Primary Characteristics of Loan Loss Reserve Funds
The four primary characteristics of a loan loss reserve fund (LRF) are:
Portfolio Approach to Credit
Loan loss reserves take a “portfolio approach,” meaning that grantees setting up LRFs do so on the basis of the entire portfolio of loans they support. For example, a 5% loss reserve on a $60 million loan portfolio means that the size of the loss reserve is $3 million.
Grantees can set the size of the loss reserve to be higher than the portfolio’s estimated loan losses. For instance, if estimated losses are 1.5% on the whole loan portfolio, the grantee might size the loss reserve at between 5% and 10%, depending on the result of negotiations between the grantee and the financial institution partner.
An LRF structure works best when the target market is a portfolio with a large number of small transactions. Typical residential energy efficiency loans, for example, are in the range of $5,000–$15,000, and a typical program will aim to fund hundreds and possibly thousands of loans. Thus, default of a single loan or several loans will represent a small portion of the total portfolio. Those first losses can be covered by the LRF, up to the limits of the LRF and according to the agreed risk-sharing formula. For target markets facing the reverse situation—a smaller number of larger loans (creating what is called a “lumpy” portfolio)—other forms of credit enhancement may be appropriate. The Primer on Lending summarizes other types of credit enhancement.
Leverage refers to the amount of private capital that a grantee might attract to a clean energy lending program by offering a loan loss reserve. For example, if a grantee has $1 million available in American Recovery and Reinvestment Act funds for the LRF, a 5% loss reserve will produce $20 million in capital to lend. The leverage ratio in that case is 20:1.
Leverage can also refer to the total amount of clean energy project investment that a grantee can support with its lending program. Other sources of funds, such as utility rebates, other capital incentives, or customer capital contributions, are typically used, so the loan may finance for example only 80% of the energy efficiency project costs. Using the example above, $20 million in energy efficiency and renewable energy loans may support $25 million in total clean energy project investment, with a leverage ratio of 25:1. Both approaches are important and valid.
Financial Institution Partner
The financial institution partner can be one or more of the following: a commercial bank, a credit union, a nonbank finance company (leasing company or specialized financial institution), a community development financial institution, utilities, or state-chartered (state-level) bond authorities. To set up the LRF program, grantees must identify potential financial institutions and research all those interested, procure the financial institution partner, establish a good working relationship, and structure the loan program with the selected financial institution. Different financial institutions have different lending practices and criteria. If the new energy efficiency/renewable energy loan program can build on the lender’s existing loan products (e.g., home improvement loans), then the financial institutions internal new product development process will likely be accelerated; and the grantee’s program can start sooner.
Secondary Market Support
Some financial institutions (e.g., credit unions) will originate and hold residential energy efficiency loans in their own portfolio until the loans mature. Other financial institutions (e.g., specialized nonbank finance companies, warehouse funds, and some commercial banks) will originate loans, assemble portfolios, and then seek to refinance or sell the portfolios to a “secondary market” capital source. The U.S. Department of Energy Financial Technical Assistance Team is collaborating with the financial community to develop secondary market capital sources. Availability of funds from the secondary market can allow lenders to recycle and relend their loan funds more quickly than they would be able to do if they had to wait for their loans to mature. Although LRFs support the primary lender, the benefits and risk coverage of the LRF must be assignable to the secondary market capital source (provider) if the loans are sold to an investor in the secondary market. That is an important provision for each grantee and financial institutions to incorporate in the program’s LRF agreement (see Steps for Developing a Clean Energy Financing Program with an LRF) if they want to have access to this secondary market.