Credit enhancements, such as loan loss reserves (LLRs) and interest rate buy-downs (IRBs), are tools that improve the chances that financing will be repaid, or de-risk the investment for the financier. They can support clean energy finance mechanisms including on-bill financing, bond issues, property-assessed clean energy financing, revolving loans funds, and more. State and local governments seeking to improve the financing options available to the private sector may choose to put funds toward credit enhancements because they can:
- Encourage private lenders and investors to put money into unfamiliar markets or products (such as residential energy efficiency lending).
- Absorb risk of loss and, as a result, be used as a negotiating tool to convince lenders to reduce interest rates or provide longer loan terms (e.g., extending the loan from 3 years to 7 years).
- Provide negotiating leverage to convince lenders to relax their underwriting criteria for lending to individuals or businesses with lower-than-typical credit profiles.
Credit enhancements can be used in any market, from residential to commercial lending to multifamily housing lending to public and nonprofit lending.
Types of Credit Enhancements
Loan loss reserves (LLRs) provide partial risk coverage to lenders—meaning that the reserve will cover a pre-specified amount of loan losses. For example, an LLR might cover a lender's losses up to 10% of the total principal of a loan portfolio. The financial institution working with state or local governments can draw on the LLR to cover losses on defaulted loans according to the terms of the loan loss agreement between the lender and the state and local government.
- ADVANTAGES: Funds put toward loan loss reserves are not depleted unless loans go unpaid. If loans are repaid, reserves can be freed up for additional loans.
- DISADVANTAGES: Funds committed may not directly reduce borrowing costs for borrowers, though LLRs typically expand access to capital for those who otherwise may not have borrowing power, e.g., individuals with poor credit.
Learn more about loan loss reserves.
Interest rate buy-downs (IRBs) lower the interest rate on a loan, resulting in a lower monthly payment for the borrower. State and local entities buy down the interest rate by making an upfront payment to the lender. The upfront payment is based on the difference between: the sum of all principal and interest payments that a lender would be projected to receive at the market-based interest rate, and the sum of payments that the lender would receive from the target (incentivized) interest rate, adjusted for the time value of money. IRBs can be a way to gain more attention for the financing program, reward early participants in a newly launched program, and build market demand.
- ADVANTAGES: Funds committed provide savings to borrowers by reducing interest due on loans.
- DISADVANTAGES: Capital put toward interest rate buy-downs does not revolve—once the funds have been committed to buy down interest rates, the funds are out the door.
Loan guarantees cover the entire amount of a capital provider's potential losses on a portfolio of loans. A guarantee differs from an LLR because it is not capped at the amount of money set aside in the reserve. Federal statute does not allow State Energy Program or Energy Efficiency and Conservation Block Grant funds to be used as a loan guarantee. The federal government provides loan guarantees through the U.S. Departments of Agriculture and Energy as well as several Small Business Administration programs.
Loan loss insurance is a private insurance product that lenders can purchase or a grantee can purchase on behalf of a lender. Loan loss insurance is similar in some respects to a loan loss reserve in that the insurance covers a portion of the total losses (in case of no repayment), up to some capped amount. The difference is that instead of setting funds aside in a reserve account to cover the losses, the grantee or lender pays an insurance premium to a private insurer. Loan loss insurance is not easy to secure at the moment.
Debt service reserves are funds set aside to cover potential delayed or defaulted payments on a debt instrument (loan). For instance, a bond might require setting aside a 6-month debt service reserve, or perhaps 10% of the total amount of the bond to cover potential defaults.
A subordinated/senior capital structure allows two types of capital to be placed into a loan. The first one, subordinated capital absorbs the potential first losses on a loan and might be set at 10% of the total loan amount. Senior capital does not absorb any losses until the subordinated capital is exhausted. This structure acts in some ways like an LLR and serves to attract the senior capital because the subordinated capital takes on the majority of the risk.
Entities involved in administering credit enhancements typically include:
- Local and state government agencies establish a credit enhancement fund or program to absorb loan risk. Public entities encourage private lenders to provide attractive loans to commercial, industrial, residential, or nonprofit sectors to support energy efficiency and renewable energy markets or products. They may also negotiate loan terms and underwriting criteria with private lenders for loans backed by their credit enhancements. Public entities also promote loan programs backed by their credit enhancements to target sectors based on their program goals.
- Third parties or private lenders issue loans and are responsible for administering the loans on behalf of the government funder. Lenders often work with local and state government agencies to ensure that financial tools are designed to target key sectors e.g., low- to moderate-income communities.
State and local governments should consider these steps and best practices during the design, approval, and management of a loan or credit enhancement program:
- Research credit enhancements and how they can be used to support your clean energy goals. The RLF Resource Library includes foundational resources for learning about credit enhancements and case studies of model programs using credit enhancements. Identify potential funding sources and develop an initial budget.
- Set goals for your credit enhancement approach. Assess gaps in access to finance in the market and consider how credit enhancements could support lending in those areas to fill those needs.
- Target a sector or a combination of sectors, based on your program goals. Determine eligible technologies or project types.
- Select a credit enhancement mechanism based on your program goals and target sector, and refine your program budget.
- Establish a program structure. Identify financial institution partners. Determine the roles and responsibilities of program staff and third-party lenders. Work with lenders to establish loan terms and underwriting criteria appropriate for your sector to make the program available to as many qualified borrowers as possible.
- Launch and manage the credit enhancement program. Drive uptake with marketing and outreach to your target sector(s); a vetted list of lenders can boost borrower confidence. Assess program performance and adapt the program as needed to support your goals. Monitor financial markets to identify changes that may make projects or loans less attractive and adapt the credit enhancement as required.
- The Credit Enhancement Overview Guide explores several credit enhancement approaches, discussing how to choose credit enhancement mechanisms based on a target sector, and strategies for establishing partnerships with private capital providers.
- Loan Terms defines loans terms used when finalizing details of loan products with financial institution partner(s).
- Underwriting Guidelines for Residential Loan Programs outlines issues covered during underwriting to support public partners working with financial institution partners to extend more flexible terms to residential borrowers.
- RLF Resource Library offers resources for designing and management credit enhancement programs, including case studies and sample third-party documents and agreements.