In a follow-up to last week’s discussion of risk-sharing within a Loan Loss Reserve Fund (LRF), this post explains how liability is shared if a loan defaults.

In our previous post, we discussed the possible range of LRFs to loan ratios in an energy efficiency loan portfolio. The second parameter in the LRF risk-sharing formula is the share of the losses on individual loans that the LRF will pay. A financial institution (FI) partner and the grantee negotiate what this share will be.

For example, if a loan in a portfolio defaults, the lender might be able to recover only 80% of the unpaid principal amount of this loan from the loss reserve. In this structure, some of the lender’s cash remains at risk, which motivates the lender to require high-quality loan origination and collection procedures.

While the recovery rate for individual loans ranges from 50% to 100%, FIs usually recover between 80% to 100%. A recovery rate of between 80% to 90% strikes a good balance, as the FI partner bears some of the first losses, which can then be covered by its normal loan loss provisioning. However, it’s important to understand that even if the LRF is able to pay a large portion of the first losses, the FI has a vested interest in minimizing these first losses if only to keep the LRF intact so that it can cover any future losses on the balance of the portfolio.

After an LRF covers its share of first losses, the FI is responsible for the balance of any losses; these are sometimes referred to as second losses. Because the FI carries the full risk for all second losses, it has a strong incentive to make certain that it originates only high-quality loans, and has adequate systems in place for administering, collecting, and recovering these funds.  Grantees should expect the FI partner to bargain hard for those provisions.

In the risk-sharing formula between the LRF and the FI, the LRF does not guarantee loans, nor does it completely eliminate a lender’s risk. The liability of the grantee (the local government or other entity using ARRA funds for the LRF) is limited to the funding provided by ARRA (and in some cases by other donors).

For a sample calculation of an LRF program budget and risk-sharing formula, please refer to the attached table: LRF Risk Sharing calculation.pdf (59.97 kb)

If you are in the process of developing or implementing an LRF program in your community, please, share your experiences with us! For support and guidance on LRFs and the risk-sharing formula, the Technical Assistance Program is available to serve you throughout the program cycle.

Content for this Blog post courtesy of The Cadmus Group