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 30th, 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.