The first rating agency has weighed in on the Federal Housing Administration’s endorsement last month of loans that finance energy efficient home improvement.

The FHA’s endorsement comes with a catch: the liens of Property Assessed Clean Energy (PACE) loans must be subordinate to those of home mortgages. In the past, rating agencies have argued that PACE liens are essentially tax assessments, making them senior to the liens of mortgage holders.

The move could set the stage for the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, to take a similar stance. Currently, the FHFA does not allow either company to purchase mortgages with a PACE lien, although such liens have been imposed on properties already encumbered by a Fannie or Freddie mortgage.

DBRS has yet to rate a PACE securitization. But it held a teleconference last week to discuss how lien subordination could impact credit ratings for these deals.

The upshot: sponsors will have to increase credit enhancement to offset the potential increase in losses incurred during the foreclosure process.

To date, two private companies, Renovate America and Ygrene's Energy Fund, have securitized PACE loans in five publicly rated transactions. All of the deals have issued notes worth 97% of the value of the collateral; there is a 3% equity tranche in each transaction.

DBRS said that cash flow expectations would need to be tweaked to reflect the recovery of due and unpaid PACE installments in second priority behind a first lien mortgage. "The recovery levels, absent of abandonment or a catastrophic event, that would take a property out usefulness is pretty minimal; so there isn't a tremendous need for loss absorption within a structure," Chuck Weilamann, a managing director and head of U.S. ABS said during the call.

However PACE loans could experience a delay in payment until the property is sold. "It is more of a liquidity exercise and that does change when you look at subordinate PACE," said Weilamann.

Lain Gutierrez, senior vice president of ABS at DBRS, who also spoke on the call, said that the rating agency may assume a severity of loss close or equal to 100%, depending on the combined loan-to-value ratio of the portfolio, the nature of the appraisal used to determine value (ie. is it a desk top, walk through, or drive by appraisal) and how recently the property was appraised.

Consumer behavior, on the other hand, isn't expected to be impacted by the subordination of the pace lien in a foreclosure sale.

In fact, Gutierrez said, subordination of the PACE lien could result in a lower mortgage deficiency balance if the first-lien mortgage is underwater. This scenario, he said, “may actually benefit homeowners in certain states.”

Gutierrez also said that subordination of the PACE lien won’t accelerate installments in a foreclosure sale; the only thing paid out of sale proceeds would be due and unpaid installments. “Following a sale, the new homeowner continues making payments according to the original amortization schedule and does not make whole any unpaid installments prior to the purchase,” he said.

The subordination of PACE liens could remove the stigma of FHFA concerns and contribute to greater securitization flow. DBRS outline which states have PACE legislation enacted in the chart below.

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