Credit Enhancement and the Positive Social Purpose Lending Program
The General Board of Pension and Health Benefits (General Board) launched its Positive Social Purpose (PSP) Lending Program in 1990 to support affordable housing. Since then, the General Board has expanded the scope of this program and financed approximately $1.5 billion to fund not only affordable housing, but also charter schools, community facilities and microfinance loans throughout the U.S. and in developing nations around the world.
Throughout its 20-year history, the PSP Lending Program has remained vigilant about providing attractive returns while mitigating participants’ potential investment risk. This article explores credit enhancement, one of the risk-reduction methods used by the PSP Lending Program.
What Is Credit Enhancement?
Credit enhancement is a technique used to absorb potential lending losses before the General Board’s funds incur any losses. Loans structured with credit enhancement require a third party to incur a loss before the General Board takes a loss.
Credit Enhancement Techniques Used by the PSP Lending Program
There are many forms of credit enhancement. The PSP Lending Program uses several types. One involves guarantees by government or quasi-governmental agencies, such as Fannie Mae or Freddie Mac. These guarantees provide for 100% principal and interest protection if the underlying property owner is unable to pay the mortgage.
Subordination is a form of credit enhancement involving a “junior” lender and a “senior” lender. The “junior” and “senior” terms refer to the order in which lenders recognize losses. A junior lender has the lower rank and consequently recognizes losses prior to a senior lender. The junior lender generally earns a higher interest rate for accepting the higher risk.
Subordination is often used with pooling to provide an even higher level of credit enhancement. Pooling is the combination of several loans into one loan pool. A pool of mortgages limits the impact of a potential loss from a single loan. The General Board purchases the “senior” class of a pool, and our lending partners purchase the “junior” class of the pool. Through its ownership of the senior class, the General Board is protected from losses on the underlying pool of loans until the losses applied against the junior class cause the value of the class to be reduced to zero.
Low Income Housing Tax Credit Program
The Low Income Housing Tax Credit (LIHTC) is a tax credit created under the Tax Reform Act of 1986 that provides incentives to invest in the development of affordable housing. In recent years, the LIHTC has played a role in nearly 90% of all affordable rental housing created in the U.S.
To take advantage of the LIHTC, a developer will propose a project to a state housing agency, seek and win a competitive allocation of tax credits (which will be sold to investors providing funds for the project), complete the construction of the project, certify its cost and rent the project to low-income tenants. The developer must agree to meet the project’s low-income requirements for a 15-year period.
Failure to comply with the applicable rules or selling the project or an ownership interest before the end of at least a 15-year period can have burdensome tax consequences for the developer. If the developer does not comply with the LIHTC rules, the government can “recapture” the tax credits. Recapture forces the developer to restate previous years’ tax returns as if it had not received the benefits of the tax credit. This could create a significant tax bill for the LIHTC investors. Consequently, the tax consequences provide strong incentive for LIHTC investors to monitor these developments and ensure that mortgage loans for the developments are current.
The strength of this tax incentive has led to dramatically lower foreclosure rates on LIHTC apartment buildings compared with “non-LIHTC” buildings. According to a 2007 Ernst & Young study, a non-LIHTC building is 10 times more likely to enter foreclosure than a LIHTC building.
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Another form of credit enhancement used by the PSP Lending Program is the use of specific government programs to support the underlying affordable housing or community facility development. This strategy does not provide protection against losses, but it reduces the chance that a loan will default. The presence of specific government programs functions as a credit enhancement in two ways. Government programs typically include additional third-party oversight by the agency administering the program. In addition, several of these programs have provisions for the government to enforce good business practices to support low- and moderate-income communities and ensure the efficient use of government resources. Currently, over half of the PSP Lending Program loans are made to affordable housing developments supported by the federal Low Income Housing Tax Credit Program. This program provides important motivations for borrowers that reduce the likelihood that a loan will default. Read more about the Low Income Housing Tax Credit Program in the sidebar.
Third-Party Partners
The PSP Lending Program also works with industry leaders in real estate servicing, pricing and loan monitoring to provide a best-in-class platform for managing the PSP Lending Program and providing excellent governance. PSP Lending Program management works through intermediaries, organizations that perform initial project due diligence, conduct ongoing loan servicing and, most importantly, provide credit enhancement for loans. These intermediaries are generally community development financial institutions that are mission-focused and have expertise in affordable housing and/or community facility lending. Use of third-party intermediaries is consistent with the General Board’s multiple-investment-manager structure and brings exceptional diversification to the loan portfolio.
The General Board is proud of its leadership role in aligning values with investing. The PSP Lending Program significantly improves the lives of underprivileged people while earning competitive rates of return. A key way we ensure competitive rates of return is to vigilantly protect investors from loss. Click here to read more about the PSP Lending Program.
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