On the surface, everything is fine. The portfolio is composed of about $9 billion of loan commitments to established public water systems, almost all with a credit rating of Aa3/AA- or even better. The loans will finance basic and much-needed water infrastructure projects, rigorously vetted to the highest engineering and environmental standards. It’s clear that the financial benefits of the loans will serve some public purpose, even if the details aren’t being assessed. Loan processing and execution continue smoothly, a rare accomplishment for a federal program. There’s a steady stream of glowing press releases and recognition of the importance of the Program in developing infrastructure legislation.

But below the waterline, a serious problem may be developing. Potential losses from rising interest rates are beginning to flood in:

The Economic Cost of WIFIA’s Current Loan Portfolio Part 1: FCRA Credit Subsidy Cost Interest Rate Re-estimates

Although obscured in the complex machinery of FCRA accounting, the basic problem is very simple. The weighted average interest rate on the $9 billion of loan commitments is about 1.5%, a legacy of loan executions and re-executions during all-time rate lows of 2020. If the commitments were all drawn today, the US Treasury would fund the loans at current 20-year UST rates of about 2.2%. This is a $1 billion unrealized loss. As the loans are actually drawn over the next 5-7 years, realized losses will be even higher if interest rates continue to rise per CBO projections, possibly as much as $2.5 billion.

Nothing can be done about the current portfolio’s potential losses. Unless rates go back to all-time lows and stay there for years, it is a “mathematical certainty” (as an ill-fated ship’s designer said) that the portfolio’s funding cost will exceed its loan income. Federal taxpayers are on the hook for the difference.

SRF leverage for additional loan capacity should be encouraged. If SRFs use tax-exempt debt, it’ll cost about $1 billion in lost federal tax revenues. If they use WIFIA loans instead, FCRA cost is about $100 million. Why not expand WIFIA funding specifically for this purpose?

By far the biggest item in CBO’s scoring of the DWWIA 2021 bill is the loss of federal tax revenue caused by increased issuance of tax-exempt debt. JCT is assuming that SRFs will leverage additional grant funding with tax-exempt munis in order to expand their loan making capacity. That’s a good outcome in itself. But more tax-exempt debt means less federal tax revenues, so DWWIA has an indirect additional cost of about $1 billion.

Assuming that JCT is using their static portfolio bond substitution methodology, it’s possible to reverse engineer some of the numbers likely involved in the $1 billion estimate:

The basic logic of the substitution methodology is straightforward: If the SRFs did not issue tax-exempt debt, investors would have bought equivalent taxable bonds instead to fill up their ‘static portfolios’. The federal revenue loss is the income taxes that would have been paid on these taxable bonds — a kind of opportunity cost.

Assuming a 25% tax rate (which seems pretty standard in JCT analyses), the taxable income that would result in $1 billion of taxes over ten years is about $4 billion. Next, assuming that the AAA taxable yield averages about 3.75% over the period, an average taxable bond portfolio of about $11 billion is implied. But this portfolio is built up over time, as indicated by the increasing annual revenue loss in the JCT numbers. The 2031 revenue loss number of $215 million implies a final taxable bond portfolio of about $23 billion.

The US EPA’s WIFIA Loan Program is an institutional lender that offers unique interest rate management loan products for infrastructure finance to the US water sector. A surprisingly successful federal program. But now it’s time for a bigger mission.

The US EPA’s WIFIA water infrastructure loan program has in fact established itself as an institutional lender to the US state & local public sector.

That’s not as easy as it sounds. Most state & local infrastructure agencies are highly rated and can issue tax-exempt bonds. In effect, state & local borrowers already have a long-established source of cost-effective, federally subsidized debt. How did a relatively new federal loan program make any headway against this alternative?

It’s not the interest rate on a WIFIA loan — the US Treasury rate WIFIA offers isn’t that different than the overall yield on a highly rated muni bond series for a highly rated issuer. But although WIFIA loans are similar to muni bonds, federal loans can include special features that make them especially attractive to public-sector infrastructure agencies. Currently, WIFIA’s primary loan product is a costless interest rate lock, which highly rated borrowers can use as an interest rate call option on long-term financing.

The free interest rate call option feature transformed WIFIA from what is was likely intended to be, an infrequently used project finance lender, to effectively a participant in the mainstream US state & local public-sector market.

Offering a free call option on long-duration debt is a great way to build a loan portfolio. But is that the point of a federal infrastructure loan program? Not exactly — the loans should have a real-world outcome that wouldn’t have happened otherwise. Free call options, though of course very welcome to borrowers, don’t really accomplish that.

But new WIFIA loan features — focused on current federal policy objectives like climate adaptation, water affordability & equity and SRF leverage — could. This potential to make a large-scale impact in US water infrastructure is the real significance of the WIFIA Bank. The federal government has built an efficient institutional lender to the US state & local public sector, an unusual achievement. Now what are policymakers going to do with it?