In an effort to promote renewable energy sources and efficient energy consumption, more than 25 states have instituted Property Assessed Clean Energy (PACE) programs. Started in 2008, PACE programs authorize local governments to make loans to homeowners for energy related home-improvement projects such as the installation of solar panels or energy efficient windows. Local governments raise the capital needed for the loans by issuing bonds to private investors. Homeowners then repay the loans through assessments added to their property taxes. The loan attaches to the property such that if the home is sold before repayment is complete the subsequent purchaser of the home assumes the obligation to pay the remainder. The program benefits homeowners by defraying the high initial cost of energy projects. It also benefits private investors by using the property-tax system as the vehicle for repayment.
A previous DechertOnPoint1discussed the potential for securitization of PACE loans as well as some of the regulatory and industry related discourse. This DechertOnPoint dis-cusses recent regulatory actions which may affect PACE loans and some of the considera-tions that should be taken into account when financing or securitizing such loans.
Mortgage holders have raised concerns about provisions in many PACE programs which give liens securing PACE loans priority over mort-gages.2 The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) (collective-ly, the GSEs) oppose such first-lien provisions, arguing that they increase the risk of a mort-gage shortfall in the event of a foreclosure. The risk is higher, they argue, because the lender has to pay off any past-due payments on the lien before it can resell the property. Further-more, the property value itself may be dimi-nished to the extent that new purchasers, who may not value the installation, will decrease their bidding price to offset the remaining PACE loan.3
In response to such concerns, the Federal Housing Finance Agency (FHFA), as conservator of the GSEs, directed the GSEs to stop purchas-ing mortgage loans secured by properties with outstanding first-lien PACE obligations.4 Several groups brought suit in response to the FHFA's directive, alleging that the FHFA failed to use the notice and comment procedure as required by law. A California federal district court agreed, and issued a preliminary injunction against the FHFA until such time as the agency used the notice and comment process. In response, on January 19, 2012, the FHFA issued an Advance Notice of Proposed Rulemak-ing (ANPR),5 in which it sought comment on three alterna-tives: (1) maintain the current directive prohibiting the purchase of mortgages subject to first-lien PACE obliga-tions; (2) retract the directive and permit the GSEs to purchase mortgage loans subject to first-lien PACE obligations; or (3) adopt an alternative policy that permits the GSEs to purchase mortgage loans with first-lien PACE obligations while minimizing the risks to the GSEs.
The FHFA received over 33,000 comments in response to the ANPR. On June 15, 2012, after considering those comments, the FHFA issued a Notice of Proposed Rule-making (NPR), 6 in which it announced a proposed rule (the Proposed Rule) and sought comment. The Proposed Rule would direct the GSEs to: (1) cease purchasing any mortgage that is subject to a first-lien PACE obligation; and (2) refuse to consent to the imposition of a first-lien PACE obligation on any mortgage.
The NPR also sought comment on three alternative rules. In the first alternative rule, the GSEs would refuse to purchase any mortgage subject to a first-lien PACE obligation unless one of the following conditions is met: (1) repayment of the PACE obligation is irrevocably guaranteed by a qualified insurer, with the guarantee obligation triggered by any foreclosure or other similar default involving transfer of the collateral property; (2) a qualified insurer insures the GSEs against 100% of any net loss attributable to the PACE obligation in the event of a foreclosure or other similar default resolution involving transfer of the collateral property; or (3) the PACE program itself provides, via a sufficient reserve fund maintained for the benefit of holders of mortgage interests on properties subject to the senior obligation under the program, for substantially the same coverage described in (2).
In the second alternative rule, the FHFA would direct the GSEs to refuse to purchase any mortgage subject to a first-lien PACE obligation unless all five of the following underwriting conditions are met: (1) the PACE obligation is no greater than $25,000 or 10% of the fair market value of the underlying property, whichever is lower; (2) the current combined loan-to-value ratio (reflecting all obligations secured by the underlying property, including the putative PACE obligation, and based on a current qualified apprais-al) would be no greater than 65%; (3) the borrower's adequately documented back-end debt-to-income ratio (all monthly recurring debt, plus the service of the putative PACE obligation, divided by gross monthly income) is no greater than 35% using the calculation methodology provided in the Enterprises' guides; (4) the borrower's FICO credit score is not lower than 720; and (5) the PACE obligation is (or promptly upon its creation will be) recorded in the relevant jurisdiction's public land-title records.7
In the third alternative rule, the GSEs would adopt key provisions of H.R. 2599, the "PACE Assessment Protection Act of 2011," which was introduced in the House of Representatives on July 20, 2011.8 The rule would impose an array of requirements, among which are: (1) the homeowner is current on all taxes and mortgage payments and has not filed for bankruptcy in the previous seven years; (2) the PACE project has been subject to an audit or feasibility study; (3) the audit or feasibility study shows that energy or water savings from the PACE project will exceed its costs; (4) the total PACE assessment for a property does not exceed 10% of the estimated value of the property; and (5) the property owner has equity in the property of not less than 15% of the estimated value of the property.9
In the Proposed Rule as well as all three alternative rules, the FHFA would direct the GSEs to amend or interpret their form loan document (called a Uniform Security Instrument or USI) as is necessary to secure their right to accelerate any obligation secured by a mortgage that becomes subject, without the consent of the mortgage holder, to a first-lien PACE obligation.
The comment period for the NPR will remain open until July 30, 2012.
Issues Relating to the Securitization of PACE Loans
The FHFA's Proposed Rule, if adopted, could cause delays in new PACE loan origination as state legislatures amend statutory provisions which grant first-lien status for PACE loans. Furthermore, the loss of first-lien status could increase the risk profile of PACE loans, which may alter the market for PACE loan-backed securities.
The FHFA's second and third alternative rules impose stricter underwriting requirements and equity cushions. Such requirements could mean lower default rates and less principal outstanding when defaults do occur. However, heightened underwriting requirements could limit the number of qualifying loan recipients and thus reduce the size of the market for PACE loan securities.
The FHFA's third alternative rule would impose several new requirements upon local governments. Such requirements could cause delays in the issuance of new PACE loans as local governments develop procedures to comply with the Rule. For instance, developing methodologies to comply with the Rule's audit requirement could be time consum-ing and subject to administrative review. However, continuing pilot programs may provide significant insight into the viability and best practices of such audits.
The FHFA's proposed regulation is a challenging issue for the securitization of PACE loans. Until the FHFA settles on a final rule, the market for securitizing PACE loans will continue to be fluid.
1 May 2012 DechertOnPoint " Securitization of Renewable Energy Loans."
2 "Loan Giants Threaten Energy-Efficiency Programs," New York Times, June 30, 2010
3 FHFA, Enterprise Underwriting Standards, 12 CFR Part 1254, RIN 2590-AA53 at 36088.
4 The FHFA issued its directive on a prospective basis, directing the GSEs to waive its first-lien prohibitions for mortgages made previous to the directive's issuance. See FHFA, FHFA Statement on Certain Energy Retrofit Loan Programs, July 6, 2010.
5 FHFA, Mortgage Assets Affected by PACE Programs, 12 CFR Part 1254, RIN 2590-AA53.
6 FHFA, Enterprise Underwriting Standards, 12 CFR Part 1254, RIN 2590-AA53.
7 The GSEs are to treat a home-purchaser's prepayment of an existing first-lien PACE obligation as an element of the purchase price in determining loan amounts and applying underwriting criteria.
8 There has been no activity regarding the Bill since August 22, 2011, when it was referred to the Subcommittee on Insurance, Housing and Community Opportunity of the House Committee on Financial Services.
9 A full and more detailed listing of the requirements may be found on page 36108 of the NPR. See FHFA, Enterprise Un-derwriting Standards, 12 CFR Part 1254, RIN 2590-AA53 at 36108.
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