Description
Loan loss reserves (LLRs) are a credit enhancement approach commonly used by state and local governments to provide partial risk coverage to lenders—meaning that the reserve will cover a prespecified amount of loan losses. For example, an LLR might cover a lender's losses up to 10% of the total principal of a loan portfolio. The financial institution working with each state or local government can draw on the LLR to cover losses on defaulted loans according to the loan loss agreement between the lender and the state and local government. By taking the most junior equity position in the overall capital structure, the provider (i.e., the public sector) takes first losses, although it sometimes also seeks risk-adjusted returns; this includes common equity in structures that incorporate preferred equity classes.
Instrument category
Risk mitigation instruments
Implementation status
Moderate - tried and tested
Enabling conditions and success factors
- Projects need to source the remaining investment capital.
Instrument benefits
- Broadens access to finance for more borrowers (e.g., homeowners) by allowing the financial institution partner to modify its underwriting criteria and accept more risk than it would otherwise.
- Allows lengthening loan tenors.
- Reduces loan interest rates, reflecting the lower risk associated with the LLR coverage.
Challenges and risks to implementation
- It is often difficult to estimate the probability of default and, therefore, the pricing.
- Increased transaction costs could deter the use.
- Inadequate (too low) pricing could generate moral hazard behaviour.
