Key Terms Used in Loan Loss Reserve Fund Agreements
The key terms of a loan loss reserve fund (LRF) agreement include the following:
- Residential EE Loan Program - The LRF agreement summarizes the grantee’s overall residential energy efficiency/renewable energy loan program and defines its lending targets.
- Loan Product - The LRF a greement defines the residential EE/RE loan product. A complete term sheet can be included as an annex to the agreement.
- Underwriting Criteria - The grantee and the financial institution will agree in advance on underwriting guidelines for the loans. The financial institution shall have the right to include loans under the LRF coverage that meet those underwriting criteria. The underwriting criteria can be adjusted during the course of the program with the approval/agreement of the grantee and the financial institution.
- Escrow Account and Reserve Account - The American Recovery and Reinvestment Act (ARRA) grantee deposits the LRF funds in an escrow account with the financial institution partner or other fiduciary, after which funds are moved in the appropriate proportion into a reserve account as loans are made. Rules for disbursements of funds from the reserve account are defined up front and tied to the definition of “Loss” and “Event of Loss.” These accounts can be held by the same financial institution that is doing the lending, but the rules for transfers and disbursements have to be clear and unambiguous. The financial institution assumes responsibility as a fiduciary for applying these rules. Reinvestment of funds in these accounts (permitted investments) is defined in the LRF agreement along with application of interest earnings.
- Definition of Loss and Event of Loss - “Loss” is usually defined as and limited to principal only on the loan. “Event of Loss” is tied to the definition of loan default and acceleration under the financial institution’s loan agreement with its borrower and occurs when the financial institution partner gives its acceleration notice to the defaulted borrower demanding all payments due under the “Loan Agreement Between Bank and Borrowers.” A certain number of days after this event (e.g., 30 days), the financial institution can disburse funds from the LRF account to cover the agreed loss share.
- Responsibility for and Distribution of Recoveries - The financial institution is responsible for recovery actions on defaulted loans. Recovered monies, net of reasonable collections costs, are deposited back in the LRF reserve account in proportion to the share of losses paid by the LRF. Grantees should not expect high levels of recovery on loans once they have defaulted.
- Reporting and Monitoring - The financial institution partner provides the grantee quarterly reports on the loan portfolio, the number and amount of loans, collections payment performance, and all activities on the LRF reserve and escrow accounts.
- Availability Period - The timeframe for adding loans to the portfolio and shifting funds from the escrow account to the reserve account must be clearly defined in the LRF agreement and tied to the ARRA grantee’s schedule requirements.
- Final Disposition of LRF Funds - The reserve account must stay in place until the entire loan portfolio is retired although the balance of the LRF fund may change as the balance of outstanding loans moves up or down. When the energy efficiency loan portfolio is fully retired, all LRF funds will be transferred back to the escrow account; and from there, the future use of the remaining funds can be redirected by the grantee (e.g., the city, county, or state designated to support further energy efficiency/renewable energy lending).
- Program Fees - The financial institution can be asked to pay fees to the energy efficiency/renewable energy loan program in the range of 1-2% of the principal amount of all loans added to the program’s loan portfolio. These fees represent another source of income to help make the energy efficiency program sustainable and scalable. These fees could also be assessed on contractors, who are accustomed to paying much larger fees for credit cards or other vendor finance programs. Grantees must, however, be sensitive to the fact that fees will be passed on to borrowers, which could affect the goal of keeping the loan program affordable. Program fees are optional.
- Reprogramming Funds in the Escrow Account - Funds in the escrow account belong to the ARRA grantee. The LRF Agreement should acknowledge the right of the ARRA grantee to reprogram use of the funds, as needed, to adapt to the program’s operating experience. However, to protect the FI partner’s investment in setting up the program, reprogramming of funds should only be permitted per agreed-upon conditions.
- Accommodating the Portfolio “Ramp-up” Period - Before the portfolio builds up, a single loan loss could represent a large percentage of the outstanding total loan principal. Thus, in the beginning, a larger contribution, per loan, to the LRF reserve account (from the escrow account) may be negotiated to give the financial institution partner the necessary level of risk sharing during the portfolio ramp-up period.
- Assignment - The financial institution partner should have to right to make the benefits of and claims payments from the LRF Reserve Account assignable to any future purchaser of the loan portfolio (under a secondary market scenario). The ARRA grantee’s approval may be required for this purpose.
See the sample LRF agreement included in this guide.
Grantees should be aware that there are multiple ways to address the required terms. In addition, energy efficiency programs can decide to include other components, such as lending to the small commercial sector, interest rate buydowns, and LRF contributions from multiple sources. Those features will require further customization of the LRF Agreement.
Also see an energy efficiency loan program agreement template. It addresses the full project marketing, development and loan origination cycle, and coordination of same between the financial institution partner and other program parties.