Loan loss reserve (LLR) funds have four primary characteristics, detailed here.
Portfolio Approach to Credit
LLRs take a "portfolio approach," meaning that state and local governments setting up LLRs do so on the basis of the entire portfolio of loans they support. For example, a 5% loss reserve on a $60 million loan portfolio means that the size of the loss reserve is $3 million.
State and local governments can set the size of the loss reserve to be higher than the portfolio's estimated loan losses. For instance, if estimated losses are 1.5% on the whole loan portfolio, the state or local government might size the loss reserve at 5% to 10%, depending on the result of negotiations between the state or local government and the financial institution partner.
An LLR structure works best when the target market is a portfolio with a large number of small transactions. Typical residential energy efficiency loans, for example, are in the range of $5,000 to $15,000, and a typical program will aim to fund hundreds, and possibly thousands, of loans. Thus, default of a single loan or several loans will represent a small portion of the total portfolio. Those first losses can be covered by the LLR, up to the limits of the LLR and according to the agreed risk-sharing formula. For target markets facing the reverse situation—a smaller number of larger loans (creating what is called a lumpy portfolio)—other forms of credit enhancement may be appropriate.
Leverage refers to the amount of private capital that a state or local government might attract to a clean energy lending program by offering an LLR. For example, if a state or local government has $1 million available in funds for the LLR, a 5% loss reserve will produce $20 million in capital to lend. The leverage ratio in that case is 20:1.
Leverage can also refer to the total amount of clean energy project investment that a state or local government can support with its lending program. Other sources of funds, such as utility rebates, other capital incentives, or customer capital contributions are typically used so the loan may finance, for example, only 80% of the energy efficiency project costs. Using the example above, $20 million in energy efficiency and renewable energy loans may support $25 million in total clean energy project investment, with a leverage ratio of 25:1. Both approaches are important and valid.
Financial Institution Partner
The financial institution partner can be one or more of the following: a commercial bank, a credit union, a nonbank finance company (leasing company or specialized financial institution), a community development financial institution, utility, or state-chartered (state-level) bond authority. To set up the LLR program, state and local governments must identify potential financial institutions and research all those interested, procure the financial institution partner, establish a good working relationship, and structure the loan program with the selected financial institution. Different financial institutions have different lending practices and criteria. If the new energy efficiency/renewable energy loan program can build on the lender's existing loan products (e.g., home improvement loans), the financial institution's internal new product development process will likely be accelerated and the state or local government's program can start sooner.
Secondary Market Support
Some financial institutions (e.g., credit unions) will originate and hold residential energy efficiency loans in their own portfolio until the loans mature. Other financial institutions (e.g., specialized nonbank finance companies, warehouse funds, and some commercial banks) will originate loans, assemble portfolios, and then seek to refinance or sell the portfolios to a secondary market capital source.
Availability of funds from the secondary market can allow lenders to recycle and relend their loan funds more quickly than they would be able to do if they had to wait for their loans to mature. Although LLRs support the primary lender, the benefits and risk coverage of the LLR must be assignable to the secondary market capital source (provider) if the loans are sold to an investor in the secondary market. That is an important provision for all state and local government and financial institutions to incorporate in the program's LLR agreement if they want to have access to this secondary market.
For more detailed discussion, see the Steps for Developing a Clean Energy Financing Program with an LLR.