Loan loss reserves (LLRs), interest rate buy-downs (IRBs), and other types of credit enhancements can support clean energy finance mechanisms including on-bill financing, bond issues, property-assessed clean energy financing, revolving loans funds, and more. A credit enhancement is anything that improves the chances that financing will be repaid. If a state or local government's goal is to improve the financing options available to the private sector, putting funds toward credit enhancements can be a good option because they:
- Encourage private lenders and investors to put money into unfamiliar markets or products (such as residential energy efficiency lending).
- Can 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.
- Can be used as negotiating leverage to convince lenders to relax their underwriting criteria in order to lend to individuals or businesses with lower than typical credit profiles.
Loan Loss Reserves
LLRs are a credit enhancement approach commonly used by state and local governments to provide partial risk coverage to lenders—meaning that the reserve will cover a prespecified 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 each state or local government 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.
LLRs and other credit enhancements can be used in any market, from residential to commercial lending to multifamily housing lending to nonprofit lending.
Learn more about the:
- Rationale and goals for LLRs
- Primary characteristics of LLRs
- LLR risk-sharing formula
- Loan terms
- Underwriting guidelines for residential loan programs
- Steps for developing a clean energy financing program with an LLR.
For more detailed discussion, download the Clean Energy Finance Guide to Residential and Commercial Building Improvements' chapter on Basic Concepts for Clean Energy Unsecured Lending and Loan Loss Reserve Funds.
Interest Rate Buy-Down
Another option for state and local entities is to use public funds to lower the interest rate that property owners will have to pay to such a point that financing becomes an attractive option. In order to lower the rate, state and local entries buy it down by making an upfront payment to the lender. This 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.
- Model Agreement Between Governmental Entity and Financial Institutions to Establish a Financing Program
- Clean Energy Finance Guide (Chapter 5: Basic Concepts for Clean Energy Unsecured Lending and Loan Loss Reserve Funds)
- Credit Enhancement Overview Guide
- Energy Efficiency Loan Program Agreement—Template.