Solyndra, Interest Rates, and the Treasury’s Federal Financing Bank

The bankruptcy of Solyndra has drawn attention to a little known financing arm of the U.S. Treasury Department – the Federal Financing Bank or "FFB" – and the interest it charges to borrowers. The Treasury's Inspector General is reportedly investigating the role of the FFB in making this loan. I do not have any personal knowledge about the particular facts of the Solyndra loan, but, as way of background, here is some information about the FFB and how it sets its rates.

The FFB was established by the Federal Financing Bank Act of 1973. (I have been told that Paul Volcker, who was the Treasury's Under Secretary for Monetary Affairs at the time, is particularly proud of helping to create the FFB.) The purpose of the bank is to make more efficient the financing of loans which are 100 percent guaranteed by the federal government. Treasury securities carry cheaper interest rates than other paper sold in the market with 100 percent federal government backing, because they have greater liquidity and do not need to be explained to potential purchasers. Accordingly, the FFB advances the funds for 100% guaranteed loans and obtains the financing for this by borrowing from the Treasury. The Treasury in turn issues more securities than it otherwise would in order to fund FFB loans, though there is no attempt by Treasury to match any particular security with the FFB's borrowings.

The FFB used to charge a 12.5 basis point spread between its cost of borrowing from Treasury and the interest rate set on the loans it makes. According to the FFB's latest financial statements, any spread that is charged now for most loans goes to the agency which guaranteed the loans, not to the FFB, except if the FFB is not able to fund its administrative expenses associated with the loans. In that case, it "may require reimbursement from loan guarantors." The FFB does impose charges for the ability of borrowers to prepay loans and for forward interest rate commitments.

The methodology for setting interest rates on loans, both those at which the Treasury lends to the FFB and those at which the FFB lends to borrowers, is complicated. It does not involve simply reading the rate for a particular maturity off the Treasury yield curve, because Treasury securities provide a different stream of payments than most loans typically do. A Treasury note or bond pays interest semiannually and the entire principal amount at maturity. A typical loan is usually a series of level payments at specific intervals, each of which can be apportioned between interest and partial principal repayment.

The technical aspects of how these loans are priced are too involved to describe here precisely. I will endeavor here to provide a general explanation, which is unavoidably somewhat technical.

The FFB utilizes a model which effectively transforms the Treasury yield curve into a "theoretical spot rate" or zero-coupon curve. In other words, the assumption behind the Treasury yield curve is that the Treasury could sell a security at a given maturity at par with a coupon rate read off the curve for that maturity. A theoretical spot rate curve is a mathematical transformation of the Treasury yield curve to give the rates on zero-coupon notes or bonds that are consistent with the Treasury yield curve. For example, if Treasury can sell a note or bond at par with a 3% coupon, one could discount each coupon payment and the principal payment at maturity by the appropriate zero-coupon rates read off the theoretical spot rate curve in order to determine their present values. The sum of the present values of all the payments would equal the par value of the note or bond.

If a FFB borrower wants to make level payments for a fixed period at periodic intervals in order to obtain a loan for a specific amount, the FFB's model will determine the necessary size of those payments so that when discounted by theoretical zero-coupon rates, the present value equals the amount of the loan. The model will also calculate a "single equivalent rate" for the loan, which, using standard formulas, are used to determine the portions of each payment which constitute principal repayment and interest.

As for Solyndra, the latest FFB press release (July 2011) indicates that it had borrowed about $2.36 million from the FFB at a rate of 1.025%. This is the lowest rate of all the loans made by the FFB in June 2011 guaranteed by Department of Energy. However, the Solyndra loan matures in August 2016, while the other loans, except for one made to Solar Partners I, are for much longer terms and carry higher interest rates, which one would expect, given that long-term rates are higher than short-term rates. The Solar I loan, which matures in June 2014 carries an interest rate of 1.126%. Part of the difference between the rates on this loan and the Solyndra loan are no doubt due to the different pricing dates and the different payment frequencies for the loans – Solyndra is quarterly and Solar Partners I is semiannually. There may have been other details in the terms and conditions of the loans, but they cannot be ascertained from the press release.

It should be emphasized that for most of the loans it makes, the FFB is relying on the government guarantee. If the borrower defaults, it is the other agency which is on the hook to make the FFB whole, which has budget implications for that agency. The FFB, though, does face credit risk on the loans it has made to the U.S. Postal Service, and the financial troubles of that agency have been receiving some attention recently.

Also, investment bankers have not liked the FFB particularly, because its use means that they do not receive underwriting fees for non-Treasury securities that are 100% backed by the U.S. government. Of course, that is the point. Sometimes there are disagreements among various government agencies about the proper role of the FFB and its implications, and some 100% guaranteed loans are financed in the market.

In the Solyndra case, journalists and Congressional committees will no doubt continue to investigate. The role of the FFB may be interesting, but any investigation of why the loan was guaranteed and what analysis of the company's financial conditions was undertaken will need to focus elsewhere.


Update:  The press reports that the Department of Energy granted Solyndra a $535 million loan guarantee.   Bloomberg reports that the FFB made loans totaling $527 million to Solyndra.  I have no reason to doubt this, but it would be helpful if they had indicated from where this information came.  At its website, the FFB does not have information about its current portfolio itemized by borrower.  It does have information about its activity with specific borrowers for the month of June.  Consequently, it is not clear how much of the $535 million DOE guarantee was used to back FFB loans and what the interest rates were, except for the $2.36 million loan in June.  It may be somewhere on the web, but I have not been able to find it.  No doubt, further information will become available as investigations and bankruptcy court proceedings continue.  Since the FFB is something new for most of the press to cover, some news reports may be unclear, but perhaps the original source material will be available to those interested in this issue.