Evaluating the REA buy down opportunity.

• Author: Engle, Vickie
• Position: Rural Electrification Administration

It is a pleasure to have this opportunity to address the subject of prepayment of loan monies to the Rural Electrification Administration (REA). The introduction of this paper is designed to establish the "flow" of logical considerations as developed by the Management Internship Program group participants.

The National Rural Utilities Cooperative Finance Corporation (CFC) has developed several models showing the effect of REA loan prepayments. Early estimates in the summer of 1992 indicated prospects for discounts between 20% to 30% depending upon the existing loans and established terms and interest rates. This information was disseminated during the summer and fall of 1992 in various regions by CFC staff. The meetings were attended by cooperative board members, consultants, general managers and many general cooperative staff.

The possibilities of substantial savings to REA borrowers are significant. Of course, the final prepayment is, at this time, an estimate consisting of the cash flow steam for the current REA note balance discounted to its net present value. As an example: an outstanding REA balance of $17.2 million discounted to an 8% rate results in a net present value of REA debt service of $13.1 million--obviously a savings of $4.1 million and a savings to the borrower of 24%. Certainly, savings of this magnitude cannot be ignored but neither can the reality of increasing interest rates on future loans and the cost of refinancing of the REA debt service, in this case, of $13.1 million. It is important to note, however, that the 8% discount rate used in this calculation approximates the current market rate for 30-year government securities. Under proposals considered by Congress, the actual discount rate used would be the government's cost for funds with comparable maturities to those notes being prepaid.

Mid year of 1992, CFC had the opportunity to express its views during hearings hosted by REA. CFC Loan Officer, Rich Bulman, stated that REA's current policies create economic disadvantages for its borrowers. Bulman said that CFC members would benefit if REA policies were more flexible and the agency's actions were more timely. He also said that "a review of approved requests for lien accommodation for distribution borrowers during the past three years shows the average request took six months to process at REA. Such delays only discourage our borrowers from exploring opportunities to improve their financial viability and, thus, our loan collateral. A further concern is the general view that REA staff discourages borrowers from considering requests to seek a lien accommodation. This direct discouragement, or the indirect discouragement, accompanying the average six month delay, may have caused borrowers to give up on formally applying for a lien accommodation."

Bulman also noted that lien accommodation policies regarding G&T's and distribution systems have not substantially changed in ten and twenty years, respectively, while the utility industry and financial markets have undergone major change. Bulman stated that current REA practice appears to base approval of lien accommodations on subjective criteria rather that a consistent application of specific standards. "The inability of private market capital sources to know what criteria will be applied and when the decision will be made has been a major impediment to attracting private capital. REA's current policies should be changed," said Mr. Bulman.

A survey of members shows that with a discount equal to the government's cost of money, 207 cooperatives would consider prepaying...