A battle is brewing over the best way to finance the retrofitting of homes to make them more energy efficient.
The outcome could make or break the fledgling industry of administrators for Property Assessed Clean Energy programs, which are funded by local governments and repaid via annual assessments on owners' property tax bills.
It has particular relevance in California, home to some of the nation's most expensive housing markets. Since 2010 dozens of counties and municipalities in the Inland Empire, an area of five million residents stretching from Riverside to San Bernardino, have made hundreds of millions of dollars of energy efficiency loans. The municipal bonds that finance this lending are themselves bundled into collateral for asset-backed securities, providing Wall Street with a relatively high-yielding investment product that can be marketed as "environmentally friendly."
Last week, the Federal Housing Administration, part of the Department of Housing and Urban Development, said it would insure mortgages on homes encumbered by Property Assessed Clean Energy liens. Department of Veterans Affairs followed suit. The July 19 announcements were part of a broader initiative by the Obama administration to increase access to solar energy and promote energy efficiency, particularly in low- and moderate-income communities.
The FHA's endorsement of PACE upset mortgage lenders, who have long objected to this form of financing. Since both types of lenders have claims on the same collateral, the borrower's home, a PACE lien could potentially reduce a mortgagee's recovery in a foreclosure. Moreover, a tax assessment is generally considered to be a type of "super lien" that takes priority over all current and future encumbrances.
Creating a "Super Lien"
Lien priority is an issue for the FHA, too, since taxpayers are on the hook for losses on loans that it insures. The new lending guidance tries to sidestep the issue, casting PACE liens structured as tax assessments as subordinate to a mortgage. But it also acknowledges that any assessments that are past due represent senior claims. Importantly, the FHA also said that a PACE lien can "travel" with the house, that is, it can be assumed by a buyer.
This does not satisfy the Mortgage Bankers Association, which has issued a bulletin urging members to "proceed very cautiously" and to carefully review the consumer and lender risks before participating in the program.
The trade group warned that the FHA's new guidance raises "critical" questions about the lack of consumer protections, poses risk to the agency's insurance fund and creates "significant compliance and indemnification risks for lenders and servicers."
It advised members to evaluate other ways of financing efficiency improvements that better protect consumers and lower costs.
The availability of FHA financing could spur additional states to adopt or implement residential PACE programs, which are currently available only in California and Florida. They will soon be available in Missouri and Colorado as well.
Stacey Lawson, president and chief executive of Ygrene Energy Fund, said the number of government agencies involved in the Obama administration's green energy initiative "provides a really strong body of support that local elected officials and state legislatures can point to" when rolling out such programs.
Without buy-in from the primary trade group for mortgage lenders and investors, however, this financing may not be easy to obtain.
"It's lenders and servicers, and particularly the secondary market, that in the end will dictate the success or failure" of FHA funding for properties with PACE liens, said Richard Andreano, a partner in the law firm Ballard Spahr's mortgage banking group.
"It's a classic government move, addressing one side of an equation and forgetting the other side. When you do that, you don't always get the result you want. That's why [the government-sponsored enterprises] had to revise HAMP and HARP," he said, referring to two federal programs designed to help struggling homeowners, the Home Affordable Modification Program and Home Affordable Refinance Program.
In endorsing PACE, the FHA has also put itself in opposition to the Federal Housing Finance Agency, which regulates Fannie Mae, Freddie Mac and the Federal Home Loan banks. FHFA Director Mel Watt released a statement last week saying that the agency "fully supports energy retrofit programs" but "continues to have serious concerns" with how PACE programs are financed and will continue to bar Fannie and Freddie from acquiring mortgages on a property with a PACE lien.
To be sure, lien priority is not the only beef that the FHFA, or lenders and investors, have with PACE.
In testimony before California's legislature last month, Alfred M. Pollard, the FHFA's general counsel, took issue with the fact that these programs look principally to the value of property to support a loan, rather than the ability of a homeowner to repay, a concept regulators have endorsed to prevent the kind of lending that contributed to the financial crisis.
Pollard also pointed out that PACE programs charge high fees, as much as 10% of the loan, and offer narrow consumer protections.
The FHFA's general counsel suggested that the regulator could take further action, noting that Fannie and Freddie "have additional authorities to protect their first-lien status."
Solution to a "Market Failure"
PACE administrators say the financing was created to solve what they describe as a market failure.
"Every year, about one in six American homeowners replaces a product or system in their home that affects the level of energy consumption," J.P. McNeill, chief executive of Renovate America, said in a statement welcoming the FHA's new guidance. "Three-quarters of the time, they select a less efficient option based on upfront sticker price, instead of factoring in the total cost of owning and maintaining the product or system over the course of its useful life."
Homeowners may also have a disincentive to pay up for a more energy efficient option if they are unsure how long they will remain in the home. McNeill said that PACE law encourages them to make a long-term investment because the remaining balance can be transferred with the property to a new owner.
There are a number of other ways to finance energy efficient retrofits that carry lower interest rates and lower fees. The FHA itself has launched an initiative with the Department of Energy that allows borrowers to obtain larger loans, roughly 2% more than the loan amount, to finance energy improvements. Fannie and Freddie also offer a number of products that allow homeowners to finance energy retrofits, including mortgages with high loan-to-income ratios and second-lien mortgages, some of which can be used to pay off PACE liens. But none of these products allow the lien to stay with the property when it is sold.
Ygrene's Lawson cited two other reasons that homeowners choose PACE over other financing options: the lien is not considered to be personal debt, and so does not impact borrower's debt-to-income ratios; it can also be underwritten very quickly, compared with add-ons to mortgages.
"The approval process is much speedier than it is for obtaining a second-lien mortgage," she said. "You can get a PACE loan approved in 15 minutes online." By comparison, underwriting a home equity line of credit can take months.
PACE liens are also problematic because they can make properties more difficult to sell or refinance, since buyers cannot get conventional loans from Fannie or Freddie. The moves by the FHA and VA give prospective homebuyers additional options for financing the purchase of a home with an existing PACE lien, assuming that lenders embrace them. Still, some buyers may not want to assume the lien, even if they can get financing. That means that, in practice, a homeowner could be forced to pay off the PACE lien before selling.
Lawson acknowledged that some lenders request that property owners prepay the PACE lien upon sale of the home. She said Ygrene discloses this fact to borrowers when it makes PACE loans, though it does not believe that the lack of financing options limits the universe of homebuyers. That's because the improvements financed by PACE improve the value of a home and lower its utility bills.
Valuation Impact Disputed
The cost effectiveness of home energy improvements is a matter of debate, however.
Research published by Laurie Goodman and Jun Zhu in the Journal of Finance in December indicates that energy-efficient improvements financed by Renovate America in California increase the value of the property by more than the PACE assessment – between $199 and $8,882 more, depending on which methodology the researchers used. "Homeowners can more than fully recover their full costs at resale, whereas most other home improvements can recover only about 60%," Goodman said in Urban Institute bulletin describing her research.
However, she conceded that the study had few data points on the sale price of homes that went into foreclosure with PACE improvements, which would speak more directly to the risk to the FHA's insurance fund.
Preliminary results from research being conducted by the California Association of Realtors is more equivocal. Alex Creel, the association's chief lobbyist, said that energy efficient retrofits appear to make more sense for homeowners with high-end homes than those with moderately priced homes.
"While solar panels can be a market differentiator at the high end of the market and draw a luxury premium, they can negatively impact the resale value and the salability of a moderately priced home," he said.