PACE: Battle of the Bondholders

It’s been a busy couple of Tweetdays as discussion about the problems and opportunities of PACE continue.

It’s well known that PACE is having trouble as the Federal Housing Finance Agency (FHFA) announces its concerns about properly underwriting properties (PDF link) with PACE. In the earlier entry, I wrote about the standard justification used by PACE advocates to liken a PACE bond to other property-based special assessments such as water or seismic improvements. The FHFA response merely takes the non-standard nature of PACE transactions as a given:

”First liens established by PACE loans are unlike routine tax assessments and pose unusual and difficult risk management challenges for lenders, servicers, and mortgage security investors.”

Note the use of “PACE loans” and mention of “mortgage security investors” among those affected. FHFA’s point of view could not be more clear: it does not consider PACE transactions to be any different from a traditional property-backed loan and feels that the popularity of PACE transactions threatens the attractiveness of GSE-backed securities to investors.

In my earlier post, I mentioned a couple of reasons why FHFA would not consider PACE transactions to be like traditional special assessments:

1. Tax levying authority does not design or complete the work directly.

1a. Contractors who actually design and complete the work may or may not be sufficiently licensed or inspected.

2. The improvements are speculative and the anticipated savings may or may not coincide with the period of repayment.

3. A property’s “share” of a water treatment plant is not due upon sale or foreclosure. In a PACE-related foreclosure, that cost can be accelerated and be payable upon foreclosure.

4. If a water treatment plant does not generate sufficient funds to repay the bond directly from user fees, the municipality is typically responsible for the shortfall. PACE bonds have no such mechanism.

One item that I failed to expand upon is the nature of collateral. When a loan is made, the first and usually only source of repayment is the property itself. When a special assessment is made to improve the seismic resistance or water quality, the presumption is that without these improvements, the collateral will no longer be inhabitable; the collateral is effectively worthless.

When a PACE transaction is made, it has no effect on the habitability. Therefore, the improvements are not essential to maintaining the value of the collateral, and FHFA sees them as optional.

Reasonable people can disagree about FHFA’s position and can effectively argue that climate change or even mere efficiency improvements are essential to maintaining or improving the value of collateral. Because efficiency is not currently evaluated by lenders or regulators in single family home transactions, FHFA will continue to consider it largely irrelevant to establishing value. Furthermore, although society accrues benefits from additional employment, improved air quality, and reduced energy use, society does not directly (or indirectly) provide a method of repayment. Unless and until municipalities incorporate energy efficiency into their tax, zoning, or other regulatory structure or until they make PACE bonds payable as a general obligation bond (see below), it will not be supporting the repayment of PACE obligations.

Indeed, FHFA might even see the presence of a PACE obligation as a factor in reducing the value of a property. Lawrence Berkeley National Lab cites the one (!) sale of a PACE-improved home in Boulder as a cautionary tale (PDF link):

In the PACE program of Boulder County, Colorado, one home with a PACE lien has sold to date. This assessment included a PV system. In this instance, the lien was paid off by the seller as a condition of the sale. The original homeowner received the full benefit of the residential investment tax credit for the PV system, which was apparently a factor in the negotiation process. While one example is not representative of what will occur across a broader collection of PACE programs, it does indicate that program administrators should be cognizant of this issue as they conduct their outreach efforts.

In this case, the seller received a 30% investment tax credit (or grant) for the installation of a solar array. It is suggested, but unclear, that the homeowner pocketed the 30% credit while the PACE funded 100% of the total installation cost. As a result, the buyer asked for the seller to essentially retroactively apply the 30% received plus the outstanding amount of the PACE obligation to pay off the total obligation early.

After much delay, here’s the question presented by FHFA: why does lien priority matter to PACE bondholders?


Lien priority matters because it provides a measurable certainty of recovery. The higher the priority the greater likelihood that in a sales action (foreclosure or short sale, e.g.), the senior lienholder will be repaid first and in toto. Because certainty of repayment reduces risk, bondholders will accept lower returns in exchange for certainty of receiving those payments.

PACE bondholders, because they are financing a new and yet-unproven model with uncertain repayment prospects, require lien priority to keep rate manageable for borrowers. They should, but rarely receive, a credit enhancement from the sponsoring PACE issuer. In this case, a municipality that sponsors a PACE issuance might provide a ‘moral obligation’ clause to their bond documents suggesting that they will likely repay or provide assurance or repayment to bondholders, but it is rarely enough to provide truly ‘affordable’ interest rates to borrowers/homeowners.

FHFA has obligations to the bondholders of the GSEs; they also provide money with lower expectations of interest paid in exchange for lien priority. Because loans from the GSEs (Fannie and Freddie) are senior to all but property taxes, there is great comfort in the ability of the GSEs to recover their principal investment.

Regarding PACE obligations, FHFA in effect announces that you cannot have a functioning low-interest rate mortgage market if you have a functioning low-interest PACE market. One must be senior to the other, and FHFA claims its product should predominate.