In the prior post, I described CIFIA’s Limited Buydown provision in some detail. That post covered why I think the provision will be important to carbon pipeline developers, and how it might be at risk if the program runs short of discretionary appropriations due to rising rates after accepting a large volume of loan applications. This post is shorter and more cheerful. It considers how CIFIA could reset the buydown if rates fall, based on recent precedents from the WIFIA loan program.
WIFIA Loan Re-Executions to Reset the Rate Lock
I wrote about WIFIA’s rate lock resets for Water Finance & Management in 2020, Resetting the Mission for WIFIA. The first part of the article describes interest rate resets for two large and highly rated public water agencies. They’d executed WIFIA loan commitments in 2018 when the 20Y UST was around 3.10%. With the 2020 re-executions, their rate was lowered to the then-current 20Y UST, about 1.00%.
Why did WIFIA agree to this? They didn’t have to. There’s nothing in WIFIA’s statute or federal loan program guidance that would require the program to re-execute prior loan commitments just because they’ve become relatively less attractive to the borrower.
But if WIFIA hadn’t done the resets, the agencies would simply have cancelled their WIFIA loans and issued muni bonds at about 1.00% instead. The second part of the article discusses some of the policy implications of the fact that WIFIA’s highly rated public-sector borrowers have excellent tax-exempt alternatives. It’s likely that the resets didn’t affect the projects at all but were useful to the borrowers’ fiscal situation, which requires some explanation for an infrastructure loan program. Of course, WIFIA was also trying to preserve its scorecard of completed loan volume. The optics of loan cancellations are not good, regardless of reason.
WIFIA’s specific policy ambiguities aren’t relevant to CIFIA, as discussed in the prior post. Instead, the key point for CIFIA here is that WIFIA chose to offer the resets. More importantly, the program found a way to grant them without requiring the water agencies to unilaterally cancel their executed commitments and go through the application process all over again to obtain lower rates, a risky and time-consuming option.
Here’s a non-confidential internal technical presentation I did for WIFIA in 2019 while I was a consultant for the EPA: Rate Resets for Out-of-the-Money Loan Commitments. I noted some of the legal and budgetary issues that might arise with the resets, but at the time I thought they’d be easily overcome, as proved to be the case. Most of the presentation focused on options to manage resets to reduce interest rate re-estimate risk. But as I expected, WIFIA just went with unconditional resets, which reflected the program’s willingness to give the borrowers exactly what they wanted.
In the presentation, I predicted that seven WIFIA loan commitments, totaling about $2.5 billion, would be subject to reset requests. They were all granted, judging from statements in WIFIA’s 2020 Annual Report. Perhaps there were more in subsequent years. I doubt it, due to rates rising off the 2020 trough and some other factors about smaller WIFIA borrowers. But it doesn’t matter – the precedent for unconditional resetting of undrawn construction rate locks at WIFIA is now firmly established. Borrowers executing WIFIA loan commitments in the current rate environment can be confident that if the 20Y UST falls significantly prior to loan funding, they’ll have another bite at the apple.
Implications for CIFIA
WIFIA precedents in this area should be applicable to the CIFIA program because the two programs share many of the relevant provisions. This is most clearly the case for post-execution rate locks since the reset of an executed but undrawn loan commitment to a carbon pipeline project would be exactly analogous to a WIFIA reset. But I’m not sure that this post-execution option will always be as important for CIFIA’s projects as it is for WIFIA’s larger projects.
A typical WIFIA project will have a long construction period, at least five years. WIFIA’s large and highly rated public-sector borrowers have multiple established sources of very cost-effective short-term financing which can be accessed for construction draws. This means that they can keep the WIFIA loan commitment as a completely undrawn option until permanent financing. That works well when the Treasury yield curve is normally sloped, which it was for 2018-2020 period preceding the first resets. Drawn loans can’t be reset at WIFIA, but undrawn commitments can, and many early WIFIA borrowers had large undrawn commitments that were very out-of-the-money by 2020. This created the demand for the first WIFIA resets.
In contrast, carbon pipeline construction is apparently quick once rights-of-way are finalized, perhaps two or three years. More importantly, CIFIA loans to this sector are closer to classic non-recourse project financings, which don’t rely on large investment-grade balance sheets or other sources of debt. A CIFIA loan commitment will probably start being drawn for construction draws as soon as it’s executed. Rates would need to fall significantly and rapidly during a two-year construction period for a reset to be compelling on whatever remains undrawn in a CIFIA loan commitment. That scenario might arise for some projects in certain circumstances, but the post-execution rate lock reset probably won’t be as generally important as it is at WIFIA. Still, whenever it becomes valuable for a specific CIFIA project, I think WIFIA’s post-execution reset precedent can apply directly, and more general demand from other borrowers shouldn’t be necessary.
Resetting the Limited Buydown
A more interesting, and potentially important, question is whether the reset principle can be applied to the limited buydown. This would useful if rates fall after the original application date but are expected to be at risk of rising again before loan execution, a recent pattern of volatility that will likely continue in these interesting times. A CIFIA applicant will want to lock in lower rates with the limited buydown by resetting the application date.
Here the analogy to WIFIA’s post-execution rate lock reset is necessarily indirect. But the basic concepts are the same. A limited buydown is always undrawn because, of course, it’s not a loan commitment. In fact, given the permissive language in the provision, CIFIA’s limited buydown is not really a commitment for anything. It simply limits what the program is allowed to do if a loan’s relevant interest rate has risen since the date on which its application was accepted. Nothing stops an applicant from withdrawing an application and re-applying. If accepted, the new application in effect resets the date and thereby the relevant rate.
These are basically the same conditions that made WIFIA’s reset possible. The reset doesn’t affect drawn loans, program law is completely silent on the matter, and in any case, the borrower can unilaterally make it happen by withdrawing and going through the process again. If anything, they’re even clearer in CIFIA’s case – limited buydowns are literally undrawable, they aren’t even a commitment, and re-application is much easier than full re-execution.
As was the case with WIFIA’s rate lock re-executions, limited buydown resets at CIFIA will likely come down to whether the program wants to offer them. I’d expect they will (or should) be generally willing to do so, based on some of the factors described in the prior post. Limited buydowns likely help accelerate carbon pipeline construction by facilitating aspects of the developers’ arduous rights-of-way negotiations. As such, the provision is part of the program’s core mission. If there’s an opportunity to improve the buydown for a specific project, doing so will presumably enhance the acceleration effect, which is better policy rationale than WIFIA’s resets seemed to have. It will also encourage the others by demonstrating an unbureaucratic willingness to help borrowers where possible, not just where required.
Yes, withdrawal and re-application can be done unilaterally. But that’s added transactional friction just when the developers must be fully focused the easement negotiation process. It’s also not without risk because in a two-step process the applicant loses the original rate cap. If something goes wrong or is significantly delayed in the re-application, project economics – or at least the certainty thereof – could be seriously impacted, resulting in a later construction start. CIFIA can eliminate this risk by accepting an identical re-application simultaneously with the withdrawal of the original application, or some similar one-step process wherein the only change is the date. Why not cut to the chase?
Well, there is one thing that CIFIA’s administrators need to consider – a possible gap in discretionary appropriations caused by resetting a large volume of limited buydown applications. The risk of rising rates for limited buydowns in the program’s original applications was discussed in the prior post. By resetting buydowns at a time when rates could, or are even expected to, rise, the program will be in the same situation.
By refusing to facilitate re-applications and discouraging unilateral action by applicants, CIFIA would presumably reduce this risk. At some point this might be a way to ration subsidy if a shortfall looks imminent. But at the outset of CIFIA’s operations, when there’s $2.1 billion of appropriations that Congress intended to be used to accelerate pipeline construction, an overly cautious approach will be both unnecessary and counterproductive. I think CIFIA will come to the same conclusion and the program should be open to considering limited buydown resets for at least the next few years.
What’s At Stake? Looking at Some Numbers
To put limited buydown resets in context, it’s worth looking at some numbers. They’re significant.
The first chart shows what happens if a project resets a lower rate on loan execution than was expected in the original application. In this illustration, the original application for a $1 billion CIFIA loan for a $1.25 billion project was accepted when the relevant rate was 3.75%, about the current 20Y UST. Project economics at this rate were acceptable, with an expected 7.5% IRR on $250 million of project equity and an adequate debt service coverage ratio.
But then the 20Y UST falls to (say) 3.00%. A loan executed at that lower rate would result in a project IRR of 10.5% if the leverage ratio was held constant. Or the project developers could hold equity return constant and increase leverage (perhaps even from CIFIA itself) by almost $150 million. The former would provide motivation, and the latter more negotiating headroom, to get the easement process done as quickly as possible. But that process will still take time, and rates could rise again before loan execution. The value of locking in the new rate with a reset application will be obvious to the project’s developers and (since it will help accelerate construction start) to CIFIA as well.
The second chart looks at a possible pattern of the 20Y UST over two years to illustrate various reset scenarios for the project described above. The pattern is based on actual 20Y UST rates from May 2019 to May 2021, adjusted upward to about the current level, 3.75%.
- Point A: This is the original application at 3.75%. Project economics are good enough, but won’t tolerate a higher rate, so the limited buydown collar is an important aspect of the CIFIA application.
- Point B: Project developers see that the 20Y UST has hit 3.00% after four months but seems headed to rise again. They ask for a reset to lock in the numbers described above, a 10.5% IRR or about $150 million of additional debt capacity.
- Point C: Alternatively, the developers believe rates have further to fall and wait about a year until the 20Y UST hits 2.20%, a possibly unsustainable low. A reset at this point results in a project IRR of 12.5% or almost $300 million of additional debt capacity.
- Point D: The developers are more cautious but can see that rates have bottomed out and will likely go steadily higher. Still, a reset at this point results in an IRR of 11.5% or additional debt capacity of more than $200 million.
- Point E: No reset. The execution rate of 3.40% is below 3.75%, with a resultant IRR of about 9.0% or nearly $100 million. Still a good outcome – but not as good as it could have been with a reset at almost any point in the pattern. All three possible resets were well within the limited buydown’s 1.50% cap, which would only have started to matter for 20Y UST rates less than 1.90%.
Note that Point B would probably have a greater impact on accelerating pipeline development than Points C or D. Even though the later numbers are better, the first reset occurs early in the process. That might be something for CIFIA to consider in terms of policy objectives, but I’m sure that developers will be more persuaded by economics. In any case, the illustration shows that both project economics and CIFIA policy outcomes are improved by resets, possibly significantly.
The case for limited buydown resets looks compelling, but it should not assumed to be an automatic aspect of CIFIA’s operations that can be requested at the last minute. It’s a relatively technical concept and WIFIA’s precedents are only indirectly applicable. There are always devils in the bureaucratic details, too. The possibility of resets should be brought to CIFIA administrators’ attention as soon as applications start being accepted, whether or not they look likely to be used at that point. As noted above, these are interesting times for interest rates, and much else besides. Certainty matters.