The lights are on.  The band plays.  Applications are submitted, loans are efficiently closed, and glowing press releases are issued.  The high credit quality of the portfolio continues.  Everything looks great above the discretionary appropriations waterline. 

But below that waterline, where the technical machinery of FCRA interest rate re-estimates operates, I think the picture is very different.  Red ink is flooding in.  WIFIA loan commitments bear interest rates that reflect Treasury’s full economic cost of funding them on the day of execution.  But actual funding will occur years later.  When rates rise, so too does the cost of funding the commitments, in a scale that dwarfs the program’s discretionary appropriations.  If rates fall?  The loan commitments are cancelled or reset lower and drawn are loans refinanced.  As currently operated, WIFIA will never have anywhere near sufficient funding gains to offset massive, ever-accumulating losses.  It is true, per the letter of the law, that such re-estimate losses are off budget, but taxpayers will bear them just the same.  Did Congress intend or even contemplate this outcome?  Is this consistent with the spirit of the Anti-deficiency Act?  Does WIFIA have only political friends and no competitors with political clout?  Government loan programs are said to be unsinkable, but they can run into trouble, as the DOE LPO’s Solyndra loan demonstrated.  And WIFIA itself was nearly defunded in 2020 over a budget issue far less substantive than this.

This post brings an analysis of the economic cost of WIFIA up to federal FYE of September 30, 2022.  Prior posts covered FYE 21 and some interim periods.  All the analyses are based on publicly available information.   The methodology is outlined in the first analysis and remains basically unchanged except for a few minor refinements.

Which Reality?   It Depends

One thing is important to note.  This post, as were prior ones on the topic, will be focused on the economic funding cost of WIFIA’s portfolio, which I think is accurately reflected by FCRA’s budgeting methodology.  The economic cost of anything is a somewhat theoretical concept.  In this case, it means an estimate of the resources that the federal government must allocate to fund WIFIA loan commitments for their full 35-year term.  The best real-world data to make that estimate at a particular point comes from the current Treasury rate curve, which can be used to price a series of zero-coupon bonds that exactly match the loan’s debt service schedule.  If the loan’s expected debt service payments cover these virtual zeroes when due, as was apparently contemplated in the Program’s legislation, then no further resources are necessary for its funding.  But if they don’t – the issue here – then the shortfall must be made up from other resources, which ultimately means taxes.  Discounting that stream of expected future taxes at Treasury’s own risk-free rates (only one thing is more certain than taxes, after all) results in a fair estimate of the present value of the nation’s resources that’ll need to be allocated to fund the WIFIA loan.  Think about it as an amount of value that will be taken out of the economy, set aside for the loan, and precluded from other uses.  Things could change, of course, for better or worse, but I think the estimate is the best snapshot of the loan’s real-world cost that you’ll get at any point.

WIFIA’s economic cost could perhaps be justified if the economic benefits of the loans equaled or exceeded it.  But I’m not sure that WIFIA loans have very much impact on water infrastructure itself since most (possibly all) of the financed projects would have gone ahead anyway.  Instead, the loans appear to have primarily facilitated indirect transfer payments in the form of slightly lower water rates for the lucky communities that got them.  It might be hard to make a serious case that WIFIA’s net economic benefits cover even the Program’s small discretionary appropriations.  But one thing is unquestionably true:  $16 billion of highly rated, bond-like WIFIA loans did not miraculously unleash billions of dollars in additional economic value for the US water infrastructure sector that was somehow overlooked by long-established local utilities, most with excellent access to infrastructure financing alternatives.  The most likely economic outcome is a deadweight loss, or close to it.

Estimates of economic reality are not the only way to look at the cost of WIFIA loans, however.  In fact, they may be the least relevant for practical purposes.  That’s demonstrated by WIFIA itself.  The Program blithely offers ‘free’ interest rate options because loan cost re-estimates, per FCRA, are completely off-budget and buried in obscure footnotes.  There’s a certain irony here – FCRA methodology does a good job of precisely estimating the economic cost of loan re-estimates, but FCRA law requires that those estimates are effectively hidden.  And the result is completely predictable: A $16 billion portfolio of high-quality loans and loan commitments was created with only about $200 million of on-budget (discretionary) appropriations by offering an unbeatable interest rate feature, the actual cost of which is likely to be about $2 billion in off-budget (mandatory) appropriations.  The Program looks fabulously successful, and in one sense I suppose it is, in terms of how bureaucratic Washington sees these things.  I doubt it was an intentional plan, however.  Most likely the Program just kept going with a loan feature that seemed to attract high-quality applicants and didn’t require any additional on-budget resources.  Further thought about it was unnecessary. 

Still, even if basically hidden, the scale of the economic cost of the WIFIA Program could be an issue in a political context.  If someone wanted to dig out the numbers, there’s plenty of soundbite material in a cost factor that’s likely to be ten times higher than the budgeted appropriations.  Add in language from interpretations of the Anti-Deficiency Act’s intent (a topic for future posts) and it would not be difficult to paint a very ugly picture.

WIFIA enjoys broad support, but it is not immune from opposition.  There’ll always be the possibility of ideological or partisan attack, which is what fueled the Solyndra uproar.  More alarmingly, the Program competes directly with the tax-exempt municipal bond market, whose lunch is eaten every time a WIFIA loan with a free interest rate option displaces an otherwise similar water revenue bond.  Their lobby can’t really make an overt attack on a program that provides state and local governments with another avenue to federally subsidized infrastructure financing.  That’s a bit too close to home.  But quietly raising a scary-sounding FCRA budgeting issue to a few key players is a perfect way to damage the competition while appearing to take a disinterested, public-spirited position.  I think such a tactic might have been behind the disproportionate reaction to WIFIA’s minor issue with loans to federally involved projects.  The Program was nearly defunded in 2020 due to a delay in publishing some technical criteria related to the tiny handful of applications from projects with federal involvement.  A bureaucratic delay?  In the middle of a pandemic?  On an issue that literally has zero economic impact?  Really?  Yes, really.  And it almost worked.  

In contrast to the sideshow of federally involved projects, the Program’s economic cost of interest rate re-estimates is both central to its current operations and huge, relative to what Congress expected the cost to be.  The numbers require some analysis, but a bond portfolio analyst wouldn’t find any difficulties in making a case if told where to look and what conclusions to draw.  In some ways, I’m surprised an attack hasn’t already occurred. 

A Packaging Alternative

Between WIFIA simply ignoring the Program’s economic cost and someone gleefully using its full impact for an agenda-driven purpose, there may be another approach that can re-package the cost issue in a softer, yet somewhat valid, way.  FCRA’s reality-based methodology is unique in federal cost budgeting, which largely utilizes cash accounting concepts.  Inserting a FCRA result into an artificial, cash budget world is arguably a category mistake given the actual degree of reality federal institutions operate in, akin to telling an undiplomatic truth at a garden party.  Instead, why not follow proper etiquette and estimate the projected cash cost of WIFIA’s portfolio?  That’ll look a bit better.  More importantly, a cash approach can be sliced and diced in ways that FCRA’s lump-sum of hard economic truth cannot.  What is truth anyway?

The next posts on this topic will start to pivot to a cash approach to WIFIA’s cost.  I have two goals in mind there.  The first is to raise some (but not complete) awareness of WIFIA’s funding cost to encourage product development at the Program.  Handing out free interest rate options is obviously an easy, fun, and effective way to create loan volume, but beyond that bureaucratic metric, it doesn’t accomplish much in the real world of US infrastructure.  WIFIA could do much more, and if it’s gently made clear to the Program and its stakeholders that the interest rate product is not in fact costless, they might try harder to find better ways to spend the same amount of money.

The second goal is to preempt, or at least to prepare a defense against, a political attack on WIFIA’s cost by having numbers out there that support a different narrative.  The cash approach is the lingua franca of federal budget policymakers and far easier to understand than FCRA, making it the right material for this purpose.

For the rest of this post, however, we’ll stay in the world of cold, hard reality.  Whatever edifices of spin need to be built for the greater good of more and better infrastructure loan programs, that reality remains the foundation.

Estimated WIFIA Portfolio at FYE 2022

Estimating the basic characteristics of WIFIA’s portfolio at FYE 2022 is straightforward.  The EPA website provides a list of closed deals, including amount and execution date.  There’s also plenty of public data about daily Treasury rates.  I’m assuming that WIFIA loans on average have a 20-year weighted average life (WAL), based on the typical amortization patterns for a 35-year project finance loan.  Per WIFIA law, a loan commitment gets an interest rate that basically corresponds to the UST rate for the loan’s WAL on the execution (or re-execution) date, hence I assume it’s the 20Y UST off Treasury’s SLG list or daily curve (they’re usually about the same).

Based on loan amounts and corresponding estimated interest rates, the weighted average interest rate (WAIR) of the portfolio at FYE 2022 appears to be 1.86%.  WIFIA’s website reports a portfolio average interest rate of 2.00%, but I believe this is a simple average, which would be closer their purpose of informing borrowers.  When I run a simple average on my numbers, I get 1.96%, which is very close.  That would seem to confirm my basic assumptions. 

The first chart breaks down loan commitments closed each month for the period in which WIFIA has been operating, the last five fiscal years 2018-2022.  Monthly averages of 20Y UST and 1YUST are also included to provide a sense, respectively, of (1) execution rates, and (2) the likelihood of the borrower using the WIFIA loan versus short-term financing for construction draws.  The lower short-term rates are, the more likely that the borrower will not draw the loan and use the rate lock as an interest rate option until construction completion.

The chart reflects WIFIA’s rapid startup in a period of huge movements in interest rates.  The last five years were certainly an interesting time to be creating a $16 billion portfolio of long-term, fixed-rate commitments, no?

It’s not surprising that there was a flurry of loans closed in the fall and early winter of 2020 when rates were hitting historic lows.  I’m sure the borrowers kept plenty of pressure on for executions and re-executions.  Volume has remained somewhat steady since, despite sharply rising 20Y rates.  Of course, planned projects will need financing on their own schedules and municipal bond yields will have risen as well.  But one factor, especially for loans closed over the last six months, might be the expectation that if rates fall over the next few years, the loan can be re-executed at a lower rate.  So why wait?  Once the loan is executed, the downside of even higher rates is capped while the upside of lower rates is still available.  I’d guess that nine of the latest loans, totaling about $2.2 billion, are likely candidates for re-execution if the 20Y UST gets back down to 2.50%.  Loan re-executions aren’t a statutory feature, but if future re-execution was a conscious expectation among these borrowers, WIFIA will have a hard time backtracking from precedents established in 2018-2021.  Most likely, the Program will continue resetting loan rates because there’s apparently no budgetary reason not to, and without that shield of fiscal prudence, it’s hard to counter unpleasant reactions from the Program’s eminently qualified beneficiaries.  How can a federal program stop giving out something that appears to cost the taxpayers nothing?  Yet in fact re-executions will lower the portfolio’s WAIR, turning the ‘FCRA re-estimate loss ratchet’ a few clicks further.

How much of the $16 billion of loan commitments have been drawn and are now funded loans?  WIFIA doesn’t directly provide any data on this, and there isn’t much information from other publicly available sources.  I don’t think this is the result of confidentiality or non-disclosure requirements, but simply the fact that loan drawdowns aren’t exactly great press release material.  In effect, no one cares.  But it is an important metric for estimating the economic cost of WIFIA’s FYE 2022 portfolio going forward.  Loans that have been 90% funded are not subject to further FCRA re-estimates, which means they’re not exposed to changing rates.  In a sense, potential gains or losses are realized when the loan is funded (in effect, a transfer to Treasury) and recorded in an off-budget account, something that should show up somewhere in WIFIA’s books.

Perhaps there’s more public disclosure of WIFIA’s accounts than I’ve been able to find, but for obvious reasons (primarily widespread indifference) locating this kind of thing is not easy.  There is one hint about WIFIA’s drawn loans in the White House 2023 budget published in the spring 2022.  In the EPA technical appendix, there’s a section for the WIFIA Program in which some numbers are presented in the federal budgeting format, a complex accounting language of its own.  From what I can understand, EPA estimates that the Program will have drawn loans of $3.8 billion and re-estimate losses of $140 million at FYE 2022.

The $3.8 billion, or 25% of the portfolio, seems plausible.  The amount would include earlier loans to smaller projects that are at or near completion, and whose smaller borrowers have fewer short-term financing alternatives.  Big projects with big borrowers, as well as recent loans, would make up the other 75%.  Or at least that was a plausible picture when the estimates were put together, perhaps early in 2022.  With the historically sharp rise in short-term rates this year, much may have changed, as drawing on WIFIA loans previously being kept as an option suddenly looks like the cheapest source of financing for construction draws.  It’s possible or even likely that the portfolio’s drawdown percentage was in fact much higher on September 30^th, but for now I’ll work with the 25%.

The $140 million of re-estimate losses (presumably solely from rising interest rates) looks lower than I would have expected.  However, as noted above, funded loans are likely to be with smaller, earlier borrowers who were drawing for construction costs before 20Y UST rates nosedived.  It’s also an EPA estimate which may have changed in the last six months, and there are likely other unfathomable factors at work, too.  Like the drawdown percentage, I’ll work with the number for now.  It’s worth noting that this loss is still about 4% of the funded loans, or over four times WIFIA’s typical credit subsidy of less than one percent.  Not huge in dollar terms, but definitely headed in the wrong direction.

Those assumptions leave 75% of the portfolio, or about $12 billion, exposed to changing rates.  For simplicity, I’ll assume that these loan commitments have the same WAIR, 1.86%, as the overall portfolio, though it’s probably lower.  The economic cost of funding these loans is the center of the analysis.

Before getting into the FCRA results, it’s worth doing a quick reality check.  Imagine you’re a bond portfolio manager doing a ‘mark-to-market’ (i.e., calculation of unrealized gains or losses) estimate for FYE value-at-risk reporting.  You’ve got a $12 billion portfolio of very high-quality, fixed-rate 35-year bonds with a weighted-average yield of 1.9% and a WAL of 20 years.  The 20Y UST at your FYE is 3.95%.  What’s the very best price you could expect, however theoretical, if you sold the entire portfolio that day?

The answer, which you can calculate with a two-line spreadsheet, is about $9 billion, for a $3 billion loss. The result could change in future of course – rates could fall, and your loss would be reduced.  They could keep rising, too, however, and it’ll get worse.  The $3 billion loss estimate is simply an estimate of risk at one point.  Still, you should expect losses, potentially big ones, if you’re committed to sell the portfolio over the next few years. Senior management will not be pleased.

Potential FCRA Re-Estimate Losses

FCRA methodology essentially does the same thing as pricing a bond, by discounting future payments to a present value.  Its process can be more precise because the appropriate discount rate need only to be derived from the US Treasury curve, as the federal government is the sole financing source (and hence ‘buyer’) of WIFIA loans.  The ‘purchase’ occurs when the loan commitment is funded, creating a federal investment that is amortized with loan revenues – or mandatory appropriation for taxes, if projected revenues are insufficient.  The exact loss to be covered by taxpayers is realized and recorded when the loan is funded.  As noted above, about $140 million of such losses have already been realized in funding $3.8 billion of loans.

For the remaining $12 billion of loan commitments, we can perform a FYE mark-to-market exercise very similar to the bond portfolio manager’s doleful task described above.  The portfolio characteristics are basically the same, in terms of amount, WAIR and WAL.  The 20Y UST was 3.95% on September 30, 2022, the federal FYE.  A few things are different.  FCRA methodology refines the discount rate using a zero-coupon curve derived from the overall UST curve for that day, called the ‘single effective rate’ or SER.  My estimate of the FYE SER was 3.78%, which was used for the analysis.

Just like the portfolio manager considering a hypothetical sale of the entire portfolio on the FYE date, we can ‘mark-to-market’ what the re-estimate losses would be in the hypothetical case that all $12 billion of the remaining loan commitments were drawn at FYE.  That unrealized loss is about $3 billion, or almost 20% of WIFIA’s portfolio.

Twenty percent?  For a portfolio that Congress apparently thought would cost taxpayers less than one percent?  Of course, these are unrealized losses, and as such just an indicator of the risk of potential losses, not the final damage.  Interest rates are high right now primarily because the Fed is attempting to control inflation, but that won’t last forever.  And the total portfolio of WIFIA loan commitments literally cannot be drawn now or even soon because draws must track construction progress, which will take place over at least five or six years.  If interest rates fall during that period, realized losses won’t be so bad.

It’s not difficult to model a range of outcomes depending on rates. The chart below shows potential realized re-estimate losses on the FYE 2022 portfolio at various 20Y UST rates (as converted into SERs in the model).

The simplest way to look at the results is as the potential losses that’ll be realized at the average 20Y UST rate during the multi-year period of portfolio funding.  That average probably won’t be close to today’s 4% level, nor will it end up in 2% territory.  Maybe somewhere around 3%?  This average rate results in about $2 billion of re-estimates losses, or about 13% of the portfolio.  That’s better than 20%, but still has plenty of sticker shock in it.  Depending on your natural optimism or lack thereof, maybe it’s 2.5% (a loss of about $900 million, or 5%) or 3.5% (a loss of about $2.5 billion, or 16%).

Who knows what Treasury rates will do over the next half-decade? But no matter how you look at the portfolio’s cost, the fundamental point is always the same – for any realistic projection of the rates at which WIFIA loan commitments will be funded, there will be re-estimate losses far in excess of WIFIA’s discretionary appropriations.  WIFIA’s FYE 2022 portfolio is irreparably holed beneath the economic cost waterline. The only question is whether the volume of red ink will sink the ship.

A recent bill proposes an extension of WIFIA’s maximum loan term to 55 years.  That could be a useful change for many stormwater systems planning long-lived projects.

Ideally, the financing term of an infrastructure project should match the project’s useful life.  That way, annual debt service is minimized, and the project’s capital cost is appropriately spread over time and generations.

This is especially true when the source of the financing is a state or federal infrastructure loan program that offers subsidized interest rates.  The maximum possible term will result in the highest present value of savings compared to market alternatives.  No mystery there.

The US EPA’s Water Infrastructure Finance and Innovation Act (WIFIA) loan program offers an interest rate based on the US Treasury yield curve when the loan is executed.  In effect, it’s the federal government’s cost of borrowing to fund the loan, without any mark-up.  For private-sector borrowers, that’s always a great deal.  For public-sector borrowers, especially highly rated ones, the situation is more complicated.   They can access another, federally subsidized alternative, the tax-exempt municipal bond market.  Rates in that market are often at —or even below—US Treasuries.

But for long-lived water infrastructure assets, WIFIA currently offers an additional advantage – a 35-year post-construction loan term.  Since infrastructure construction periods are usually in the range of five-to-ten years, a WIFIA loan can have a total term of 40-45 years, significantly better than the 30-year municipal bond market.  A WIFIA loan is limited to 49% of project cost, but it can be very flexibly combined with shorter term tax-exempt or other subsidized financing, optimizing the overall cost.

For water infrastructure projects with a large proportion of mechanical equipment (e.g., water treatment plants), WIFIA’s current maximum loan term is completely adequate to match the project’s overall useful life.  That’s not necessarily the case for projects with a high proportion of non-mechanical assets like concrete structures and site modification.  These projects often have an overall useful life well beyond 45 years.  Obvious examples include large-scale water management systems involving dams and canals, which are very long-lived.  But it’s also applicable to many local stormwater projects where the primary assets, conveyance systems, have useful lives of 50-100 years, according to ASCE.  Shouldn’t the financing needs of these types of projects be on WIFIA’s radar screen?

Extending WIFIA’s Maximum Loan Term

Successful federal programs aren’t cast in stone at inception.  They evolve over time, expanding and modifying their capabilities to reflect experience and needs.  Currently, WIFIA loans to stormwater projects total about $700 million, only 4.5% of the program’s $15.4 portfolio, by far its smallest percentage.  From a US water infrastructure policy perspective, WIFIA should seek a more balanced mix.  Extending WIFIA’s maximum loan term for very long-lived infrastructure projects will make the program more useful to the stormwater sector, increasing application and loan volume.

A statutory amendment will be required.  But it’s not difficult to make the case for implementing this change.  Long-term lending is a federal strength, relative to the private debt markets.  Extending WIFIA’s loan term is a simple amendment.  There’s a direct recent precedent in the 2021 Infrastructure Investment and Jobs Act.  In that law, the US DOT’s TIFIA loan program, WIFIA’s predecessor in the transportation sector, amended its maximum loan term to 75 years.

Unsurprisingly, proponents of another water infrastructure sector have come to the same conclusion.  The ‘‘Water Infrastructure Finance and Innovation Act Amendments of 2022’’ (H.R. 8127) was introduced in Congress in June 2022.  Most of the amendments are intended for large-scale Western water management projects, especially those where the Army Corps of Engineers is involved (the Corps recently began the process of utilizing its own allocation of WIFIA funding).  However, the loan term extension to 55 years included in the bill will apply to all WIFIA projects with a useful life at least that long.  Obviously, that’s relevant for Western dams and canals – but it will apply to many local stormwater projects, too.

What would a 55-year WIFIA loan term look like for long-lived project?  The chart below shows one important aspect, annual debt service after construction completion.  Its underlying model is highly simplified.  Assumptions include a $100 million project financed with a 51%/49% combination of tax-exempt bonds and a WIFIA loan, both with a Treasury-like 3.0% interest rate and a level-payment debt service payment schedule over the post-construction term.  For clarity, some other WIFIA features are excluded.  But even with these simplifications, the chart accurately reflects the significant magnitude of lowered payments.  Apart from annual debt service, the discounted present value of additional savings for a 55-year WIFIA term are about 5% of project cost.  That’s on top of the other benefits of a WIFIA loan compared to market alternatives.

The Bigger Picture

The simple change of extending WIFIA’s maximum loan term should also be considered in the context of the program’s bigger picture, especially for the stormwater sector.  WIFIA has been remarkably, albeit somewhat narrowly, successful in the past few years, becoming an important resource for relatively large and highly rated drinking water and wastewater utilities.  That success is an excellent foundation for future growth.  WIFIA growth is usually understood in terms of more funding for greater loan volume, but it’s equally important for its loan capabilities, which can be refined to meet the specific needs of many areas of water infrastructure financing.  Extending WIFIA’s loan term, either by the current bill or through other legislative paths, is a way to begin this process, which still has a long way to go.  The stormwater infrastructure sector, with its specific funding challenges and asset types, can be engaged from the start by supporting an extension of WIFIA’s maximum loan term.

The last two posts here were about CIFIA’s pre-execution rate collar, or limited buydown.  The posts considered several things:

• Limited buydowns are potentially important to carbon pipeline developers during the process of negotiating and finalizing rights-of-way and other contracts.  A rate collar will help stabilize the project’s financing economics at a time when many difficult time/money decisions are being made, well before construction starts.  To the extent that also helps accelerate pipeline development, it’s presumably at the core of CIFIA’s policy mission.

• If rates rise after a CIFIA application is accepted, the limited buydown feature will prove its value.  But in this situation, CIFIA may find it difficult to manage the impact of a large volume of limited buydowns on the program’s available discretionary appropriations.  Unlike post-execution rate locks, which automatically receive permanent indefinite budget authority, an in-the-money pre-execution rate collar will likely require an apportionment of CIFIA’s Congressional funding when the loan is executed.

• If rates fall, I think CIFIA can (and should) reset developers’ original applications to reflect the lower rates.  This is based on precedents from the WIFIA loan program, which has reset many post-execution rate locks.  The analogy is not exact for limited buydowns, but substantively very close.  The lower reset rates, however, will be prone to the budget issue noted above.

One general conclusion arises from all this:  If I’m correct that limited buydowns will be important both to pipeline developers (for project economics) and CIFIA (for fundamental policy outcomes), the program’s budget authority will be the limiting factor on offering this feature, unless rates become relatively stable, something that’s not likely to happen over the next few years.

An Arbitrary Limit

That kind of limiting factor on a useful interest rate management policy tool seems arbitrary.   Its origin is solely in FCRA’s distinction between what gets permanent indefinite authority (interest rate re-estimates on executed loans) and what does not (anything pre-execution).  That’s not based on any real-world factors in infrastructure investment.  WIFIA’s highly rated public water agencies certainly appreciate the post-execution rate lock because it avoids negative arbitrage cost if they’d had to escrow a muni bond issue instead.  But did they really need it?  Did it make any difference to their projects’ designs or timelines?  Yet WIFIA’s success was built on the ability to offer and then to enhance (by resets and expanding project definition to include long-term construction programs) free post-execution rate locks without worrying in the slightest about a discretionary budget impact.

In complete contrast, even if CIFIA pre-execution rate collars are critical to carbon pipeline development the program will likely need to worry about their discretionary budget impact, possibly to the point of rationing the feature under some circumstances.  This is true despite the lack of any substantive difference between a five-year post-execution rate lock and a three-year pre-execution collar followed by a two-year post-execution rate lock in terms of taxpayer cost.   As noted in a prior post, both simply amount to the federal government locking in an interest rate five years before the loans are funded.

Mitigating the Limiting Factor

FCRA law isn’t going to change anytime soon.  Still, there might be some scope to improve the budgetary treatment of those interest rate management tools that are useful to CIFIA and to future federal programs that might find themselves in the same situation.  The rest of this post outlines one approach that might be workable.

The key concept is what constitutes ‘execution’ in FCRA.  It’s apparently based on incurring an obligation, which makes sense in the context of a major theme in federal budgeting, anti-deficiency.  Here’s the language from Section 502 (2) of the FCRA statute:

The authority to incur new direct loan obligations…shall constitute new budget authority in an amount equal to the cost of the direct loan…

I think that’s black-and-white, both in language and in principle.  If a government agency incurs an obligation by executing a loan agreement, it’ll need authorized appropriations to cover the estimated cost at that point.  Cost here means the discounted present value of expected loan losses due to default but also Treasury’s economic funding loss if the loan’s interest rate is less than the relevant Treasury yield that day.  WIFIA’s loans are executed and re-executed with a current Treasury rate, so there’s no funding loss and no need for appropriations beyond the PV of expected defaults.  However, an in-the-money limited buydown will, by definition, result in an executed loan with a sub-Treasury rate and a funding loss.  Hence the problem.  I don’t think there’s any way around this part of the equation.

There’s more latitude in the definition of a ‘direct loan obligation’ in Section 504 (d)(1) of FCRA.  The definition needs to reflect an intrinsic reality of credit agreements, that there are always conditions the borrower must fulfill before the lender is obligated to write a check: 

The term “direct loan obligation” means a binding agreement by a Federal agency to make a direct loan when specified conditions are fulfilled by the borrower.

In a multi-billion-dollar project financing loan agreement, ‘specified conditions’ will naturally be a long list, especially if it includes the usual array of federal policy compliance items.  Absent other considerations, the developer will want to make sure that the list can be checked-off expeditiously and the lender undisputedly obliged to deliver the money.  In practice, this means executing the loan agreement only when project variables are settled down and construction draws are soon to be necessary.

In theory, however, a loan agreement could be executed well before any construction drawdowns were required.  The list of specified conditions might be longer and less precise, and project variables not quite so settled.  But the lender is still in effect making a ‘binding agreement’ of some sort.  A private-sector lender might use the additional conditionality to wiggle out of funding the loan, though a public-sector lending program will almost certainly be more forgiving.  Most importantly for this discussion, however, I think any kind of ‘binding agreement’ will be sufficient to trigger a loan execution for FCRA purposes – and put any further interest rate re-estimates into permanent indefinite budget authority territory.

Loan Execution-Lite

We can call this approach ‘Loan Execution-Lite’ – a loan agreement that isn’t meant to be funded in the near-future but binds the federal lender in a way that’s sufficient to trigger FCRA permanent indefinite budget authority.  For CIFIA in a rising rate environment, the point is to ‘convert’ budget-absorbing limited buydowns into worry-free executed loans.  During falling rates, CIFIA should be able to offer WIFIA-type resets and interest-rate management enhancements with confidence.

For developers, the value of execution-lite loans is added certainty with respect to interest rates, rising or falling, compared to limited buydowns.  That’s its primary purpose.  Of course, an execution-lite loan is less certain about everything else due to its expanded conditionality.  But this conditionality would need to have been worked through anyway for a typical, close-to-drawdown loan execution.  Term-sheet negotiations will continue as before, except that in legal form they’ll be about amendments to an existing agreement, not a new loan.  Nothing needs to change in the developer’s real-world actions.

A loan execution-lite agreement can be seen as a formalizing a step between loan application (with its limited buydown) and full, near-drawable loan execution (with its permanent indefinite budget authority).  In some ways, that’s more consistent with project real-world development, which is an incremental, not binary, process.

The diagram below illustrates the three-phase concept with a timeline.  The loan process will still start with an application and limited buydown, and that’s all it should be during the initial stages of development.  But once project development is sufficiently advanced for contract negotiations and finalizations to begin, an executed-lite loan agreement will be increasingly possible.  Interest rate certainty is important to the developer in this phase, and the program should want the budget treatment to support it.  The executed-lite loan agreement then gets amended to the extent necessary to be a drawable commitment shortly before construction begins.

How realistic is this execution-lite approach?  I can visualize the legal forms and I believe they’re basically consistent with the relevant FCRA statutes and published budget methodologies.  But it’s certainly new ground and, as such, prone to all sorts of negative bureaucratic interpretations, especially since the point of the exercise is to expand budget authority in a way that wasn’t explicitly described in FCRA law.  Still, WIFIA’s resets and other rate-lock enhancements relied on similar expansive interpretations, and they got through.

Naturally, CIFIA motivation is necessary, something that could surface quickly if a budget shortfall appears possible.  Otherwise, demand from borrowers for execution-lite loans will be the needed impetus.  During a period of rising rates, that’ll require a somewhat theoretical mindset from the developers, since the limited buydowns will appear to be working and the program’s budget is not their direct problem.  But if a raft of applications is made during a time of peaking rates that then consistently decline (a very possible scenario in 2022-2024), the demand for limited buydown resets could be more visceral, given the numbers involved.  WIFIA’s resets were driven by similar dynamics.  Since application resets at CIFIA will in any case require approvals and new processes, that might be the time for the program and its stakeholders to consider pushing the budget envelope a little further with an innovative approach. Sooner, of course, would be better.

In the prior post, I described CIFIA’s Limited Buydown provision in some detail.  That post covered why I think the provision will be important to carbon pipeline developers, and how it might be at risk if the program runs short of discretionary appropriations due to rising rates after accepting a large volume of loan applications.  This post is shorter and more cheerful.  It considers how CIFIA could reset the buydown if rates fall, based on recent precedents from the WIFIA loan program.

WIFIA Loan Re-Executions to Reset the Rate Lock

I wrote about WIFIA’s rate lock resets for Water Finance & Management in 2020, Resetting the Mission for WIFIA.  The first part of the article describes interest rate resets for two large and highly rated public water agencies.  They’d executed WIFIA loan commitments in 2018 when the 20Y UST was around 3.10%.  With the 2020 re-executions, their rate was lowered to the then-current 20Y UST, about 1.00%.

Why did WIFIA agree to this?  They didn’t have to.  There’s nothing in WIFIA’s statute or federal loan program guidance that would require the program to re-execute prior loan commitments just because they’ve become relatively less attractive to the borrower.

But if WIFIA hadn’t done the resets, the agencies would simply have cancelled their WIFIA loans and issued muni bonds at about 1.00% instead.  The second part of the article discusses some of the policy implications of the fact that WIFIA’s highly rated public-sector borrowers have excellent tax-exempt alternatives.  It’s likely that the resets didn’t affect the projects at all but were useful to the borrowers’ fiscal situation, which requires some explanation for an infrastructure loan program.  Of course, WIFIA was also trying to preserve its scorecard of completed loan volume.  The optics of loan cancellations are not good, regardless of reason.

WIFIA’s specific policy ambiguities aren’t relevant to CIFIA, as discussed in the prior post.  Instead, the key point for CIFIA here is that WIFIA chose to offer the resets.  More importantly, the program found a way to grant them without requiring the water agencies to unilaterally cancel their executed commitments and go through the application process all over again to obtain lower rates, a risky and time-consuming option.

Here’s a non-confidential internal technical presentation I did for WIFIA in 2019 while I was a consultant for the EPA: Rate Resets for Out-of-the-Money Loan Commitments.  I noted some of the legal and budgetary issues that might arise with the resets, but at the time I thought they’d be easily overcome, as proved to be the case.  Most of the presentation focused on options to manage resets to reduce interest rate re-estimate risk.  But as I expected, WIFIA just went with unconditional resets, which reflected the program’s willingness to give the borrowers exactly what they wanted.

In the presentation, I predicted that seven WIFIA loan commitments, totaling about $2.5 billion, would be subject to reset requests.  They were all granted, judging from statements in WIFIA’s 2020 Annual Report.  Perhaps there were more in subsequent years.  I doubt it, due to rates rising off the 2020 trough and some other factors about smaller WIFIA borrowers.  But it doesn’t matter – the precedent for unconditional resetting of undrawn construction rate locks at WIFIA is now firmly established.  Borrowers executing WIFIA loan commitments in the current rate environment can be confident that if the 20Y UST falls significantly prior to loan funding, they’ll have another bite at the apple.

Implications for CIFIA

WIFIA precedents in this area should be applicable to the CIFIA program because the two programs share many of the relevant provisions.  This is most clearly the case for post-execution rate locks since the reset of an executed but undrawn loan commitment to a carbon pipeline project would be exactly analogous to a WIFIA reset.  But I’m not sure that this post-execution option will always be as important for CIFIA’s projects as it is for WIFIA’s larger projects.

A typical WIFIA project will have a long construction period, at least five years.  WIFIA’s large and highly rated public-sector borrowers have multiple established sources of very cost-effective short-term financing which can be accessed for construction draws.  This means that they can keep the WIFIA loan commitment as a completely undrawn option until permanent financing.  That works well when the Treasury yield curve is normally sloped, which it was for 2018-2020 period preceding the first resets.  Drawn loans can’t be reset at WIFIA, but undrawn commitments can, and many early WIFIA borrowers had large undrawn commitments that were very out-of-the-money by 2020.  This created the demand for the first WIFIA resets.

In contrast, carbon pipeline construction is apparently quick once rights-of-way are finalized, perhaps two or three years.  More importantly, CIFIA loans to this sector are closer to classic non-recourse project financings, which don’t rely on large investment-grade balance sheets or other sources of debt.  A CIFIA loan commitment will probably start being drawn for construction draws as soon as it’s executed.  Rates would need to fall significantly and rapidly during a two-year construction period for a reset to be compelling on whatever remains undrawn in a CIFIA loan commitment.  That scenario might arise for some projects in certain circumstances, but the post-execution rate lock reset probably won’t be as generally important as it is at WIFIA.  Still, whenever it becomes valuable for a specific CIFIA project, I think WIFIA’s post-execution reset precedent can apply directly, and more general demand from other borrowers shouldn’t be necessary.

Resetting the Limited Buydown

A more interesting, and potentially important, question is whether the reset principle can be applied to the limited buydown.  This would useful if rates fall after the original application date but are expected to be at risk of rising again before loan execution, a recent pattern of volatility that will likely continue in these interesting times.  A CIFIA applicant will want to lock in lower rates with the limited buydown by resetting the application date.

Here the analogy to WIFIA’s post-execution rate lock reset is necessarily indirect.  But the basic concepts are the same.  A limited buydown is always undrawn because, of course, it’s not a loan commitment.  In fact, given the permissive language in the provision, CIFIA’s limited buydown is not really a commitment for anything.  It simply limits what the program is allowed to do if a loan’s relevant interest rate has risen since the date on which its application was accepted.  Nothing stops an applicant from withdrawing an application and re-applying.  If accepted, the new application in effect resets the date and thereby the relevant rate.

These are basically the same conditions that made WIFIA’s reset possible.  The reset doesn’t affect drawn loans, program law is completely silent on the matter, and in any case, the borrower can unilaterally make it happen by withdrawing and going through the process again.  If anything, they’re even clearer in CIFIA’s case – limited buydowns are literally undrawable, they aren’t even a commitment, and re-application is much easier than full re-execution.

As was the case with WIFIA’s rate lock re-executions, limited buydown resets at CIFIA will likely come down to whether the program wants to offer them.  I’d expect they will (or should) be generally willing to do so, based on some of the factors described in the prior post.  Limited buydowns likely help accelerate carbon pipeline construction by facilitating aspects of the developers’ arduous rights-of-way negotiations.  As such, the provision is part of the program’s core mission.  If there’s an opportunity to improve the buydown for a specific project, doing so will presumably enhance the acceleration effect, which is better policy rationale than WIFIA’s resets seemed to have.  It will also encourage the others by demonstrating an unbureaucratic willingness to help borrowers where possible, not just where required.

Yes, withdrawal and re-application can be done unilaterally.  But that’s added transactional friction just when the developers must be fully focused the easement negotiation process.  It’s also not without risk because in a two-step process the applicant loses the original rate cap.  If something goes wrong or is significantly delayed in the re-application, project economics – or at least the certainty thereof – could be seriously impacted, resulting in a later construction start.  CIFIA can eliminate this risk by accepting an identical re-application simultaneously with the withdrawal of the original application, or some similar one-step process wherein the only change is the date.  Why not cut to the chase?

Well, there is one thing that CIFIA’s administrators need to consider – a possible gap in discretionary appropriations caused by resetting a large volume of limited buydown applications.  The risk of rising rates for limited buydowns in the program’s original applications was discussed in the prior post.  By resetting buydowns at a time when rates could, or are even expected to, rise, the program will be in the same situation.

By refusing to facilitate re-applications and discouraging unilateral action by applicants, CIFIA would presumably reduce this risk.  At some point this might be a way to ration subsidy if a shortfall looks imminent.  But at the outset of CIFIA’s operations, when there’s $2.1 billion of appropriations that Congress intended to be used to accelerate pipeline construction, an overly cautious approach will be both unnecessary and counterproductive.  I think CIFIA will come to the same conclusion and the program should be open to considering limited buydown resets for at least the next few years.

What’s At Stake?  Looking at Some Numbers

To put limited buydown resets in context, it’s worth looking at some numbers.  They’re significant.

The first chart shows what happens if a project resets a lower rate on loan execution than was expected in the original application.  In this illustration, the original application for a $1 billion CIFIA loan for a $1.25 billion project was accepted when the relevant rate was 3.75%, about the current 20Y UST.  Project economics at this rate were acceptable, with an expected 7.5% IRR on $250 million of project equity and an adequate debt service coverage ratio.

But then the 20Y UST falls to (say) 3.00%.  A loan executed at that lower rate would result in a project IRR of 10.5% if the leverage ratio was held constant.  Or the project developers could hold equity return constant and increase leverage (perhaps even from CIFIA itself) by almost $150 million.  The former would provide motivation, and the latter more negotiating headroom, to get the easement process done as quickly as possible.  But that process will still take time, and rates could rise again before loan execution.  The value of locking in the new rate with a reset application will be obvious to the project’s developers and (since it will help accelerate construction start) to CIFIA as well.

The second chart looks at a possible pattern of the 20Y UST over two years to illustrate various reset scenarios for the project described above.  The pattern is based on actual 20Y UST rates from May 2019 to May 2021, adjusted upward to about the current level, 3.75%.

• Point A:  This is the original application at 3.75%.  Project economics are good enough, but won’t tolerate a higher rate, so the limited buydown collar is an important aspect of the CIFIA application.

• Point B:  Project developers see that the 20Y UST has hit 3.00% after four months but seems headed to rise again.  They ask for a reset to lock in the numbers described above, a 10.5% IRR or about $150 million of additional debt capacity.

• Point C:  Alternatively, the developers believe rates have further to fall and wait about a year until the 20Y UST hits 2.20%, a possibly unsustainable low.  A reset at this point results in a project IRR of 12.5% or almost $300 million of additional debt capacity.

• Point D:   The developers are more cautious but can see that rates have bottomed out and will likely go steadily higher.  Still, a reset at this point results in an IRR of 11.5% or additional debt capacity of more than $200 million.

• Point E:  No reset. The execution rate of 3.40% is below 3.75%, with a resultant IRR of about 9.0% or nearly $100 million.  Still a good outcome – but not as good as it could have been with a reset at almost any point in the pattern. All three possible resets were well within the limited buydown’s 1.50% cap, which would only have started to matter for 20Y UST rates less than 1.90%.

Note that Point B would probably have a greater impact on accelerating pipeline development than Points C or D. Even though the later numbers are better, the first reset occurs early in the process. That might be something for CIFIA to consider in terms of policy objectives, but I’m sure that developers will be more persuaded by economics. In any case, the illustration shows that both project economics and CIFIA policy outcomes are improved by resets, possibly significantly.

The case for limited buydown resets looks compelling, but it should not assumed to be an automatic aspect of CIFIA’s operations that can be requested at the last minute. It’s a relatively technical concept and WIFIA’s precedents are only indirectly applicable. There are always devils in the bureaucratic details, too. The possibility of resets should be brought to CIFIA administrators’ attention as soon as applications start being accepted, whether or not they look likely to be used at that point. As noted above, these are interesting times for interest rates, and much else besides. Certainty matters.

This post is the first of three on the topic. The second is here, and the third here.

The ‘Limited Buydown’ provision in TIFIA and CIFIA loan program legislation allows a loan’s construction period interest rate lock to be set at application, not loan execution, as in the WIFIA program.  That’ll be an especially useful feature for carbon pipelines, but it might use a lot of discretionary appropriations.  This long post sets out the context and risks associated with that.

WIFIA’s Off-Budget Post-Execution Rate Lock

A WIFIA loan’s construction period interest rate lock is one of its most valuable features.  In effect, it works as an interest rate option, both on construction draws and (more importantly) on the loan’s post-construction permanent financing phase.  The option is costless to the borrower, but potentially very expensive for federal taxpayers if rates rise during the lock period.  However, under FCRA budgeting methodology, this cost is not WIFIA’s problem.  The water program’s lock begins at loan execution when the loan’s interest rate is set at then-current Treasury rates.  Hence, the required discretionary appropriation (the ‘credit subsidy’) for the loan’s cost is only about its expected credit loss, a small amount for WIFIA’s highly rated borrowers.  If Treasury rates rise between loan execution and final drawdown, the discounted present value of Treasury’s funding loss shows up as a positive adjustment to the credit subsidy amount (an ‘interest rate re-estimate’) that is automatically authorized (under FCRA’s ‘permanent indefinite authority’) and receives a mandatory appropriation covering Treasury’s loss.  The accumulated balance of these mandatory appropriations is recorded in an off-budget account, and WIFIA’s discretionary appropriations are not affected.

The theory behind this special budget treatment appears to be that post-execution interest rate changes are an exogenous and uncontrollable factor for federal loan programs and will likely balance out over time, as both positive and negative interest rate re-estimates should occur.  I think the reality is much more complicated in WIFIA’s case, but that’s another topic.

TIFIA’s and CIFIA’s (Likely) On-Budget Limited Buydown

TIFIA and CIFIA loans offer the same construction period rate lock feature with the same FCRA budget treatment after execution – with one crucial difference:  For these programs, the loan’s execution interest rate can be set at what it would have been if the loan had been executed on its application date, if that’s lower than the current Treasury rate, up to a maximum 1.50% reduction.

This pre-execution rate lock (or more precisely, ‘collar’) is called a ‘Limited Buydown’ in the legislation for both programs.  The language is not very detailed in TIFIA’s case but has apparently been interpreted to include the application date trigger.  In CIFIA’s law, the application date (or a somewhat equivalent execution of a ‘master credit agreement’) is explicitly defined as the relevant start point.

The name of the provision, introduced in the TIFIA section of the 2012 MAP-21 act, is a bit odd – the ‘limited’ part is clear enough (the 1.50% limit), but the ‘buydown’ seems to derive from a home mortgage feature whereby the borrower can lower their rate with a payment.  In the loan program’s case, the lender is doing the ‘buying’.  The provision is probably more accurately described as a ‘limited loan interest rate reduction’ or more transparently as a ‘limited sub-Treasury rate adjustment’.  Perhaps a Congressional TIFIA drafter in 2012 had worked on FHA legislation and thought that ‘buydown’ was a quick way to convey the concept, since the net effect (a lower loan rate) is the same?  Or was the name intentionally a bit obscure because the provision is in essence a kind of grant in a loan program that is otherwise generally funded at Treasury cost?  In any case, for CIFIA legislation the name was almost certainly simply inherited, even if the concept clearly got more focus.

Although the pre-execution rate collar is limited to 1.50% and has relatively more optionality than the post-execution rate lock, both have substantially the same type of benefit to the borrower and cost to the federal lender.  A WIFIA loan’s rate lock over a five-year construction period when rates are rising will cost federal taxpayers about the same as a two-year CIFIA or TIFIA rate collar followed by a post-execution rate lock on a three-year construction period.  In both cases, the federal government has committed to the interest rate on a 35-year loan five years before Treasury funds it.  If rates have risen, the borrower receives the same benefit, and the taxpayer gets stuck with the same economic cost.

But there is almost certainly a huge difference in federal budgeting between the two.  As noted above, the cost of the post-execution rate lock is covered by FCRA’s indefinite budget authority and gets buried in off-budget accounts.  The cost of the pre-execution rate collar, however, is not likely to receive that free pass.  Instead, I expect it will need to be apportioned from the program’s available discretionary appropriations when the loan is executed.  FCRA language and established methodology is straightforward about estimating and budgeting for the cost of a loan (including the cost of a sub-Treasury interest rate) when it is executed.  I can’t see any reason why the pre-execution start point of the limited buydown provision would make any difference to that.

Does this matter?  Not to WIFIA and Probably Not to TIFIA

The additional on-budget cost of the pre-execution rate collar is not necessarily important per se.  The loan is going to require some credit subsidy anyway and the cost of the rate collar just adds to that amount.  However, when the aggregate additional amount of subsidy required by the full application of the limited buydown feature is high relative to the available appropriations because rates have risen, the feature could impede loan executions at the reduced rates the borrowers expected.

Obviously, WIFIA won’t have this budgeting issue because the pre-execution rate collar is not included in the program’s statute.  But it’s interesting to consider what might have happened if it did.  The sophisticated financial staffers at WIFIA’s highly rated water agency borrowers would have immediately seen the collar’s value and timed their applications accordingly, aiming for low points in UST rates.  WIFIA hasn’t had any problem attracting applicants without the rate collar.  With this feature, the volume of applications certainly would have increased or at least been accelerated.  The program’s loan volume is very high relative to its appropriations (more than a 50:1 ratio), a sustainable path because the high quality of the program’s borrowers requires only a small amount subsidy for expected credit losses. But there’s not much headroom.   Even a slight increase in the percentage cost of the loans would impact WIFIA’s ability to execute loan volume as planned.  The cost of pre-execution rate collars during the 2020-2022 timeframe, if they had been offered, would probably have been many times WIFIA’s available appropriations.

A loan program’s likely response in this hypothetical situation would presumably be to restrict rate adjustments under the limited buydown provision to whatever budget authority was available (if any) after an adequate amount was allocated for planned loan executions at unadjusted rates.  Such rationing is possible because the buydown language in both TIFIA and CIFIA laws is explicitly permissive, not prescriptive, for program administrators.  How such subsidy rationing would be implemented practically in this situation, especially over a multi-year period, isn’t at all clear, however.  There’d certainly be disappointed borrowers.    

That still may not have mattered in WIFIA’s case.  An un-disappointed borrower is not a policy objective for federal infrastructure loan programs – a completed infrastructure project is.  The important question about possible cutbacks in limited buydowns should be simply whether the borrower’s project can go forward or not.  The vast majority (or even all) of WIFIA’s water infrastructure projects to date would have gone forward with or without a WIFIA loan in the first place (a fundamental policy topic that should get more attention).  In that low-impact outcome context, the additional benefit of a pre-execution rate collar, or the failure to deliver that expected benefit, would have made no significant difference to US water infrastructure renewal, regardless of WIFIA borrowers’ feelings.   

The same net result is the likely outcome at TIFIA, though for different reasons.  I believe TIFIA’s limited buydown provision has been utilized at least a few times.  But I doubt that it created any serious budgeting issues because TIFIA’s loan execution volume is quite slow relative to its appropriations and much of the program’s activity took place when rates were generally falling.  Even if the program’s budget headroom for limited buydowns becomes more restricted in the future, a cutback in the rate adjustments isn’t likely to stall the borrowers’ projects.  Most of the cost benefit of a TIFIA loan comes from the avoided spread between the program’s UST rate and a BBB-ish private-sector project finance loan, which will range from 0.50% to as much as 2.00%.  That’s valuable and might be an important factor enabling a transportation project, which is the right policy outcome.  A limited buydown, in contrast, is closer to a ‘nice to have’ as opposed to ‘need to have’ with respect to the viability and timing of these types of projects.  This is especially true due to the relatively small proportion of a TIFIA loan in a project’s capital stack – the statutory limit is 49% of project cost, but program policy has further limited that to about 33%.

If TIFIA’s limited buydown becomes restricted or even zeroed-out in a budget year, that might make a difference to project economics and perhaps even to some minor aspects of final project design.  But I doubt that the effect will be enough to stop the project altogether, borrower disappointment notwithstanding.  Hence, for TIFIA, the limited buydown is likely not a critical feature to the program’s policy outcomes – it may be utilized if the budget headroom is there, but probably not a showstopper if there isn’t.

It Might Matter a Lot for CIFIA

In contrast to WIFIA and TIFIA, a possible rationing of CIFIA’s limited buydown provision will probably matter, because (1) the provision is likely important for CIFIA projects, and (2) although the new program has a high level of credit subsidy appropriations, that might get used up surprisingly quickly by even a slight rise in rates.

Apparently, though not explicitly, CIFIA is really all about midwestern carbon pipelines.  There are three big ones in development that get a lot of press, with a rough total cost of about $10 billion.  The point of these pipelines is to monetize 45Q carbon tax credits, something which is now easier and much more lucrative with the passage of the Inflation Reduction Act.  I’m guessing that other pipelines are or will soon be planned.  A lot of financing for a relatively new sector will need to be found, and project sponsors will want to move quickly.

Although the basic form of CIFIA follows its similarly named predecessors, the carbon program appears to have been designed within the framework of federal credit rules to facilitate financing for exactly this pipeline development situation.  Unlike WIFIA and TIFIA, CIFIA can offer financing for 80% of project cost, regardless of size.  And, although the projects must (of course) be creditworthy, an investment grade rating is not required.  Assuming the project developer is putting in the 20% balance as straight-up equity, CIFIA is in effect a ‘one-stop, one-step’ financing program – put in a good application, check the well-established federal crosscutter boxes, and you get approval for the only loan you need.

That’s just as well, because getting the pipeline built appears to be anything but a one-stop process.  Actual construction is likely straightforward and won’t take too long once started – about two years, even for the big ones.  But securing all the easements and rights-of-way across thousands of miles of privately owned, agriculturally productive, and savvily managed property looks like a nightmare.  Moreover, it’ll be intrinsically time-consuming.  Two or three years is publicly mentioned, but I’m sure outcomes will vary widely.  Progress mainly depends on multiple price negotiations, then on bureaucratic processes for the last steps if eminent domain is required, all with a steep trade-off between time and money.  In that process, project economics could swing wildly from expectation.

It’s easy to see why a pre-execution rate collar would be critical in this phase of carbon pipeline development.  Project economics will also be highly sensitive to the interest rate on the permanent financing.  Capping that volatile factor at the start of the process of securing rights-of-way would stabilize the numbers for pipeline cost and define clearer limits for the process’ time/money trade-offs.  Waiting until loan execution to set the permanent financing rate, when all the contracts are basically done and trade-offs set in stone, could result in some nasty surprises.  It’s no surprise that when the CIFIA legislation was being drafted, someone took particular care to define the limited buydown provision in detail – it’s intended to be used.

Mind the Discretionary Appropriation Gap If Rates Rise

Since the current interest rate environment is uncertain and expected to get worse, I’d guess that the three big pipelines (which are now in the process of rights-of-way negotiations) will put in CIFIA applications as soon as the program’s doors open. There’ll likely be some other, smaller projects applying, too.  It’s therefore possible that CIFIA will have roughly $10 billion of financing subject to pre-execution rate collars by year end, from the projects currently underway.  That’s a big number on which to set rate collars for 35-year loans fixed-rate loans.  But CIFIA has $2.1 billion in appropriations over the next five years, so the FCRA impact on the program’s budget should be easily absorbed if rates rise in the next few years, right?  Right?

I’m not so sure.  Obviously, there isn’t much specific data to work with, but if a few assumptions are basically correct, avoiding subsidy rationing at CIFIA might be a near-run thing if rates rise – even a little — over the next few years.

• Let’s assume that $10 billion of applications accepted this year result in $10 billion of executed loans towards the end of 2024, when the project developers to get their rights-of-way and contract negotiations finalized.  At that point, the program should have $1.5 billion of appropriations available, the accumulated balance of scheduled authorization (the total, $2.1 billion, becomes available over a five-year schedule, accumulating until expended).  That’s the green line in the chart below.

• Also assume that the $10 billion of loans will require 8% or $800 million to cover the subsidy for projected credit losses.  This is higher than TIFIA (about 6% for minimally investment-grade loans) and much higher than WIFIA (less than 1% for that program’s average Aa3/AA- loans).  But 8% seems about right for unrated and likely sub-investment grade project finance loans to a relatively new sector, or in any case reflective of OMB’s perception of the risk thereof.  This part of the subsidy is not related to interest rates – hence ‘Non-Interest Subsidy’ in the chart.

• The final assumption is that the applications were all set with a relevant US Treasury rate (the 20Y UST, approximately reflecting weighted average loan life) of 2.75%.  I know that’s lower than the current yield, but it’s chosen to illustrate a point about change, not levels.  And because – who knows?  A few months in the current volatile economic and political environment is a long time.  It could be the actual 20Y UST rate in the near future.  Or rates might rise dramatically instead, and the 20Y UST goes from current 3.75% to 5.25%, with roughly the same effect on the illustrative model.  One thing looks for sure – CIFIA will not be setting limited buydown rates in a calm and predictable world. 

• If the 2.75% 20Y UST rate at which the applications were assumed to be set is higher two years later at loan execution, the lowered discounted present value of the loan will require additional subsidy in an equally higher amount, per FCRA methodology.  That’s the ‘Subsidy Due to Rate Change’.

The chart summarizes what happens if the 20Y UST rises between the application and execution dates.  If no change from 2.75%, then the only subsidy required is the $800 million for projected credit losses, well within CIFIA’s available appropriations.  A rise to 3%?  A little tighter, but still some headroom.  To 3.25%, an unremarkable rise of 50 bps. over two years?  Things get interesting.

If the relevant rate rises above 3.25% in this illustration case, CIFIA will probably need to start the kind of messy subsidy rationing mentioned above.  The simplest step would be to delay loan execution a few months until the FY 2025 appropriation of $300 million becomes available.  But what if rates keep rising during and after the delay?  At 3.5%, the $1.8 billion is used up, and at 3.75%, the total subsidy required exceeds the $2.1 billion initially authorized.  Note that this is all for the original 2022 applications.  Presumably, there’ll be others in the meantime, soon requiring at least the 8% subsidy at execution for the non-interest part, for which they’ll presumably have a priority claim.

In this hypothetical scenario, the limited buydown would cause CIFIA to run out of appropriations for loans to just a handful of pipelines if rates rise by about 1% over two or three years – again, well within recent experience and only two-thirds of the 1.50% limit.

The math is no mystery.  Anyone who has ever dealt with the valuation of long-term, fixed-rate bonds and loans knows that their discounted present value, or price, is very sensitive to interest rate changes.  Was the 1.50% limit in MAP-21 determined by Congressional staffers after modelling various scenarios?  Not likely. The provision’s original proponents might have known the potential benefit of a wide collar, and even suggested the number, but the Congressional staffers probably settled on 1.50% because it sounds benign – properly prudential but not overly restrictive – until you do the math.  In any case, CIFIA got the buydown provision and its limit by inheritance, and (with the inheritors properly appreciating its value for pipeline development, and making sure details were included this time) that’s now the law.

Failing in the Core Mission

If CIFIA’s available credit subsidy needs to be rationed with respect to the limited buydown, there will of course be disappointed borrowers.  As discussed above, that shouldn’t matter much in itself.  But unlike the typical projects financed by WIFIA and TIFIA, for CIFIA’s carbon pipeline projects I think the impact may go well beyond disappointment and affect the program’s policy outcomes.  Paying an unexpectedly higher interest rate on the project’s permanent financing, after all the contract negotiations have been finalized with an expectation of a lower rate, could wreak havoc on a highly leveraged project’s economics.  Whether that’s enough to stop the project altogether obviously depends on a lot of specific factors and isn’t broadly predictable.  My guess is that full showstopper situations will be rare.  Perhaps there’ll be some capital restructuring and even contract re-negotiations – painful, but not fatal.

However, if rationing ever occurs or even comes close, future CIFIA applicants may not put a lot of faith in the limited buydown provision. That may have a marginal impact on the program’s volume of applications and closed loans, the usual (and somewhat specious) soundbite measure of a loan program’s success.  But I think it will also negatively affect a much more fundamental aspect of CIFIA’s potential success – the effectiveness of the program to accelerate the volume of carbon sequestration, compared to what it would have been if CIFIA never offered limited buydowns.

As described above, a pre-execution rate collar helps pipeline developers make better – and presumably faster – decisions about the numerous time/money trade-offs that’ll be required to secure the project’s rights-of-way.  Without it, the project’s economics are less certain, and money perceived to be scarcer.  The trade-off then tilts towards extending the time involved before construction starts – lengthier, hard-ball negotiations and more chance of eminent domain proceedings.  Every delay has a quantifiable impact in terms of tons of carbon that could have been sequestered if the pipeline had been there to carry them.

The loss of 45Q revenue from those un-carried tons is the type of disappointment that goes with the territory of almost all project development when things get delayed.  But from the CIFIA program’s perspective, there is perhaps a unique policy aspect to minimizing delays.   WIFIA’s water projects and TIFIA’s transportation projects will marginally enhance a long-established stock of basic public infrastructure, the need for which is unquestionable.  A few years of delay on specific projects financed by those programs won’t make any difference to the programs’ long-term policy rationale.  In contrast, CIFIA’s infrastructure projects are all about climate change mitigation – a policy area where time is very much of the essence.

In theory, every ton of carbon not emitted into the atmosphere will mitigate climate change, and the sooner the better, starting today.  CIFIA’s policy objectives are doubtless more pragmatic, but time is still a central focus, for at least two reasons.

First, there’s the political context.  The obvious need to renew US water, transportation and other basic public infrastructure will cut through almost any level of federal political polarization or dysfunction – if anything, it might become a rare area of growing bipartisan agreement.  That’s not at all true for any federal initiatives involving climate change, to put it mildly.  I don’t think anyone can predict what future policy in this area will look like, especially for specialized climate change mitigation infrastructure, the need for which is intrinsically less visible than it is for climate resilient investment in basic infrastructure.  Stakeholders in this sector need to make hay while the sun shines, and they’ll expect CIFIA to help produce results with the level of appropriations the program currently has.  Future top-ups to CIFIA’s funding bucket are by no means assured, regardless of carbon pipeline development demand.

Second, time is really at the heart of CIFIA’s entire reason for being.  The basic economics of carbon pipelines look fundamentally creditworthy.  Carbon producers, especially ethanol plants, have an immediate and continuing need for large-scale sequestration.  The sequestration locations are many miles away, but carbon pipeline construction and operations are straightforward. Once the carbon gets there, it’s monetizable at a firm price, $85/ton, through 45Q credits.  That kind of story is eminently financeable in the private-sector debt markets, specifically with project finance bank syndicates, though the process might take some time.  Yes, a CIFIA loan will be cheaper, but the current 45Q price should make the whole operation lucrative enough – what’s the point of an additional federal program to indirectly deliver more of the same incentives?

The answer, I think, is that faster and more certain, not solely cheaper, financing is the primary purpose of CIFIA.  That’s reflected in two of the program’s notable differences to its WIFIA and TIFIA predecessors – the ability to finance 80% of project cost and the lack of an investment-grade requirement.  It’s also reflected in the evident attention that was paid to the language in the limited buydown provision.  Carbon pipeline developers will want to move fast but with as much certainty as possible.  CIFIA’s role is to deliver financing in a way that uniquely meets those two goals.  The program’s lower interest rate is simply the usual side-benefit you get with federal credit, not the main event.

I don’t know whether CIFIA was consciously designed from the start with this purpose in mind.  The program’s industry proponents probably had a clear idea about what they wanted, but began the process (again, with an eye towards speed) with pre-existing federal infrastructure loan program models and added the necessary technical-seeming modifications.  The precise federal policy rationale and objectives for CIFIA was not their problem.  I’d guess that federal policymakers didn’t put much thought into those either, and simply assumed that CIFIA would automatically incorporate the policy aspects of WIFIA and TIFIA, like a new flavor in an established consumer brand.

Regardless of CIFIA’s history or nominal policy objectives, however, the program will be evaluated by its stakeholders with respect to what it appears to be promising carbon pipeline developers in terms of faster and more certain financing.  If interest rates rise over the next few years, the limited buydown provision could be an important aspect of delivering on that promise.  In this context, any inability to execute loans at the interest rate expected by applicants due to a lack of available subsidy appropriations would be a major failure for the program.  It will be the kind of failure that has specific and quantifiable consequences for the affected projects, possibly including a delayed start to construction due to contract re-negotiation, and I’m sure that the borrowers won’t be shy about describing them.

More importantly, such a failure may impact perceptions among existing and future applicants about what overall level of certainty the program provides for the terms of an executed loan, not only with respect to the limited buydown, but other aspects of loan economics that aren’t precisely prescribed and required in the program’s legislation.  If CIFIA fails to fully deliver on the limited buydown rate, what else might the program fail to deliver?  Timely loan execution?  OMB and other approvals?  Acceptance of environmental reports?  Common-sense loan covenants and documentation?  The list goes on and on, all based on a long history of borrowers’ experience of things that go wrong at federal loan programs.

If carbon pipeline developers lose the faith that CIFIA will deliver speed and certainty, the program will have failed in its core mission.  I see the limited buydown provision as a central part of what the program is expected to do.  It’s not the only thing, but the provision is relevant to the first and perhaps most difficult part of the show, securing easements and other rights-of-way for pipeline construction.  CIFIA’s stakeholders, especially including program administrators, need to keep an eye on how rising rates might affect available discretionary appropriations.  However technical and abstract these FCRA mechanics might seem, a budgetary shortfall at CIFIA is a gap that’s well worth minding.