# Presentation: 569752

## Using a Federal Policy Comparator  

***to put “Innovative Finance” in Context***

***David Seltzer, Distinguished Practitioner***
***National Center for Innovations in Public Finance***
***University of Southern California***

- Joint Committee Hearing on Innovative Finance
- Senate Committee on Environment and Public WorksSenate Committee on FinanceSeptember 25, 2002

## Four Features of “Innovative Finance” Tools

**Innovative Finance**

**1. New Sources of**
**Debt Repayment**
***GARVEE Bonds***

**2. New Sources of Investment Capital**
***TIFIA Instruments***

**3. New Methods**
**of Project**
**Delivery**
***Private Activity Bonds***

**4. New Types of Financial Return****    *****Tax Credit Bonds***

***Four Features of “Innovative Finance” Tools***

## Balancing the Interests ofThree Key Stakeholder Perspectiveswhen Designing Innovative Finance Tools

## Project Sponsor Drivers

- What is the effective financing cost (IRR)?
- How high is the annual payment factor?
- Is there a direct or contingent financial liability to the sponsor’s balance sheet?
- What is the book and legal accounting treatment (e.g. approval requirements, debt ceilings)?
- How difficult is it to implement?

- 

## Investor Decision Drivers

- Is the risk-adjusted rate of return competitive?
- Is there a secondary market (liquidity)?
- Are there other investment risks (tax compliance, call risk, etc.)?
- Will it help diversify portfolio exposure?
- Are there any other strategic reasons for investing?

****

## Federal Policy Drivers

- What is the budgetary cost?
- Is the finance tool cost-effective (how much leveraging)?
- What is the overall economic return (benefit/cost ratio)?
- Does it support federal policy objectives (e.g. access, mobility, safety through better management, private participation, project acceleration)?

****

## 1. New Sources of Debt Repayment:    GARVEE Bonds (23 U.S.C. 122)

- State issues tax-exempt bonds to fund federal share (e.g. 80%) of Federal-aid eligible project costs.
- Principal and interest are repayable from future years’ anticipated FHWA apportionments.
- Bonds may stand alone or be backed by the state.
- State must meet match on a present-value basis.

## Flow Chart of GARVEE Bonds

**Tax-Exempt Debt Investors**

**Issuer**

**Project**

- FederalHighwayAdministration

**Matching Source**

***Proceeds of Debt***

***Federal-aid Eligible Project Costs***

***Debt Service***

***Non-federal Match (20%)***

***Federal Apportionments (80%)***

## Project Sponsor Pros and Cons ofGARVEE Bonds

- Accelerates non-revenue projects (avoided costs and accelerated benefits).
- Avoids having one large “pay-as-you-go” project displace numerous small ones.
- Promotes efficient resource allocation by matching term of payments with life of asset.
- Protects the state’s general credit rating (if stand-alone).

- Reduces out-year capacity / flexibility by consuming future years’ grants.
- If stand-alone, may entail slightly higher interest cost than G.O. or State Highway Fund backed debt.
- State may need to obtain legislative authority or voter approval.
- State must demonstrate that acceleration benefits outweigh financing costs.

**Advantages**

**Disadvantages**

## Investor Pros and Cons ofGARVEE Bonds

- Mid-investment grade ratings reflect adequate security.
- Growing number of states issuing GARVEEs builds political constituency for continuing the Federal-aid program.
- Direct assignment of grants to trustee reduces risk.

- No assurance that the Federal-aid program will be reauthorized over the life of the bonds (no federal guarantee of payment).
- Bonds may be non-recourse to the issuer (no state back-stop or security interest in the facility being financed).

**Advantages**

**Disadvantages**

## Federal Policy Pros and Cons of GARVEE Bonds

- Simple “program” with little additional federal administration.
- As a regulatory / eligibility initiative, avoids explicit budget scoring.
- Consistent with efficient / equitable pay-as-you-use funding strategy that accelerates project benefits.

- Some policymakers see tax-exempt bonds as an inefficient subsidy, since the federal revenue loss exceeds the interest savings benefit to the borrower/issuer.
- GARVEE projects are still funded mostly (e.g. 80%) by the federal government (limited leveraging with non-federal funds).
- Use of GARVEEs slightly increases the Federal-aid program spend-out rate.

**Advantages**

**Disadvantages**

## 2. New Sources of Investment Capital:  TIFIA Instruments (23 U.S.C. 181-189)

- Direct federal credit assistance in the form of loans, loan guarantees and lines of credit.
- Designed to provide supplemental and subordinate capital for large project financings.
- Twin-test volume cap of the lesser of $10.6 billion in credit authority or $530 million in budget authority.
- Limited to 33% of eligible project costs.
- Project must cost $100 million (or 50% of state’s apportionments).
- Project’s senior debt must be investment grade (“BBB-” or higher).

## Flow Chart of TIFIA Assistance

- Senior Debt Investors

- Public or Private Issuer

- Project

***Proceeds of ******Senior Debt***

***Project Costs***

***Senior Lien******Debt Service***

***Proceeds of Junior Lien TIFIA Financing****** (up to 33% of costs)***

- USDOTTIFIAAssistance

* ****Junior Lien Debt  Service***

- f

- Federal Highway Trust Fund

***Fractional Budget Authority Needed******(avg. 5 %) to Fund Credit Instruments***

## Project Sponsor Pros and Cons of TIFIA

- Source of “patient capital” for large projects.
- Flexible payment structures, including deferrals and prepayments.
- TIFIA lending rate (U.S. Treasuries) is competitive with tax-exempt borrowing rates for weaker (low-rated) credits.
- Reduced transaction fees and no credit facility fees.

- Limited to 33% of project costs.
- Direct loans may not be attractive for stronger (high-rated) projects with access to the tax-exempt market.
- TIFIA makes the entire project subject to federal rules, including NEPA.

**Advantages**

**Disadvantages**

## Direct loan strengthens senior bondholders’ security by shifting up to 33% of borrowings to a junior position.
Loan guarantee secures bondholders with pledge of the U.S. government.
Line of credit provides supplemental capital to mitigate revenue “ramp-up” risk.
Co-investment by federal government indicates public sector commitment to and due diligence on the project.

- Loan guarantee secures bondholders with pledge of the U.S. government.
- Line of credit provides supplemental capital to mitigate revenue “ramp-up” risk.
- Co-investment by federal government indicates public sector commitment to and due diligence on the project.

- For weaker (low-rated) projects, the “springing lien” may erode the functional subordination of TIFIA assistance.
- Co-investment by the federal government does not imply any U.S. backing of the non-TIFIA debt (TIFIA assistance mitigates but does not eliminate project financing risks).

***Investor****** ******Pros and Cons of TIFIA***

**Advantages**

**Disadvantages**

## Substantial leverage both internally (fractional risk-scoring) and externally (federal share 33% or less).
Costs only 5 cents per dollar lent, on average.
Substantial co-investment by private sector helps ensure fiscal discipline.
Investment grade requirement for senior debt limits federal exposure.
Facilitates large project financings with significant public benefits.

- Costs only 5 cents per dollar lent, on average.
- Substantial co-investment by private sector helps ensure fiscal discipline.
- Investment grade requirement for senior debt limits federal exposure.
- Facilitates large project financings with significant public benefits.

- Federal government generally is opposed to taking a subordinate lien position.
- TIFIA assistance for non-project financings may displace rather than induce capital markets participation.
- “Procrustes’ Bed” syndrome: credit applicants are either too risky or too well off, meaning program assistance is either inadvisable or unnecessary!

***Federal Policy ******Pros and Cons of TIFIA***

**Advantages**

**Disadvantages**

## 3. New Methods of Project Delivery:  Private Activity Bonds

- Proposed tax code change (S. 870 – The Multimodal Transportation Financing Act, or “Multitrans”).
- Authorizes certain highway, transit, rail and intermodal projects with ongoing private participation to issue tax-exempt private activity bonds (exempt from volume caps).
- Allows for-profit companies to share in commercial risks and rewards of projects through long-term management contracts.
- Permits 2 advance refundings for revenue bond-financed projects (vs. one or none under current law).

## Flow Chart of Private Activity Bonds

- Tax-Exempt Debt Investors

- Issuer

- Private Sector Operator

***Proceeds of Debt***

***Project Costs***

***Debt Service***

- Project

***Operating Concession***

***Commercial Risks, Incentivized Compensation***

- NetOperating Revenues

***Use or Lease******Agreement***

## Project Sponsor Pros and Cons of Private Activity Bonds

- Tax-exempt debt is cheaper (20-25% interest savings in p.v. terms).
- Broader universe of investors in the tax-exempt market who understand infrastructure projects.
- Familiar funding mechanism to most state and local governments.
- Private participation in development and/or operation aligns motives and reduces costs and risks.

- Must adhere to IRS requirements concerning investment yields, permitted uses, etc.
- May not be a deep enough subsidy in and of itself to advance larger, more complex projects.

**Advantages**

**Disadvantages**

## Slightly higher yield (approx. 0.10%) due to the Alternative Minimum Tax.
Reassuring participation of the government in the project approval process through issuer conduit, franchise award, etc.
Alignment of interests between private developer / operator and investors. 
Potential co-investment by vendors and other project participants.

- Reassuring participation of the government in the project approval process through issuer conduit, franchise award, etc.
- Alignment of interests between private developer / operator and investors.
- Potential co-investment by vendors and other project participants.

- Bonds likely to be non-recourse to the issuer (no “deep pocket”).
- Perception of riskier tax status than for governmental purpose bonds.

***Investor ******Pros and Cons of******Private Activity Bonds***

**Advantages**

**Disadvantages**

## Encourages private investment (and associated benefits / efficiencies) in public infrastructure with little administrative cost.
Levels the playing field by providing the same tax incentives for all modes of transportation.
Budget scoring should be minimal, since much of the financing activity should be a substitution for governmental purpose bonds.

- Levels the playing field by providing the same tax incentives for all modes of transportation.
- Budget scoring *should *be minimal, since much of the financing activity should be a substitution for governmental purpose bonds.

- Some policymakers see tax-exempt bonds as an inefficient subsidy, since the federal revenue loss exceeds the interest savings benefit to the borrower/issuer.
- Despite the likely “substitution effect,” significant tax expenditures are scored against such proposals (up to $18m per $100m of bonds over 10 years).

***Federal Policy****** ******Pros and Cons of Private Activity Bonds***

**Advantages**

**Disadvantages**

## Proposed tax code change (S. 250 – The High-Speed Rail Investment Act of 2001) to provide annual federal tax credits to bond purchasers.
Investors would receive annual tax credits in lieu of cash interest payments from the issuer.
Tax credit would be set at mid investment grade corporate bond yield (e.g. 6.50%) and would be taxable.

- Investors would receive annual tax credits in lieu of cash interest payments from the issuer.
- Tax credit would be set at mid investment grade corporate bond yield (e.g. 6.50%) and would be taxable.

***4. New Types of Financial Return:  ******Tax Credit Bonds***

## Flow Chart of Tax Credit Bonds(assuming interest is split from principal)

- Investors in Taxable Debt *e.g. Pension Funds*

- Issuer

- Project

***Project Costs***

- Investors in Tax Credits*e.g. Corporations*

***Principal Repayments***

- U.S. Treasury

***Annual Federal ******Tax Credits (Rate ******set at AA Corporate Bond Yield)***

***Proceeds from Sale of Debt***

***Proceeds from ******Sale of Tax Credits***

## 0% effective cost of borrowing represents approximate 50% total savings in p.v. terms.
Potential for accessing new category of institutional investors for infrastructure projects – Pension Funds.
Doesn’t compete with issuer’s traditional investor base.

- Potential for accessing new category of institutional investors for infrastructure projects – Pension Funds.
- Doesn’t compete with issuer’s traditional investor base.

- Limited investor familiarity may hinder marketability of bonds.
- Program volume is controlled by Congress, rather than issuers (as with tax-exempt bonds).

***Project Sponsor****** ******Pros and Cons of ******Tax Credit Bonds***

**Advantages**

**Disadvantages**

## Should be of reasonably high credit quality, since there is no risk of payment default on the “interest” portion (the tax credit). 
If principal de-coupled from tax credits, opportunity for pension funds to diversify into the infrastructure sector.

- If principal de-coupled from tax credits, opportunity for pension funds to diversify into the infrastructure sector.

- Non-cash nature of the interest component limits marketability.
- New instrument with limited volume lacks an active secondary market, if investor needs to sell due to change in its tax position.
- May face tax risk, if issuer fails to meet federal requirements of the program.

***Investor ******Pros and Cons of******Tax Credit Bonds***

**Advantages**

**Disadvantages**

## Little administrative cost compared to grant and credit programs.
Some policymakers believe tax credit bonds are a more efficient subsidy than tax-exempt bonds – borrower gets 100% of tax benefit.
May reduce muni bond tax expenditures, to the extent it substitutes for issuance of tax-exempt bonds.
New form of public-private partnership, new source of capital for public infrastructure.

- Some policymakers believe tax credit bonds are a more efficient subsidy than tax-exempt bonds – borrower gets 100% of tax benefit.
- May reduce muni bond tax expenditures, to the extent it substitutes for issuance of tax-exempt bonds.
- New form of public-private partnership, new source of capital for public infrastructure.

- Compared to tax-exempt bonds, much deeper subsidy (50% vs. 10% debt service savings to borrower) with higher tax expenditures.
- Tax expenditures scored at up to $46m per $100m of bonds over 10 years.

***Federal Policy****** ******Pros and Cons of ******Tax Credit Bonds***

**Advantages**

**Disadvantages**

## Innovative Finance Comparator

| Finance Mechanism 
(Policy Tool) | Type of Federal Policy Incentive | Key Benefit of
IF Tool to
Project Sponsor | 
Cost of Funds to Project Sponsor | Federal Budgetary Cost
(per $100m borrowed) |
| --- | --- | --- | --- | --- |
| 
GARVEE Bonds
 (20-yr, “A” credit) | 
RegulatoryReform | Enables States to monetize future Federal grant receivables | 
4.80% | 
10 Yr Cash:  $79m
20 Yr PV:    $100m |
| 
TIFIA Instruments
 (35-yr, “BB+” credit) | 
 FederalCredit | Provides supplemental & subordinate capital for large projects
 | 
5.00% | 
10 Yr Cash:    $5m
35 Yr PV:        $5m  |
| 
Private Activity Bonds 
(20-yr, “A” credit) | 
Tax Code Change | Allows projects with private participation to access lower interest rates | 
4.90% | 10 Yr Cash:  $18m
20 Yr PV:     $19m |
| Tax Credit Bonds
(20-yr, “AA” 6.5% credit) | 
Tax Code
Change | Cuts effective financing cost in half by eliminating interest expense
 | 
0.00% | 10 Yr Cash:  $46m
20 Yr PV:      $57m |