest rates may dramatically affect this during a long construction and amortization period. Likewise, an SRF contemplating leverage for a portfolio of new loans needs to consider how the cash flow from the portfolio will match the cash flow requirements of the related debt liability. Any mismatch in this case may be exposed to changing interest rates, perhaps significantly if the portfolio takes time to build or is prone to uncertainty in repayment schedule. Since an SRF will generally be lending to smaller, more idiosyncratic borrowers at discounted or below-market rates, managing portfolio leverage is intrinsically challenging.
A water system’s ability to match a large, long-term liability (financing for an infrastructure project) with a long-term asset (funding from water rates) in the face of a volatile primary factor (interest rates) is improved by a WIFIA loan’s rate lock, specifically when used in the innovative ways described above. Could the rate lock feature also improve an SRF’s ability to match a long-term liability (leverage for a loan portfolio) with its long-term asset (cash flow from the leveraged portfolio)?
It should, from a theoretical perspective.
It is likely that the leveraged SRFs that have applied for a WIFIA loan are in fact focused on the potential value of rate lock features. But to be effective in meeting the program’s goal of increased lending to currently unleveraged and under-leveraged SRFs, financial theory and transactional precedents from already-leveraged SRFs are not enough. Active exploration and development of the specific ways that a WIFIA loan’s rate lock feature might be able help unleveraged and under-leveraged SRFs will be required to achieve the program’s policy objective. That process can start by considering the innovative uses for the rate lock that WIFIA has established for water system borrowers, and noting the potential analogous uses for SRF leverage:
- As noted above, WIFIA’s Master Agreement increases the scope and flexibility of the rate lock for long-term construction programs where purposes are broadly defined but not specified. For SRFs in the process of assembling a loan portfolio that is generally defined but uncertain with respect to specific details and timing of individual loans, the usefulness of an analogous ‘Master Portfolio Agreement’ would be significantly enhanced with a rate lock.
- Water systems use WIFIA’s five-year debt service deferral option to help manage water rates. For planning purposes, this option is only prudent and effective if interest can be capitalized at a rate fixed at closing, which the rate lock makes possible. Likewise, deferral of debt service on SRF portfolio leverage (which will change the match between cash flow sources and uses) can improve planning flexibility but should not be exposed to interest rate uncertainty. Allowing SRFs to access the five-year deferral option with a specific emphasis on the rate lock would introduce an element of prudent portfolio planning flexibility in a WIFIA loan.
- The rate lock re-execution feature is most valuable for water systems when a WIFIA loan is used as final construction draw, because this effectively extends the window of downward adjustment. If SRFs could do the same delayed draws on a WIFIA loan, especially in the context of a Master Portfolio Agreement, this would add significant value. In a falling rate environment, lower rates from portfolio loans would be correlated with a lower, re-executed WIFIA loan rate.
However, although it is a starting point, development of innovative uses for WIFIA loan features should not be limited to water system precedents. There may other innovative and unique ways for SRFs to use WIFIA features, based on a holistic and long-term view of an SRFs fundamental lending function. For example, matching cash flow from the loan portfolio and WIFIA loan leverage might be even more flexible with the inclusion of an investable sinking fund facility. With tax-exempt bond leverage, this would not be cost-effective for SRFs due to low and restricted fund investment rates due to tax arbitrage rules. But the combination of the rate lock feature, the absence of arbitrage restrictions from WIFIA leverage priced at a U.S. Treasury rate and the scope for customized WIFIA loan amortization schedules might make a sinking fund facility a source of flexibility and positive yield for an SRF.
Next Steps
The innovative ways that the WIFIA program’s water system borrowers utilize a unique WIFIA loan feature, and the program’s proactive responsiveness to these developments, is in itself a positive outcome that demonstrates the inherent strengths of a successfully managed federal loan program. This outcome will also provide guidance about how WIFIA can achieve one of its most important, but challenging, policy objectives — increased lending to unleveraged and under-leveraged SRFs.
At this point, many of the factors and circumstances necessary for the development of innovative WIFIA loan features for SRFs are clear and well-defined. The next steps therefore appear to be simple, though not prescriptive or limiting. First, the program should consider explicitly indicating that it will be open to innovative proposals from SRFs, perhaps including guidance about what those might look like. Second, SRFs and their proponents should recognize (as water system precedents show) that there is considerable scope for innovation in using WIFIA loans as portfolio leverage. Ideally, these steps will result in discussion and dialogue — which is where the innovative development process really starts.
John Ryan is principal of InRecap LLC, focusing on debt alternatives for the recapitalization of basic public infrastructure. He has an extensive background in structured and project finance and recently served as an expert consultant to the U.S. Environmental Protection Agency. Views expressed in this article are solely those of the author.
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