In a prior, unexpectedly long, post, I explored the relationship between the intent of various laws underlying WIFIA’s budget and the ‘FCRA loss ratchet’ that made the Program’s actual, presumably unintentional results possible.  At the end of that post, I outlined some ideas to solve the issues going forward in a constructive way:

• The FCRA loss ratchet is probably an inevitable result (under current budget law and oversight methodology) of federal lending to highly rated borrowers with excellent financing alternatives who are building projects with long construction periods – two factors that practically define the state & local public agencies that do large-scale infrastructure projects in the US.  If federal infrastructure loan programs are going to have any significant impact on US public infrastructure, they’ll need to offer loans to this group.

• It’s not easy to develop loan features that are simultaneously attractive to these borrowers and fair to taxpayers when properly reflected in the budget.  The first thing to do, which is immediately applicable to WIFIA’s case, is to improve disclosure of a features’ real cost, especially with respect to future mandatory appropriations.  Disclosure will take the unintended fun out of offering ‘free’ products and encourage the development of less fun, but more impactful products.

• Innovation is the key to this kind of development.  An important principle should guide the process: Federal infrastructure loan features should always be based on deploying a federal lending strength, relative to private sector debt alternatives.  These strengths exist, even in times when the debt markets are operating normally.  If a loan feature deploys a federal strength, then a true increase in national economic welfare is possible along the lines of the benefits of ‘comparative advantage’ in trade theory.  If not, the feature probably involves some form of zero-sum transfer payments.  Transfer payments are the delight of rent-seekers and power-hungry bureaucrats, but in this context (loans to borrowers with excellent alternatives), the economic outcomes will be at best negligible, at worst significantly misallocating.

Innovation for federal infrastructure programs will be a central theme here.  This post will be limited to identifying two distinct paths to the goal.

I’ve written before about the potential for innovation at WIFIA and its implications for other programs.  Below is a presentation from about three years ago.  This was before I understood the scale of the FCRA loss ratchet issue, but I did highlight the fact that WIFIA was lending to highly rated borrowers, and many of the basic concepts are still relevant.

Wifia-Transformational-Development-Discussion-Outline-12302019

Two Paths: Project-Focused and Borrower-Focused

It’s useful to make a distinction between two areas of innovation that can improve federal loan products for large-scale public infrastructure because there are intrinsically two different elements involved – the physical projects themselves and the borrowers that make them happen.

Project-focused innovation should center on federal strengths that are relevant to specific infrastructure sectors or sub-sectors and don’t have efficiently accessed analogues in private-sector.  Some quick examples:

• Loan Term:  The most obvious and probably most substantive federal strength relative to any private-sector market is the ability to take a very long-term view of an investment.  It’s not universally relevant since many projects have useful lives well within standard tax-exempt bond market terms.  But where project life exceeds those, especially by a wide margin, loan programs should seek to maximize their ability to lend for the longest term possible.

• Specific Risks:  I don’t think the federal government has any unique comparative advantage in infrastructure risk assessment compared to private sector investors.  Probably the opposite, to be honest.  Certainly, a large government can simply absorb bad outcomes to a much greater extent, but then we’re back to transfer payments.  However, there are areas where the federal government already has an ineluctable risk position for basic policy reasons – disaster relief, for example.  To the extent that loan features can be designed to ‘hedge’ this risk by having contingent repayment terms that work in the opposite direction, real economic benefits could be realized.  I wrote about an example here: Contingent Loans for Climate Adaptation. Bit theoretical, no?  Well, innovation always starts like that – and there are probably more straightforward situations, especially at the infrastructure sub-sector or region-specific level.

• Interaction with Other Federal or State Policy:  When infrastructure projects need to conform with federal or state requirements anyway, that resets the ‘economic baseline’ on which the value of financing can be measured.  Who better to design federal loan features that exactly dovetail with such requirements than the government itself?  An example would be federal mandates for CSO improvements where WIFIA could specifically specialize in the financial aspects of compliance.  Not exactly a ‘federal strength’ in Pareto optimal terms perhaps (since the government created the economic friction that its loans seek to reduce), but close enough to our basic guiding principle here.

Project-focused innovation is very specific to different project types and sectors.  It can’t easily be centralized and ought to be kept at the individual agencies that host infrastructure loan programs.   

Borrower-focused innovation should center on federal strengths that are relevant to the financial goals and limitations of the type of borrower that typically implements US public infrastructure — highly rated public agencies. Quick examples:

• Interest Rate Management: The long construction periods of large-scale infrastructure projects require interest rate management products. Yes, I know — when they’re ‘free’, borrowers will snap them up, as they did at WIFIA. But I don’t think the development needs to be based on a budget loophole. Treasury has huge economies of scale, expertise and existing risk positions, all of which can be the basis of attractive loan features that are both based on federal strengths and properly budgeted for.

• Balance Sheet Management: Financing for large-scale infrastructure projects will put pressure on even the largest investment-grade balance sheet. I think the federal government has relative strengths in adding flexibility to large federal loans that wouldn’t be possible in the private-sector debt markets — single investor, buy-and-hold, deferral options, etc. A few are already deployed at WIFIA — more can be developed.

• Wholesale Lending to Retail Lending: There’s another type of highly rated infrastructure borrower that doesn’t in fact build projects itself — leveraged state-level infrastructure programs. Economies and efficiencies of scale are the fundamental strengths that federal loan programs could share with these lenders. I think there’s a lot of scope for purely financial innovation in this area.

Borrower-focused innovation can be centralized because the financial concepts and mechanics will generally be applicable across sectors. And because that type of innovation requires sophisticated financial and market expertise, it shouldn’t stay in silos at the host agency level, bureaucratic turf questions notwithstanding. The agency innovators should be busy enough with the project-focused features.

I think a natural center for borrower-focused innovation will be Treasury, since they’re funding the loans anyway. Here’s a diagram I had included in the 2019 presentation, updated to include CIFIA the new Corps’ program, CWIFP: