In 2010, when Fannie Mae and Freddie Mac were ordered by their regulator, the Federal Housing Finance Agency, to stop buying mortgages on properties that are subject to assessments financing energy efficient upgrades, most of the Property Assessed Clean Energy (PACE) programs then in existence were suspended.
Except in California, where Sonoma County’s program and others remain open and where, despite objections from the GSEs to the senior lien that this financing creates, new programs continue to be launched. In 2013 alone, 50 additional local governments in the state voted to offer residential PACE financing.
California municipalities are at the forefront again: On March 15, the Western Riverside Council of Governments (WROCG) completed the first securitization of PACE bonds. The $104 million deal is secured by 5,898 assessments on 5,890 residential properties.
Deutsche Bank was the lead underwriter for the deal, HERO Funding Class A Notes, Series 2014-1 which was sold via a private placement. Kroll Bond Rating Agency assigned preliminary ratings of AA’ to the notes, which mature in 10 years and priced with a coupon of 4.75%.
While residential PACE origination has been slow, in part because of the threat of a legal challenge from the FHFA, participants are hopeful that this lending can now accelerate.
“It is a maturing market in terms of the volume of payment obligations that are there to be securitized in total,” said Daniel Passage, a securitization partner at Winston & Strawn.
Passage, who worked on WRCOG’s deal in his previous role as a partner in the structured finance group at Bingham McCutchen, said that, when he first started looking at the sector, in 2010, these assessments numbered only in the tens of millions of dollars. “Even now, residential and commercial PACE combined, we are still only talking about some hundreds of millions in assessments,” he said.
Nevertheless, a number of investment funds have been buying up PACE bonds to hold pending securitization, and some have used bank lines of credit to defray some of their acquisition costs. “This securitization shows there is a market for this asset, and so should lead to more warehouse lenders willingly making lines available to buyers who want to accumulate the asset,” Passage said.
Chuck Weilamann, a senior vice president at DBRS, agrees. He notes that there are other areas in California that might be able to take advantage of securitization funding, such that the increase in issuance could be pretty dramatic. “And that is only California, there are another 30 states that have PACE legislation in place, with many operating and originating,” the ratings analyst said.
Florida’s statewide PACE program, for example, has the ability to finance up to $2 billion in loans.
DBRS did not rate WRCOG’s securitization, but it has followed the asset class for several years.
WRCOG’s HERO program was launched in 2012. Currently all of its members are in Riverside County, but the council plans to expand into additional jurisdictions throughout California and Florida.
The council’s residential PACE loan program is administered and funded by Renovate America, a San Diego based company founded in 2008. Renovate America is directly responsible for developing and marketing the program and originating each assessment. The minimum project size is $5,000 and projects could be financed for up to 25 years.
To date no major credit rating agency has published a methodology for rating PACE bonds.
In its presale report on HERO 2014-1, KBRA said that it applied its general rating methodology for asset-backed securities. It classifies PACE assessments within the category of “financial assets,” and considers the key rating considerations to be the structural of the transaction, the treatment of PACE assessments as senior tax liens, and the creditworthiness Riverside County.
Brian Ford, associate director at KBRA, said that the biggest challenge in rating the asset class is the lack of historical data on default rates for PACE assessments. Instead, KBRA used historical delinquency data on property taxes from Riverside County over the last nine years as a proxy. The rating agency views this “an acceptable proxy, since PACE assessments are equal in priority to other real estate taxes,” he said.
The advance rate, or the size of the loan in relation to the value of collateral, is fairly high, at 97%. By comparison, SolarCity’s $54 million securitization of solar panel leases, completed in November 2013 and rated by BBB+’ by Standard & Poor’s, had an advance rate of 62%.
According to Passage, this higher advance rate for the PACE deal is justified because there is more “delay risk” than “loss risk,” for these loans. “This asset is unique in terms of lien position and the types of risks to timing and recovery on the relevant payment streams,” he said.
Passage added, “it would be wrong to analyze PACE bonds and PACE assessments the same way you would analyze residential or commercial solar lease and power purchase agreement receivables on the identical projects,” which he said are comparable to consumer receivables such as auto leases or home equity loans of the same size or term. Instead, PACE assessements are comparable to other special assessment charges.
Weilamann is not so sure that the higher advance rate is justified, however. That’s because there are limitations to using municipal tax collection data as guage of default risk. While this data may depict defaults on tax assessment due on a particular date, there may be no indication of how or when those defaults were ultimately collected.
“Incorporating this understanding into PACE analysis can be an important supplement to the historical tax collection data and reduce basis risk,” DBRS stated in a recent report on the asset class. “This can be particularly important where expectations include significant levels of recovery and low ultimate losses with commensurate high advance rates on securities primarily at risk to liquidity stresses.”
Another concern somewhat unique to PACE assessments, according to DBRS, is counterparty risk. In certain cases the municipality may have set up a PACE program where the cash flows are not specifically identifiable such that they would be able to be clearly segregated from the general collections of the county, Weilamann said.
“In those cases there may be the risk that you will not be able to obtain the legal comfort that these cash flows would be indeed segregated in the event of the bankruptcy of the municipality,” he said.
This could result in a temporary delay in access to PACE payments, the permanent loss of such cash flows before redirection of PACE away from the municipality bankruptcy estate, or even permanent loss of the PACE obligation cash flows if they are not redirected following a bankruptcy of the municipality and instead are used for satisfaction of general debts of the municipality.
The FHFA’s opposition to PACE assessments is also a ratings consideration, since there is a risk that the regulator could challenge the validity of a PACE lien against a mortgagee’s security interest in federal court. “If the FHFA wants to read it as violating no prior encumbrances or no prior liens that could call the home owner into default,” said Weilamann.
In its presale report, KBRA said it had to ensure that the deal was structured such that it could withstand the stress of a successful challenge by the FHFA.
However Ford believes that the risk of a legal challenge is “relatively remote.” WRCOG obtained a final, non-appealable judicial order from the Riverside County Superior Court affirming the validity, enforceability and seniority of the PACE liens. The PACE liens therefore rank more senior than mortgages, giving them a greater right to foreclosure.
Investors may also take comfort from the fact that California created a $10 million reserve fund in March to pay off Fannie and Freddie Mac loans in the event of a PACE loan default. The program will be administered by the California Alternative Energy and Advanced Transportation Financing Authority.