number of potential bond purchasers and typically results in significantly lower interest rates). A rating is a key feature for any bank or lender looking to participate. To achieve similar investment grade rating and attractiveness to banks or lenders, program planners can set up a slightly more sophisticated “senior- subordinate” payment structure (also described more fully below).
Second, local or state governments can fully or partially guarantee repayment by placing a general or moral obligation on the bonds. Under a general obligation, local or state governments pledge their full faith and credit to the bonds—effectively guaranteeing that if tax receipts fall short, they will make up the difference out of their own treasury. A moral obligation is a similar, but somewhat weaker, enhancement that is being used by Boulder County, Colorado, for its PACE program. Moral obligation bonds do not require a local government to cover bond defaults, but do indicate it is very likely they will do so. Such guarantees improve the credit quality of the bonds or loan, but also affect the credit quality of the local government and count against the government’s indebtedness limits.
Grantees have a number of options for using ARRA funds to support their commercial PACE programs, some of which address the credit enhancement options above. Details on several of the major options are presented in the next sections.
4.2 Debt Service Reserve Fund
Bond investors typically expect there to be a debt service reserve fund (DSRF) to cover bond debt service (i.e., payments made to bond investors) in the event of late payments or defaults by participants. This is commonly an amount set aside with a trustee. Note that other chapters in this Finance Guide refer to this reserve as a loan loss reserve fund (LRF), but in this chapter it is called a DSRF. For assessment bonds, the typical DSRF is in the range of 5% to 10%. The reserve can be funded in several ways, but is usually added to the financed amount for each participant, so participants pay for it. For example, a $10,000 project would be financed at an $11,000 level in the case of a 10% DSRF. If a bond experiences low or no defaults, then the money in the reserve fund is generally used by the PACE program toward making the final payment on behalf of the property owner (assuming the owner funded the reserve). A DSRF may or may not be required for owner-arranged financing, but such a reserve will be expected in all other forms of property assessment bonds.
Adding an additional 5% to 10% on top of the total project financing amount increases the annual percentage rate (APR) and can give applicants significant reason to pause and think hard about the costs of the PACE financing option. Therefore, anything that can be done to lower or alleviate that cost can bolster program participation. One appealing option is for grantees to use their ARRA funds to provide the debt service reserve fund so that program applicants do not have to cover its cost.
If ARRA funds are used for a 10% DSRF, the APR to the property owner will be reduced by approximately 1.6% (in contrast to the property owner funding the DSRF and having it added to the financed amount). The difference can be seen by contrasting columns 1 and 2 in Table 2 (note the applicant APR of 9.6% versus 8.0%).
A common capital markets approach to establishing a DSRF to enhance the credit of the financing would be to set up a “senior-subordinate” structure. In such an approach, the ARRA funds would be combined with private capital and provided for project financing rather than held in reserve. In the event of a default, the losses are taken first by the ARRA funds, leaving the private investor unharmed unless all ARRA funds are exhausted. Using ARRA funds in this “first loss” position has two advantages. First, it allows for more total project funding. Second, it is set up in a manner more appropriate for a securitized capital markets takeout (i.e., combining all the project financings into a bond or security and selling it to investors).
Chapter 13 —