Loan Loss Reserve Fund Risk-Sharing Formula
When “leveraging” a loan loss reserve fund (LRF), a grantee and financial institution must negotiate and agree to a risk-sharing formula.
An LRF risk-sharing formula typically has two main parameters. The first is the ratio of the LRF funds to the total original principal amount of the loans in the energy efficiency/renewable energy loan portfolio. The single-family residential programs that currently use a loan loss reserve structure frequently have a loss reserve of between 5% and 10% of the total portfolio original principal, implying a leverage ratio between 10:1 and 20:1. Lending in some of the residential markets with low credit quality might require higher loan loss reserves.
For instance, one commercial loan program now available in Detroit will likely require a loss reserve of as much as 50% (only a 2:1 leverage) because borrowers in that program have less than ideal credit. A higher leverage ratio means that the program can offer more loans than it could with a lower leverage ratio. But it also implies less risk protection for the lender. A lower leverage ratio implies greater risk protection for the lender. Another program for residential homeowners in a very low-income area of Indianapolis also has a 50% loan loss reserve in order to attract capital to that neighborhood.
Loan loss reserve funds may come from multiple sources. In addition to the grantee’s American Recovery and Reinvestment Act (ARRA) funds, potential sources include contributions from local vendors/contractors, utilities (as part of their energy efficiency/renewable energy or demand side management program funds), and other donors interested in energy efficiency/renewable energy residential improvements.
The second parameter in the LRF risk-sharing formula is the share of the losses on individual loans that the LRF will pay. This is negotiated by the financial institution partner and the grantee. For instance, if one loan in a portfolio defaults, the lender might be able to recover only 80% of the unpaid principal amount of the loan from the loss reserve. This structure leaves the lender with some cash still at risk and motivates the lender to require high-quality loan origination and collection procedures.
The recovery for individual loans ranges from 50% to 100%; but the higher end of the range, 80% to 100%, is typical. Eighty to ninety percent strikes a good balance, leaving some of the first losses to be borne by the financial institution partner, covered through its normal loan loss provisioning. Even if the LRF pays a large portion of the financial institution’s losses, the financial institutions has a vested interest in minimizing first losses to keep the LRF intact so that it can cover any future losses on the balance of the portfolio.
The financial institution is responsible for all losses in excess of those covered by the loan loss reserve; these are sometimes referred to as second losses. Because the financial institution is fully at risk for all second losses, it has a strong incentive to ensure high-quality loan origination, collections, administration, and recoveries. Grantees should expect the financial institution partner to bargain hard for those provisions.
The entire risk-sharing formula between the loan loss reserve fund and the financial institution is important and further demonstrates that the LRF is not a loan guarantee, nor does it eliminate risk altogether for the lender. The liability of the grantee (the local government or other entity using ARRA funds for the LRF) is limited to the funding provided by ARRA (and in some cases by other donors).
The table below presents a sample calculation for an LRF program budget and risk-sharing formula.
|1||LRF ARRA grant budget||$1,000,000|
|2||Grant funds for program development & operations||$100,000|
|3||Net funds for LRF escrow account||$900,000|
|4||"First Losses" as % of total original principal||5.00%|
|5||Share of first losses borne by LRF||90.00%|
|6||Share of first losses borne by financial institution partner||10.00%|
|7||Total lending that can be supported with this LRF risk-sharing formula||$20,000,000|
|8||Average portion of EE projects paid by loans (homeowners/utilities/others cover the remaining 20%)||80.00%|
|9||Total EE Project Investment that can be supported||$25,000,000|
|10||Leverage ratio #1 (LRF funds to total lending product size supported)||22.22|
|11||Leverage ratio #2 (LRF funds to total EE project investment supported)||27.78|