Security refers to the security of the stream of principal and interest repayments and what happens in the event that a loan defaults
Security can come in several forms:
- A lien on property, in the form of a first mortgage lien or a tax lien, establishes the right of the lien holder (almost always the lender) to make a claim on the proceeds from the sale of foreclosed property. The best lien position to be in is “the first priority lien.” It means that, if a bank holds a mortgage on a home for $250,000 and a foreclosure sale yields $270,000, then the bank with its first position lien gets the full $250,000, and any other creditors (lenders) in second or third position must fight for the remaining $20,000. That would include the lenders who provided capital for clean energy improvements.
- In weighing various financing options for a clean energy program, grantees must understand that an unpaid property tax always trumps the first lien position of a bank mortgage. In other words, the property tax gets paid first out of the proceeds from a foreclosure sale, then the mortgage holder is paid, and then all of the other creditors must fight for any remaining funds.
- One innovative financing option presented in this Guide is property-assessed clean energy (PACE) loans. They attach the obligation to pay for the energy efficiency improvements financing to the property tax, thus trumping the mortgage holder’s first position lien. The fact that PACE assessments can trump a first mortgage lien on a home has caused federal mortgage regulators to object strenuously to residential PACE, essentially crippling residential PACE programs for the moment. The issue remains contentious, with federal legislation under consideration in addition to several lawsuits pending on the issue. Commercial PACE programs remain viable financing options because they require the first mortgage holder’s agreement before trumping their first lien position. (See Chapter 13 for more information on commercial PACE loans.)
- Fixture filings (UCC-1 Filings) allow the entity that holds a loan to repossess the property in the event of foreclosure. Fixture filings are most useful when the property is easy to repossess, for example, equipment that could be easily re-used elsewhere. But in the case of most energy efficiency installations, fixture filings do not provide much security because, for example, it is difficult to repossess insulation. Even so, the filings can be useful to the lender because a title search will bring them to light upon sale of the property and may trigger some kind of settlement at that point.
- Soft lien/lien at the meter refers to the threat to disconnect utility service in the event of non-payment. This threat can be a powerful incentive to settle a debt, although both the utilities and their state regulators must feel comfortable with this approach. Attitudes toward the threat of disconnection vary.
Unsecured loans have none of the above types of security and rely instead on careful loan underwriting and origination processes. Unsecured lending is usually less expensive and faster to do than secured lending, which takes time and money to carry out the appropriate filings and searches. If a borrower defaults on an unsecured loan, the lender typically “charges off” the loan on its books, and sends that loan to a collection agency for further action. If the collection agency manages to recover some or all of the amount due, that agency typically keeps the majority of what it collects. The borrower, meanwhile, receives a bad mark on the credit scoring. In some cases, the lender inserts an intermediate step of offering to renegotiate principal and interest payments on the loan.
Each of the five major components of the financing structure is dependent on and affects the others. For instance, robust security in the form of a property tax lien can mean that lower levels of credit enhancement, such as a loan loss reserve, are acceptable. Robust repayment structures that financial institutions understand and have confidence in also require lower levels of credit enhancement. Weak security in the form of an unsecured loan, however, can require higher levels of credit enhancement.