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:
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.
New loans in the portfolio won’t mitigate the problem. Given the high credit quality of WIFIA’s borrowers, these loans will never be drawn at above-market rates, and hence they will never be a source of portfolio gains. At best they’re neutral — more likely new loan commitments will just add to the problem in a slowly rising rate environment.
The portfolio does have one factor that partly mitigates taxpayers’ economic losses, albeit in a completely unrelated and somewhat abstract way. WIFIA loans and loan commitments will displace tax-exempt debt, resulting in higher projected federal tax revenue:
Economic Cost of WIFIA Loan Portfolio Part 2: Federal Tax Revenue Impact
The (very) approximate value of the increased revenue is coincidently about $1 billion, though this will decrease as rates rise, diminishing the hedging effect. There’s no accounting path that connects WIFIA’s impact on tax revenues to FCRA credit subsidy costs, but the effect seems significant enough to be considered in the context of high-level policy review. Official recognition of the value will require a change in JCT assumptions (the real purpose of this letter, actually) and some finessing of the OMB 129 issues – messy, but probably worth the effort.
Does This Matter?
In some ways, all this shouldn’t matter. WIFIA borrowers and their water ratepayers get the benefit of the low, locked-in interest rates, so at worst the funding cost mismatch is just an off-budget transfer payment from federal taxpayers to WIFIA borrowers’ ratepayers. That’s money well spent compared to much other off-budget federal spending. And in the scale of what federal taxpayers are (and soon will be) on the hook for anyway, even a few billion dollars are less than a rounding error.
But in other, less edifying ways it may matter a lot. The Program’s annual appropriation is about $50 million. That’s solely intended to cover the (minor) cost of credit losses on a portfolio of investment-grade infrastructure loans. Loan interest income is meant to completely cover Treasury funding cost. When funding cost mismatches in the scale of $1-2 billion start to surface as loans are drawn and losses realized, they’ll become increasingly visible in various federal budgeting reports. And increasingly difficult to ignore.
What happens then will likely be political, which is not exactly the best forum for a calm discussion about the technicalities of loan portfolio management. WIFIA has plenty of supporters, but a few powerful enemies, too. Markets don’t like their deal volume to be displaced by government programs, regardless of the greater good, and it should be assumed that their lobbyists will be on the case.
They’ll have a lot of negative spin and soundbite material when the inevitability of funding losses become apparent this situation. Comparisons to prior headline-grabbers are ready-mixed. The numbers are big enough to invoke Solyndra, and the origin of the losses can be made to sound like the interest rate derivative investments which caused Orange County’s bankruptcy. That’s all apart from whatever other ideological or election cycle agendas might bubble up in connection with a loan program operated by the EPA, originated under Obama, operational in the Trump era and now on the Biden administration’s watch.
The resulting narrative won’t be pretty. It has the potential to influence public perception about what the Program actually has done to date or could accomplish in the future. That’s what matters, not the portfolio losses per se. And it’s probably enough to sink the ship.