5. Addressing Federal Credit and Tax Policy Issues

Introduction

A credit program for surface transportation should be consistent not only with federal transportation policy objectives but also with federal credit and tax policy objectives. The Office of Management and Budget (OMB) is responsible for administering federal policy on credit matters, and the Department of the Treasury is responsible for administering federal policy on tax-related matters. This chapter examines key features of a potential surface transportation credit program in light of OMB and Treasury policy guidelines and describes how such a program could be structured to address those policy issues while offering meaningful assistance to project sponsors.

Summary of OMB Circular A-129

Federal policy for credit programs is outlined in OMB Circular No. A-129. The circular specifies that credit assistance should be provided "only when it is necessary and the best means to achieve clearly specified federal objectives." ¹ When credit assistance is deemed necessary for meeting federal objectives, it should adhere to the policy guidelines set forth by OMB. While not legally binding, these guidelines are designed to protect the government's interests and minimize costs to the taxpayers.

The circular sets forth four central principles for the justification, design, management, and implementation of federal credit programs:

1. Program Justification. Credit programs should have clearly defined objectives that specify why private sources of capital are inadequate to meet investment needs. The objectives should specify whether the purpose of the program is to correct imperfections in the capital markets or to subsidize borrowers. The program should: explain why a credit subsidy is the most efficient way of providing assistance; estimate the benefits to be received; and describe any features of the program which encourage and supplement private lending activity with minimal federal intrusion. The program should provide an explicit estimate of the subsidy costs pursuant to the Federal Credit Reform Act of 1990 (FCRA), including administrative costs.
2. Forms of Assistance. Loan guarantees should be favored over direct loans because they are viewed as more likely to reflect commercial credit terms. However, direct loans may be justified if the programmatic objectives cannot be readily achieved through reliance on guarantees.
   
   Federal guarantees of tax-exempt obligations are specifically prohibited. Such guarantees are deemed economically inefficient because they confer greater costs to the government than interest savings to the borrower. The circular treats as "federally guaranteed" any tax-exempt obligations secured or collateralized by federal guarantees, as well as direct or guaranteed loans that are subordinate to tax-exempt obligations.
3. Financial Standards. As required by FCRA, agencies must control the risks and costs associated with their credit programs. Default risk should be estimated using recognized statistical models. Lenders and borrowers should have a substantial stake in the transaction of at least 20 percent of total exposure. Interest rates on direct loans should reflect the federal government's own cost of funds, as determined by comparable-term Treasury borrowing yields. Fees and charges on direct or guaranteed loans should be set sufficiently high to cover the subsidy and administrative costs of the program, unless the agency considers such practice inconsistent with its programmatic objectives. In such case, the agency should obtain budget authority in accordance with FCRA to cover that portion of the subsidy cost not offset by interest and fees. The credit instrument should contain contractual terms and conditions necessary to protect the federal interest. The maturity of the loan or guarantee should not exceed the estimated useful economic life of the asset being financed, and the federal government's claim on assets should not be subordinated to the claims of other lenders in the event of a default by the borrower. There should be specific ceilings on the maximum nominal amount of credit that may be supported by the subsidy costs.
4. Program Implementation. Proposed legislation should be submitted for review by OMB. To the extent the proposed terms of the credit program do not adhere to the guidelines, agencies may request waivers or modifications from OMB. The agency should provide periodic evaluations of the effectiveness of the credit program to determine the extent to which it is achieving the intended objectives.

Analysis of Compliance with A-129

The federal credit program structure described in this report would comply in most respects with the key policy guidelines set forth by OMB. The program objectives as stated would constrain the federal role so as not to displace conventional funding sources. The credit program would be targeted specifically to fill market gaps not being filled by private sources of credit, and the substantial co-investment from non-federal sources would be required to ensure market discipline in project selection.

The maximum federal share as outlined in this report would be 33 percent of project costs, significantly lower than the 80 percent recommended maximum which is utilized by other federal credit programs. The scoring of the subsidy costs would be based on statistical models from independent third-party experts, such as rating agencies (as described more fully in Appendix A), and budget authority would be provided to cover the subsidy costs of credit instruments not offset by fees or charges.

All direct loans would be required to be made at rates not less than prevailing yields on comparable-term Treasury obligations. The credit agreements would be required to contain customary security features (rate covenants, additional bonds tests, etc.) designed to minimize the risk to the federal government, and the government's claim on assets would not be subordinated to that of other lenders in the event of liquidation of assets following a default.

Items Requiring Policy Waivers

There remain two items in OMB's guidelines, as well as one Treasury policy, which would require a waiver or modification if a surface transportation credit program were to serve as an effective tool in advancing infrastructure projects. These are discussed below:

Credit Policy: Agencies shall not subordinate direct loans or guaranteed loans to tax-exempt obligations.

Recommendation: Transportation credit should be permitted to be subordinate in its claim on project revenues to other, privately-financed debt, which may be tax-exempt.

Rationale:

1. A federal loan with a claim on annual project revenues junior to that of other lenders should not be viewed as a direct or indirect guarantee of the senior-lien obligations. As envisioned under a surface transportation credit program, in no event would the federal government ever be obligated to make any payments to the senior lenders. Rather, the federal government's junior position would facilitate the borrower's ability to obtain financing on its privately-funded debt by allowing those bondholders to have a first claim on annual project revenues. The same argument should apply on a junior-lien guaranteed loan. The federal guarantee clearly would extend to the lenders of the guaranteed loan, not to the lenders or investors for the non-guaranteed senior obligations.

2. As described in this report, the federal government would possess a parity or equal claim on project assets with other lenders in the event of default and liquidation, and thus would be in compliance with OMB guidelines.

3. Based on current and projected project activity, it appears that most transportation projects requiring assistance under a credit program would be eligible to issue tax-exempt debt under current tax law, whether by state and local instrumentalities or by other nonprofit entities. (See the illustrative project list in Appendix E.) Barring such issuers from gaining access to the municipal market for the majority of their financing would offset the intended funding benefit of the federal credit assistance and defeat the fundamental program goal of stimulating capital investment.

4. Taxable interest levels place a greater burden on the long-term economic viability of capital-intensive infrastructure projects. Allowing project sponsors that are otherwise eligible to issue tax-exempt debt to do so in conjunction with a separate federal loan or guaranteed loan would improve the creditworthiness of the government's investment by reducing the project's senior debt service burden.

5. There is no prohibition against state or local governments receiving outright federal grants for a project, and financing the non-federal share with tax-exempt debt. In fact, this is the prevailing practice for financing surface transportation infrastructure. Such grants are not deemed a federal guarantee of the bonds. Therefore, from a federal budgetary perspective, it would be counterproductive to impose a policy that prohibits federal participation from taking the form of federal credit in favor of more costly outright federal grants that will never be recovered.

6. As a practical matter, there are many current examples where federal credit is subordinate to or exists side-by-side with tax-exempt debt (e.g., Transportation Corridor Agencies, Alameda Corridor Transportation Authority, Washington Metropolitan Area Transit Authority, and Farmer's Home Administration).

Credit Policy: Loan guarantees should be favored over direct loans.

Recommendation: Provide a mix of credit tools that includes both loan guarantees and direct loans.

Rationale:

1. Project sponsors would benefit most from a variety of credit instruments that provide the flexibility to match a particular type of credit assistance to each project's unique characteristics and financial needs. This would be consistent with other major federal credit programs, in areas such as housing, agriculture, and small business, which offer both direct loans and loan guarantees.

2. A surface transportation credit program could be designed to give preference to project applicants seeking loan guarantees over direct loans, in full compliance with OMB policy. Over time, private investors might gain greater familiarity with the payment features of junior loans based on federal credit experience, thus supplanting the need for direct loan assistance.

3. However, a direct loan option might be an important component of a credit program, especially in its early years. Even a guaranteed loan backed by the federal government would probably require a yield somewhat above comparable-term Treasury securities, due to its lesser liquidity and greater uncertainty as to the timing of repayments. This would cause project sponsors to favor direct loans over loan guarantees, all other things being equal.

Tax Clarification Required for Standby Line of Credit

Tax Policy: Any obligation whose principal or interest is directly or indirectly guaranteed, in whole or in part, by the United States, shall not be tax-exempt.

Recommendation: Broaden the purposes for which a standby line of credit can be used, or alternatively revise the Internal Revenue Code to clarify that a standby line of credit provided by DOT under a surface transportation credit program does not constitute a federal guarantee.

Rationale:

1. The statutory prohibition against federal guarantees of tax-exempt debt in Section 149(b) of the Internal Revenue Code is extremely broad. An obligation's tax-exempt status is called into question if there is any implication that the bond holder can rely upon the federal government directly or indirectly, in whole or in part, for repayment of the bond's interest or principal. A standby line of credit which can be drawn upon to support debt service if project revenues prove insufficient during the ramp-up phase could be construed as an indirect guarantee under this broad language, precluding its use in connection with tax-exempt debt.

2. A line of credit differs from a guarantee in a number of important respects, including the degree to which an investor relies on the presence of the line in making an investment decision. Unlike a guarantee, a line of credit represents only fractional and temporary assistance. It may succeed in elevating the rating of a sub-investment-grade issue to BBB, but that issue clearly would not be viewed by investors as being federally backed or of AAA caliber.

3. Section 149 provides exceptions for certain areas deemed important for achieving national objectives, such as federal guarantees and insurance programs for housing, student loans, and certain power facilities. Currently, however, there is no exception for standby lines of credit for surface transportation facilities.

4. The tax-exempt status of transportation project debt could be preserved by providing that the purpose of the line not be limited solely to making debt service payments. Recent experience with standby lines of credit for two toll road projects in southern California has shown that broadening the lines permitted purpose can be sufficient to enable bond counsel to render an unqualified opinion that the tax-exempt status of the bonds would not be jeopardized should the line be drawn upon.

5. Another way to ensure that a standby line of credit does not undermine the status of tax-exempt debt would be to revise the Internal Revenue Code to clarify that a standby line of credit under a surface transportation credit program does not constitute a federal guarantee. (See Appendix B for a more complete discussion of this option.)

¹ Circular No. A-129, Policies for Federal Credit Programs and Non-tax Receivables, Executive Office of the President, Office of Management and Budget, January 1993.