Could high-efficiency homes turn a mortgage backed security into a green bond?

Could mortgage backed securities (MBS), backed by loans for high-efficiency houses, be the "impact investment" many investors are seeking? If so, the MBS, the "toxic asset" of the 2008 financial crisis, could become a virtuous "green bond."

What are Green Bonds? According to KPMG: "[L]ike any other bond, [a green bond] is a fixed-income financial instrument for raising capital....The key difference between a 'green' bond and a regular bond is that the issuer publicly states it is raising capital to fund 'green' projects, assets or business activities with an environmental benefit, such as renewable energy, low carbon transport or forestry projects."(from Gearing up for Green Bonds.)

$36 billion in green bonds were issued in 2014. An example is bonds issued by NY State to fund clean drinking water projects. Goldman Sachs's recent acquisition of Imprint Capital, an advisor and asset manager for impact investments, is seen as a signal of expected growth for the green bonds market.

Homes are a great fit for a green bond. High-efficiency homes are environmentally-friendly assets for obvious reasons: more insulation, better air sealing, and better air conditioners, mean utilities must deliver less power. Less heating and cooling goes out the windows, through the walls, and up the chimney. Electric power plants are the largest source of pollution in the nation. Residential houses account for almost 40% of the electricity used in the U.S. With each additional energy efficient house, the public realizes real value from less pollution and a better electricity system.

Many mortgages are already "green" but investors are in the dark about it. About $1.0 trillion of U.S. single-family mortgage loans were sold in mortgage-backed securities in 2014. (See Freddie Mac report). Many of the loans backing MBSs are conventional purchase and refinancing loans for energy efficient houses. About 1.6 million new houses have been built to Energy Star standards. In 2015, about 15% of all housing starts are expected to be Energy Star houses. In addition, every year many thousands of existing houses go through programs for energy efficiency repairs and improvements, such as Home Performance with Energy Star, Energy Upgrade California, Duke Energy's Home Energy Improvement Program, the Energy Smart program from Entergy New Orleans, and similar programs across the country.

In other words, many loans already are "green," but lenders generally do not track the efficiency status of the house. Loans to owners of these high efficiency properties are sprinkled into in the giant pool of loans backing ordinary MBSs.

Why might investors want a green MBS? Many investors might prefer a MBS backed by high efficiency houses. Some pension funds (e.g., CalPers, CalSters, and New York City's funds) might seek to support their state's policy goals to improve efficiency of the building stock.Some insurance funds might want to support efficient housing as a way to reduce power plant emissions known to worsen health and increase risks from flooding and storms.

Some argue loans for high-efficiency houses could out-perform loans on ordinary houses. One reason this could occur is that houses built to higher efficiency standards could maintain higher property values relative to the market. (Reports from the Appraisal Institute describe the challenge of valuing a house with efficiency attributes when the same factors are not known in comparable houses.) Another reason high-efficiency houses might produce better-performing loans is because of lower utility expenses for residents. One report suggests this can occur. Another possibility is some form of self-selection -- borrowers who select a high-efficiency house could have higher propensity to pay for some other reason.

Even if these factors are true and investors prefer a green MBS, a pricing differential for a green MBS might not occur with the current market structure for residential mortgage loans. The vast majority of all single-family MBS today are essentially backed by the U.S. Government (through Fannie Mae, Freddie Mac, and GNMA). And, the Federal Reserve could continue to be a very large purchaser of residential MBS.

Regardless of why an investor might (or might not) prefer a green MBS, giving investors more information about the energy efficiency status of the house makes sense because it allows a better understanding of risk and value.

Key advantage of housing for a green MBS: verification. A reliable system for scoring the efficiency level of houses -- like the MPG sticker on cars -- is already in use in the U.S. The Home Energy Rating System (HERS) scores the efficiency level of a house. A HERS score of 100 is average, while HERS 70 house is 30% better than average. The rating system was developed years ago to support federal and state tax credits for energy efficient houses. A newer rating, the Home Energy Score (developed by the Dept. of Energy) relies on a quicker inspection and a 1 to 10 score, aimed to estimate efficiency levels after an improvement project. The LEED designation assess factors beyond energy use.

This home ratings infrastructure solves a challenge in the green bonds market: how to assure the proceeds of a bond or investment are, in fact, devoted to projects that merit the green bond label.

Cautions. There are sensible reasons to be cautious about a green MBS. Grouping high-performance houses into a bond might cause conventional MBSs with lower-efficiency houses, on average, to suffer in comparison. Fair lending factors could be present, which must be tested. And, some might worry about the "slippery slope." That is, mortgage loans could potentially be divided into many subgroupings, and putting loans into small subgroups could undermine the very benefits of pooling loans into securities -- diversification and large numbers.

Isn't there already a green MBS for residential apartment buildings? Yes. Fannie Mae's multifamily team already established a green MBS backed by its Green Preservation Plus loans, which allow borrowers to purchase an apartment building certified as "green" or refinance with added proceeds to fund needed efficiency repairs and improvements. One difference is that these are often single-loan securities, not backed by large pools of loans.

Single family mortgages are not the only candidate -- the green MBS concept could work for commercial offices, manufactured houses, and data centers. These are all high-impact assets in terms of environmental benefits and the efficiency levels are verifiable with good rating systems, so the investor achieves a green bond with information easily collected in the loan origination process. And, the concept could potentially work for mortgages for homes with renewable power factored into the ratings. SolarCity's has issued a "green bond" backed by revenue from solar facilities, though this is different from an MBS backed by primary-lien mortgages since the power facility is often a seperate asset.

An intriguing variation for a green commercial mortgage-backed security is to require the borrower to maintain Energy Star certification of the property during the loan term. This is interesting because the Energy Star score for office buildings is based on actual energy use per square foot, which produces an incentive to operate the building efficiently.

Ultimately, this is about transparency. Through mortgage backed securities, investors fund America's housing needs. The energy needs of our houses determine the output of power plants, which has important consequences for the country. The question raised here is whether major issuers of MBS - primarily, Fannie Mae, Freddie Mac, and GNMA - should give investors the information needed to direct their funds to support high-efficiency properties.

About the Authors

Philip Henderson

Senior Financial Policy Specialist, Center for Market Innovation

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