Once lauded by the Harvard Business Review as a “Breakthrough Idea of 2010,” the promise of an innovative financing method for residential renewable energy and energy conservation retrofits under Property Assessed Clean Energy (PACE) programs has been running into a seemingly insurmountable roadblock by the the Federal Housing Finance Agency (FHFA). Despite an August 9 Federal court ruling in California, that roadblock is unlikely to be removed. While the California ruling bucks the trend of courts dismissing legal challenges to the FHFA’s position, it may be only a momentary procedural victory for the plaintiffs as the agency forges ahead with adopting regulations that would continue to halt, or at best severely limit, PACE in its tracks.
In theory at least PACE seemed like a genuine breakthrough idea. State and local governments, with money primarily from bonds, would provide the financing for installing residential solar panels and energy and water efficiency upgrades. The property owner would be obligated to repay the costs through assessments added to their property taxes for a period up to 20 years. The arguments favoring PACE – among them creating local jobs, use of private capital and not taxes, saving money for building owners and increasing property values, voluntary, promoting energy security without driving up energy costs, avoiding the need to build costly new power plants and reducing air pollution — led twenty-eight states and the District of Columbia to authorize PACE programs.
But the very popularity of PACE ran headlong into the FHFA, which oversees the Federal National Mortgage Association (“Fannie”) and the Federal Home Loan Mortgage Corporation (“Freddie”), the two government-sponsored entities that guarantee the majority of home mortgages in the U.S. Just as PACE programs were gaining popularity, Fannie and Freddie were encountering existential threats following the collapse of the housing market. As the appointed conservator of Fannie and Freddie, FHFA was charged with minimizing future financial risk to the two entities. FHFA worried about PACE programs harming Fannie and Freddie because the liens to repay the financing of clean energy retrofits in most, but not all, cases take a first position priority over pre-existing first mortgages. Thus, in FHFA’s view, a mortgagee foreclosing on a property subject to a PACE lien must pay off any past-due and future PACE assessments and, therefore, is at risk for any diminution in property value caused by the outstanding lien or retrofit project.
In July 2010, FHFA issued a statement that PACE programs “present signficant safety and soundness concerns that must be addressed by Fannie, Freddie and the Federal Home Loan Banks.” Subsequently, Fannie and Freddie announced that they would not purchase mortgages issued after July 6, 2010, that were secured by properties encumbered by PACE liens.
Litigation ensued but challenges to the FHFA in the Eastern and Southern Districts of New York and in Florida were uniformly unsuccessful. Those courts relied on the statute that created the FHFA and bars courts from taking any action to restrain or affect the FHFA’s exercise of powers or functions as a conservator. The courts considered any action on FHFA’s PACE statements as improper interference.
This summer’s decision, however, by Northern District of California Judge Claudia Wilken in California ex rel. Harris v. Federal Housing Finance Agency ruled that the FHFA was not acting as a conservator, but instead as a regulator that had improperly exercised substantive regulatory oversight in stopping PACE programs. Judge Wilken ruled that the FHFA should have followed the proper administrative notice and comment procedure for rulemaking. Although the FHFA is appealing an earlier similar decision by the same court, and appeals are pending on the other courts’ rulings, FHFA has been taking comment on proposed rules (PDF) that would still bar most PACE liens, but offer some very narrow exceptions.
Proposed Rule & Exceptions
The FHFA Notice of Proposed Rule would direct Fannie and Freddie ”not to purchase any mortgage that is subject to a first-lien PACE obligation or that could become subject to first-lien PACE obligations without the consent of the mortgage holder.” The agency, however, is considering three alternative exceptions:
- Alternative 1: in the event of a foreclosure or similar default, repayment is irrevocably guaranteed by a qualified insurer or a qualified insurer that guarantees Fannie and Freddie against 100 percent of any net loss attributable to the PACE obligation, or the PACE program provides a sufficient reserve fund for mortgage holders that would cover 100 percent of the any net loss from a PACE obligation;
- Alternative 2: if the PACE obligation is less than or equal to $25,000 or 10 percent of fair market value, whichever is lower; the loan-to-value ratio is less than or equal to 65 percent; the debt-to-income ratio is less than or equal to 35 percent; the borrower’s credit score is greater than or equal to 720; and the PACE lien is recorded;
- Alternative 3: the underwriting standards in HR 2599 (PDF) are satisfied (i.e. total PACE assessments for the property not to exceed 10 percent of appraised value, homeowner equite at least 15 percent of appraisal without the PACE assessment or improvement, 20 year maximum term on assessment, all property taxes are current, no involuntary liens in excess of $1000, the property has not filed bankruptcy in the previous seven years, the mortgage debt is current, the property owner is the holder of record, title is not subject to any restrictions on the owner’s authority to subject the property to a PACE lien, the property meets geographic eligibility requirements, the improvement has been subject to an audit or feasibility study that includes the estimated potential cost savings, useful life, benefit-cost ratio and return on investment, and an estimate of the estimated overall difference in annual energy costs with or without the improvements).
The FHFA has expressed “reservations” about each of these alternatives. The guarantee/insurance alternative might not effectively insulate Fannie and Freddie from material financial risks if the insurance provider fails, “potentially leaving the [government-sponsored entities] to bear the the very risks they were to be insured against.” The agency is concerned about the second alternative’s reliance on a substantial equity cushion because “market conditons in which equity is substantially eroded (i.e. severe declines in home prices) would cause the risks associated with such liens and borne by [Fannie and Freddie] to become even more material.” Finally, the FHFA has reservations about the third alternative because, among other things, there is no methodology for computing the costs and savings and “assumptions as to applicable discount rates are significant and indeed can be determinative — especially since PACE-funded projects may be cash-flow negative for the first several years.”
A coalition of PACE supporters has been organizing to respond to the Notice of Proposed Rule, including drafting a joint comment letter that 1) diagrees with FHFA’s position that PACE poses significant safety and soundness concerns; 2) challenges the legal right of FHFA to determine how and under what circumstances state and local governments can make valid special assessments that meet public purposes; 3) recommends adopting a revised rule that allows Fannie and Freddie to purchase and consent to mortgages with PACE liens if an appropriately constructed Alternative 1 (insurance/loan loss reserve) or Alternative 3 (HR 2599 standards) is satsified; and 4) provide additional evidence to support PACE and the two alternatives.
The comment period on the rule was scheduled to expire on July 30, 2012, but has been extended to September 13, 2012. It’s not clear how long the agency will take to finalize the proposed rule, and there are likely to be legal challenges once it is finalized. But given the extensive analysis in the proposed rulemaking, the decisions of the lower courts shielding the FHFA from judicial review, and the high “arbitrary and capricious” standard for overturning an agency rulemaking, it will be an uphill battle to revive what was heralded as a breakthrough program.