Thursday, 8 May 2014

FNMA, FMCC - You Can't Go Home Again


  • Pershing Square's thesis makes sense, except, there's no there there.
  • Property appreciation will increasingly be linked to on site clean energy generating capacity.
  • Predatory "green finance" practices fleece property appreciation from mortgage holders.
Fannie MAE (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) (I call them F&F) make a fascinating story and studying the recent Pershing Square presentation is well worth the effort. A few years ago, when F&F were at the height of their sub-prime malfeasance, an opportunity came along that they promptly dismissed at their own peril, and it is now coming back to haunt them. One of the consequences is that they cannot simply go back to their knitting as Bill Ackman would like to suggest.
The incident I am referring to was the confrontation with the initiators of the PACE (Property Assessed Clean Energy) finance concept. What upset the GSEs at the time, was that PACE would have seniority over first mortgages because the payments are collected with property taxes. Of course it was all a thinly veiled way of deflecting attention from the deterioration of underwriting at the GSEs themselves, under the guise of safeguarding the repayment ability of mortgage holders, but the GSEs achieved the exact opposite of what they claimed to want by foregoing this opportunity to control the process by means of an adequate underwriting standard.

The missed opportunity of PACE

At the time these events took place, I contributed some advice to the point that the right Clean Energy projects would be constructive to property values, and lead to appreciation, and therefore improve asset values and the ability to repay, thus reducing mortgage risk.
However, the PACE advocates themselves at that time were their own worst enemies, for like so many greenies, they ruined their own cause by co-opting "energy efficiency" as a substitute for clean energy, and thereby scuttled the value of their proposition.
The best the PACE folks could do was to come up with a study documenting a number of "energy efficient" homes with a number of comparables without efficiency upgrades, and they were narrowly able to demonstrate a slightly better appreciation. The outcome was a compromise which included among other things that energy retrofits could not be more than 10% of the assessed value of the property, thereby largely locking PACE-financed energy retrofits into the value destroying "energy efficiency" racket.
What was missed was the opportunity to introduce an FHA underwriting standard that could have guaranteed that ONLY energy projects that were additive to property values should be undertaken. The percentage of the assessed value is irrelevant if a permanent energy price hedge can be created by means of clean energy generation on site. On the contrary, this limitation leads to a focus on projects (predominantly of the "energy efficiency" variety) that make only incremental improvements, instead of doing the things that PACE was meant to do, which is on-site clean energy retrofits, where the real capital need and value enhancement is.

Diminishing returns versus compounding returns

Financially, "energy efficiency" destroys value, for it is a proposition withdiminishing returns, therefore undermines long term capital appreciation and by implication the ability to repay mortgages. From an engineering standpoint also, it should be understood that if you compare a fossil fuel based system to a renewable energy system the spending on energy efficiency will be partially the same, but very definitely different in important ways.
Notably, energy efficiency in a clean energy system pays off in reductions of installed capacity (i.e. reduces capital investment), while energy efficiency applied to a fossil fuel system pays off in reductions of future fuel bills. Moreover, to name just one example, in a clean energy system you are reducing indoor air pollution, so it lends itself to a tighter building envelope, and possibly heat-recovery ventilation. In short, you cannot assume that you can just blindly start with energy efficiency (of a fossil fuel based system) and switch to clean energy later - you need to have a comprehensive energy plan to make sure you do not lock yourself out of opportunities. Without such a plan, switching tracks from efficiency to renewables will produce write-offs.
Seen as the intra-marginal investment that it is, clean energy moves energy production on-site, and financially moves energy from liabilities to assets, and therein lies the magic of property appreciation, assuming we select the projects that are financially most rewarding based on a long term (thirty year) capital budget (CAPM). I.e. maximizing Site Derived Renewable Energy (SDRE) generation paid for by energy savings, enabled by appropriate (PACE?) finance.

Sub-prime in green: PACE, Solar PPAs, and "energy efficiency"

With the GSEs passing on the opportunity to set underwriting standards for energy retrofits, they turned loose the wolves of Wall Street in yet another raid on other people's property appreciation, under the guise of "green finance," which is merely a variant of Asset Backed Lending (ABL), based on "energy savings," and therefore deemed "self liquidating" and a low credit risk for lenders.
Nobody is paying attention that the resulting finance business is driven by the interests of the vendors of screwy light bulbs, window caulking and even solar panels, and their financiers, not to mention the customer retention interests of energy companies. And these "self liquidating" propositions, helped along by tax incentives, are presented to property owners in a manner that leads to the serial adoption of small (least cost), energy efficiency enhancements, usually prioritized based on payback periods from energy savings.
The serial undertaking of these "energy efficiency" enhancements faces diminishing returns, enough so that after exhausting the screwy light bulbs and the window caulking, not to mention fuel switching, and upgrading boilers, property owners eventually get desperate enough to take ridiculous technology risks and bolt a solar PV panel to the roof of their leaky properties, because it will save some percentage of their energy bills. At that point, property owners have been completely backed into a corner. The incremental decision making has locked them in for 20 years into the proposition of saving 20 or 25% on their energy, when current technology might have allowed 80% reduction, if you understand the engineering and the finance.
Example: Hybrid Solar Thermal HVAC system. Solar thermal is harder to implement but delivers 5-8 times more energy per square area than current PV, so who, at NY real estate prices, can afford to put PV on their roof, instead of Solar thermal? Answer: the victim of the latest "green scam," the "free" solar PV panel, courtesy of the Solar PPA.

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