An extended recession could blow up a new type of bond that is eerily reminiscent of failed subprime mortgage-backed securities that led to the Great Recession of 2008. Like the subprime mortgages of that era, these new debt instruments are plagued by questionable underwriting practices and aggressive bond ratings. Unlike subprime mortgage securities, however, these bonds are entwined with county property tax assessments and collections in multiple states.
Property Assessed Clean Energy (PACE) loans are used by homeowners to help finance solar panels, roof replacements, new heating and air conditioning systems, replacement windows, and other energy-conserving improvements. PACE loans are repaid through additional property tax assessments. The extra property taxes are meant to be offset for homeowners by savings from lower energy bills, making the installations a no-brainer for many homeowners who pay nothing upfront and then expect to save money each year. Typically, state and local governments implement a PACE program and collect the property taxes as part of their efforts to reduce greenhouse gas emissions.
Financing companies—including Renew Financial, Renovate America, and Ygrene Energy Fund—package the energy loans into asset-backed securities (ABS) that are sold to institutional investors. These ABS deals typically include multiple bonds with different levels of seniority: junior bonds carry higher interest rates but absorb the first property tax delinquencies and defaults in the mortgage pool, hopefully protecting senior bondholders who receive more modest interest rates, although still generous by the paltry standards of today’s bond markets.
For example, Good Green 2020-1 Class A bonds, issued in August by Ygrene, pay annual interest of 2.63 percent—which is about 2 percent more than Treasury bonds with similar maturities. And the bonds are rated AAA so that institutional investors with very conservative investment policies, like insurance companies, can buy them.
On the surface, these deals seem to be a win for everyone: homeowners get improvements at no out-of-pocket costs, governments reduce fossil fuel consumption in the fight against climate change, and institutional investors can buy high-yielding bonds that also align with environmental, social, and governance (ESG) investment goals that are now common on Wall Street.
Unfortunately, there have been problems with PACE loans and these issues may get worse if the coronavirus pandemic and related economic shutdowns provide another hit to the U.S. economy this winter.
In some cases, homeowners who participated in PACE may not have properly understood the program when signing up and may have taken on long-term financial commitments that they’ll struggle to afford. Some contractors have been marketing PACE loans, in part, because they receive commissions when the loans close. And some improvement professionals may lack the incentive or financial knowledge to fully explain the risks and downsides of these loans — which include high borrowing costs and the risk of losing the home — to homeowners.
In Los Angeles, for example, the public interest law firm Bet Tzedek sued on behalf of two homeowners saddled with predatory PACE loans. According to the firm’s press release:
Violeta Senac … is 87 years old, cannot read English, and her only income is Social Security. Ms. Senac allegedly agreed to a $47,000 contract through Renovate America, and a second $30,700 contract through Renew Financial. Together, those contracts represent an annual repayment obligation of $8,200 for the next 20 years, which is 40 percent of her gross annual income.
The Los Angeles Times told the story of Reginald Nemore, a retired bus driver, who was trying to find an affordable way, on his limited disability income, to keep his home cooler in the summer to help his wife, who suffers from multiple sclerosis. Given his fixed income, poor credit, and high level of debt, Mr. Nemore would not qualify for a traditional home improvement loan, yet he was approved for a Renovate America PACE loan for solar panels that will ultimately cost him $71,778 over 25-years. This sum far outweighs any financial benefit he is receiving from solar power.
Data suggests many PACE loans are being taken on by homeowners in a low socio-economic class with limited incomes, and/or who are unable to communicate effectively in English. Thus, they are not dissimilar to some disadvantaged homeowners who took on cash-out refinancing mortgages in 2003-2007 and then lost their homes in 2008-2009.
The difference now is that county governments are placed in the awkward position of having to collect the taxes and potentially ejecting homeowners from their longtime residences if tax sales become necessary.
In response to pressure from Bet Tzedek and other advocates, the California state legislature increased its regulation of the PACE loan industry in 2017. The Department of Business Oversight was empowered to oversee the industry and mandated to issue an annual report on PACE activity. The department’s 2019 report, issued last month, contained some disturbing findings. Specifically:
- 64 percent of PACE loans closed in 2019 carried annual percentage rates (APRs) of between 8 percent and 12 percent
- A small number of loans, 0.3 percent of the total, carried APRs of over 12 percent
- The department received 157 complaints including allegations of unethical behavior or fraud
- 760 parcels were in default on their PACE property tax assessments
Earlier this year, Los Angeles County ended its PACE program, although some county residents can still borrow through state programs. In explaining its decision to cancel the program the county took note of the state reforms but said that it “cannot be certain these measures will provide sufficient protection for all consumers.” It also noted the uncertainty of new loan volume given the COVID-19 pandemic.
As the coronavirus pandemic and recession continues, we can expect more PACE borrowers to default. Undoubtedly, many homeowners have lost their jobs and some have contracted the virus. A winter resurgence of COVID-19 could hit junior PACE bonds and trigger financial losses on the more senior securities, which could call into question the wisdom of assigning these bonds AAA ratings.
Rating agencies suffered major reputational damage, lawsuits and government sanctions for their overly optimistic AAA ratings on subprime mortgage-backed securities. Perhaps for that reason, the big three agencies—Moody’s, S&P, and Fitch—have mostly (but not totally) avoided assigning credit ratings to these bonds. Instead, credit assessments are being handled by upstart rating agencies that have recently run afoul of the Securities and Exchange Commission (SEC).
A partial list of PACE securitizations and their ratings follows:
Property Assessed Clean Energy Loan Ratings
|Deal Name||Initial Deal Size ($M)||Financing Firm||DBRS Morningstar Senior Rating||KBRA Senior Rating||S&P Senior Rating|
|GOODG 2016-1||184||Ygrene Energy Fund||AAA||AA|
|GOODG 2017-1||176||Ygrene Energy Fund||AAA||AA|
|GOODG 2017-2||280||Ygrene Energy Fund||AAA||AA|
|GOODG 2018-1||340||Ygrene Energy Fund||AAA||AA+||AA|
|GOODG 2019-1||218||Ygrene Energy Fund||AAA||AA|
|GOODG 2019-2||315||Ygrene Energy Fund||AAA||AAA|
|GOODG 2020-1||318||Ygrene Energy Fund||AAA|
|HERO 2014-1||104||Renovate America||AAA|
|HERO 2014-2||129||Renovate America||AAA|
|HERO 2015-1||240||Renovate America||AAA|
|HERO 2015-2||160||Renovate America||AAA|
|HERO 2015-3||202||Renovate America||AAA||AAA|
|HERO 2016-1||218||Renovate America||AAA||AAA|
|HERO 2016-2||305||Renovate America||AAA||AAA|
|HERO 2016-3||377||Renovate America||AAA||AAA|
|HERO 2016-4||284||Renovate America||AAA||AAA|
|HERO 2017-1||232||Renovate America||AAA||AAA|
|HERO 2017-2||182||Renovate America||AAA||AAA|
|HERO 2017-3||254||Renovate America||AAA||AAA|
|HERO 2018-1||205||Renovate America||AAA||AAA|
|HERO 2018-2||54||Renovate America||AAA|
|HERO 2020-1||47||Renovate America||AAA|
|RENEW 2017-1||223||Renew Financial||AA||AA|
|RENEW 2017-2||174||Renew Financial||AA||AA|
|RENEW 2018-1||147||Renew Financial||AAA||AA|
Moody’s did not assign credit ratings to the bonds but has issued “Green Bond Assessments” for the RENEW bonds. Moody’s rated the bonds GB1 (excellent) because their proceeds were being “used for residential property improvements that result in energy savings, carbon dioxide emission reductions and water savings.”
This Green Bond Assessment would appear to fall short of a full ESG rating because the rating methodology does not take into account the adverse impacts the loans have had on the many low-income homeowners who have taken them on.
Retrofitting homes with energy-saving technology is undoubtedly a good investment in many cases. But a costly financing method that offers perverse incentives to home contractors, imposes administrative costs on local governments, and causes low-income and elderly homeowners to lose their homes seems like the wrong way to do so.
Update: On October 22, Moody’s ended its Green Bond Assessment service and withdrew all ratings including those assigned to RENEW 2018-1. Moody’s announced that it would instead rely on ESG assessments produced by an affiliated company, Vigeo Eiris (V.E.), in which it owns a majority stake.