EFAB
Robert Lenna
Chair
John Wise
Executive Director
Members
Hon. Pete Domenici
Hon. Maynard Jackson
George Butcher
Pete Butkus
Michael Curley
Peter Emerson
Deeohn Ferris
Shockley Gardner
Evan Henry
Anne Pendergrass Hill
Langdon Marsh
John McCarthy
Linda Descano Nelson
George Raftelis
Arthur Ray
Heather Ruth
Sonia Toledo
JimTozzi
Mary Ellen Whitworth
Robin Wiessmann
Joseph Young
Elizabeth Ytell
Cross-Collateralization Issues
Affecting the
State Revolving Fund Program
Comments on the Safe Drinking Water Act Guidance
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.
November 1996
Printed on Recycled Paper
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SDWA GUIDANCE AiND CROSS-COLLATERALIZATION
The Environmental Financial Advisory Board the foDowing comments to the Office
of Water in the spirit of encouraging greater flexibility and efficiency in its guidance for the Safe
Drinking Water Act State Revolving Fund Program.
OVERVIEW
The Safe Drinking Water Act (SDWA) provides that published guidance contain provisions to assist
in meeting key objectives, including "to ensure that each State commits expends funds allotted
to the State ,, , as efficiently as possible in accordance with this title mid applicable State laws. "
SDWA State Revolving Fund (SRF) guidance must recognize that, in order to maximize available
funding,-each state will need flexibility to implement the SRF in ways which best meet local needs.
Nothing provides a clearer testimony of this fact than the different security structures used by the 25
leveraged and related Clean Water Act (CWA) SRF across the country,
Implementation of CWA SRFs has varied because of the diversity of needs and issues faced by each
state, For example, while the SRF programs in Massachusetts, Connecticut, New York, Colorado,
Alabama, Arizona, Rhode Island, Michigan, Minnesota and Missouri all follow a "Reserve Fund"
model, the characteristics of each program vary substantially. The same can be said
for the states that follow "Blended Rate" or "Cash Flow" leveraging approaches such as Arkansas,
Ohio, Arizona, Maryland, North Dakota, Texas and South Dakota. The factors that will ultimately
influence financial structure will include the composition of each State's loan portfolio, the targeted
loan rate and method of providing subsidies, law and the form of match, among
others.
It is critical that we learn from and build upon the experience of CWA SRFs nationwide. This
experience points towards the has developed, first through the CWA
SRF and now with the SDWA SRF, as a way of financing environmental mandates. A cornerstone
of this partnership has. been trusting states to manage the financial aspects of SRFs in the most
prudent fashion. The vast amount of administrative discretion allowed to the in the
management of the CWA SRF has been the most important factor in the of that
program.
For states pursuing joint management of the two SRFs, flexibility with respect to cross-
eoilatefatization between the CWA SRF and the SDWA SRF is critical, Cross-collateraJization is
as having the to use CWA SRF or to act as security for SDWA SRF loans
and vice versa within the context of jointly-managed programs. Cross-colIateraJization does not mean
that funds authorized for one purpose will ultimately be used for an unauthorized purpose. The
inability to cross-collateralize could result in added management costs — something meant to be
avoided by the joint management provisions of the SDWA •— as well as borrowing costs,
not only respect to the SDWA SRF, but potentially with respect to the existing CWA SRE.
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INTRODUCTION TO LEVERAGE, BOND POOLS AND INDENTURES
There are three basic approaches a state can take in the administration of its state revolving fund: the
direct loan approach, the reserve fund leveraged approach, and the cash flow or blended rate
leveraged approach. As the name implies, the direct loan approach is simply a loan program based
on the pool of revenues derived from the lending of federal SRF capitalization grants and the state
match. Though leveraging, an SRF sells bonds today to enhance finding capacity beyond that which
would be derived from a direct lending approach. Leveraging benefits a state whose local
governments have current needs which are greater than the SRF funds presently available. (For
additional information on SRF leveraging, see Guide to State Revolving funds, 1996 Edition, Merrill
Lynch and Co, by Christopher Mauro, CFA.)
Under reserve fund leveraging, capitalization dollars are invested in a large reserve fund which
provides subsidy income to borrowers and security to bondholders. Blended rate leveraging is
accomplished through the funding of loans from bonds which are secured and subsidized by a direct
loan component of the SRF.
With bond issuance or leveraging, SRFs enter into contracts with bondholders - usually called Trust
agreements, Resolutions or Indentures - which bind the issuer to certain covenants. These contracts
govern the way in which repayments from SRF loan pools are recaptured to meet bond debt service
payments and in which SRF collateral is established as additional security to protect bondholders from
loan defaults. Cross-collateralization • meaning the ability to use loan repayments or reserves from
Borrower A as security for Borrower B and vice versa - is a key security feature of existing SRF
bonds.
CROSS-COLLATERALIZATION IS CONSISTENT WITH OTHER PROVISIONS OF THE
ACT AND CONFERENCE REPORT
In recognition of the importance of cross-collateralization to the efficient management of the SDWA
SRF, the Conference Report states that:
"States are allowed to jointly manage the corpus of the new drinking
water State loan fund with other revolving loan funds. The
requirement that thefitnds be used solely for purposes that meet the
objectives of the Safe Drinking Water Act does not preclude bond
pooling arrangements, including cross-collateralization, provided
that revenues from the bonds are allocated to the purposes of the
Safe Drinking Water Act m the same portion as thefitnds are used as
security for the bonds."
The Act recognizes that combined management of the SDWA SRF with other revolving funds,
including the CWA SRF, will help ensure that states commit and expend funds in an efficient fashion.
This is particularly true for states which leverage their funds. By not having to reinvent the wheel
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with respect to security structures and loan repayment monitoring mechanisms, both the SDWA and
CWA SRFs win as fixed expenses are kept to a minimum and are shared by a greater number of
participants. For certain SRFs, cross-collateralization will be essential from a security structure
perceptive.
In its transferability provisions, the SDWA recognizes that giving states the ability to transfer moneys
between the CWA and the SDWA up to a predetermined amount will be of benefit to the state in
helping finance its environmental needs. The transferability provisions of the Act would permit the
use of CWA SRF moneys to cure SDWA loan defaults and vice versa up to the amount subject to
transfer. Cross-collateralization is a moderate alternative in comparison with asset transfers because
it does not involve the initial transfer of funds from one SRF to another. Further, even in the unlikely
event that capital from one SRF is used to cure a default on a loan generated by the other SRF,
mechanisms can easily be implemented to assure the timely reimbursement of the SRF, as discussed
later in the "Management of the Cross-Collateralization Mechanism." Figure A is a generalized
diagram of the cross-collateralization concept.
JOINT
BOND ISSUE
TRUST AGREEMENT
BONDHOLDERS
DEBT
SERVICE
ss
LEVERAGED
STATE
REVOLVING
FUNDS
PROCEEDS
SS
PROCEEDS
SS
CROSS
COLLATERALIZATION
MECHANISM
COMMON
LOAN
POOL
LOANS
SS
REPAYMENTS
SS
SAFE
DRINKING
WATER
SRF
LOANS
SS
REPAYMENTS
$$_
THE CROSS-COLLATERALIZATION CONCEPT
FIGURE A
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THE IMPACT OF CROSS-COLLATERALIZATION ON LOAN CAPACITY FOR CWA
AND SDWA SRFS IS MEANINGFUL
Rating agency criteria has evolved over the past six years for measuring SRF bond credit quality. The
criteria was advanced in response to the high levels of collateral and diversification developed by
leveraged CWA SRFs. As a result, most SRF bonds are now rated in one of the two highest rating
components will in turn affect funding capacity for a leveraged SRF.
For those states that leverage or are looking to leverage their SRFs, the flexibility to implement the
SDWA SRF in a fashion which is consistent with the credit characteristics of existing CWA SRFs is
important. In the rating process, key structural SRF components include the size of a pool, the
number of borrowers and the level of reserves and collateral in a pool. Each of these structural
components will in turn affect funding capacity for a leveraged SRF.
1. Diversification Enhances Funding Capacity for Leveraged SRFs
The diversity and size of a pool is a key determinant of an SRF's ability to use its capital efficiently
to fund loans. Diversity is viewed as broadening the programmatic strength of an SRF, thereby
allowing that SRF to spread the benefits of a program to a wider group of borrowers. With smaller
poofs, the ability to fund borrowers is more constrained. For example, at least one rating agency
(Standard & Poor's) evaluates pools smaller than 10 borrowers according to the weakest link, i.e.
the weakest borrower in the pool. A pool being rated based on a "weak link" approach would in
essence be limited to including the strongest credits in the program in order to ensure strong ratings
and enhance the marketability of a leveraged issue. With larger pools, these issues become less
relevant because diversity makes the pool less sensitive to any single borrower. Standard & Poor's
criteria stipulates that pools with fewer than 20 borrowers must provide 100% collateral on non-rated
credits as well as collateral levels for all other borrowers which are 25% to 50% greater than those
for larger pools. One SRF administrator estimates that diversity in his state's CWA SRF program
has allowed it to fund $15-20 million in loans which would otherwise not have received funding.
Another rating factor and therefore a determinant of funding capacity is concentration, or the
presence of single borrowers responsible for more than 10% of a portfolio. Concentration penalties
are assigned such that, in order for an SRF to achieve ratings higher that those of the concentrated
borrower, 100% collateral must be reserved for those borrowers rated below the target program
rating. For example, according to certain rating criteria, an SRF program targeting AA ratings for
its leveraged bonds must reserve 100% collateral for any borrower rated below AA which constitutes
10% or more of the loan portfolio. Clearly, the smaller the program, the larger the probability that
concentration will be a factor and the greater the need to limit funding of certain loans to manage
single borrower exposure.
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For those states which currently leverage their CWA SRFs and are planning to leverage the SDWA
SFR, it is likely that bond issues will be sold jointly in order to reduce costs of issuance. Without
cross-collateralization, SDWA SRF portfolios would need to initially fund only the strongest credits
in the state in order not to be viewed as "start-ups" lacking the diversity of their CWA SRF
counterparts. Cross-collateralization benefits therefore run both ways as the CWA SRF benefits from
greater diversity, lower concentrations and increased ability to fund borrowers which were being
"managed" into the program in order to reduce their concentration impact on the program.
2. Quality Spreads from Ratine Differentials Affect Funding Capacity
Ratings affect funding capacity in a similar way as diversification and collateral requirements. The
higher the ratings, the larger the dollar amount of loans that can be generated by a leveraged SRF.
For SRFs with fixed loan rates, the higher the rating, the lower the interest rate on the bonds and the
lower the subsidy needed from program earnings to "buy down" the rate on a loan. Higher ratings
therefore free up program resources for additional loans, which corresponds to the admonitions of
Congress that SDWA SRFs pursue efficiency in the management and expenditure of funds. As
discussed in the previous section, cross-collateralization between CWA SRF loans and SDWA SRF
loans will help SDWA SRFs benefit from the stability of seasoned and diversified CWA loan
portfolios, will assist in maintaining the already high ratings achieved by CWA SRFs and will help
maximize funding for both programs in compliance with CWA and SDWA regulations.
Without cross-collateralization, the bond rating of a single issue funding both types of SRF loans will
trend towards the lowest of the CWA SRF or SDWA SRF evaluated on a stand-alone basis rather
than that of a stronger, more diversified whole. The following table shows an example of how the
ability to cross-collateralize or the lade thereof will affect funding for an SRF targeting 3% loan rates
for each program in a 6% market rate environment given certain ratings assumptions.
Leveraged Bond Funding Scenarios
Assumptions
Combined FY 97 Grant Amount (Millions)
Target Loan Rate
Reserves to Meet Subsidy
Bond Ratings
Bond Yield Spread between Ratings
Combined SRF Funding (Millions)
CWA/ SDWA
Cross-
Collateralized
$120
3.00%
50%
Aaa/AAA
_...
$240
CWA/SDWA
Non-Cross-
. Collateralized
$120
3.00%
50%
Aa/A
.15%
$234
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The above analysis assumes that a sufficient amount of reserves are used as security for the bonds to
produce a 3% loan rate. The yield premium of IS basis points that will be demanded by buyers of
the lower rated, non-cross-collateralized bond issue will result in a direct reduction in the combined
funding capacity of both SRFs of $6 million, or 5% of the combined capitalization moneys. The 15
basis point differential assumed above, while accurate under current market conditions, would be
understated in an environment of wider "quality" spreads. It would also be understated if the non-
collateralized SRF ratings were lower than those assumed in our analysis because of concentration
penalties or other rating factors such as a "weak link" approach to the rating of the jointly-managed
program. The next table provides a sensitivity analysis showing how wider spreads could affect
funding between the cross-coUateralized and non-cross-collateralized bond issues.
Reduction in Funding from Leveraging per S120 Million in Capitalization Grants
Spread
to Higher Rated
Structure
.15%
.20%
.25%
.30%
.35%
Reduced Funding
Amount
(5,714,286)
(7,500,000)
(9,230,769)
(10,909,091)
(12,537,313)
MANAGEMENT OF THE CROSS-COLLATERALIZATION MECHANISM
It is important to emphasize that cross-collateralization can take place without jeopardizing the use
of capitalization grants to fund those projects for which they were originally intended. States can
benefit from cross-collateralization while at the same time ensuring compliance with CWA and
SDWA project funding thresholds by implementing: (I) simple accounting mechanisms to ensure that
the percentage of project types funded meet original capitalization grant proportions; and (ii)
mechanisms to ensure replenishment of one SRF from repayment moneys or new capitalization grants
destined for another SRF in order to maintain appropriate funding levels in each program.
With respect to the cross-collateralization mechanism itself and the accounting mechanisms used to
track CWA and SDWA grants, each state should be given the flexibility to implement whichever
structure provides the best fit Although the low default incidence of SRF loans makes it unlikely that
cross-collateralization will result in CWA SRF moneys beings used to cure SDWA loan defaults and
vice versa, SRF administrators are actively thinking about mechanisms to ensure compliance with
fund use requirements. For example, an administrator of a leveraged "reserve model" CWA SRF
intends to implement cross-collateralization in a way which would force releases from CWA-funded
reserves to be used first to cure CWA loan defaults before tapping SDWA moneys for that purpose.
The same would hold for SDWA loan defaults with respect to SDWA and CWA-funde4 reserves.
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SRF administrators are experienced in the financial management of complex structures and are best
equipped to develop an approach to monitoring loan repayments, reserve fund flows and cross-
collateralization of jointly-managed CWA and SDWA SRFs. SRF managers are widely acknowledged
in the industry, particularly rating agencies and investors, for the control systems they have
implemented to manage SRFs and the credit review processes that have been established to evaluate
borrower repayment obligations.
CONCLUSION
The experience of the CWA SRF clearly points to the fact that states have the managerial capabilities
to ensure compliance with federal requirements within the vast amount of administrative discretion
granted to them under the CWA. This discretion has resulted in efficiently-managed structures
nationwide which have met the individual environmental needs of the states.
The Environmental Financial Advisory Board strongly encourages EPA and state management efforts
that maximize available funding for environmental projects under both the SDWA SRF and CWA
SRF programs in compliance with the respective authorizing Acts. The ability to cross-collateralize
is an option which should be made available to states as a management tool to maximize funding. Not
doing so would be a missed opportunity. The Board is supported in this view by the Council of
Infrastructure Financing Authorities, the principal association representing the State Revolving
Funds.
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