Innovative federal credit programs for the renewal of American public infrastructure are an important part of the solution to a major problem.  We all agree on that, right?

I’m sure we’d also all agree that innovation requires experimentation.  That means building and operating prototypes which will inevitably have both good and bad results.  The good results are the basis of further development and full-scale implementation.  The bad results show what needs to be fixed.  A successful prototype is one that demonstrates clear results and produces useful data.  It is not the final version, and to evaluate a prototype that way is a wasteful and dangerous category mistake.

The WIFIA Loan Program at this point is a successful prototype.  The Program has demonstrated that the federal government can be an efficient institutional lender to highly rated public-sector agencies, giving them a cost-effective alternative to the municipal bond market.  It has also shown that a federal loan program can offer relatively sophisticated and much-needed financial management products for large-scale public infrastructure, not just cheap loans.

But operationally and statutorily, WIFIA is not by any means in a final form.  The Program’s good results noted above are quite limited in terms of scope and policy outcomes relative to the multi-faceted needs for infrastructure financing in the water sector.  Further development is clearly possible and fundamentally required.

Unsurprisingly at this stage of development, the prototype has also shown some bad results.  These are less visible but equally significant.  As discussed in a prior post, WIFIA’s exposure to rising rates will almost certainly result in large and apparently unanticipated funding losses.  The Program’s impact on the municipal bond market is obvious, but the serious policy ambiguities surrounding such an interaction with a fully functioning (and politically powerful) private-sector market have not yet been officially acknowledged, much less resolved.  Both issues are fatal flaws in WIFIA’s current design.  Until they are thoroughly addressed, the Program is not realistically sustainable.

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.