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When using a loan loss reserve (LLR) fund, the state or local government and financial institution must negotiate and agree to a risk-sharing formula with agreed-upon parameters.
An LLR risk-sharing formula typically has two main parameters. The first is the ratio of the LLR 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 an LLR 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 LLRs.
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.
LLR funds may come from multiple sources, potential sources include contributions from local vendors and 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 LLR risk-sharing formula is the share of the losses on individual loans that the LLR will pay. This is negotiated by the financial institution partner and the state or local government. 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 percent to 90% 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 LLR pays a large portion of the financial institution's losses, the financial institution has a vested interest in minimizing first losses to keep the LLR 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 LLR; 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. State and local governments should expect the financial institution partner to bargain hard for those provisions.
The entire risk-sharing formula between the LLR fund and the financial institution is important and further demonstrates that the LLR is not a loan guarantee, nor does it eliminate risk altogether for the lender. The liability of the state or local government using the LLR is limited to the funding provided by the lender.
The table below presents a sample calculation for an LLR program budget and risk-sharing formula.
|Loan Loss Reserve Fund Program, Sample Budget and Risk-Sharing Formula Calculations|
|1||LLR grant budget||$1 million|
|2||Grant funds for program development and operations||$100,000|
|3||Net funds for LLR escrow account||$900,000|
|4||"First losses" as % of total original principal||5%|
|5||Share of first losses borne by LLR||90%|
|6||Share of first losses borne by financial institution partner||10%|
|7||Total lending that can be supported with this LLR risk-sharing formula||$20 million|
|8||Average portion of energy efficiency projects paid by loans (homeowners/utilities/others cover the remaining 20%)||80%|
|9||Total energy efficiency project investment that can be supported||$25 million|
|10||Leverage ratio #1 (LLR funds to total lending product size supported)||22.22|
|11||Leverage ratio #2 (LLR funds to total energy efficiency project investment supported)||27.78|