The government's mortgage-finance agencies Fannie Mae and Freddie Mac are resisting a White House-backed effort to make it easier for homeowners to get loans to make their houses more energy efficient.
The problem: deciding who gets paid first if the borrower defaults.
Under the program, homeowners would borrow money from their local government to pay for energy improvements—from high-efficiency furnaces that cost a few thousand dollars, to solar-panel systems that can cost more than $30,000. They would then repay the loan over 15 to 20 years through a special assessment added to their property-tax bills. Local governments would get the funding by selling municipal bonds to investors.
This debt would be senior to existing mortgage debt, so if the homeowner defaults or goes into foreclosure, it would be repaid before the mortgage lender gets any money. While property-tax assessments are usually senior to existing property debt, cities have traditionally used their assessment authority for community-wide improvements like sewers and roads—not for upgrades that homeowners elect to make on their own homes.
Proponents of the program, called Property Assessed Clean Energy, or PACE, say it is necessary for the loans to be paid before mortgages if local governments are to raise funds for the program from municipal-bond investors.
Backers also say the programs offer a novel financing mechanism to address the high upfront costs that so far have limited the widespread adoption of practical energy-saving improvements.
But the regulator of Fannie Mae and Freddie Mac—which guarantee half of the nation's $11 trillion in mortgages—has raised concerns in meetings about the program with federal and state officials. Alfred Pollard, general counsel for the mortgage companies' regulator, the Federal Housing Finance Agency, said he was worried about the problems that a first-lien, or first-in-line, loan could create. "The goal of enhancing energy efficiency, which we share, should not overcome the need for prudent underwriting," he said.
Fannie and Freddie aren't allowed to speak out on public policy, and the companies declined to comment for this article. PACE advocates have lobbied for a measure barring Fannie and Freddie from taking any adverse action over the next two years on communities participating in PACE.
Critics of the program say that Fannie and Freddie, or mortgage lenders themselves, could raise rates in such communities to cover the risk that a PACE loan will displace payments to the mortgage holder. Cities could also face legal challenges, they say. The state of Maine is considering making energy loans junior to existing debt in legislation that would establish its PACE program.
"The fundamental problem is that there isn't a free lunch but there often appears to be," said William K. Black, a professor of economics and law at the University of Missouri-Kansas City.
Sixteen states have passed legislation that would allow municipalities to establish PACE programs, including Texas, Virginia, California and Colorado. San Francisco, Los Angeles and San Diego are set to launch pilot programs this year, joining Berkeley, Calif., and Boulder County, Colo., which last year financed $10 million of improvements for 600 homeowners.
Advocates say the programs could fund $1 billion in projects in California.
Local governments establish their own rules for eligibility, although a White House task force has issued guidelines.
PACE critics say homeowners, prodded by contractors, could pile on more debt at a time when home values are falling. They also say cities aren't equipped to underwrite loans.
"It's got all the right economics to take off in a huge way and then cause huge losses," said David Felt, a retired senior FHFA lawyer. "When you're able to market to people who can't get financing for an ordinary home-equity loan, that should set off alarm bells."
PACE supporters say the programs will attract responsible homeowners and those who have equity in their homes or are mortgage-free. Cities are also being instructed by the task force on PACE loans to promote high-yield investments that lower energy costs and offset higher payments.
"The nature of the investment is such that it is typically going to lead to cautious investments, not granite countertops or vacations," said Will Toor, a Boulder County commissioner.
Unlike home-equity loans, which allow homeowners to take money out of the home and spend it on things that don't improve property value, PACE loans are targeted narrowly on improvements that should add value to homes and create energy savings.
Some new PACE programs are limiting their scope to assuage lenders' concerns. In San Francisco, for example, financing can't exceed 10% of the assessed value of the property, and homes that are worth less than the outstanding mortgage debt aren't eligible. Homeowners must be current on all property debt, and the existing mortgage lenders must sign off on any projects of more than $50,000.
Dwight Jaffee, a professor of finance and real estate at the University of California, Berkeley, said PACE programs could be structured to satisfy lenders' concerns by providing lenders with evidence that improvements reduce energy costs and add value, as lower energy bills offset the costs from the higher tax assessment.
"Presented with this evidence, the bank lenders should say in their own interest, 'Bless you, we're happy to sign off on this,' " Mr. Jaffee said.