Understanding Credit Subsidy

When the Federal government offers a loan or loan guarantee, it must assess and budget for any expected unreimbursed cost of the loan or loan guarantee, called the “credit subsidy cost,” per the Federal Credit Reform Act of 1990. The credit subsidy cost equals the net present value of estimated cash flows from the government minus estimated cash flows to the government over the life of the loan, excluding administrative costs. Depending on deal factors, the credit subsidy cost can be positive or negative. Positive credit subsidy values indicate an expected loss and must be accounted for in an office's or program’s budget. Negative credit subsidy indicates expected revenue to the government.  The credit subsidy cost payment is analogous to a Loan Loss Reserve Fund created for a single project. 

Planning for Risk and Using Credit Subsidy at the Loan Programs Office

The potential for losses, indicated by positive credit subsidy, is an inherent characteristic of high-impact lending. The U.S. Department of Energy's Loan Programs Office (LPO) must take on and manage this risk to fulfill its mission and mandate. LPO conducts rigorous due diligence to ensure that all financed projects meet LPO’s statutory requirement of having a reasonable prospect of repayment. As part of its diligence, LPO’s Risk Management Division determines the probability of default, which is reflected in the credit rating assigned to the loan. LPO also determines the recovery rate (i.e., the percentage of the loan that is expected to be recovered in the event of default). LPO structures loans such that even if a borrower defaults, some or all the remaining value of the loan can be recovered. 

Even with these mitigants, providing high-impact debt financing carries risk. It is possible—and to be expected—that some projects with a reasonable prospect of repayment might not be repaid or recovered in full. Credit subsidy allows the government to budget for these expected losses.

Calculating Credit Subsidy

The credit subsidy cost is calculated by LPO using a model approved by the Office of Management and Budget (OMB) called the “Credit Subsidy Calculator.” 

The credit subsidy calculation accounts for: 

1. Principal and interest repayments over time, including any risk-based charges.
2. Risk-related factors: Default probability, likelihood of missed payments, and recovery rate according to deal structure.
3. Certain fees paid to the government.
4. Other relevant cash flows (e.g., loan prepayments).

The cash inflow and outflow variables are loaded into the Credit Subsidy Calculator, which returns the credit subsidy cost. This value is the estimated “cost to the government,” or expected loss (if any) from the loan when the above factors are considered. The calculation discounts future payments—both disbursements and loan repayment—to account for the time value of money (i.e., the principle that a dollar today, which can be invested and earn a return, is worth more than a dollar in the future). Discount rates that reflect the federal government's cost of financing are used to determine the net present value of estimated cash flows.

Credit subsidy cost for LPO loans is calculated and payment is due at conditional commitment. Projects that have a higher likelihood of default and/or a lower expected recovery rate (in the event of default) carry a higher credit subsidy rate (i.e., credit subsidy cost per dollar of loan). For LPO loans, Congress may appropriate funds to cover the credit subsidy cost.

Example: How the credit subsidy cost works in practice

Say the government plans to make a $100, 1-year loan, which the borrower is required to repay with interest at the end of the year.

Assume that for the initial $100 loan, LPO affirms that there is a X% chance of default, and the deal has a Y% recovery rate. This information—along with expected principal and interest repayments over time, facility fees, discount rate, and other relevant cash flow factors—is entered into the OMB Credit Subsidy Calculator, which reports a credit subsidy cost of $10. 

That result is the difference between the value of the loan ($100) and the total amount the government expects to be repaid or recover, accounting for all relevant factors (in this example, $90). A credit subsidy cost of $10 means that the government should budget $10 in expected losses, formally referred to as the “cost of the loan to the government.”

The credit subsidy rate is the result of the credit subsidy cost divided by the total loan obligation. In the example above, the rate would equal 10/100, or 10%.

In reality, LPO’s loans are much more complicated than this example. They are often disbursed in tranches and repaid over time. The credit subsidy cost is calculated in present value using a discount rate based on the loan term. This ensures that the credit subsidy calculation accounts for the time value of money.