ENVIRONMENTAL FINANCIAL ADVISORY  BOARD
    Members

A. James Barnes, Chair

    Terry Agriss

    Julie Belaga

    John Boland

   George Butcher

   Donald Comll

   Michael Cviiey

   Rachel Doming

   Pete Domenlcl

   Kelly Downard

   Mary Francoeur

   Vincent Girardy

   Steve Grossman

 Jennifer Hernandez

    Keith Hinds

   Steve Mahfood

   Langdon Marsh

    Greg Mason

    Cherle Rice

    Helen Sahl

   Andrew Sawyers

     Jim Smith

    Greg Swartz

    Sonia Toledo

     Jim Tozzl

    Billy Turner

    Justin Wilson

     John Wise

    Stan Melburg
    Designated
   Federal Official
                            JAN   5 2007
Hon. Stephen L. Johnson
Administrator
United States Environmental Protection Agency
1200 Pennsylvania Avenue, NW
Washington, DC 20460

Dear Administrator Johnson:

       The Environmental Financial Advisory Board is pleased to submit the
enclosed report, "Expanding the Definition of SRF Financial Assistance" for
the Agency's consideration and use. This report supports authorizing SRFs to
provide a form of financial assistance to eligible projects that would not
require that invested program equity be yield restricted under IRS arbitrage
regulations.  Without the restrictions, SRF programs could earn more interest
and use that money for projects. The perpetuity requirement applicable to
SRFs would remain unchanged.

       Under EPA's current SRF regulations, a subsidy can be given to a
borrower in order to provide a below market interest rate on a loan either
made or local debt obligation purchased by the SRF.  However, the use of
SRF equity to provide a debt service subsidy triggers the federal arbitrage
restrictions on the investment of SRF program equity. Efforts to obtain relief
from the arbitrage regulations by exempting SRFs from application of the
generally applicable arbitrage rules have not been successful thus far.

        The proposed alternative is to permit SRF assistance to eligible
projects for capital or operating costs. Project eligibility would be determined
under the same set of rules as presently exist, so that the kinds of projects
eligible for assistance would not change under this new program. For
example, an SRF could provide assistance (in an amount equivalent to what
would currently be provided as a debt service subsidy) either by funding
construction costs or funding an annual operating subsidy for a project that
receives a market rate SRF financing. The SRF would still  have to be
 maintained  in perpetuity. The effect of the perpetuity requirement is that
 whatever the form of the financial assistance (i.e., for debt service, capital or
 operating cost of an eligible project), it would have to be provided from
 accumulated, current or future earnings on SRF equity.
                             Proviriinn Arivir.fi on "How To Paw" for Fnvironmfintal Protection

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       By combining a guaranty of borrower debt (or a market rate loan from the SRF to
the borrower or a purchased local debt obligation) with the provision of capital or
operating assistance, there would be no basis under the arbitrage regulations for any yield
restriction of SRF money relating to the provision of that assistance. While the
Department of the Treasury may have some concerns with this approach, we believe this
idea derived from a guaranty approach, creates the possibility of realizing the benefit of
arbitrage relief without the need  to change existing IRS regulations.

       Rather than requiring a change in or exception to IRS regulations, this approach
allows SRF assistance to be structured in a way that does not trigger the application of the
IRS arbitrage rules.  Amendments to Clean Water SRF and Drinking Water SRF
regulations that could be made to implement this  concept (with complementary statutory
authority) are offered in this paper.

       No significant change in  the administration or supervision of the state SRFs
would be required under this approach. Also, this would not change the SRF program
into a traditional  "grant" program since the SRF would still be maintained in perpetuity.
However, small communities, in particular, that may have previously been reluctant to
take advantage of the SRF program because of lack of understanding of the benefits of
reduced interest rates may be attracted  to  the idea of operating subsidies (even though the
net financial impact would be the same).  Thus, this programmatic change may have the
collateral benefit of attracting new participants to the SRF program. This would be
especially beneficial because a community that participates in the SRF program is  subject
to conditions that move the community toward improved financial management and full-
cost pricing.

       The Board appreciates the continuing opportunity to provide financial advisory
assistance to the  Agency on issues of national importance.

                           Sincerely,
   J   -
    Z_<-
 A. James Barnes                                 A. Stanley Meiburg
 Chair                                           Executive Director

 Enclosure

 cc:    Ben Grumbles, Assistant Administrator for Water
       Lyons Gray, Chief Financial Officer

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               Environmental Financial
                       Advisory  Board
EFAB
A. James Barnes
Chair

A. Stanley Meiburg
Designated Federal
Official
Members

Hon. Pete Domenici
Terry Agriss
Julie Belaga
John Boland
George Butcher
Donald Correll
Michael Curley
Rachel Deming
Kelly Downard
Mary Francoeur
Hon. Vincent Girardy
Steve Grossman
Jennifer Hernandez
Keith Hinds
Stephen Mahfood
Langdon Marsh
Greg Mason
Cherie Rice
Helen Sahi
Andrew Sawyers
Greg Swartz
James Smith
Sonia Toledo
Jim Tozzi
Billy Turner
Justin Wilson
John Wise
     Expanding the Definition of
      SRF Financial Assistance
This report has not been reviewed for approval by the U.S. Environmental
 Protection Agency; and hence, the views and opinions expressed in the
  report do not necessarily represent those of the Agency or any other
            agencies in the Federal Government.
                 January 2007

               Printed on Recycled Paper

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               Expanding the Definition of SRF Financial Assistance

The goal of the concept discussed herein is to permit SRFs to be managed more
efficiently and provide more funding for SRF-eligible projects. The proposed mechanism
for allowing more efficient operation is to authorize SRFs to provide a form of financial
assistance to eligible projects that would not require that invested program equity be yield
restricted under IRS arbitrage regulations. Without the restrictions, SRF programs could
earn more interest and use that money for projects. The perpetuity requirement
applicable to SRFs would remain unchanged.

Under EPA's current SRF regulations, a subsidy can be given to a borrower in order to
provide a below market interest rate on a loan either made or local debt obligation
purchased by the SRF.  However, the use of SRF equity to provide a debt service subsidy
triggers the federal arbitrage restrictions on the investment of SRF program equity.
Efforts to obtain relief from the arbitrage regulations by exempting SRFs from
application of the generally applicable arbitrage rules have not been  successful thus far.

The proposed alternative is to permit SRF assistance to eligible projects for capital or
operating costs. Project eligibility would be determined under the same set of rules as
presently exist, so that the kinds of projects eligible for assistance would not change
under this new program.  For example, an SRF could provide assistance (in an amount
equivalent to what would currently be provided as a debt  service subsidy) either by
funding construction costs or funding an annual operating subsidy for a project that
receives a market rate SRF financing.  The SRF would still have to be maintained in
perpetuity. The effect of the perpetuity requirement is that whatever the form of the
financial assistance (i.e., for debt service, capital or operating cost of an eligible project),
it would have to be provided from accumulated, current or future earnings on SRF equity.

By combining a guaranty of borrower debt (or a market rate loan from the SRF to the
borrower or a purchased local debt obligation) with the provision of capital or operating
assistance, there would be no basis under the arbitrage regulations for any yield
restriction of SRF money relating to the provision of that assistance. While  the
Department of the Treasury may have some concerns with this approach, we believe this
idea derived from a guaranty approach, creates the possibility of realizing the benefit of
arbitrage relief without the need to change existing IRS regulations.

Rather than requiring a change in or exception to IRS regulations,  this approach allows
SRF assistance to be structured in a way that does not trigger the application of the IRS
arbitrage rules. Amendments to CWF and DWF regulations that could be made to
implement this concept (with complementary statutory authority) are attached
hereto.

No significant change in the administration or supervision of the state SRFs  would be
required under this approach (although a modest change of interpretation described below
would maximize the benefits of the new approach). Also, this would not change the SRF
program into a traditional "grant" program since the SRF would still be maintained in
Expanding Definition of SRF Financial Assistance

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perpetuity. However, small communities, in particular, that may have previously been
reluctant to take advantage of the SRF program because of lack of understanding of the
benefits of reduced interest rates may be attracted to the idea of operating subsidies (even
though the net financial impact would be the same). Thus, this programmatic change
may have  the collateral benefit of attracting new participants to the SRF program. This
would be especially beneficial because a community that participates in the SRF program
is subject to conditions that move the community toward improved financial management
and full-cost pricing.

Currently  SRFs are permitted to provide assistance in an amount (the "Maximum
Assistance Amount" or "MAA") up to the cumulative retained earnings available at any
time.  (In the case of direct loans, the SRF forgoes earnings by making below-market
investments in the form of borrower loans). The decision as to how much of the MAA to
apply currently to provide assistance is made by each state.  Each state certifies on an
annual basis that it has not provided assistance in excess of that amount - i.e., that it is in
compliance with the perpetuity requirement. Currently, the portion of the MAA applied
to provide assistance is applied to provide an interest subsidy either:

      By paying down a portion of the interest on bonds used to fund a loan to or
       purchase a debt obligation from the borrower or
      By providing financing to the borrower from SRF equity at a below-market
       interest rate.

Under the proposed approach, each state SRF would also have the option of applying its
accumulated earnings to fund construction or operating costs rather than to provide an
interest subsidy.  The provision of capital assistance would reduce the amount of SRF
financing that the borrower would need  for the project.  The SRF would also make or
guarantee  the market-rate SRF financing (a loan or purchased debt obligation) for the
balance of the borrower's construction costs.  In the case of operating assistance, the SRF
would also make or guarantee financing for the construction costs of the project.

The reason that only 40% to 60% of the benefit of arbitrage relief would be obtained
from the provision of capital assistance is that to provide an equivalent amount of capital
assistance, at  the outset the SRF would need to pay to the borrower an amount equal to
the present value of the interest subsidy that is currently being provided. If the present
value of the assistance were 40% of the  amount of equity allocable to provide the
subsidy, then  only 60% of the equity would remain to be invested on an unrestricted
basis. Hence, only 60% of the benefit of arbitrage relief would be achieved.

The payment  of up-front capital assistance could raise a potential question of
interpretation of the perpetuity rule.  No question is raised to the extent that the  capital
assistance is funded from previously accumulated earnings. However,  to the extent that
future earnings on the SRF's invested capital will be needed to maintain perpetuity, the
current application of the rule (which looks only at earnings in hand) may limit the use of
this more beneficial approach.  This issue could be eliminated by interpreting the
perpetuity requirement to allow SRFs to take into account of:
Expanding Definition of SRF Financial Assistance

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      Expected earnings on existing investments:

           >  Since the SRF had credit exposure to the investment provider for both
              principal and interest, there is no reason to only consider investment
              earnings that have already been "earned".

      Projected earnings on invested equity based on reasonable assumptions made by
       the SRF:

           >  To maximize its investment earnings, an SRF may want to adopt a more
              innovative investment strategy than locking up its investments for the full
              period that it would otherwise have funded loans or purchased
              obligations. This should be encouraged by authorizing SRFs to make
              reasonable projections of future earnings on reinvestments of its existing
              equity.

           >  Under this approach, the projections would be over the entire period for
              which the SRF has outstanding financial assistance in the form of loans,
              purchased local debt  obligations or guarantees.

Providing operating assistance payable annually for a period equal to what the term of an
SRF financing would be, has the benefit of allowing 100% of the SRF's equity to be
invested on an unrestricted basis. So, the full benefit of arbitrage relief would be
achieved.  Also, the current interpretation of the perpetuity rule would not pose any
problem to implementation of this approach. The attached diagrams contrast the cash
flows for an SRF providing operating assistance to the cash flows of an SRF that uses the
reserve model.

For SRFs that currently use the Reserve Fund approach, there would likely be no federal
budgetary impact of the proposal. The amount of borrowing by such SRFs would not
change. Also, while they are currently required to invest at a restricted yield, they have
not complied with such restriction by investing in SLGS (which benefit the US Treasury)
but by investing in other lower yielding investments (from which the US Treasury
derives no benefit).  Those programs would modify their structures to look more like the
General Revenue Bond approach adopted by Connecticut or the Subordinate Bonds
approach utilized by New York which would permit unrestricted investment of program
equity if financial assistance were provide for either capital costs of operating expenses.

However, if capital assistance or operating assistance were permitted, SRFs in states (a)
that have to date made only direct loans (i.e., funded from program equity) or (b) that use
a combination of direct financing and bond-funded financing (referred to  as the Cash
Flow approach), would be likely to convert to an approach in which SRF financing is
provided from bond proceeds rather than from equity.  This could significantly increase
the amount of funding available for clean water and drinking water projects in those
states, but it would also increase the amount of their tax-exempt borrowing.  So, there
Expanding Definition of SRF Financial Assistance

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would be budgetary impact relating to the SRFs that use direct loans or the Cash Flow
approach. The budgetary impact would be the same as if arbitrage relief were granted.
Expanding Definition of SRF Financial Assistance

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Cash Flows Under Revised Model
X
\
SRF Borrower:
$100 Loan Par

Gross Interest
Paid by Borrower:
4% on
Outstanding Loan
Amount
T '
Bond Interest
Allocable to
Borrower Loan: 4%
on Outstanding
Loan Amount
State SRF
\ " r
N. $50 of Equity
N. Dedicated to Net Earnings
N. Funding Operating on Equity:
N. Subsidy 0.5% on 50%
N. \ Balance =
^ 	 j. \ $50*0.5% for
( \ \ avglifeof12
Operating Subsidy \ years = $3
Equal to 2% on \
Outstanding Loan \ * 	 L
Amount \ /
N. SRF Equity Equal
NV 50% of Outstandir
^ Loan Amount
Invested at
Unrestricted Yield
4.5%


$50 of Equity De-
Allocated Pro-Rata
as Loan is Repaid

to
g
of


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              Proposed Language for CWF and DWF Regulation Amendments


35.3115 Eligible activities of the SRF.

       Funds in the SRF shall not be used to provide grants. SRF balances must be available in
perpetuity and must be used solely to provide loans and other authorized forms of financial
assistance:

       (a) to municipalities, intermunicipal, interstate, or State agencies for the construction of
publicly owned wastewater treatment works as these are defined in section 212 of the Act and
that appear on the State's priority list developed pursuant to section 216 of the Act; and

       (b) for implementation of a nonpoint source pollution control management program
under section 319 of the Act; and

       (c) for development and implementation of an estuary conservation and management plan
under section 320 of the Act.

 35.3120 Authorized types of assistance.

       The SRF may provide seven general types of financial assistance.

       (a) Loans. The SRF may award loans at or below market interest rates, or for zero
interest.

       (1) Loans may be awarded only if:

       (i) all principal and interest payments on loans are credited directly to the SRF;

       (ii) the annual repayment of principal and payment of interest begins not later than one
year after project completion;

       (iii) the loan is fully amortized not later than twenty years after project completion; and

       (iv) each loan recipient establishes one or more dedicated sources of revenue for
repayment of the loan.

       (2) Where construction of a treatment works has been phased or segmented, loan
repayment requirements apply to the completion of individual phases or segments.

       (b) Refinancing existing  debt obligations. The SRF may buy or refinance local debt
obligations at or below market rates, where the initial debt was incurred after March 7,1985, and
building began after that date.

       (1) Projects otherwise eligible for refinancing under this section on which building began:

       (i) before January 28, 1988 (the effective date of the Initial Guidance for State Revolving
Funds) must meet the requirements of title VI to be fully eligible.

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               Proposed Language for CWF and DWF Regulation Amendments
       (ii) after January 28, 1988, but before the effective date of this rule, must meet the
requirements of title VI and of the Initial Guidance for State Revolving Funds to be fully
eligible.

       (iii) after (effective date of the rule) must meet the requirements of this rule to be fully
eligible.

       (2) Where the original debt for a project was in the form of a multi-purpose bond incurred
for purposes in addition to wastewater treatment facility construction, an SRF may provide
refinancing only for eligible purposes, and not for the entire debt.

       (c) Guarantee or purchase insurance for local debt obligations. The SRF may guarantee
local debt obligations where such action would improve credit market access or reduce interest
rates. The SRF may also purchase or provide bond insurance to guarantee debt service payment.

       (d) Guarantee SRF debt obligations. The SRF may be used as security or as a source of
revenue for the payment of principal and interest on revenue or general obligation bonds issued
by the State provided that the net proceeds of the sale of such bonds are deposited in the SRF.

       (e) Loan guarantees for "sub-State revolving funds." The SRF may provide loan
guarantees for similar revolving funds established by municipal or intermunicipal  agencies, to
finance activities eligible under title VI.

       (f) Earn interest on fund accounts. The SRF may earn interest on Fund accounts. Interest
earned on Fund accounts may be used to provide financial assistance for debt service, capital
expenditures, operations, treatment facilities or be retained to grow SRF balances. Such
assistance may only be provided to support eligible activities, identified in 35.3115, and may
be provided pursuant to or in connection with one of the seven general types of financial
assistance.

       (g) SRF administrative expenses.

       (1) Money in the SRF may be used for the reasonable costs of administering the SRF,
provided that the amount does not exceed 4 percent of all grant awards received by the SRF.
Expenses of the SRF in excess of the amount permitted under this section must be paid for from
sources outside the SRF.

       (2) Allowable administrative costs include all reasonable costs incurred for management
of the SRF program and for management of projects receiving financial assistance from the SRF.
Reasonable costs unique to the SRF, such as costs of servicing loans and issuing debt, SRF
program  start-up costs, financial, management, and legal consulting fees, and reimbursement
costs for support services from other State agencies are  also allowable.

       (3) Unallowable administrative costs include the costs of administering the construction
grant program under section 205(g), permit programs under sections 402 and 404  and Statewide

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              Proposed Language for CWF and DWF Regulation Amendments


wastewater management planning programs under section 208(b)(4).

       (4) Expenses incurred issuing bonds guaranteed by the SRF, including the costs of
insuring the issue, may be absorbed by the proceeds of the bonds, and need not be charged
against the 4 percent administrative costs ceiling. The net proceeds of those issues must be
deposited in the Fund.

 35.3125 Limitations on SRF assistance.

       (a) Prevention of double benefit. If the SRF makes a loan in part to finance the
cost of facility planning and preparation of plans, specifications, and estimates for the building of
treatment works and the recipient subsequently receives a grant under section 201(g) for the
building of treatment works and an allowance under section 201(1)(1), the SRF shall ensure that
the recipient will promptly repay the loan to the extent of the allowance.

       (b) Assistance for the non-Federal share.

       (1) The SRF shall not provide a loan for the non-Federal share of the cost of a treatment
works project for which the recipient is receiving assistance from the EPA under any other
authority.

       (2) The SRF may provide authorized financial assistance other than a loan for the
non-Federal share of a treatment works project receiving EPA assistance if the Governor or the
Governor's designee determines that such assistance is necessary to allow the project to proceed.

       (3) The SRF may provide loans for subsequent phases, segments, or stages of wastewater
treatment works that previously received grant assistance for earlier phases, segments, or stages
of the same treatment works.

       (4) A community that receives a title II construction grant after the community has begun
building with its own financing, may receive SRF assistance to refinance the pre-grant work, in
accordance with the requirements for refinancing set forth under  35.3120(b) of this part.

       (c) Publicly owned portions. The SRF may provide assistance for only the publicly
owned portion of the  treatment works.

       (d) Private operation. Contractual arrangements for the private operation of a publicly
owned treatment works will not affect the eligibility of the treatment works for SRF financing.

       (e) Water quality management planning. The SRF may provide  assistance only to
projects that are consistent with any plans developed under sections 205(j), 208, 303(e), 319 and
3 20 of the Act.

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                                 Proposed Language for CWF  and DWF Regulation Amendments
48302 Federal Register / Vol. 65, No. 152 /
Monday, August 7, 2000 / Rules and
Regulations

installation or replacement of transmission and
distribution pipes to improve water pressure to
safe levels or to prevent contamination caused
by leaks or breaks in the pipes.
(iii) Source. Examples of projects include
rehabilitation of wells or development of
eligible sources to replace contaminated
sources.
(iv) Storage. Examples of projects include
installation or upgrade of eligible storage
facilities, including finished water reservoirs, to
prevent microbiological contaminants from
entering a public water system.
(v) Consolidation. Eligible projects are those
needed to consolidate water supplies where, for
example, a supply has become contaminated or
a system is unable to maintain compliance for
technical, financial,  or managerial reasons.
(vi) Creation of new systems. Eligible projects
are those that, upon  completion, will create a
community water system to address existing
public health problems  with serious risks
caused by unsafe drinking water provided by
individual wells or surface water sources.
Eligible projects are also those that create a new
regional community water system by
consolidating existing systems that have
technical, financial,  or managerial difficulties.
Projects to address existing public health
problems associated with individual wells or
surface water sources must be limited in scope
to the specific geographic area affected by
contamination. Projects that create new
regional community water systems by
consolidating existing systems must be limited
in scope to the service area of the systems being
consolidated. A project must be a cost-effective
solution to addressing the problem. A State
must ensure that the applicant has given
sufficient public notice to potentially  affected
parties and has considered alternative solutions
to addressing the problem. Capacity to serve
future population growth cannot be a  substantial
portion of a project.
(c) Eligible project-related costs. In addition to
costs needed for the project itself, the following
project-related costs are eligible for assistance
from the Fund:
(1) Costs for planning and design and
associated pre-project costs. A State that makes
a loan for only planning and design is not
required to provide assistance for completion of
the project.
(2) Costs for the acquisition of land only if
needed for the purposes of locating eligible
project components. The land must be acquired
from a willing seller.
(3) Costs for restructuring systems that are in
significant noncompliance with any national
primary drinking water regulation or variance  or
that lack the technical, financial, and managerial
capability to ensure compliance with the
requirements of the Act, unless the systems are
ineligible under paragraph (d)(2) or (d)(3) of
this section.
(d) Ineligible systems. Assistance from the Fund
may not be provided to:
(1) Federally-owned public water systems and
for-profit noncommunity water systems.
(2) Systems that lack the technical, financial,
and managerial capability to ensure compliance
with the requirements of the Act, unless the
assistance will ensure compliance and the
owners or operators of the systems agree to
undertake feasible and appropriate changes in
operations to ensure compliance over the long-
term.
(3) Systems that are in significant
noncompliance with any national primary
drinking water regulation or variance, unless:
(i) The purpose of the assistance is to address
the cause of the significant noncompliance and
will ensure that the systems return to
compliance; or
(ii) The purpose of the assistance is unrelated to
the cause of the significant noncompliance and
the systems are on enforcement schedules (for
maximum contaminant level and treatment
technique violations) or have compliance plans
(for monitoring and reporting violations) to
return to compliance.
(e) Ineligible projects. The following projects
are ineligible for assistance from the Fund:
(1) Dams or rehabilitation  of dams.
(2) Water rights, except if the water rights are
owned by a system that is being purchased
through consolidation as part of a capacity
development strategy.
(3) Reservoirs or rehabilitation of reservoirs,
except for finished water reservoirs and those
reservoirs that are part of the treatment process
and are on the property where the treatment
facility is located.
(4) Projects needed primarily for fire protection.
(5) Projects needed primarily to serve future
population growth. Projects must be sized only
to accommodate a reasonable amount of
population growth expected to occur over the
useful life of the facility.
(6) Projects that have received assistance from
the national se t-aside for Indian Tribes and
Alaska Native Villages under section 1452(i) of
the Act.
(f) Ineligible project-related costs. The
following project-related costs are ineligible for
assistance from the Fund:
(1) Laboratory fees for routine compliance
monitoring.
(2) Operation and maintenance expenses.

 35.3525 Authorized types of assistance
from the Fund.
A State may only provide the following types of
assistance from the Fund:
(a) Loans. (1) A State may make loans at or
below the market interest rate, including zero
interest rate loans. Loans may be awarded only
if:
(i) An assistance recipient begins annual
repayment of principal and interest no later than
one year after project completion. A project is
completed when operations are initiated or are
capable of being initiated.
(ii) A recipient completes loan repayment no
later than 20 years after project completion
except as provided in paragraph (b)(3) of this
section.
(iii) A recipient establishes a dedicated  source
of revenue for repayment of the loan which is
consistent with local ordinances and State laws
or, for privately-owned systems, a recipient
demonstrates that there is adequate security to
assure repayment of the loan.
(2) A State may include eligible project
reimbursement costs within loans if:
(i) A system received approval, authorization to
proceed, or any similar action by a State prior to
initiation of project construction and the
construction costs were incurred after such State
action; and
(ii) The project met all of the requirements of
this subpart and was on the  State's  fundable list,
developed using a priority system approved by
EPA. A project on the comprehensive list which
is funded when  a project on the fundable list is
bypassed using the State's bypass procedures in
accordance with  35.3555(c)(2)(ii) may be
eligible for reimbursement of costs incurred
after the system has been informed that it will
receive funding.
(3) A State may include eligible planning and
design  and other associated pre-project  costs
within  loans regardless of when the costs were
incurred.
(4) All payments of principal and interest on
each loan  must be credited to the Fund.
(5) Of the total amount available for assistance
from the Fund each year, a State must make at
least 15 percent available solely for providing
loan assistance to small systems, to the  extent
such funds can be obligated for eligible
projects. A State that provides assistance in an
amount that is greater than 15 percent of the
available funds in one year may credit the
excess  toward the 15 percent requirement in
future years.
(6) A State may provide incremental assistance
for a project (e.g., for a particularly large,
expensive project) over a period of years.
(b) Assistance to disadvantaged
communities. (1) A State may provide loan
subsidies (e.g., loans which include principal
forgiveness, negative interest rate loans) to
benefit communities meeting the State's
definition  of "disadvantaged" or which the
State expects to become "disadvantaged" as a
result of the project. Loan subsidies in the form
of reduced interest rate loans that are at or
above zero percent do not fall under the 30
percent allowance described in paragraph (b)(2)
of this  section.

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(2) A State may take an amount equal to no
more than 30 percent of the amount of a
particular fiscal year's capitalization grant to
provide loan subsidies to disadvantaged
communities. If a State does not take the entire
30 percent allowance associated with a
particular fiscal year's capitalization grant, it
cannot reserve the authority to take the
remaining balance of the allowance from future
capitalization grants. In addition, a State must:
(i) Indicate in the Intended Use Plan (IUP) the
amount of the allowance it is taking for loan
subsidies;
(ii) Commit capitalization grant and required
State match dollars taken for loan subsidies in
accordance with the binding commitment
requirements in  35.3550(e); and
(iii) Commit any other dollars (e.g., principal
and interest repayments, investment earnings)
taken for loan subsidies to projects over the
same time period during which binding
commitments are made for the capitalization
grant from which the allowance was taken.
(3) A State may extend the term for a loan to a
disadvantaged community, provided that a
recipient completes loan repayment no later
than 30 years after project completion and the
term of the loan does not exceed the expected
design life of the project.
(c) Refinance or purchase of local debt
obligations.(1) General. A State may buy or
refinance local debt obligations of municipal,
intermunicipal, or interstate agencies where the
debt obligation was incurred and the project was
initiated after July 1, 1993. Projects must have
met the eligibility requirements under section
1452 of the Act and this subpart to be eligible
for refinancing. Privately-owned systems are
not eligible for refinancing.
(2) Multi-purpose debt. If the original debt for a
project was in the form of a multi-purpose bond
incurred for purposes in addition to eligible
purposes under section 1452 of the Act and this
subpart, a State may provide refinancing only
for the eligible portion of the debt, not the entire
debt.
(3) Refinancing and State match. If a State has
credited repayments of loans made under a pre-
existing State loan program as part of its State
match, the State cannot also refinance the
projects under the DWSRF program. If the State
has already counted certain projects toward its
State match which it now wants to refinance,
the State must provide replacement funds for
the amounts previously credited as match.
(d) Purchase insurance or guarantee for local
debt obligations. A State may provide
assistance by purchasing insurance or
guaranteeing a local debt obligation to improve
credit market access or to reduce interest rates.
Assistance of this type is limited to local debt
obligations that are undertaken to finance
projects eligible for assistance under section
1452 of the Act and this subpart.
(e) Revenue or security for Fund debt
obligations (leveraging). A State may use Fund
assets as a source of revenue or security for the
payment of principal and interest on  revenue or
general obligation bonds issued by the State in
order to increase the total amount of funds
available for providing assistance. The net
proceeds of the sale of the bonds must be
deposited into the Fund and must be used for
                                  Proposed Language for CWF and DWF Regulation
providing loans and other assistance to finance
projects eligible under section 1452 of the Act
and this subpart.
(f) Application of interest earned on fund
accounts. Interest earned on fund accounts may
be used to provide financial assistance for debt
service, capital expenditures, operations,
treatment facilities or be retained to grow SRF
balances. Such assistance may only be provided
to support eligible systems, projects and costs
identified in 35.3520 and may be provided
pursuant to or in connection with one of  the
eligible types of financial assistance identified
in this Part.

 35.3530 Limitations on uses of the Fund.

(a) Earn interest. A  State may earn interest on
monies deposited into the Fund prior to
disbursement of assistance (e.g., on reserve
accounts used as security or guarantees).
Monies deposited must not remain in the Fund
primarily to earn interest. Amounts not required
for current obligation or expenditure must be
invested in interest bearing obligations.
(b) Program administration. A State may not
use monies deposited into the Fund to cover its
program administration costs. In addition to
using the funds available from the
administration and technical assistance set-aside
under  35.3535(b),  a State may use the
following methods to cover its program
administration and other program costs.
(1) A State may use the proceeds of bonds
guaranteed by the Fund to absorb expenses
incurred issuing the  bonds. The net proceeds of
the bonds must be deposited into the Fund.
(2) A State may assess fees on an assistance
recipient which are paid directly by the recipient
and are not included as principal in a loan as
allowed in paragraph (b)(3) of this section.
These fees, which include interest earned on
fees, must be deposited into the Fund or into an
account outside of the Fund. If the fees are
deposited into the Fund, they are subject to the
authorized uses of the Fund. If the fees are
deposited into an account outside of the Fund,
they must be used for program administration,
other purposes for which capitalization grants
can be awarded under section 1452, State match
under sections 1452(e) and (g)(2) of the Act, or
combined financial administration of the
DWSRF program and CWSRF program Funds
where the programs  are administered by the
same State agency.
(3) A State may assess fees on an assistance
recipient which are included as principal in a
loan. These fees, which include interest earned
on fees, must be deposited into the Fund  or into
an account outside of the Fund. If the fees are
deposited into the Fund, they are subject to the
authorized uses of the Fund. If the fees are
deposited into an account outside of the Fund,
they must be used for program administration or
other purposes for which capitalization grants
can be awarded under section 1452. Fees
included as principal in a loan cannot be used
for State match under sections 1452(e) and
(g)(2) of the Act or combined financial
administration of the DWSRF program and
CWSRF program Funds. Additionally, fees
included as principal in a loan:
Amendments
       (i) Cannot be assessed on a disadvantaged
       community which receives a loan subsidy
       provided from the 30 percent allowance in
       35.3525(b)(2);
       (ii) Cannot cause the effective rate of a loan
       (which includes both interest and fees) to
       exceed the market rate; and
       (iii) Cannot be assessed if the effective
       rate of a loan could reasonably be expected to
       cause a system to fail to meet the technical,
       financial, and managerial capability
       requirements under section 1452 of the Act.
       (c) Transfers. The Governor of a  State, or a
       State official acting pursuant to authorization
       from the Governor, may transfer an amount
       equal to 33 percent of a fiscal year's DWSRF
       program capitalization grant to the CWSRF
       program or an equivalent amount from the
       CWSRF program to the DWSRF program. The
       following conditions apply:
       (1) When a State initially decides to transfer
       funds:
       (i) The State's Attorney General,  or someone
       designated by the AttorneyGeneral, must sign
       or concur in a certification for the DWSRF
       program and the CWSRF program that State
       law permits the  State to transfer funds; and
       (ii) The Operating Agreements or other parts of
       the capitalization grant agreements for the
       DWSRF program and the CWSRF program
       must be amended to detail the method the State
       will use to transfer funds.
       (2) A State may not use the transfer provision to
       acquire State match for either program or use
       transferred funds to secure or repay State match
       bonds.
       (3) Funds may be transferred after one year has
       elapsed since a State established its Fund (i.e.,
       one year after the State has received its first
       DWSRF program capitalization grant for
       projects), and may include an amount equal to
       the allowance associated with its fiscal year
       1997 capitalization grant.
       (4) A State may reserve the authority to transfer
       funds in future years.
       (5) Funds may be transferred on a net basis
       between the DWSRF program and CWSRF
       program, provided that the 33 percent transfer
       allowance associated with DWSRF program
       capitalization grants received is not exceeded.
       (6) Funds may not be transferred or reserved
       after September 30, 2001.
       (d) Cross-collateralization. A State may
       combine the Fund assets of the DWSRF
       program and CWSRF program as security for
       bond issues to enhance the lending capacity of
       one or both of the programs. The following
       conditions apply:
       (1) When a State initially decides to cross-
       collateralize:
       (i) The State's Attorney General,  or someone
       designated by the Attorney General, must sign
       or concur in a certification for the DWSRF
       program and the CWSRF program that State
       law permits the  State to cross-collateralize
       the Fund assets of the DWSRF program
       and CWSRF program; and
       (ii) The Operating Agreements or other parts of
       the capitalization grant agreements for the
       DWSRF program and the CWSRF program
       must be amended to detail the method the State
       will use to cross-collateralize.
       (2) The proceeds generated by the issuance of
       bonds must be allocated to the purposes of the

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                                Proposed Language for CWF and DWF Regulation Amendments
DWSRF program and CWSRF program in the
same proportion as the assets from the Funds
that are used as security for the bonds. A State
must demonstrate at the time of bond issuance
that the proportionality requirements have been
or will be met. If a default should occur, and the
Fund assets from one program are used for
debt service in the other program to cure
the default, the security would no longer need to
be proportional.
(3) A State may not combine the Fund assets of
the DWSRF program and the CWSRF program
as security for bond issues to acquire State
match for either program or use the assets of
one program to secure match bonds for the
other program.
(4) The debt service reserves for the DWSRF
program and the CWSRF program must be
accounted for separately.
(5) Loan repayments must be made to the
respective program from which the loan was
made.

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          >
                  UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
         S                       WASHINGTON, D.C. 20460
                                       MAR  2   2007
                                                                              OFFICE OF
                                                                               WATER
Mr. A. James Barnes
Professor of Public and Environmental Affairs
Indiana University
1315 East 10th Street, Suite 418
Bloomington, Indiana 47405
Dear Mr. Basses:

       Thank you for your letter of January 5, 2007, to Administrator Stephen L. Johnson, in
which you transmit on behalf of the Environmental Financial Advisory Board (EFAB), the
report, Expanding the Definition ofSRF Financial Assistance. I appreciate the opportunity to
review recommendations from EFAB.

       The report proposes expanding existing State Revolving Fund (SRF) authority to allow
SRFs to use fund earnings in a new way. The concept is to use earnings to provide assistance for
project capital and operating cost subsidies. According to the report, this approach would allow
the SRFs to earn more interest by relieving the programs from certain yield restriction provisions
of Internal Revenue Service arbitrage regulations. The additional earnings retained in the fund
could be used to assist more projects and provide subsidies to borrowers.

       The Board presents a novel approach for using SRF resources. As the report
acknowledges, however, the  approach is beyond the existing authority of the clean water and
drinking water SRF programs, and would require new statutory authority to the programs and
amending the programs' regulations. As you know, Congress is considering legislation to
reauthorize the SRF. The work of EFAB and this report will add value and additional
perspective to that debate.

       As you are aware, the Agency has undertaken an ambitious effort in collaboration with
States, the water utility industry, and many other stakeholders, including the Board, to develop
innovative ways to bolster limited financial resources and promote the sustainability of local
water infrastructure.  An important part of this effort is a conference on Paying for Sustainable
Water Infrastructure in Atlanta from March 21-23. The conference will look at a full array of
innovative and useful tools for addressing water infrastructure needs.  I look forward to  the
participation of a number of the EFAB Board members in the conference.
                                 Internet Address (URL)  http://www.epa.gov
         Recycled/Recyclable  Printed with Vegetable Oil Based Inks on 100% Postconsumer, Process Chlorine Free Recycled Paper

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       Thank you again for providing this report. I encourage you to continue examining
innovative methods for addressing the nation's water infrastructure needs, and I look forward to
hearing recommendations in the future. If you have questions or wish to speak further about this
issue, please contact James A. Hanlon, Director, Office of Wastewater Management, at
(202) 564-0748.
                                               Sincerely,
                                               Benjamin H. Grumbles
                                               Assistant Administrator

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