A credit enhancement is anything that improves the chances that financing will be repaid. Credit enhancements are useful because they:
Encourage lenders and investors to put money into unfamiliar markets or products (such as residential energy efficiency lending).
Can absorb risk of loss and, as a result, be used as a negotiating tool to convince lenders to reduce interest rates or provide longer loan terms.
Can be used as negotiating leverage to convince lenders to relax their underwriting criteria in order to lend to individuals or businesses with lower than typical credit profiles.
Sometimes a credit enhancement takes the form of American Recovery and Reinvestment Act (ARRA) funds set aside to cover potential losses in case of nonpayment. A credit enhancement can take one of several forms:
A loan loss reserve sets aside (reserves) a certain amount of money to cover potential losses (in case of no repayment). For instance, a 5% loan loss reserve on a $60 million loan portfolio would cover up to $3 million of a capital provider’s losses on that loan portfolio.
A loan guarantee covers the entire amount of a capital provider’s potential losses on a portfolio of loans. A guarantee differs from a loss reserve because it is not capped at the amount of money set aside in the reserve. Federal statute does not allow State Energy Program or Energy Efficiency and Conservation Block Grant funds (and by extension ARRA funds) to be used as a loan guarantee. The federal government provides loan guarantees through the U.S. Departments of Agriculture and Energy as well as several Small Business Administration programs.
Loan loss insurance is a private insurance product that lenders can purchase or a grantee can purchase on behalf of a lender. Loan loss insurance is similar in some respects to a loan loss reserve in that the insurance covers a portion of the total losses (in case of no repayment), up to some capped amount. The difference is that instead of setting funds aside in a reserve account to cover the losses, the grantee or lender pays an insurance premium to a private insurer. Loan loss insurance is not easy to secure at the moment.
Debt service reserves are funds set aside to cover potential delayed or defaulted payments on a debt instrument (loan). For instance, a bond might require setting aside a 6-month debt service reserve, or perhaps 10% of the total amount of the bond to cover potential defaults.
A subordinated/senior capital structure allows two types of capital to be placed into a loan. The first one, subordinated capital (which could be provided by a grantee using ARRA funds) absorbs the potential first losses on a loan and might be set at 10% of the total loan amount. The second one, senior capital, does not absorb any losses until the subordinated capital is exhausted. This structure acts in some ways like a loan loss reserve and serves to attract the senior capital because the subordinated capital takes on the majority of the risk.