A major incentive of a Loan Loss Reserve Fund (LRF) is the leverage it provides for financing projects that enhance energy efficiency.
By leveraging grantee dollars, an LRF effectively expands available credit through “risk sharing” to achieve strong results. This blog post tackles the basic question: What is risk sharing, and how does it work?
An LRF risk-sharing formula typically has two defining parameters:
- The ratio of the LRF to the total original principal amount of the loans in the energy efficiency loan portfolio
- The negotiated sharing on individual loan losses between a grantee and lender
This post will clarify the first parameter.
Third-party loan programs supported by an LRF frequently have a loss reserve of between 5% and 10% of the total portfolio’s original principal, which means there is a leverage ratio of between 10:1 and 20:1.
Lending in residential markets that have low credit quality might require higher loan loss reserves. For instance, one loan program under development in Detroit will likely require a loss reserve of as much as 50% (only a 2:1 leverage) because borrowers in that program have less than ideal credit.
A higher leverage ratio means that the program can offer more loans than it could with a lower leverage ratio. However, it can also result in less protection against risk for the lender. A lower leverage ratio indicates a greater risk protection for the lender.
Loan loss reserve funds may come from multiple sources, spreading the risk and providing more funding opportunities. In addition to the grantee’s ARRA funds, potential sources can include local vendors/contractors, utilities (as part of their energy efficiency or demand side management program funds), and other donors interested in energy-efficiency/renewable energy residential improvements.
If you are in the process of developing or implementing an LRF program in your community, please share your experiences by commenting to this post! For support and guidance on LRFs and the risk-sharing formula, the Technical Assistance Program is available to serve you throughout the development cycle.
Content for this Blog post courtesy of The Cadmus Group