Hedged PACE Mortgage-Backed Securities

An Opportunity for Lenders in Property Assessed Clean Energy Financing

Timothy McWhirter, Ph. D. Broward County Green Workforce Innovation Project

www.greenworkforce.wordpress.com 9/7/2010

9/7/2010 |www.greenworkforce.wordpress.com | Timothy McWhirter, Ph. D.

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Hedged PACE Mortgage-Backed Securities

Property Assessed Clean Energy (PACE) financing programs were described in the Harvard Business

Review as one of the top ten breakthrough ideas for 2010.1 These programs enable home and business

owners to finance energy efficiency retrofits and renewable energy installations through their

municipality at low interest rates and pay them back through their property taxes over periods as long

as 20 years. The responsibility for making the payments stays with the home if it is sold. These

programs essentially provide citizens the same kind of long term low-interest rate financing

municipalities have provided public utilities. They increase economic activity, energy efficiency, the use

of renewable energy technology, and the disposable income of homeowners; they reduce carbon

emissions and pollution. This is why 22 states have passed legislation over the past three years

supporting PACE programs.

Most PACE programs have however been put on hold recently because of concerns raised by Fannie

Mae, Freddie Mac and the Federal Housing Finance Agency (FHFA). This proposal outlines a way for

communities to work with financial institutions to address these concerns and implement PACE

financing programs in a responsible and financial secure manner.

Two Kinds of Risk

Risk Posed by Senior Lien Status

The primary source of the concern with PACE financing programs raised by Fannie Mae, Freddie Mac,

and FHFA is the senior status of the PACE lien which, in their view, represents a financial risk to the

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mortgage holder.2 Since PACE assessments are paid through property taxes, they like all other property

taxes are considered to be senior to the mortgage at foreclosure.

Because the PACE lien is senior to the mortgage, they increase the risk that if there is a foreclosure, the

mortgage holder may lose a small percentage of the home value. Since the size of the PACE investment

will be limited by the Savings to Investment ratio requirement (discussed below) and the PACE

assessment will not be accelerated at foreclosure, estimates place the average outstanding PACE

balance at foreclosure to be around $1000 or $2000 (or less than 1% of the home value).3

Reduced Risk of Foreclosure

PACE programs also have another impact on the risks associated with mortgages: when the White

House guidelines are followed, PACE programs decrease the risk of foreclosure. The first White House

guideline for homeowners is that the Savings to Investment ratio for projects should be greater than

one.4 That means that homeowners should save more on their energy bill than they will have to pay in

additional taxes for the project. This leaves homeowners more disposable income to cover their

mortgage. The risk of foreclosure is also decreased because of the added value the home has for the

homeowner.

One analysis done in 2009 found that homes that had achieved energy star standards of efficiency had

an 11% lower rate of foreclosure.5 The Sonoma County PACE program is the largest in the country. As

of July 22, the program included 1,010 homes and 22 commercial properties. Presently there have been

no notices of default in the program. There is a 7% general mortgage default rate in the county. The tax

delinquency rate is also 60% lower in the PACE program than it is throughout the county: 3.5% in the

county; 1.2% in the PACE program.6

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The Hedge Many have legitimately questioned the relative value of the risk posed by the senior lien status of PACE

assessments. For the sake of this argument, we can put this question aside. Regardless of its size, this

risk can be hedged. If a financial institution or investor owns both the mortgage and the PACE

assessment on the property the risk associated with the senior status of the PACE lien disappears—

because the same agent is in both the senior and junior position.

The idea of PACE financing was originally developed by Cisco DeVries. In an article on PACE financing

written in Bloomberg Law Reports, he writes, “If the delinquent assessments are secured by a senior

lien, a subordinate private lender may protect its lien by paying the delinquent assessment amount

(which will typically be a nominal amount compared to the outstanding balance of the private mortgage)

and adding the amount of any such protective advance to the amount of its loan.”7 This is how virtually

all cases in California that involve foreclosed properties and delinquent assessments are resolved,

according to an attorney who specializes in foreclosing delinquent special taxes and assessments on

behalf of local agencies in California: the lenders essentially pay for a small part of the assessment at

foreclosure and protect their private lien.8

This idea of private lenders protecting their subordinate liens by acquiring a part of an assessment can

be further developed. The lender could acquire the assessment before foreclosure. If securities were

created that included both the mortgage and the PACE assessment on the property and they were sold

on the secondary market, it would enable investors to hedge the risk associated with the senior status of

PACE liens and profit from the reduced risk of foreclosure.

Energy Efficiency Mortgages

In an August 31, 2010 bulletin, Freddie Mac agreed to take a similar approach on a limited basis.9 They

agreed to allow home and business owners that participated in PACE programs before July 6th to

refinance their mortgages and roll their PACE assessments into their mortgage. This allows the same

investor to own both the mortgage and the financing for the PACE assessment. It also moves the

assessment into the junior position as part of the mortgage. This form of refinancing enables investors

to avoid the risk of the senior lien of PACE assessments and to profit from the decreased risk of

foreclosure.

Freddie Mac sponsors an Energy Efficiency Mortgage program.10 This program allows homeowners to

use their mortgage to finance energy efficiency retrofits for their home that either have or will be made.

This financing is provided without any additional down payment and the existing debt-to-income

qualifying ratios are stretched to include the cost of the energy efficiency retrofit. These ratios are

stretched because the retrofits reduce utility costs and increase the owner’s ability to pay the mortgage.

Energy efficiency mortgages are also sponsored by HUD and FHA. They have been around since the

1970’s. They have only recently become popular. In the past, they required more paperwork than

standard mortgages and mortgage originators had no incentive to feature them; it was difficult to

document increases in efficiency; and fossil fuel was abundant. Things have changed. There were

improvements made recently that streamlined processing. There are now energy auditors that can

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document increases in efficiency. And there is now more attention being paid to energy costs and

environmental considerations.

Hedged PACE Mortgage-backed Securities

Energy efficiency mortgages provide a number of advantages; but there is a more secure way for

investors to hedge the financial risk associated with the senior lien status of PACE assessments. When

these assessments are rolled into mortgages, investors actually lose the most secure component of the

investment—the PACE assessment.

PACE assessments are more secure than mortgages for, at least, two reasons. First, as evidenced by the

information from Sonoma, tax default rates are much lower than mortgage default rates. So there is

less credit risk with PACE assessments. Second, mortgages can be paid off early and this creates a risk to

the profit of the mortgage holder. PACE programs can be setup so that payments cannot be accelerated

and this protects the profit of the assessment holder from repayment risk.

When PACE assessments are rolled into mortgages, the credit and repayment risk of the investment is

increased. It is in an investor’s interest to combine mortgages with PACE assessments in mortgage

securities that maintain the integrity of the assessment so that it is repaid through property taxes rather

than as a part of the mortgage.

Presently mortgage-backed securities group

mortgages according to different levels of

risk in order to enable investors to better

manage the risks of their investments.

Grouping PACE assessments with mortgages

would be a further development of this same

trend: investments are grouped strategically

to better manage risk.

There are some fundamental reasons to

combine PACE assessments with mortgages.

PACE assessments and mortgages

are both attached to the property and use it as collateral.

Both can be long term commitments: up to 20 years with PACE assessments.

PACE assessments affect the risks associated with mortgages.

Their risks can be managed more effectively by combining them.

In Practice Securities that include both the mortgage and the PACE assessment on the property – or Hedged PACE

Mortgage-Backed Securities – can be created when the lien is placed on the property for the PACE

assessment. A community can implement a PACE program that follows White House guidelines and

others agreed to by the financial institutions involved. The financial institutions can agree to create a

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market for hedged PACE mortgage-backed securities for mortgages and assessments from the

community’s PACE program. When homeowners and businesses decide to participate in the program,

administrators will create a hedged PACE mortgage-backed security from their mortgage and PACE

assessment and sell it on this market. These mortgages and assessments can be grouped together with

other mortgages and assessments in securities to enhance the value and choice for investors.

Right now mortgage companies sell mortgages on the secondary market, often at foreclosure or soon

after. Homeowners receive a notice in the mail. From their perspective, the sale does not affect their

mortgage in any way: e.g., interest rate or amortization period. The same will be true of the process of

creating and selling the hedged PACE mortgage-backed securities.

The community will agree to sell a municipal bond based on the proceeds of the PACE tax assessments

as a part of these securities. When the security is sold, homeowners and businesses will continue to

pay their tax assessments through their property taxes. These payments will then be passed on by the

program administrator to the owner of the security.

One way communities have financed the loan or assessment fund used in PACE programs is by selling

municipal bonds. The approach outlined here would be to slice these bonds up and sell each piece with

the mortgage to which it is attached on the secondary mortgage market. This market would therefore

provide the financing for a community’s PACE loan or assessment fund.

Secondary Mortgage Market Why would investors in the secondary mortgage market be interested in investing in Hedged PACE

Mortgage-Backed Securities?

A Secure Investment First, hedged PACE mortgage-backed securities remove the financial risk associated with the senior lien

status of PACE assessments. This risk is the only argument Fannie Mae, Freddie Mac, and FHFA have

used to block PACE programs. In its July 6th statement, FHFA writes “nothing in this Statement affects

the normal underwriting programs of the regulated entities or their dealings with PACE programs that

do not have a senior lien priority” (endnote 2). FHFA supports PACE programs that do not have a senior

lien that presents a financial risk to investors. Since hedged PACE mortgage-backed securities remove

the only argument, Fannie Mae, Freddie Mac, and FHFA have used to block PACE programs, these

agencies will not be in a position legally, politically, or logically to block PACE programs that are funded

using these securities.

Second, hedged PACE mortgage-backed securities will provide a more secure investment than energy

efficiency mortgages and standard mortgage securities. They will have less credit and repayment risk.

And like energy efficiency mortgages, they will reduce the risk of foreclosure on properties by increasing

their energy efficiency. This is a particular significant fact to take into account in the present economic

environment. Sales of existing homes fell 27% in July. The number of unsold homes is at an all time

high. Foreclosure rates have been extremely high over the past three years. The number of

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foreclosures went up 25% in August relative to last year. In this environment, investments that decrease

the risk of foreclosure for mortgages have an increased value.

Emerging Energy Financing Market

Hedged PACE mortgage-backed securities provide a secure way for a financial institution to position

itself to profit from the emerging energy efficiency and renewable energy financing market. The money

homeowners and businesses can save on energy costs represents a new source of profit for financial

institutions, at a time when these are in short supply. According to a recent study by Pike Research, by

2015 PACE financing for commercial buildings could reach $2.5 billion annually.11

When Freddie Mac released its bulletin stating it would enable those who participated in PACE programs

before July 6th to refinance their mortgage and roll their PACE assessment into the mortgage, the

Treasurer and Tax Collector in Sonoma County, Rodney Dole, was quoted as saying, “It almost looks like

a land-grab.” He suggests that Freddie Mac is now trying to profit from PACE programs by skimming “off

the top borrowers.”12

A financial institution that demonstrates it can accurately evaluate and manage the risks associated with

this innovative and extremely popular PACE financing method using this new security will take a

leadership position in this emerging energy financing market.

Conclusion Hedged PACE Mortgage-backed Securities provide a number of advantages over Energy Efficiency

Mortgages. First, they provide investors a more secure and profitable investment.

Second, they provide a way to use the process of securitization and the secondary mortgage market to

finance PACE programs across the country in a secure and responsible fashion. This will enable our

federal, state, and local governments to stop wasting millions of dollars both supporting and opposing

the same program at the same time — PACE financing.

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The U. S. Department of Energy allocated $150 million to get PACE programs going. FHFA’s most recent

statement on PACE programs has put them on hold; it claims these programs “do not have the

traditional community benefits associated with taxing initiatives” (see endnote 2). One problem with

FHFA’s statement is that communities around the country have the legal authority to determine what

the appropriate community benefits for their tax initiatives are. 22 states have passed legislation

authorizing the use of PACE programs over the past three years. Democratically elected representatives

have clearly decided that PACE programs provide “community benefits” that are appropriate for taxing

initiatives. Fannie Mae’s, Freddie Mac’s and FHFA’s opposition to PACE programs has violated the legal

authority of states and municipalities and consequently they are being sued by the state of California

and counties and municipalities across the country. There is also legislation under consideration in both

the Senate and the House of Representatives that is intended to force Fannie Mae and Freddie Mac to

support PACE programs.

Instead of the $150 million provided by the Department of Energy being used to implement PACE

programs, federal, state, and local tax dollars are now actually being spent to prepare for court cases.

This is occurring at a time when our country is trying to recover from one of the worst economic

collapses since the great depression and unemployment is at record levels. Hedged PACE mortgage-

back securities provide a unique opportunity for the government and federal agencies to work together

with financial institutions to implement PACE programs in a responsible and secure fashion across the

country and stop wasting time and tax dollars.

Notes 1 Jack Hidary, Harvard Business Review, January-February 2010, p. 52. 2 FHFA Statement on Certain Energy Retrofit Loan Programs, July 6, 2010: http://www.fhfa.gov/webfiles/15884/PACESTMT7610.pdf 3 This estimate is developed in this PACEnow memo: http://pacenow.org/documents/PACE%20Concerns%20and%20White%20House%20Solutions.pdf 4 http://www.whitehouse.gov/assets/documents/PACE_Principles.pdf 5 Johnathon Hiskes, “Energy Efficiency Helps Homeowners Avoid foreclosure,” Grist, July, 7, 2010:

http://www.grist.org/article/2010-07-12-home-energy-efficiency-cuts-mortgage-default-rates.-fannie-

fredd

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6 These statistics on the Sonoma program come from a presentation to the Senate Banking Committee by PACEnow 7/22/2010, http://pacenow.org/blog/. 7 Cisco DeVries, Bloomberg Law Reports, volume 3, edition 1, pg. 6: http://pacenow.org/documents/Bloomberg%20Law%20Article.pdf 8 Mark Zimring and Merrian Fuller, “Accelerating the Payment of PACE Assessments,” Clean Energy Financing Brief, Lawrence Berkeley National Laboratory, May 4, 2010, p. 2-3.: http://eetd.lbl.gov/ea/EMS/reports/ee-policybrief_050410.pdf 9 http://www.freddiemac.com/sell/guide/bulletins/pdf/bll1020.pdf 10 For information about Energy Efficiency Mortgages sponsored by Fannie Mae and Freddie Mac see: http://www.energystar.gov/index.cfm?c=bldrs_lenders_raters.energy_efficient_mortgage 11 “PACE Financing for Commercial Buildings Could Reach $2.5 Billion by 2015,” SustainableBusiness.com, June 23, 2010: http://www.sustainablebusiness.com/index.cfm/go/news.display/id/20553 12 Loralee Stevens, “Federal housing officials ease some existing energy loan rules,” Business Journal: Sonoma, Marin, and Napa Counties, September 13th, 2010, http://www.northbaybusinessjournal.com/24795/federal-housing-officials-ease-some-existing-energy-loan-rules/?tc=ar __________________________________

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