Environmental Disaster

By Megan McArdle

At the time it was passed, I thought of the administration's energy retrofit program as the sort of blandly heartwarming program that wasn't likely to do all that much good, but was considerably less bad than many alternative uses of the money.  However, I didn't realize that whoever drafted this policy had come up with an absolutely moronic way to finance it:

Under the program, known as "Property Assessed Clean Energy," or PACE, the obligation to repay the loan stays with the home, transferring to a future owner if the home is sold. Because the PACE financing is a so-called "first lien" on the property, if the home lands in foreclosure, mortgage lenders take a backseat in pursuit of repayment.

In addition to providing business for home improvement contractors, the program could spur the emergence of a new financial market in bonds backed by PACE loans. That could create fresh opportunities for Wall Street.

Mortgage agencies Fannie Mae and Freddie Mac left the program's future in doubt in May when they sent lenders an alert noting that they do not take on mortgages that are subordinate to other loans. Fannie and Freddie dominate the market for home loans.

I'm not sure how big these loans are, but surely no one thought that first lienholders were just going to agreeably step aside to make way for a loan of any real size?  There's a reason that second mortgages carry higher interest rates, and less attractive terms. 

Moreover, I'm not even clear on how this is supposed to help.  The theory behind a loan that conveys with the property is that people won't take energy conserving measures because it's too expensive--it takes many years to get your money back, and meanwhile, if you sell the house, people won't pay you extra just because your house is super-energy efficient.  (Maybe this is a market failure--but that's neither here nor there, really.)  Thus, if you take out a $20,000 loan to enhance the energy efficiency of your house, and have to sell when you still have $15,000 left on the loan--well, you're going to have to take $15,000 out of the sale price of the house and pay off that loan.  Unless you can get a big price premium for a more energy efficient house (and apparently, you can't), that means that making your house more energy efficient just cost you $15,000*.  Unless you know that you're going to stay in your house for a very long time, you're better off not making the upgrades.

But having established that people won't pay enough for energy efficiency improvements, how do we think that making the loan convey with the property improves matters?  Imagine a property with no energy efficiency improvements, and a conveying lien of, say, $15,000 on the property.  The buyer is probably going to want you to discount the price of the house by, oh, $15,000--maybe even more, if the loan has a higher interest rate than their mortgage.  So you're, um, out $15,000.

Now, imagine a newly retrofitted property that is 30% more energy efficient, and has a conveying lien of $15,000.  If people won't pay you any substantial premium for your awesome new energy-efficient upgrades, then, well, they're going to pay you the market rate for a similar, but non-energy efficient house . . . and they're going to demand a $15,000 discount to account for the loan.  So you're still out $15,000. 

Now it turns out that they're probably going to want an even bigger discount, because they won't be able to get a mortgage.  Not so blandly heartwarming after all; more like an unmitigated disaster for anyone who took one of these loans.  Maybe the Muslim nations have the right idea after all.  Neither our government nor our banking sector have a very good track record at designing loans, so perhaps we should just outlaw them entirely.

But won't you have had some annual benefit from lower energy costs?  Probably.  On the other hand, you've also had to pay interest on the loan.  I'm guessing that at best, these two cancel each other out, so that you don't actually start to save money until the loan is paid off.

This article available online at: