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Fannie/Freddie VS. PACE

PACE (Property Assessed Clean Energy) financing has run into some trouble over the last few weeks.  Fannie Mae and Freddie Mac (big players in the whole mortgage meltdown mess) have decided that they don't necessarily want to help out clean energy and have thrown up a huge road block to PACE financing without offering any potential solutions.  In our earlier post on PACE financing I gave a brief overview on how PACE works saying:

In times like these, many people don’t have the cash laying around to cover that initial costs; even if these projects do pay off in the long run.  Luckily many states are adopting a a form of financing called PACE to remove the burden of residents having to come up with the cash for their clean energy projects.

PACE stands for Property Assessed Clean Energy.  In its simplest it works like this:

• Your local government puts down the cash to pay for your retrofit (clean energy)
• You pay back the initial cost through your property tax (property assessed)
• Everyone wins (except your local utility, who wont be selling you as much energy.  Boo Hoo.)

I've had a little trouble understanding why Fannie Mae and Freddie Mac have put up an opposition to PACE so I was lucky to find this great article on Grist titled, "Fannie and Freddie to Clean Program: Drop Dead". The article is an excellent summary of the dilemma (it all comes down to who gets their money first if a homeowner defaults on a home loan).  But the best analysis I found was from a Grist reader "rjmart01" who posted a comment on the article attempting to explain why Fannie Mae and Freddie Mac have an issue with PACE financing.  I would visit the Grist article to read all the replies to rjmart01's comment, because it is a nice discussion.  His comment which was posted on Grist is presented below:

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"I used to work for Freddie (many, many moons ago), so let me see if I can explain this.

Let's say you buy a home and get a mortgage to help pay for it. The mortgage company or bank sells your mortgage to Freddie or Fannie. They, in turn, package your loan with a lot of other loans and use the package to back securities (bonds) which they sell to investors. (If that's confusing, I'm sorry. It's as stripped down and simple as I can make it.)

The reason Freddie and Fannie insist on underwriting standards is that they guarantee payment of interest and principle to the investors who buy their securities. If enough people default on their mortgages, Freddie or Fannie have to make up the difference. That means they eat the loss.

The reason they can make their guarantees (and, I would point out, at very low rates) is that they set underwriting standards. Back when I worked for Freddie, the standards were pretty reasonable and default rates were quite low. Then Congress got into the act, wanted them to refuse fewer mortgages, standards were relaxed and the financial sector went into the toilet. (NB -- Freddie and Fannie were only minor contributors to the financial crash. But contributors, at some level, they were.)

"Think of it this way. I'm Freddie. I buy your loan, sell it (in pieces) to some investor, and guarantee the investor gets paid. I can do this because I know you've got some equity in your house (which you've put up as collateral for the mortgage), and I know you've got a reasonable income and not too much other debt. Also, I know that if push comes to shove and you have to sell your house, my lien (the mortgage lien) is in first position. I get first dibs on whatever monies come out of the sale.

Anyways, that's how it's supposed to work. With so many mortgages underwater (money owed is more than the house would sell for), however, Freddie and Fannie are already looking at more risk than they priced into their rates. They're going to take big losses, already.

So the PACE idea comes along. In a PACE situation, the local government fronts money for "green" improvements. The homeowner invests the money in the improvements, saves on his/her monthly energy bills, uses the savings to repay the local government. Of course, the government -- to be sure it's going to get its money back -- wants a lien against the (improved) house. But, like Freddie and Fannie, the government wants to be in first position -- if there's a foreclosure sale and not enough money to go around (typical of foreclosures), the government wants to be absolutely certain of getting paid one hundred cents on the dollar.

Which means that Freddie or Fannie (as appropriate) have to agree to subordinate their lien to the new (PACE) lien. And why would they want to do that?

In an ideal world, the investments made in making the house more energy-efficient would raise the market value of the house one dollar for every dollar invested. In reality, it doesn't work that way. They market value of the house may go up, but not one-for-one. Here's a simple example:

House was bought for $100K, with a mortgage of $80K.

House (in a down market) is now worth $85K. Mortgage is still effectively $80K. In a foreclosure, sale of the house (after expenses) might net $60K. (Foreclosure is an expensive process.) Freddie or Fannie would have to eat the other $20K. That doesn't make them happy.

Now, homeowner wants to participate in PACE. Invests $15K in efficiency improvements. Improvements raise the value of the house by $10K. Local government now gets a lien of $15K, in first position. (Freddie/Fannie lien slips to second position.)

Now, if there's a foreclosure, the house might net $70K (the original $60K, plus $10K for the improvements). But now, before Freddie or Fannie get a dime, the local government takes back its $15K. So now, all that's left for F/F is $55K (down from $60K). Now they eat $25K in losses. That makes them even less happy.

Remember all those papers you signed at the closing table? One of them was a contract between you and the bank/mortgage co. that guaranteed your mortgage lien would be in first position. You agreed to that when you signed it. Freddie or Fannie bought that contract, with all the guarantees it contained, when they bought your loan. They own first spot on the lien list, because they paid good money for it. If they agree to subordinate their lien, they'll lose money (maybe not on each individual house, but overall for sure).

Why would they agree to do that? Given that Federal dollars will need to bail both Freddie and Fannie anyways, why would you want them to do that?

In today's (down) market, PACE is not a revenue-neutral sustainability financing mechanism. Rather, it's a government subsidy for certain products, certain technologies, certain consumers. If what you want to do is subsidize energy efficiency with Federal dollars (and that's not a bad idea at all), there are simpler, cheaper ways to do it."

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I would like to end this post with what I think the most important part of the story is, coming from the author of the Grist article, Jonathan Hiskes:

Here's the most surprising part of FHFA's (Federal Housing Finance Agency) letter:

"First liens established by PACE loans are unlike routine tax assessments and pose unusual and difficult risk management challenges for lenders, servicers, and mortgage securities investors. The size and duration of PACE loans exceed typical local tax programs and do not have the traditional community benefits associated with taxing initiatives. [emphasis mine]"

The agency is arguing that reducing greenhouse-gas emissions, saving homeowners money on utility bills, and creating local jobs working on homes are not "traditional community benefits." It's making another argument too: That it should get to decide what projects have local-community benefits.

And this seems to be the main issue: Fannie Mae and Freddie Mac seem to have some "beef" with clean energy.  Why else would they say clean energy doesn't provide "traditional community benefits"?   Let's hope that some of the big players in the whole mortgage crisis decide to get their act straight and be big leaders in accepting the clean energy revolution.