Seattle Bank Letters of Credit for Tax-Exempt Funding: Supporting Public Purpose and Industrial Revenue Development Projects

Traditionally, Federal Home Loan Bank (FHLBank) Standby Letters of Credit (LOCs) have offered FHLBank members an efficient and low-cost way to enhance financial support for a range of efforts. From collateralizing public deposits, to assisting in asset/liability management, to facilitating the purchase of mortgage loans—Standby LOCs offer a guaranty of payment and enable our members to leverage the FHLBank System’s AAA debt rating.

More recently, passage of the Housing and Economic Recovery Act (HERA) of 2008 spurred a new, fast-growing application of FHLBank LOCs. This legislation permitted changes in the Internal Revenue Code, which allow FHLBanks to issue Standby LOCs on behalf of eligible non-housing-related projects for which FHLBank members issue direct LOCs in support of tax-exempt bonds. Previously, FHLBank tax-exempt LOC activities were confined to projects involving residential housing or mortgage revenue bonds. The legislation, however, contains a “sunset” provision that suspends the program on December 31, 2010.

The ability of FHLBanks to provide Standby LOCs on eligible tax-exempt financings helps to fill the gap left by former providers, such as monoline insurers and large domestic and international banks, many of which have sustained ratings downgrades or are limiting LOC activity to preserve capital.

The structure of a Seatte Bank Standby LOC—in support of any eligible financing—is fairly simple in that it basically guarantees an LOC issued by an FHLBank member. Seattle Bank LOCs must be secured with eligible collateral, just like an advance. The process works like this:

  1. A Seattle Bank member issues a direct LOC in favor of a bond issuer (e.g., an eligible health care facility, retirement community, public or private school, industrial development, water/sewer/power infrastructure project, nonprofit community organizations). As the direct LOC issuer, the member would assume the credit and liquidity risk of the issued bond and would be first in line to make any required payment under a draw request. Figure 1 depicts a typical tax-exempt funding transaction (involving non-housing and other projects made eligible by the 2008 HERA legislation) employing a Seattle Bank Standby LOC.
  2. The Seattle Bank then issues a Standby LOC, which would be drawn in the event the member financial institution does not perform its responsibilities under its direct LOC. As such, in the eyes of the bondholders, the Seattle Bank’s Standby LOC serves as the ultimate source of repayment of obligations in the event of a principal or interest default. Figure 2 depicts the flow of funds if there was a need to exercise the Standby LOC.

The total LOC cost to the issuer would consist of the sum of Seattle Bank’s Standby LOC fee and any fees charged by the member issuing the direct LOC. Seattle Bank LOC fees are payable annually in advance and may be subject to early termination fees. The member institution determines its fee for the direct LOC, and the member and Seattle Bank would negotiate a separate fee for the Standby LOC.

Figure 1. Funds Flow: Seattle Bank Standby LOC Supporting Eligible Tax-Exempt Financing

Figure 2. Funds Flow: Exercise of Seattle Bank Standby LOC

In addition to new bond issues, existing bond issues may qualify for LOC backing for re-funding or refinancing purposes, provided that significant changes in such terms as amount, rate, and maturity take place.

Since the passage of the HERA legislation, FHLBanks have issued confirming letters of credit on behalf of:

  • Community Service Organizations (e.g., family, senior, or youth services)
  • Industrial Development (e.g., manufacturing or distribution facilities that result in job growth)
  • Multi-family and Student Housing
  • Eligible Retirement Facilities
  • Educational Facilities (public and private schools, colleges, and universities)
  • Water and Sewer Treatment Infrastructure Projects
  • Healthcare Projects

The Seattle Bank stands ready to assist its members, bond underwriters, and the legal and accounting communities in identifying specific eligible projects, generating fee-generating opportunities, and serving their communities by lowering the cost of capital on behalf of issuers of eligible tax-exempt debt.

To learn more about Seattle Bank Standby LOC structures and the role they can play in designing an optimal tax-exempt financing, contact your Seattle Bank Relationship Manager.