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Panel on the Credit-Worthiness of Federal CreditIntroductory Remarks
Tom McLoughlin, MBIA Insurance Corporation, introduced the third and last panel as one that would review alternative risk scoring methodologies for Federal credit and assess the implications of the OMB Circular A-129 policy concerning the subordination of Federal debt. He noted that panelist David Litvack, Fitch IBCA, would provide an overview of the risk model developed by Fitch IBCA for evaluating the default risk associated with a Federal credit program involving direct loans, loan guarantees and standby lines of credit for surface transportation projects. He said that panelist Chee Mee Hu, Moody's Investors Service, would draw upon her vast experience in transportation credit analysis to discuss issues relating to potential risk scoring methodologies for Federal credit.
A Capital Charge Scoring Methodology for Federal Credit
David Litvack, Fitch IBCA, began his presentation by noting that as part of FHWA's draft policy discussion paper called Federal Credit for Surface Transportation: Exploring Concepts and Issues, Fitch IBCA was asked to develop a model for evaluating the default risk for a Federal credit program involving direct loans, loan guarantees and standby lines of credit for surface transportation projects. (A summary of the Fitch IBCA methodology is contained within Appendix A of Federal Credit for Surface Transportation: Exploring Concepts and Issues.)
Mr. Litvack reviewed the methodology used by the Office of Management and Budget (OMB) to score the Alameda Corridor loan. Under the Federal Credit Reform Act, the budgetary cost of loans and loan guarantees is based on the subsidy cost of the loan, representing the credit risk and any interest rate subsidy. The Alameda Corridor loan was scored using a "yield premium" approach to assess potential default cost. The loan was assumed to be made at an interest rate equal to the U.S. Treasury bond yield. The net present value of loan repayments on the project was then calculated, discounted at both the Treasury yield and the loan's assumed market yield, based on the project's preliminary rating (105 basis points above the Treasury yield). The difference in net present values was deemed to represent the cost of the default risk. Using this methodology, OMB calculated the default risk to be around 15 percent of the $400 million loan amount. Thus, the budgetary cost for the Alameda Corridor loan was estimated at around $59 million.
Mr. Litvack stated that in his opinion, the yield spread approach was not a valid measure of the expected default risk. Market yields take into account other factors beside default risk, such as liquidity risk and call risk. Since liquidity risk and call risk are not relevant factors in the cost of the program to the Federal Government, the yield premium results in a cost estimate that is too high.
Mr. Litvack said that the fact that market yield spreads overestimate default risk is evidenced by the existence of a private, for-profit bond insurance industry that guarantees the principal and interest on municipal bonds, as well as asset-backed and mortgage-backed securities. Bond insurers guarantee municipal bonds that have mostly A and BBB underlying ratings; the insurance raises the bonds' public ratings to AAA. The premiums on these policies, which are usually paid by the issuer, amount to about half of the issuer's interest cost savings as a result of the higher credit rating. At that premium base, bond insurers average around four percent losses on those premiums collected.
Mr. Litvack stated that bond insurers incur other costs besides losses, such as underwriting, surveillance, and administration; however, during the period from 1992 to mid-year 1996, bond insurers averaged 13.1 percent return on equity (income after expenses and taxes, divided by average shareholder's equity).
Mr. Litvack reviewed the methodology employed by Fitch IBCA in rating the claims-paying ability of the bond insurers. He said that a large part of the analysis focuses on the insurers' capital adequacy. To measure capital adequacy, Fitch IBCA uses a stress test model that subjects a bond insurer's portfolio to an economic downturn that produces an extraordinary level of bond defaults. For an insurer to receive a AAA claims-paying ability rating, it must be able to pay all projected claims through the peak years of the stress period and be left with sufficient resources to write new business when more stable economic conditions resume.
Claims during the stress period are forecast using capital charges that Fitch developed based on bond defaults experienced during the Great Depression of the 1930's. Fitch has adjusted the capital charges to reflect regulatory changes and the relative probability and severity of defaults for the types of insured risks in today's market. For example, current banking laws enacted after the Great Depression reduce the potential severity of another depression. However, in the 1930's all municipal bonds were backed by a general obligation pledge; most municipals today are limited recourse revenue bonds which have potentially greater risk. For this reason, Fitch has developed different benchmark capital charges for various types of insured bonds. For example, transportation bonds on existing facilities are more risky and, therefore, have higher benchmark capital charges than water and sewer bonds. They are, however, less risky and have lower benchmark capital charges than private higher education and hospital bonds. These benchmark capital charges are then adjusted further based on Fitch IBCA's evaluation of the actual credit quality and diversity of the bonds within each sector of the individual insurer's portfolio.
Bond insurers do not currently insure start-up toll roads. Fitch IBCA developed capital charges for this category specifically for FHWA's discussion paper Federal Credit for Surface Transportation: Exploring Concepts and Issues. Fitch IBCA's methodology for developing these charges is described in the following paragraphs.
Based on historical evidence, although some start-up toll road projects experience late payment delinquencies in years one through five, and less frequently in years six through ten, almost all do get built, begin operations, and eventually pay off their debt, including interest on interest. Subordinate lenders to projects of investment-grade quality should get paid as well, although perhaps over a somewhat longer time frame than the senior bondholders. It is estimated that only about one percent of the loans rated BBB will not be recovered within a reasonable time frame, which for discussion purposes is defined as 30 years.
A project is rated below investment grade (lower than BBB-) if there is a foreseeable risk that it will not be successfully completed on time or generate sufficient revenues to fully pay creditors. Indeed, default rates are much higher for unrated and below investment-grade municipal bonds than they are for investment-grade bonds. Because start-up toll roads have only recently received ratings, there is little empirical data on default rates specifically for this sector. Based on the default experience in other sectors of the municipal market, Fitch IBCA estimates that a portfolio of loans on start-up toll road projects rated BB will experience a four percent loss rate and start-up toll road projects rated B an eight percent loss rate (net of recoveries).
Highly rated financial institutions not only require enough capital for an expected level of losses, but for a multiple of such losses. Fitch IBCA has concluded that for start-up infrastructure projects, a multiple of four to five times expected losses is needed to provide the highest credit standard of AAA. Multiplying the expected losses by five produces the capital charges that should be used on loans to start-up toll road projects; these charges (expressed as a percentage of original principal) are shown in Table 1.
Table 1
Capital Charges for Start-up Toll Road Projects
Project Rating Expected Loss (%) Multiplier Capital Charge AAA Scenario (%) BBB 1.0 5 5.0 BBB- 1.6 5 8.0 BB+ 2.6 5 13.0 BB 4.0 5 20.0 BB- 5.0 5 25.0 B+ 6.4 5 32.0 B 8.0 5 40.0 Fitch IBCA recognizes that, in many cases, the Federal loan will be junior to the senior debt, but believes the same capital charges are applicable for subordinate, flexible payment debt. The flexibility in the Federal credit program reduces the demands on a project to make timely payments; however, full repayment is still required. An important element in Fitch IBCA's capital charge calculation is that most loan defaults that occur during the initial ten-year period will be recovered. Fitch IBCA assumes that interest on delinquent loan payments is equal to the U.S. Treasury rate, so timing defaults will not affect the net present value cost of the loan credit program. The same analysis should hold true whether the Federal credit takes the form of a direct loan, a guaranteed loan, or a contingent standby line of credit.
Mr. Litvack said that it should also be noted that the capital charge methodology for private, for-profit bond insurers applies to a large and diversified portfolio of loans. If an insurer were to guarantee loans to only a handful of projects, and one of these projects defaulted, then the overall cost could conceivably be higher than the weighted average capital charge. Fitch IBCA would require considerably more capital to assign a rating of AAA to a private company insuring only a small, non-diversified portfolio of loans. Considering the fact that the Federal Government has no liquidity constraints and these transportation loans would be only one piece of an existing diversified portfolio of approximately one trillion dollars of Federal Government loans and guarantees in a wide range of industry sectors, this capital charge method is considered appropriate.
Mr. Litvack reviewed the suggested rating category for the Federal credit program portfolio. The capital charges Fitch IBCA recommends are consistent with AAA security. For an ongoing Federal credit program that encompasses a portfolio of loans and guarantees, the likelihood of underestimating default cost is remote. In other words, the capital reserves should absorb all anticipated default risk, in essence representing a proxy for Federal subsidy cost. This makes it a useful and conservative tool for budgeting purposes.
Comments on Risk Scoring Methodologies
Chee Mee Hu, Moody's Investors Service, is the managing director of a group that focuses on high profile sectors, including all areas of transportation. Ms. Hu indicated that the portfolio capital charge approach for estimating default rates was a useful tool, but it was important to note a number of issues. These issues are reviewed below:
- The portfolio modeling approach is just a tool, and only as useful as the assumptions and data that are used to structure the model. Moody's has been studying corporate default rates since the 1920's. The factors used to study corporate default rates are very different from those used to study municipal default rates. Toll road projects have limited default history. The lack of history means that the numbers will be tricky and data interpretation will be key.
- Critical mass is an issue. In order to optimize a portfolio approach which looks to blend risk, critical mass must be reached. With respect to the types of financial assistance envisioned under TIFIA, it could take a long time to build up to critical mass.
- Portfolio approaches work best when there is diversification. The portfolio of loans offered under TIFIA and TICA may exhibit geographic, size and project diversity; however, all the projects funded under the proposed Federal credit programs will be transportation projects and thus the portfolio will not have sector diversity.
Ms. Hu said that in the portfolio modeling approach, there are two levels of analysis. The first is the micro level, which is where a probability of default is assigned to a particular project. The second is the macro level, which is where a probability of default is assigned to a portfolio of projects. The default assumptions made for the entire portfolio of loans is based on the micro-level analysis performed for the individual projects.
Ms. Hu concluded by noting that the types of projects targeted for assistance under TIFIA and TICA are start-up projects and thus involve individual project finance. She stated that project finance is perceived as one of the most complex and riskiest areas of credit analysis. When analyzing start-up projects, a probability of risk is assigned to something that does not yet exist. Therefore, it is important to perform a complete and thorough micro level analysis. The focus, therefore, should be placed on the micro level.
Discussion
Mr. McLoughlin commented that Nathalie Cohen had performed an excellent analysis of municipal default risk. Her study, entitled Municipal Default Risk, was published by the Enhance Reinsurance Company. The paper had no parallel in terms of depth of its analysis of historical municipal default rates. The study looks as far back as the 1870's, and particularly focuses on defaults occurring during the great depression of the 1930's.
Mr. Litvack said that other studies on municipal default rates were performed by the Public Securities Association (PSA) and J.J. Kenny. Few studies on municipal defaults exist because municipal defaults are rare. There is a strong negative correlation between investment grade rated debt and default risk. Virtually all defaults occur in the sub investment-grade sector.
Mr. McLoughlin stated that the historical negative correlation between investment grade debt and default risk speaks well to the ability of rating agencies to assess default risk and assign ratings to bond issues.
Mr. McLoughlin asked Mr. Litvack whether the Fitch IBCA model would assign a percentage capital charge to all projects within a certain category of projects, or would the charges only be applied to specific projects, based on project-level analysis.
Mr. Litvack responded that micro-level analysis would be performed to assign a project-specific rating to each project receiving assistance under the Federal credit program. The rating would be plugged into a matrix (see Table 3) in order to assign appropriate capital charges for that project.
Mr. McLoughlin asked Ms. Hu how instrumental the Federal line of credit was in obtaining an investment grade rating on the bonds issued by the Transportation Corridor Agencies for the San Joaquin Hills Corridor Project.
Ms. Hu responded that the Federal line of credit, while helpful, was not determinative. The project still must make sense. If the project makes sense and the political, legal and structural issues are resolved, the project receives an investment-grade rating. If not, a Federal line of credit does not help. What the Federal line of credit did was provide a source of contingent revenues during the project's ramp-up phase and, most importantly, demonstrate public support for the project.
Mr. McLoughlin asked Ms. Hu how important public support was for start-up toll road projects seeking debt financing through the capital markets.
Ms. Hu responded that public support for a project was absolutely critical. When rating agencies hold discussions with project sponsors, warning bells go off when the rating agency is not hearing from Federal, State, and local governments. Government support for a project is essential, especially because of all the permitting, paperwork, and bureaucratic issues that must be addressed. If there is any doubt that public acceptance is solid, the rating agency will typically step back and delve further into the transaction.
Mr. McLoughlin asked Ms. Hu how important the subordination of Federal debt was to the San Joaquin Hills Corridor project.
Ms. Hu responded that the subordination of debt was important, but was not the key issue.
A spokesperson from the Federal Railroad Administration (FRA) stated that the scoring of Federal loans and loan guarantees was a dilemma facing the FRA. The FRA has provided loans and loan guarantees for high-speed rail, rail acquisition and track acquisition. These transactions require significant micro-level analysis. Unfortunately, FRA doesn't have the appropriate level of expertise to accurately score the budgetary costs associated with the provision of credit.
Mr. McLoughlin responded that the issue of timing was also important. Projects are not in their final form when project sponsors first come to the Federal Government for assistance. Between the time a project requests Federal assistance and it issues bonds, the project's plan evolves and may change completely.
A member of the audience stated that to qualify for assistance under TIFIA, projects would be required to produce a preliminary credit assessment by a nationally recognized rating agency. The audience member asked Ms. Hu how Moody's would treat a project that was well on its way, but needed more refinement before it could obtain an investment grade rating.
Ms. Hu responded that Moody's might take a two-step approach to such a project. Moody's would first assign a rating estimate. The rating estimate takes into account all available information. The rating estimate states that a project is investment-grade provided key project parameters stay within a certain tolerable level of variation. The second step involves comparing the original structure of the transaction to its final form and determining whether the project parameters remained within the scope of the rating estimate. A rating is assigned if the final structure is within the bandwidth established by the rating estimate.
An audience member said that historically, bond insurers had not insured start-up toll road projects. Given recent project experience, is MBIA rethinking its position on insuring start-up toll road projects?
Mr. McLoughlin responded that start-up toll roads were assessed on a case-by-case basis. Initially, the San Joaquin Hills and Denver E-470 toll road projects were not viewed as insurable; however, when they were refinanced, MBIA was comfortable with providing unconditional guarantees for both of the projects. MBIA is not going around the country specifically looking for start-up toll road projects to insure, but it will listen to project sponsors that are interested in obtaining insurance for their projects.
A member of the audience said that there is a particular level of support that must be demonstrated over a period of time before a bond insurer will feel comfortable with start-up toll roads. There have been a couple of very successful start-up toll road facilities. Does that mean the bond insurers are going to be more receptive to start-up toll road projects in the future? Mr. McLoughlin responded that the answer is probably yes; however, the ultimate judgment will be made on a project-by-project basis.
An audience member noted that Federal agencies face significant time constraints in assembling their budgets. Annual budget requests must include assumptions about program and project costs, including subsidy estimates for credit activity, many months before enactment and finalization of plans. How could project sponsors be assured that Federal budgetary resources would be available at subsequent times when projects are ready to draw on Federal credit?
Another audience member responded that the answer for dealing with the budgetary process lies with a two-step portfolio approach. Initial estimates of subsidy costs should be conservative placeholders, based on the capital charges and related multipliers assigned to minimum investment grade (BBB) applicants. Those conservative (high) capital charges or subsidy costs would then be revised when credit agreements are finalized and projects are ready to receive assistance.
A member of the audience suggested that the Federal Government could assess capital charges based on project type for a given project rating. For example, a five percent capital charge could be assigned to all start-up toll road projects and a three percent capital charge assigned to investment grade port facilities.
An audience member stated that it was important to note that on a project-by-project basis, the subsidy cost estimate would always be wrong. However, the aggregate, program-level estimate would be roughly accurate.
A member of the audience noted that when bond rating agencies rate an individual project, the focus is on the project's ability to pay off its debt in full and on time. Since, under TIFIA, the Federal Government would be a "patient investor" willing to accept deferrals, should the timing of the repayment be a factor?
Ms. Hu responded that the flexible features of the loans proposed under TIFIA would be important. These features would not be present in capital markets debt. In the capital markets, late payments are not acceptable.
An audience member stated that before DOT gets too involved in the credit business, it must first structure itself like a lender. Thus, DOT should establish a credit committee to review applications and provide appropriate procedural checks and balances.
An audience member noted that government agencies must be able to demonstrate due diligence when monitoring credit activities. In order to do so, officers of the Federal Government must fully understand each credit transaction. That doesn't mean that Federal officers should be second-guessing rating agencies. What it does mean is that the Federal Government could incur substantial losses if its officers failed to understand the nature of the risks associated with the provision of credit.
Mr. McLoughlin responded by stating that due diligence would be essential on the part of the lender. There are, however, some safeguards built into the market now. The projects targeted by TIFIA would have continuing disclosure obligations and senior-lien debt instruments held by the public. In theory, any private organization that somehow attempts to cloak continuing losses would be subject to anti-fraud rules. To a certain degree, there is access to information without the need to establish a separate parallel organization.
An audience member noted that because TIFIA limits Federal credit to 33 percent of project costs, the Federal Government would be sharing the risk with other investors. This co-investment should provide some reassurance.
An audience member stated that credit analysis is only one step in the process. Moreover, some projects may offer substantial economic benefits, but for one reason or another are not deemed to be credit-worthy. The policy goals should be weighed against the outcome of the credit analysis. Political considerations must also be weighed.
A member of the audience said that the projects targeted by TIFIA would be those that otherwise might be delayed or not constructed at all because of risk or cost. Part of the analysis should focus on the question of whether or not the project could be constructed in the absence of Federal credit. The Federal Government should not offer credit assistance to projects with access to the capital markets. The Federal loans envisioned under TIFIA and TICA should be viewed as credit enhancements for marginal projects.
An audience member stated that the Federal Government is in a much different position than that of a private lender. A private lender does not care about ancillary project benefits. Moreover, the Federal Government is not interested solely in the rate of return on investment. By offering Federal credit, the Federal Government is also in the enviable position of replacing grants with loans. Thus, there are other factors to weigh in addition to risk.
An audience member commented that Federal loans as proposed under TIFIA would act as a credit enhancement. The net effect of which would be to lower the overall cost of financing, reduce the risk to investors, and lower the costs to users of the facility. The Joint Committee on Taxation (JCT) should note that in many cases, the Federal loans actually could reduce the cost of capital and thus reduce the volume of tax-exempt debt issued for transportation infrastructure.
Mr. Seltzer stated that OMB Circular A-129 specifies that Federal credit should not be repaid or refinanced with the proceeds of tax-exempt debt. If a project initially financed with Federal credit later demonstrates that it can support itself without Federal involvement, why shouldn't it be allowed to do so with tax-exempt debt? In such a case, the Federal Government is repaid in full, and the project is completed at no cost to the Federal Government.
A member of the audience responded that the Federal Government's primary objective should not be to reduce the volume of tax-exempt debt. The main objective of the Federal credit programs envisaged under TIFIA and TICA would be to provide financing to nationally significant projects. By refinancing Federal loans with tax-exempt debt, projects reduce Federal exposure and promote private investment in public infrastructure.
