Keeping PACE: federal mortgage lenders halt local clean energy programs.

• Author: Larson, Ian M.
• Position: Property assessed clean energy

1. INTRODUCTION

   Due to rapid technological improvements and growing concerns over global warming and per capita energy consumption, low-energy appliances and environmental retrofits (1) have become increasingly available to homeowners in the past few years. (2) During this period, there has been a concomitant rise in the number of programs available for financing such improvements. (3) In the burgeoning market for clean energy, no program has proved as dynamic (4) or controversial (5) as property assessed clean energy (PACE) financing. PACE, a local government initiative now established in twenty-two states, expands upon traditional land-secured finance authority for the purpose of improving household and commercial energy efficiency. (6) PACE programs provide bond-financed funding to qualifying property owners for the purpose of financing energy improvements. (7) Under such a program, the cost of qualified energy improvements is added as an assessment tax to the owner's yearly property tax bill, with the obligation to pay being secured by a lien on the encumbered property. (8)

   The controversy surrounding PACE programs stems from the nature of local assessment law and the doctrine of "tax lien seniority"; because the PACE program administers funds to homeowners via assessments against their property, rather than as loans to the homeowners, municipalities are entitled to senior status in the case of default. (9) This controversy culminated in July 2010, when federal mortgage lenders, the Federal National Mortgage Association (Fannie Mae), (10) and the Federal Home Loan Mortgage Corporation (Freddie Mac), (11) acting under the supervision of their regulatory agency, the Federal Housing Finance Authority (FHFA), (12) refused to purchase any mortgages encumbered by a PACE lien. (13)

   Missouri citizens have a special interest in the outcome of this dispute, as Missouri was the last of twenty-two states to pass PACE enabling legislation, a product of vociferous support by Missouri environmental interest groups and small businesses that recognized the potential of spending initiatives in a recessed economy. (14) Unfortunately, federal suspension of PACE occurred almost simultaneously with Missouri's enactment of PACE legislation. (15) Missouri lenders, legislators, homeowners, environmentalists, and small businesses have thus been unable to move forward with a PACE program since federal lenders halted the initiative nationwide.

   This Law Summary analyzes and comments upon the legal arguments put forth by supporters and critics of PACE liens in the wake of the July 2010 disputes. Part II discusses the origins of PACE in 2008 and its rapid expansion across the United States, paying particular attention to the passage of PACE legislation in Missouri. Part III analyzes the escalating dispute between PACE supporters and the federal mortgage lenders who oppose it, commenting upon the legal arguments articulated by both sides. Part IV proposes a resolution to the conflict that provides a more secure position for federal mortgage groups while still allowing PACE to continue. This Law summary concludes that while federal mortgage groups overreacted to PACE's potential dangers by unilaterally halting the programs, their substantive concerns are legitimate and both parties would be well-served by resuming negotiations so that PACE lending can continue providing a benefit to worthy borrowers.

2. LEGAL BACKGROUND

   1. The Mechanics of a PACE Lien

      The starting point for any PACE program is the enactment of a PACE enabling statute, authorizing municipalities to establish PACE assessment boards. (16) once receiving statutory authority, the municipality must develop a source of capital from which the money for homeowner retrofits may be tapped: many local governments have looked to bonds to provide that capital. (17) These bonds allow local governments to finance new energy improvements with private funds. The municipalities repay those bonds with interest provided from assessment payments made by homeowners as part of their yearly property tax bill. (18)

      In Missouri, a homeowner seeking to take advantage of such a program would first obtain an energy audit to verify his need for energy-efficient improvements and then apply with a local PACE assessment board for consideration. (19) Having obtained approval, a borrower would receive a payout from the municipal board in the amount of the proposed improvement. (20) Repayment would consist of a yearly supplement to the homeowner's property tax bill, typically for up to twenty years. (21)

      The promise to repay is secured by a tax lien filed by the municipal board against the homeowner's property. (22) This means that repaying the debt is an obligation on the benefitted property, not the individual taking out the loan. (23) If the property is foreclosed upon, or the property owner fails to pay his property taxes (resulting in foreclosure), the PACE lien would take seniority over the mortgage, and the amount past due would be paid first to the municipality. (24) The remaining balance of the lien would stay with the property and be paid by subsequent purchasers of the land. (25)

   2. California Pioneers PACE Financing

      The first PACE program was established in Berkeley, California in 2008. (26) The program was immediately popular, (27) and Berkeley's local assessment board granted its first PACE bond in January 2009. (28) The program raised capital through the issuance of municipal bonds for the purpose of providing low-interest energy efficiency loans to local homeowners, administered by municipal "clean energy" boards. (29) In early 2009, the program was copied in select cities and counties across California, (30) and shortly thereafter the program went statewide. (31) During the following two years, twenty-two states followed suit by enacting some form of PACE legislation. (32)

   3. PACE's Rapid Expansion

      PACE bonds rely upon the municipality's inherent power to levy special tax assessments against properties that lie within its jurisdiction. (33) This power exists in many municipal governments around the country (34) and has been recognized for more than one hundred years. (35) Traditional special tax assessments have been used to finance public improvements such as sewers, sidewalks, road repaving, seismic retrofitting, and fire safety improvements. (36)

      One of the disconcerting issues for lenders regarding the current status of clean energy bonds is how quickly states moved to pass PACE enabling statutes. The following chart demonstrates the rapidity with which enabling bills were passed in each of PACE's three operational years. (37)

      However, while almost half the states have enabled PACE programs, actual active PACE programs are rare: as of May 2010, less than ten active programs were in existence, each located in either California, Colorado, or New York. (38) Rather than indicative of an unwillingness to initiate PACE programs, the small number of operational programs is probably reflective of the rapid enactment of PACE enabling legislation, (39) as well as the slower local processes of establishing boards and issuing bonds, given that one-quarter of all enabling statutes were not passed until the 2010 sessions. (40)

      According to PACE supporters, the government's inherent power to assess taxes not only gave municipalities the capacity to establish PACE boards but also gave board-approved bonds seniority over any outstanding land-secured debts. (41) The seniority of municipal assessments effectively means that the lender's private mortgage loans are instantly subordinated to the municipality. (42) Seniority is premised on the distinction made by the PACE programs between lending and assessments: any loans would follow the "first-in-time, first-in-right" principle that gives seniority to any antecedent loan. (43) Under the state assessment power, however, the state is entitled to be reimbursed prior to any existing mortgages, regardless of chronology. (44)

      Municipal bonds rely on private investment as a tool for raising money and are attractive to investors because they ensure regular returns on a relatively safe investment. PACE programs are particularly attractive to investors because they offer the added assurance of senior lien status. (45) Municipal bonds backed by property taxes traditionally have experienced low default rates, (46) and the assurance of being repaid first even when default occurs provides a prime incentive for investors. (47) PACE supporters argue that this seniority ensures the program's viability and its attractiveness as an investment vehicle; as explained in one lawsuit recently filed against FHFA, first lien priority is critical to the program's success because "there is currently almost no demand in the secondary market for conventional junior mortgage instruments." (48) In contrast, there has been great demand for senior mortgage instruments: as of April 2010, $300 million worth of PACE bonds had been sold in the State of California, and that number has been predicted (by its supporters) to reach several billion dollars within the next few years. (49)

      By the fall of 2009, commentators had begun to spread the word about PACE's potential. (50) Environmentalists and interest groups began to advocate for the establishment of PACE programs as both an opportunity to reduce energy consumption and to spur economic growth through increased retrofitting projects. (51) Sensing the mood, Vice President Joe Biden, as head of the Middle Class Task Force's Council on Environmental Quality, released the "Recovery Through Retrofit" announcement on October 19, 2009, propelling the federal government into the clean energy financing discussion. (52) The task force announced that the federal goal would be "[to] lay the groundwork for a self-sustaining home energy efficiency retrofit industry" by "do[ing] for homes what ENERGY STAR[R] has done for appliances." (53)

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