This post will add another concept to a prior one, CWIFP Loans to Small Dam Funds. There I outlined why I think an eligible financial entity (like a trust) can bundle a portfolio of small dam project loans to meet CWIFP’s $20 million project cost threshold without requiring full cross-default. The key element is that the entity has capitalization that will be subordinated to the CWIFP loan, thereby making the entity a substantive ‘borrower’ even though the loan’s repayment will in effect rely on cash flow from the small dam loan portfolio. I noted that such capitalization would probably be necessary to meet CWIFP’s investment-grade requirement anyway, and suggested there might be a variety of third-party sources for it.
The added concept here is that maybe the entity’s capitalization doesn’t need to come exclusively or even at all from third parties but might be provided by the small dam projects themselves. This isn’t a new idea by any means — co-operative banks and credit unions are of course a well-established feature in many sectors, especially agriculture. Small operators in a sector might find it difficult to obtain efficient or cost-effective financing individually, but a larger institution collectively owned by them can achieve economies of scale and pass on the savings. Similarly, small dam projects, especially within a state or region, seem to have a lot in common, including an apparent lack of efficient or cost-effective financing. A CWIFP loan could help address this issue, but the $20 million threshold is in effect the required ‘scale’ to access this particular ‘economy’.
How such a small dam financing co-op would work is best approached by a hypothetical illustration. Imagine a collection of ten small dam projects within a state or region that have an average cost of $2 million and the ability to start construction at roughly the same time once financing is obtained. As a bundle, this meets the CWIFP threshold and permits an application to be made for a $10 million CWIFP loan. The project borrowers are willing to cooperate with each other, but they’ll never agree to a full cross-default of their individual loans or being on the hook in any way to other borrowers. They might consider, however, contributing something to capitalize an entity for the purpose of obtaining CWIFP financing.
How Much?
The real-world question is ‘how much?’. As discussed in the prior post, the borrowing entity can’t be a shell SPV. Though it’s not explicitly stated, I think some substance is required to comply with WIFIA’s bundling rule in Section 3905.10. But the minimally adequate amount of substance should be judged in the context of what the entity is expected to do.
That’s pretty limited, at least initially. The trust will apply for a single fixed-rate, long-term loan with very flexible terms from a buy-and-hold, policy-oriented federal program. If the application is successful, the entity will on-lend the proceeds on the exact same fixed-rate, long-term basis to a specific group of ten, otherwise completely CWIFP-eligible, small dam projects. There aren’t many moving parts in this picture — the only important risk is a credit default by one of the projects. The entity’s capitalization should therefore be evaluated primarily with regard to a substantive mitigation of that risk.
Assume for the moment that each one of the project loans could obtain a minimal investment-grade rating of Baa3/BBB- [1]. The NPV of the expected default loss associated with such a rating for a public infrastructure project loan is (very) roughly 5% of the loan amount. If the borrowing entity was capitalized with $500,000 of equity to cover expected losses from the $10 million loan portfolio, that would certainly seem to be substantive. After all, WIFIA and the other federal infrastructure loan programs do exactly the same exercise per FCRA rules to determine the adequacy of the required credit subsidy for their own loan portfolios. If the approach is good enough for OMB, why shouldn’t it be good enough for this small dam financing co-op?
For the project sponsor, $50,000 per project doesn’t sound like much — but remember we’re only talking about a $1 million loan each. Since it’s extremely unlikely that all the loans will default, they’ll likely get most or all back when the trust winds up, though that will be decades in the future. Perhaps a smaller amount will work if the portfolio is somewhat diversified? Or grant funding or philanthropic assistance could be sought for the purpose? All that, and many other angels and devils in the details, will need to be considered and worked out in any real-world situation. The only point here is that adequate capitalization for the purpose of Section 3905.10 should not be a large amount, probably in the range of 5% of the CWIFP loan.
A Revealing Simplification
It’s worth noting a possible simplification to co-op capitalization that doesn’t change the substance of the approach. For the very limited purposes of the CWIFP borrower entity, upfront cash capitalization to cover expected loan losses doesn’t seem to be necessary. The capital is there only to offset final losses after default, work-out and recovery. For public infrastructure project loans, this process happens very rarely, very slowly and takes a long time to complete. There’s no point in keeping $500,000 in cash available for that purpose. Presumably, a capital call or similar undertaking by each of the co-op’s members for their share would be sufficient.
That simplification also reveals another perspective on the co-op approach with respect to Section 3905.10. As discussed towards the end of the prior post, hardliners might insist that full cross-collateralization and cross-default is required from each borrower in the project bundle. Well, okay — I can see the principle of some substantive connection between the project loans. But why does it need to be an unlimited cross-collateralization or cross-default obligation? Why wouldn’t a limited obligation that reflects some important substantive risk aspect of the project loans be sufficient? Especially if that limited obligation is assessed in a very similar way to federal FCRA budgeting for loan program credit loss reserves? No one expects a 100% credit subsidy for investment-grade infrastructure project loans to be necessary [2]. Why a hard line against small dam borrowers with projects that are demonstrably consistent with CWIFP policy objectives but a soft line for the amount of credit subsidy required from federal taxpayers?
Of course, the capital call described above for the co-op CWIFP borrower is essentially a limited cross-collateralization obligation directly to the CWIFP loan. If one works, the other should, too. There may well be other reasons to develop a small dam financing co-op, not the least of which is the option or the need for third-party capital to be involved in the mix. But at the very least, it strikes me that a co-op approach might be a useful way to start the narrative that project bundling for small dams ought to be actively encouraged at CWIFP in the expectation that hardliners will inevitably surface sooner or later.
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Notes
[1] This assumption is probably not realistic in many cases, which means that the third-party capitalization discussed in the original post will likely be necessary and the substantive nature of the borrower entity will automatically follow. Other, more classic reasons for a co-op approach — control, cost-savings, scale economies, etc. — would still be applicable, especially with respect to getting the ball rolling.
[2] Well, perhaps in a way some hardliners do.