1. Environmental Financial Advisory Board Report Relative Benefits of Direct and Leveraged Loans in State Revolving Loan Fund (SRF) Programs State/EPA Workgroup October 21, 2008

2. Questions Posed To EFAB In Light of the Growing Needs Gap In August 2006, EFAB initiated a review of the leveraging financing technique, including: –Whether States that use leveraging tend to have higher rates of loans as a percentage of their capitalization grants. –Whether leveraging could improve the sustainability of the SRFs. –Whether the Board ought to recommend that EPA do more to promote the use of leveraging. 2

3. EFAB Leveraging Workgroup George Butcher (Chair)* Staff Lead: Vera Hannigan Terry Agriss* Michael Curley Steve Grossman Steve Mahfood Andrew Sawyers Jim Smith* Greg Swartz* Sonia Toledo Scott Haskins Justin Wilson Jim Gebhardt * Dave Miller (EW) Heather Himmelberger (EW) Jeff Hughes (EW) Program Contacts: Kit Farber-CW Howard Rubin-DW Stan Meiburg - DFO CW – Clean Water program contact DW – Drinking Water program contact EW – Expert Witness (non-EFAB member) DFO – Designated Federal Official 3

4. Categories of SRF Structures Direct loan – 100% funded with SRF equity Leveraged Low – up to 33.33% of loans funded with bond proceeds Leveraged Medium – between 33.33% and 66.67% of loans funded with bond proceeds Leveraged High – more than 66.67% of loans funded with bond proceeds Number of States by Lending Structure SRF Program Direct Loan Leveraged Low Leveraged Medium Leveraged High Clean Water24999 Drinking Water314610 4

5. Population Served By SRF Category Populations Served (millions) SRF Program Direct Loan Leverage Low Leveraged Medium Leveraged High Clean Water87.083.766.561.7 Drinking Water182.115.534.366.9 5

6. Grants And Loans by SRF Category SRF Capitalization and Loans – As of June 30, 2007 (Billions) Lending Structure CWSRF Capitalization Grants CWSRF Loans Executed DWSRF Capitalization Grants DWSRF Loans Executed Direct Loan $7.398$12.833$3.501$4.412 Leveraged Low $5.658$11.814$0.520$0.771 Leveraged Medium $5.768$15.968$0.888$2.084 Leveraged High $7.197$23.333$1.612$4.683 6

7. Leveraging Factor By SRF Category Leveraging factor is the ratio of loans made to capitalization grants. SRF Leveraging Factor– As of June 30, 2007 ` Lending StructureCWSRFDWSRF Direct Loan 1.731.26 Leveraged Low 2.091.48 Leveraged Medium 2.772.35 Leveraged High 3.242.91 Both direct and leveraged SRF programs have made loans with a significantly greater value than their federal capitalization grants. 7

8. Key Attributes Of SRF Structures In both direct loan and leveraged SRFs, the subsidy is provided by using or forgoing earnings that could otherwise have been earned on program equity and retained to grow program equity. If states are making loans at identical interest rates (above 0%), leveraged loan states use less equity. So, with the same amount of equity, a leveraged loan state can fund more projects. 8

9. Sustainability Is A Key Objective An SRF will become sustainable when on an annual basis, its recycled federal and state capitalization grants and retained earnings are sufficient to continue its existing level of project funding in inflation-adjusted dollars. Although the primary goal of any SRF is to make loans, another important goal is to ensure that over time the program is sustainable. If federal capitalization grants decline as was anticipated at the initiation of the SRF programs, the SRFs will have to depend more on growth of retained earnings to sustain their programs. 9

10. Retained Earnings For CWF SRFs 10 CWSRF Retained Earnings as % of SRF Equity Grouping of States By Retained EarningsTop Third Middle Third Bottom Third Average Retained Earnings as % of Equity25.95%16.97%7.68% Direct Loan (24 States)1275 Leveraged Low (9 States)270 Leveraged Medium (9 States)225 Leveraged High (9 States)117 Average Loan Rates (Overall Average is 2.10%)2.14%2.42%2.01% Borrowed State Match as % of Total Match9.31%15.96%41.65% Loan Disbursements as % of Loans79.31%87.51%91.11%

11. Retained Earnings For DWF SRFs 11 DWSRF Retained Earnings as % of SRF Equity Grouping of States By Retained EarningsTop Third Middle Third Bottom Third Average Retained Earnings as % of Equity14.90%6.34%3.10% Direct Loan (31States)911 Leveraged Low (4 States)040 Leveraged Medium (6 States)312 Leveraged High (10 States)514 Average Loan Rates (Overall Average is 2.20%)2.38%2.08%2.16% Borrowed State Match as % of Total Match16.37%13.65%34.64% Loan Disbursements as % of Loans79.55%80.39%77.30%

12. The Opportunity Cost For Equity Used To Make Loans Affects Sustainability The “opportunity cost” of an SRF loan is the difference between (a) how much the SRF earns on the equity used to make or support the loan, and (b) the investment return that the SRF could otherwise earn on the equity. The higher the opportunity cost to an SRF of funding its loans, the less sustainable its program will be. 12

13. Equity Used To Make Direct Loan Is In Effect Yield Restricted If a state makes a direct loan with a 50% interest rate subsidy versus the borrower’s normal 4% borrowing cost, the SRF’s return on equity has two components: –First, the interest rate paid by the borrower on its loan – in this case 2%, and –Second, the interest subsidy provided to the borrower, which is the difference between the rate the borrower would otherwise pay (4%) and the actual rate (2%). 13 The SRF’s return on its equity is 4%, the borrower’s tax-exempt borrowing cost.

14. Direct Loan SRFs Can Leverage to Grow Earnings By Reducing Their Opportunity Cost If a state makes a $100 direct loan and provides a 50% interest rate subsidy versus the borrower’s normal 4% tax-exempt borrowing cost, the SRF’s retained earnings would be 2% on the $100, or $2.00. If the state issued bonds to fund the $100 loan, it could use $50 of equity to support the loan and invest the remaining $50 of equity at a taxable market rate of about 4.5% on the invested $50, or $2.25, a 12.5% better return. 14 The key is to use separate portions of the SRF’s equity to provide subsidies and to grow earnings.

15. EPA Can Take Administrative Steps To Enhance SRFs Ability to Grow Earnings First, EPA could allow states to elect an approach that would eliminate the connection between federal capitalization grant draws by the state and the construction pace of SRF funded projects. –A perceived nexus between the capitalization grant draws and the expenditure of bond proceeds has caused bond counsel to subject the SRF equity to arbitrage restrictions, even if it is solely invested to grow earnings. 15

16. EPA Can Take Administrative Steps To Enhance SRFs Ability to Grow Earnings Second, EPA could interpret the “perpetuity rule” by measuring compliance based on expected earnings over time, rather than current year-end results. –The static test has been viewed to restrict the use of retained earnings to fund interest subsidies. By using both the principal and interest on retained earnings to fund subsidies the amount subjected to restriction can be reduced. 16

17. EFAB Conclusions SRF programs have been very successful in financing clean water and drinking water projects, regardless of program design. State programs that have leveraged their SRF funds have provided greater assistance as a percentage of their capitalization grants than those that have not leveraged. 17

18. EFAB Conclusions (cont.) In both direct and leveraged programs, the subsidy is by using earnings that could otherwise be used to grow equity. If capitalization grants decline in the future, SRFs will depend more on growth in retained earnings to sustain their programs. 18

19. EFAB Conclusions (cont.) Leveraged programs make it possible to meet greater loan demand by using earnings to provide loan subsidies on a larger amount of loans. Direct loans have been used by SRFs that have less loan demand or that place more emphasis on growing retained earnings for future use. 19

20. EFAB Conclusions (cont.) States can increase retained earnings growth by utilizing innovative financing concepts that are now being applied in some states. Direct loan states can use leveraging to fund the same amount of loans and increase the growth of retained earnings. 20

21. EFAB Recommendations EPA should encourage direct loan states to improve SRF sustainability by showing the states how leveraging can be used to increase their retained earnings. EPA should assist states to develop sustainable SRFs by administratively allowing states to accelerate draws of capitalization grants, modifying its interpretation of the perpetuity rule and by advocating for arbitrage. 21

22. EFAB Recommendations (cont.) EFAB should explore the benefits of developing more aggressive parameters for SRF equity investments and recommend appropriate program changes to EPA. 22

23. Overall, There Is A Tradeoff Between Retained Earnings and Loans CWSRF Data by Lending Structure as of June 30, 2007 (millions) SRF CategorySRF Equity Retained Earnings as % of Equity Leveraged Bonds as % of Loans Executed Loans as % of Capitalization Grants Leveraged High $ 8,47710.6%85.6%343.6% Leveraged Medium $ 7,31116.4%45.2%304.0% Leveraged Low $ 7,44218.9%11.7%229.5% Direct Loan $ 9,66720.3%0.0%193.0% United States $ 32,89916.6%44.0%267.3% 23

24. Overall, There Is A Tradeoff Between Retained Earnings and Loans (cont.) DWSRF Data by Lending Structure as of June 30, 2007 (millions) SRF CategorySRF Equity Retained Earnings as % of Equity Leveraged Bonds as % of Loans Executed Loans as % of Capitalization Grants Leveraged High $ 2,46511.5%78.7%290.6% Leveraged Medium $ 1,26912.9%47.2%234.7% Leveraged Low $ 6795.8%24.2%147.5% Direct Loan $ 4,7976.6%0.0%125.7% United States $ 9,2128.7%40.6%182.9% 24

25. The Leveraged Approaches Achieve A Higher Leverage Factor CWSRF Leverage Factor and Lending Structure Lending Structure Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Leveraged High 720 Leveraged Medium 711 Leveraged Low 252 Direct Loan 1914 Total States 17 25

26. The Leveraged Approaches Achieve A Higher Leverage Factor (cont.) DWSRF Leverage Factor and Lending Structure Lending Structure Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Leveraged High 820 Leveraged Medium 510 Leveraged Low 031 Direct Loan 41116 Total States 17 26

27. Role Of Financing Agency In Day- T0-Day Management Lead Role – Lead contact and manages all aspects of SRF from generating Intended Use Plan to servicing loans Significant Role – Manages some, but not all, aspects of SRF including programmatic and financial aspects Minor Role – May service loans and may issue state match or leveraged bonds No Role – No finance agency involvement 27

28. Role Of Financing Agency In Day- T0-Day Management (cont.) CWSRF Financing Agency Role Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Lead Role1153 Significant Role423 Minor Role255 No Role056 Total States17 28 CWSRF Leveraging Factor and Finance Agency Role

29. Role Of Financing Agency In Day- T0-Day Management (cont.) DWSRF Financing Agency Role Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Lead Role1033 Significant Role343 Minor Role152 No Role359 Total States17 29 DWSRF Leveraging Factor and Finance Agency Role

30. Averages For Five Program Measures By Leveraging Factor Rankings CWSRF Leveraging Factor and Program Measures Program Measure CWSRF National Average Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Average Interest Rate 2.10%2.32%2.28%1.96% Loans Funded with Bonds as % of Total Loans 44.1%62.4%29.5%4.9% Match Bonds as % of Total State Match 24.1%37.2%14.6%13.8% Disadvantaged Assistance as % of Total Assistance 10.9%10.1%5.4%21.2% Retained Earnings as % of Equity 16.6%13.5%20.1%16.7% 30

31. Averages For Five Program Measures By Leveraging Factor Rankings (cont.) DWSRF Leveraging Factor and Program Measures Program Measure DWSRF National Average Top Third Leveraging Factor Middle Third Leveraging Factor Bottom Third Leveraging Factor Average Interest Rate 2.20%2.47%2.36%1.79% Loans Funded with Bonds as % of Total Loans 40.6%62.8%25.3%0.34% Match Bonds as % of Total State Match 21.5%24.4%18.8%19.9% Disadvantaged Assistance as % of Total Assistance 32.3%42.2%31.3%21.3% Retained Earnings as % of Equity 8.7%13.2%7.2%4.8% 31