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Appendix B: Perspectives on Forms of SIB Assistance
This appendix considers the means by which SIBs can provide assistance to project sponsors. It describes the forms of assistance (e.g., loans, credit enhancements) that SIBs may offer and the mechanisms by which SIBs’ equity may be leveraged.
Eligible Forms of AssistanceThe types of financial assistance that may be provided by SIBs can be divided into two broad categories: loans and credit enhancements. The NHS Designation Act gives SIBs a high degree of flexibility in providing loans and credit enhancements to project sponsors, as explained below. This flexibility should enable SIBs to tailor their programs to individual projects, subject only to the practical constraints on cash availability and leverage.
LoansA loan is a form of financial assistance made available by the SIB to a project sponsor, with the provision that the loan principal be repaid, subject to terms and conditions (e.g., interest rate, loan term) agreed to at the time the loan is made. Loans are repaid from revenues available to the project sponsor. Most commonly, the revenue stream used to repay the loan consists of tax revenues or project-related user charges (e.g., tolls), but could also include Federal funds made available to the project sponsor.
The NHS Designation Act established three distinguishing features of SIB loans that should be attractive to project sponsors:
Low interest rates. The Act specifies that any SIB loans bear interest at or below market interest rates. Within this limitation, each SIB is free to structure interest rates in any way it chooses.
Flexible repayment terms. The Act allows the repayment of SIB loans to be deferred up to 5 years after the project has been completed or opened. Further, the term of the loan can extend to 30 years following the date of the first payment. These features allow a loan to be tailored to the income stream available to the project sponsor.
Subordination to other forms of debt. If a project sponsor is also using other sources of borrowed funds to finance a portion of the projects, a SIB loan may be made on a junior-lien basis. A subordinated loan hasa second claim on the net revenues used to secure the debt (i.e., the senior lien has a first claim). Use of a subordinated loan provides the project sponsor two benefits: (i) a lower overall cost of capital, which is a product of a lower interest rate on the senior lien debt (since the senior lender’s risk is reduced) and the potentially below-market interest rate of the SIB loan; and (ii) the ability to leverage more debt from the project’s income stream, since the overall debt service coverage ratio can be minimized.
Direct loans provide the simplest form of assistance that a SIB can offer. These loans typically fill a gap in a project’s financial plan, and can thus permit a project to move forward sooner than would otherwise have been the case. Use of a loan can also encourage identification of a new source of revenue with which the loan is ultimately repaid.
In addition to filling a gap in financing, SIB loans may offer special benefits that are specific to a SIB’s ability to absorb risks that other commercial lenders may not be willing or able to absorb. For example, a SIB can enhance the feasibility of revenue-generating projects by making loans during the earlier, and thus riskier, phases of project development. This could improve and/or expedite the project sponsor’s access to permanent financing than would otherwise be the case. As an example, the Gateway Multimodal Center in Missouri, described in Appendix E, will be using this approach.
A SIB loan can also provide an interest rate subsidy, either directly or in combination with another form of debt. In their simplest form, interest rate subsidies are achieved through the provision of below-market interest rates. Most of the SIB projects identified to date are anticipated to receive a concessionary rate on their loans. SIB loans can also be used in combination with other loans to lower the overall cost of capital for a project. In Oregon, for example, SIB loans may be used in combination with bank loans to fund the purchase of vans, thus achieving a lower blended cost of capital than would otherwise have been the case. In Florida, the Turnpike Authority is using a SIB loan to reduce the present value of debt service payments on a $30 million revenue bond, and to create a more advantageous timing of debt repayment. Additional details on the Oregon and Florida projects are also provided in Appendix E.
Another eligible use of SIB capital, funding lease-purchase agreements, is functionally similar to the SIB loans described above. Capital leases are a form of debt financing used widely within the transit industry for the acquisition of rolling stock (e.g., buses and rail cars). A lease typically provides for a lessee’s use of rolling stock owned by the lessor, with the term of the lease payments approximating the useful life of the equipment (e.g., 12 years for buses). A SIB may finance such equipment leases from its own capital, or may issue bonds that are secured by the lease payments. In either case, the infrastructure bank may provide economic benefits to transit systems by: (i) providing interest rate subsidies on lease agreements that would lower the cost of the lease for the transit system; or (ii) providing for the pooled acquisition of rolling stock, thereby achieving lower costs than could be achieved by smaller, independent purchases.
In summary, SIB loans provide a flexible means to provide financial assistance to projects, either as a major or supplemental source of funds. In some cases, a SIB loan’s flexible terms, including its potentially subordinate status when combined with other debt, can improve a project sponsor’s ability to obtain other external financing and reduce the overall cost of capital. While these roles do not, strictly speaking, constitute credit enhancement as discussed in the next section, they do demonstrate loans’ capacity to serve similar ends through alternative means.
Credit EnhancementsWhen a project sponsor borrows funds from investors (e.g., bond purchasers or another lender), a SIB can offer a credit enhancement by guaranteeing, either entirely or partially, the sponsor’s repayment of principal and/or interest to its investors. Credit enhancements thus improve the credit worthiness of a debt issue by reducing the risk borne by investors. As a result, a project sponsor may either gain access to external financing that it could not have obtained otherwise, or may be able to obtain that financing at a lower rate of interest.
Credit enhancements are theoretically a more effective use of SIB capital than loans, in that they hold much more potential to "multiply" the SIB’s capital by assisting a larger dollar volume of projects. Whereas loans require a SIB to make outlays at the origination date of a loan, most forms of credit enhancement require a SIB to make outlays only if triggered by an unfavorable event (e.g., a loan or bond issue that is guaranteed by the SIB is in default). The dollar value of projects that can be supported from credit enhancements is generally a function of a SIB’s capital, the expected default rate of its project portfolio, and the coverage that is required on the expected value of payouts. The ability of SIBs to realize this potential, however, will be determined by market demand for SIB credit enhancements, and by the capital markets’ perception of the strength of these credit enhancements.
The NHS Designation Act refers to credit enhancements in broad terms. Several types of credit enhancement are commonly used in municipal finance, including capital reserves, lines of credit, and debt services guarantees (alternatively provided as letters of credit and bond insurance). A SIB may provide these forms of credit enhancement to project sponsors at a lower cost than would be the case if arranged through a private financial institution, or may be willing to provide credit enhancement when other sources would not.
Capital reserves. Capital reserves are funds set aside for future contingencies that could affect the repayment of debt service on revenue bonds. One definition of this type of assistance would be reserves that are kept on deposit to protect against default on debt service payments. Alternatively, capital reserves can take the form of special funds used to finance future repairs that are material to a project’s revenue stream (e.g., resurfacing a toll road).
Under the simplest approach to SIB provision of capital reserves, the SIB would lend a project sponsor the funds needed to establish a capital reserve. Given a SIB’s ability to offer flexible terms and subsidized interest rates to the project sponsor, the sponsor might find it more attractive to acquire the capital reserve from a SIB rather than relying on a larger bond issuance. Alternatively, the cash associated with the reserve might not actually change hands via a loan, but instead remain within the SIB as a contingency fund.
An important distinction when considering capital reserves is whether they are fully-funded or fractional. When offering fully-funded capital reserves, a SIB limits its capital reserve commitments to its cash on hand; thus, if all entities obtaining capital reserves needed to access those reserves to meet debt service payments or other commitments, the SIB would have cash available to satisfy all calls on the reserve funds. If a SIB opts for thisapproach, the SIB does not need to obtain a credit rating, since there is no risk that commitments will exceed available resources. A fractional reserve, in contrast, amounts to a leveraging strategy wherein the bank provides a number of projects with capital reserves in an amount that exceeds its cash on hand. The fractional amount of funding set aside in the bank is determined in accordance with the expected value of anticipated draws on the various projects’ reserves. In this instance, a SIB would need to obtain a credit rating to ensure that its provision of a reserve would convey a benefit (i.e., an enhancement) to the borrower.
Lines of credit. A line of credit is a type of revolving loan which allows a borrower to draw funds up to a predetermined amount, over a specified period of time, and to repay or redraw these funds as circumstances permit or require. While essentially a loan, a line of credit takes the form of a credit enhancement when used as a contingency to address cost or revenue risks associated with a project. For example, a line of credit can be used to cover unanticipated construction expenses (which would not have been covered by a construction loan), or to cover temporary revenue shortfalls once a project is operational. It thus provides a type of safety valve that reduces the risk to lenders or bond holders.
Assuming that contingent commitments do not exceed available cash, SIBs could provide lines of credit without having to obtain their own credit rating. However, as with capital reserves, it would be possible for a SIB to leverage its cash on hand by having outstanding lines of credit in excess of its immediate resources. Again, this leveraging strategy would necessitate that a SIB obtain a credit rating.
Debt service guarantees. Guarantees to meet debt service payment requirements are currently offered both by commercial banks, as letters of credit, and by bond insurance companies, as bond insurance. In both cases, the guarantee represents an irrevocable, direct commitment of the guarantor to the bondholders to cover debt service payments in the event that project revenues are insufficient to meet debt service. In this way, letters of credit (and bond insurance) are like a line of credit, except that it runs directly to the lender/bondholder rather than through the borrower (in this case, the project sponsor). Bond insurance differs from letters of credit because it is in effect for the entire life of a debt issuance; letters of credit typically extend for no more than eight years. It is likely that when offering debt service guarantees, SIBs would issue letters of credit to project sponsors. Regardless of terminology, provision of any kind of multi-year debt service guarantee in excess of available assets would almost certainly require a SIB to obtain a credit rating. The criteria applied by rating agencies to entities providing debt service guarantees are stringent (e.g., a minimum of $200 million in capital, and a diversified insurance portfolio of investment-grade bonds, for bond insurance companies).
Leveraging SIB FundsLeveraging can have a powerful effect on the amount of assistance that can be generated from a given level of SIB capitalization grants. A bank is considered leveraged if its total potential liabilities exceed its liquid assets. Leverage thus increases the amount of assistance a SIB may offer well beyond its cash-on-hand. It is for this reason that the leveraging of SIBs draws a good deal of attention—leveraging can make scarce Federal capitalization grants go further.
A SIB may be leveraged in two ways: (i) by issuing debt (typically, bonds) on its own behalf; or (ii) by guaranteeing or otherwise assuming liability for others’ debts in an amount greater than the SIB’s own cash.
Leveraging a SIB by issuing debt means that a SIB uses its existing assets plus anticipated project revenues to provide security for the issue. The proceeds from the debt issuance can then be provided to project sponsors as either loans or credit enhancements. This approach can make sense if demand for SIB assistance outstrips the amount of cash immediately available for outlays.
If a SIB were leveraged through assuming liability for others’ debts in excess of the SIB’s own cash on hand, the likely means of doing so would involve provision of some of the forms of credit enhancement discussed in the previous section. Under this model, leverage is derived from the fact that the debt service thus guaranteed is substantially greater than the reserves set aside to meet expected payouts.
Both forms of leverage would require the inspection of the SIB by rating agencies, since paragraph 350(e)(2) of the NHS Designation Act requires that a SIB maintain an investment grade rating on its debt issuances or obtain bond or other debt financing instrument insurance sufficient to maintain the viability of the bank. This statutory requirement applies in instances where banks are leveraged either through issuing bonds or by guaranteeing others’ debt in excess of the SIB’s own liquid assets. Even if the NHS Designation Act did not include this requirement, leveraged SIBs would probably have to obtain a rating anyway, as a practical matter. This would certainly be true under the first model, in which the SIB itself is issuing debt and would wish to ensure market acceptance of its issuances. It would also hold true under the second leveraging model, for the value of the SIB’s guarantee to back project sponsors who themselves issue debt will only be as strong as the credit worthiness of the SIB itself.
Rating criteria normally applied to leveraged institutions appear to exceed the current capabilities of most SIBs. The aforementioned SRFs for wastewater treatment facilities serve as a useful model. Without external credit support, SRF bonds are rated on the credit quality of the borrowers, the additional liquidity provided through reserve funds, and additional coverage provided by the excess of loan repayments over bond debt service payments. To attain a rating that is higher than the least creditworthy participant, SRFs with 20 or more borrowers must present liquidity or excess coverage that provides an adequate cushion in the event of an interruption in payments from borrowers over a period of time. If the loan pool is smaller, or if the repayment stream is dominated by a few borrowers, more stringent liquidity and coverage requirements will apply. Since SIB loan pools are fairly small and new, SIBs will probably have to provide healthy liquidity and/or coverage ratios to attain an investment grade rating, thus constraining the remaining amount of cash available to offer to project sponsors.
