Securitizations are becoming a more common technique to raise low-cost debt for energy projects.
To understand securitization structures, take Macy’s department store as an example. Macy’s issues its own private-label credit cards. Customers use the cards to buy items on credit and pay for them over time.
Macy’s can convert the future customer payment streams into current cash. It does so by selling the customer receivables to a bankruptcy-remote special-purpose entity, and that entity issues bonds backed by the receivables.
Macy’s makes a true sale of the receivables to the bankruptcy-remote entity so that a Macy’s bankruptcy would not prevent the entity continuing to receive the customer payments. The lawyers give a non-consolidation opinion confirming that the special-purpose entity would not be consolidated with Macy’s in a Macy’s bankruptcy.
Macy’s gets cash today. It sells the payment stream to the special-purpose entity, and the bond proceeds come back through that entity to Macy’s. The bonds issued by the special-purpose entity are issued at a much lower interest rate than if Macy’s were to issue debt directly, because the special-purpose entity has been insulated from Macy’s bankruptcy risk and it has an independent director and other required language in its LLC agreement or charter to make it bankruptcy remote.
Historically, securitization has not been an option in the project finance market because, in most project finance deals, you have a single borrower. There is not the diversification of customer risk that you have in more traditional securitization transactions where there may be thousands of customers as in the case of a residential mortgage loan securitization. Nevertheless, people have become more comfortable over the last five to eight years with such securitizations.
Several project finance bond infrastructure securitizations in Latin America are in process now involving government payment receivables.
An investment-grade company has a lot of different financing options. For a sub-investment-grade or non-investment-grade company like Macy’s or a special-purpose entity that owns a single project, it is a way to access the capital markets and borrow at a much lower interest rate than if the company issued the debt directly. The debt will be rated. The interest rate will be the same rate that would be charged to an investment-grade borrower.
A subset of securitizations involves PACE bonds.
PACE stands for Property Assessed Clean Energy. Municipalities borrow and make loans to local residents and businesses to install solar systems and make other energy efficiency improvements. The local homeowners and businesses repay the amounts borrowed through additional property tax payments over time.
PACE has been around since 2012, and PACE bonds have been securitized since around 2014. The first PACE program was in Berkeley, California. Such programs relied initially on a 1918 highway improvements statute in California and then moved to reliance on another law called the Mello-Roos statute.
The bonds issued by the municipality are secured by a lien over the house or building on which the improvements are made. The lien is a first-priority lien in almost all states, so it comes ahead of all other creditor claims to the property other than other property taxes.
The additional assessment is a separate line item on the property tax bill.
The PACE assessment travels with the house or building. Thus, if the house or building is sold, the new owner must continue making the additional property tax payments.
If there is a default on the additional property tax payment, only the defaulted installment of the PACE assessment gets accelerated. Thus, the trustee for bondholders holding the securitized paper cannot accelerate the full remaining payment obligation of a defaulting customer.
PACE borrowings are set up through a master bond indenture where a municipality — typically a county or joint powers authority — issues nonrecourse bonds secured by the assessments. A trustee acts on behalf of the bondholders. The trustee has a right to cause the municipality to initiate a foreclosure against a particular house or business.
The municipality enters into a contract with a program administrator to handle almost everything associated with the PACE program. The program administrator helps the municipality set up the program. In California, this is done through a court proceeding in which local residents and mortgage lenders and other interested parties are given a chance to object and the court eventually issues an order authorizing the program.
The program administrator vets potential candidates for loans to make efficiency improvements. It gets the customers signed up. It does the underwriting, approves the contractors who put in solar panels or other improvements, and makes sure the additional property tax assessment and lien are filed in the real estate records.
The program administrator gets a fee for running the program and usually gets first claim on buying the underlying PACE bonds that are issued. The program administrator aggregates the bonds in a warehouse facility and then securitizes them by issuing a wrap bond against all the paper.
Residential v. commercial
There are both residential and commercial PACE programs. The residential PACE market is much more active, but in residential PACE, the program administrator does not usually try to get consent from any existing holder of a mortgage on the property. In commercial PACE, by statute or just by practice, the program administrators always get the consent from any first-mortgage lender for the property tax assessment to take priority.
The typical PACE assessment on a residential property is about $18,000, and it is considered too small to bother with lining up consents from mortgage lenders. On the commercial side, the assessments typically start at $1 million and can be multi-million dollar assessments. Even where mortgage lender consent is not required by statute, the litigation risk and the dollars involved are too big not to get consent.
There is an 800-pound gorilla in the room on the residential side, which is the Federal Housing Finance Agency, which is the overseer of Fannie Mae and Freddie Mac. Fannie and Freddie have objected since the outset of residential PACE to any first lien for PACE lenders, and they have told their correspondent lenders over the years not to buy any mortgage loans on properties that have residential PACE assessments on them.
We understand anecdotally that not all correspondent lenders follow that guidance, so some do buy mortgage loans with PACE assessments on the properties.
The FHFA takes the position that a PACE assessment coming after the fact changes the bargain for the mortgage lender. The PACE assessment takes priority over the mortgage lien. The FHFA historically has also questioned whether solar systems and other energy efficiency improvements actually improve the value of the property and to what extent they reduce energy costs over time.
The FHFA has also heard from real estate brokers in California that PACE liens place a cloud on the title of the property when the homeowner goes to sell his or her house. It says the homeowner will need to pay off the remaining property tax assessment or else he or she will be paid less for the house.
The FHFA has litigated issues like condo association liens in Nevada, but it has never litigated the issue whether a PACE assessment trumps the mortgage lender’s lien. Thus, to date, the first lien for the PACE lender has always been respected.
One of the issues that is covered by the court order when a PACE program is first established in California is the constitutionality of the arrangement: whether there is an impermissible taking of a property right belonging to the mortgage holder. The court order blesses the indenture, the program administration agreement, and the form of assessment contract between the homeowner and the county and the program administrator. The FHFA has not challenged these court orders.
For the last four years, California has been the market leader for residential PACE programs. Florida is also a significant market, but PACE was slower to get traction there after the mortgage bankers association litigated over the first-lien issue. Missouri has seen some activity on the residential side.
Connecticut is the leading state for commercial PACE programs. The Connecticut Green Bank made an effort to educate both developers and local first-mortgage lenders about the benefits of PACE and how it can improve the value of commercial buildings.
Commercial PACE activity has also been picking up in places like California and Texas. Commercial PACE has been slower to take hold because commercial developers tend to have other financing options and their first-mortgage lenders, who hold the liens on the commercial buildings, must be convinced to consent to a lien to secure the PACE assessment.
Many first-mortgage lenders do not want to hire lawyers to review consents, so it can be a slow process to line up consents. However, the market is gaining momentum. DBRS did the first 144A publicly rated C-PACE transaction in August 2018. Twain Financial Partners did a section 4(a)(2) private placement a few weeks before that was not publicly rated. At the end of 2017, Green Works Lending did a section 4(a)(2) private placement of C-PACE bonds that was also not publicly rated.
The three C-PACE securitizations done so far have each raised between $75 and $105 million. Contrast that to PACE offerings in the residential sector, which have amounted to about $4 billion since 2014. All of the residential deals involved publicly rated debt issued under Rule 144A.
California at the end of last year enacted some consumer-focused statutes. PACE originators took the position in the past that PACE loans are not consumer loans and do not have to comply with consumer lending laws. That changed last year when California enacted two bills focused on building up the federal and state consumer protections, and then President Trump earlier this year signed into law a bill that directs the federal Consumer Financial Protection Bureau to focus on consumer protections in residential PACE programs, thus subjecting PACE originators of residential loans for the first time to federal regulation.
Ironically, when Obama appointee Richard Cordray was head of the CFPB, he took the position that consumer PACE was something the states could deal with without the need for federal intervention. Originators now have an obligation to determine whether consumer PACE borrowers have the ability to repay the assessment. Consumers have a right of rescission. A lot more disclosure is required to consumers. Residential PACE originations in California are down significantly this year.
Senior tranches of PACE bond securitizations are often rated AAA.
It is generally not worth the transaction costs to do a C-PACE securitization until the bond amount is at least $75 million. Deals on the residential side tend to be in the $300 million range.