Supplemental Information for Seltzer Testimony

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Using a Federal Policy Comparator to put
Innovative Finance in Context
Joint Committee Hearing on Innovative
Finance Senate Committee on Environment and
Public WorksSenate Committee on
FinanceSeptember 25, 2002
David Seltzer, Distinguished Practitioner National
Center for Innovations in Public
Finance University of Southern California
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Four Features of Innovative Finance Tools
1. New Sources of Debt Repayment GARVEE Bonds
2. New Sources of Investment Capital TIFIA
Instruments
Innovative Finance
4. New Types of Financial Return Tax Credit
Bonds
3. New Methods of Project Delivery Private
Activity Bonds
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Balancing the Interests ofThree Key Stakeholder
Perspectiveswhen Designing Innovative Finance
Tools
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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 sponsors balance sheet?
• What is the book and legal accounting treatment
  (e.g. approval requirements, debt ceilings)?
• How difficult is it to implement?

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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?

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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)?

?
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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.

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Flow Chart of GARVEE Bonds
Tax-Exempt Debt Investors
FederalHighwayAdministration
Proceeds of Debt
Debt Service
Issuer
Federal Apportionments (80)
Federal-aid Eligible Project Costs
Matching Source
Project
Non-federal Match (20)
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Project Sponsor Pros and Cons ofGARVEE Bonds
Advantages
Disadvantages

• 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 states 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.

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Investor Pros and Cons ofGARVEE Bonds
Advantages
Disadvantages

• 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).

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Federal Policy Pros and Cons of GARVEE Bonds
Advantages
Disadvantages

• 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.

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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 states
  apportionments).
• Projects senior debt must be investment grade
  (BBB- or higher).

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Flow Chart of TIFIA Assistance
Senior Debt Investors
USDOTTIFIAAssistance
Senior LienDebt Service
Proceeds of Senior Debt
Junior Lien Debt Service
Fractional Budget Authority Needed(avg. 5 ) to
Fund Credit Instruments
Public or Private Issuer
Proceeds of Junior Lien TIFIA Financing (up to
33 of costs)
Project Costs
f
Federal Highway Trust Fund
Project
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Project Sponsor Pros and Cons of TIFIA
Advantages
Disadvantages

• 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.

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Investor Pros and Cons of TIFIA
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.

• 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).

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Federal Policy 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.

• 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!

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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).

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Flow Chart of Private Activity Bonds
Tax-Exempt Debt Investors
Proceeds of Debt
Debt Service
Project
Issuer
Project Costs
Use or LeaseAgreement
Operating Concession
NetOperating Revenues
Private Sector Operator
Commercial Risks, Incentivized Compensation
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Project Sponsor Pros and Cons of Private Activity
Bonds
Advantages
Disadvantages

• 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.

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Investor Pros and Cons ofPrivate Activity Bonds
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.

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

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Federal Policy 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.

• 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).

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4. New Types of Financial Return Tax Credit
Bonds

• 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.

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Flow Chart of Tax Credit Bonds(assuming interest
is split from principal)
Proceeds from Sale of Debt
Proceeds from Sale of Tax Credits
Investors in Taxable Debt e.g. Pension Funds
Investors in Tax Creditse.g. Corporations
Principal Repayments
Annual Federal Tax Credits (Rate set at AA
Corporate Bond Yield)
Issuer
Project Costs
Project
U.S. Treasury
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Project Sponsor Pros and Cons of Tax Credit Bonds
Advantages
Disadvantages

• 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.
• Doesnt compete with issuers 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).

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Investor Pros and Cons ofTax 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.

• 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.

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Federal Policy 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.

• 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.

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Innovative Finance Comparator