EECBG Creating Liquidity for Energy Efficiency Loans in Secondary Markets (Text Version)
Below is a text version of the January 22, 2010 Financing Program Support for ARRA Recipients.
Announcer: Matthew Brown
Good afternoon, this is Matthew Brown. I'd like to welcome you all to another in our series of webinars sponsored by the U.S. Department of Energy designed to assist state and local governments and other stake holders in the design of their financing programs that are related, that are using EECBG and SEP Program funds. We're happy that those of you who are on the call are here and able to participate.
We have today a set of two presenters, Jeanine Hull and Howard Banker, who will be talking about secondary markets. This is a relatively new area for both many states and local governments that are considering financing programs, it's a new area in some ways for the U.S. Department of Energy, and so we are in many respects treading new ground and so this will be a very interesting discussion. We envision that this will be the first of at least different webinars that will address this topic.
Before we get started I want to just note a couple of housekeeping items. One is that the attendees, all attendees, on this call are muted so you cannot be heard, however if you would like to pose questions, you'll note that in the bottom right hand side of your screen you will see a place to pose questions and we will, I will, be moderating those questions and sending them out to, verbally sending them out to the presenters at the end of the call.
Second of all I'd also like to remind you, and I'll remind again at the end of this that this is again a part of a series of webinars, next week January 28th there is a webinar that is going to be focusing in some detail on a very successful Pennsylvania energy efficiency loan program in the residential sector. The next week there will be a webinar focusing on a Washington State loan program that's in development and the following week a loan, a discussion of a Portland Oregon loan program.
So we are here to talk about secondary markets, secondary markets are a very important element of the Department of Energy's strategy for usage and leveraging of ARRA funds and they are important because they provide a way for private investors to participate in and fund energy efficiency loan programs. This is a, as I've said before, relatively new kind of approach, we are treading new ground and so what we are going to do is we're going to be discussing today why secondary markets are so important, what are secondary markets, how to access some of those secondary markets and then talking about based on some example some implications for the design of your loan products that may influence the way that you are able to, the design for those loan products such that you can, that they can be sold into the market.
We are pleased to have as the first presenter Jeanine Hull and Jeanine is going to give kickoff and do a brief self introduction. Then we'll move to Howard Banker's presentation.
Do note again that on the bottom right hand corner you will have the Question and Answer box, please feel free as youâ€™re going through, as weâ€™re going through the presentations, to pose questions using that Question and Answer box.
Thank you Matthew. Good afternoon ladies and gentleman, I appreciate the opportunity to talk with you today about leveraging ARRA funds through the SEP and EECBG programs. To maximize participation in and the results of energy efficiency building retrofits.
I have participated in the development of the secondary market for energy products and hope to bring the benefits of that experience, to developing energy efficiency markets.
Energy efficiency is often called the low hanging fruit in the energy space and the building retrofit market is the largest of those fruits, that's because in market terms it's where you get the biggest bang for the buck.
Energy efficiency translates into increased energy security, better air and water quality, reduced green house gas contributions and improved cash flows for homes and businesses.
There are over 100 million households in the United States, a typical retrofit consisting of insulation, duct ceiling and HVAC requirements, replacements excuse me, runs on average between $7,500 to $10,000 per home, thus the size for the residential market only not including commercial industrial is potentially 750 billion to 1 trillion dollars. So we can all see that as big as the stimulus is, it will never be able to reach more than an ____ ____ small percentage of those homes, unless we harness the power of private capital markets to capture this opportunity and achieve the scope and scale necessary to actually impact energy consumption patterns.
_____ actually there's only really one key to accessing the opportunity and that's aggregation. We will need to aggregate the individual building contributions; we'll need to aggregate individual loans into portfolios and individual portfolios into a market. To wreak the benefits of ____ aggregation, there must be a relationship among the individual loans so that apples can be added to apples to make bushels of apples and oranges added to oranges to make orange crates and then shipped to market for apples and oranges, and this is called conformity.
Right now we have a relatively small developing market but this administration and many states and local governments are attempting to jump start this ____ and other funding and support for PACE which is Property Assess Clean Energy Programs and on bills and other utility financing programs.
As the origination market grows, the need for a secondary market will become pressing and the market itself will form.
The secondary market is essentially a risk allocation _____. Entities seeking to reduce ____ self in this case energy efficiency loans to entities willing to incur risks. The amount of debt originators may hold is limited by a number of considerations including regulatory capital, corporate risk _____, limitations on exposure to any single market or single market participants and other factors.
The risk limitations is the risk of default on the loan so originators sell the loans they have written to others who are willing to accept the default risk in exchange for the cash flows from those loans. These loans or loan portfolios can be aggregated into various buckets that share similar characteristics such as high quality loan buckets and lower quality loan buckets or buckets of high value loans and buckets of many more lower value loans.
The market will create the, in response to the products it wants. That's the role of the secondary market and the exchanges in specialist in that market. Once the loans have been sold into the secondary market the primary lenders will then have the cash in hand to be able to again write loans that will in due ____ be sold into the secondary market and so on. Through this mechanism the division of ____ is that the lenders who are good at underwriting the loans will be favored sellers who will be able to find buyers for their products. They will then have the necessary capital to continue writing loans. The secondary market is the place where buying and reselling the loans will occur. The loans will be serviced in absent of default the capital necessary for energy efficiency loans will be targeted where it's needed.
The sooner we can move to scale the more we can maximize the benefits for example, a reduction of 20% today in energy usage in the building sector will, as the banker in the Mary Poppins movie notes, through the miracle of compounding result over the ensuing years to much more than a reduction of for example 1%. Annually 20%, by 20%, my computer just went blank, umm, by 20% multiples on an ____ ____ rather than geometric progression.
We need to move in secondary in terms of the size, we need to move into the ranks of people who are not necessarily primary or first adopters. We have probably reached many of the early adopters and these tend to be a smaller part of the market. The way to achieve scope is to reach those who are not necessarily installing energy efficiency for the good of the planet but because it is a smart business or home investment and obviously scale, itâ€™s all about size. Money is attracted to money; we need loan portfolio sizes that are in the range of at least 15-20 million dollars on a regular basis which means perhaps monthly. To attract significant lending capital and to create the liquidity that is necessary to provide the risk mitigation aspects of a secondary market.
There are also enormous economies of scale to be achieved in this market. Once there is a significant demand manufacturing costs will be reduced, installation costs will reduce and importantly transaction cost to both the lender and the borrower will be reduced as conformity and transparency of risk will become better understood. So conformity size and transparency of risks are the requirements of the secondary markets, but it is also what the secondary market brings so it is a, an upward spiral.
Next Slide: Elements of Conformity
We're going a little deeper into the conformity, what exactly does that mean? It means we, the major elements of the loan have to be similar and the biggest difference between loans is between secured and unsecured loans. As you know secured loans are protected by collateral of equal or greater value of the loan, unsecured is ___ consumer lending essentially.
The next major difference is in the ___ of the loan between less than $15,000, between $15,000 and $250,000 and then greater than $250,000. And these tend to conform to the type of purchaser for example; homeowner loans or consumer loans tend to be unsecured and tend to be smaller than $15,000. Secured loans tend to be greater than $15,000 and tend to be commercial loans, so those are the two big differences. The next major difference is in the term of the loan. The short, the medium term and the longer term, for those three elements are how you tell whether you got an apple or orange or a honey crisp and a Jonathan, for example borrower credit and the underwriting standards have to be similar because that is the transparency of risk. If all potential purchasers know that the underwriting or the lender, the originator of the loan, look at pretty much the same type of, conducted pretty much the same evaluations then they're going to be able to match risks. So underwriting standards and borrower credit standards are required to be within a reasonably similar group of standards.
Finally the terms relating to default, to remedy and the terms of credit enhancement facilities if any that support the loan, those all need to be, reasonable conformed because the language of the contract not only the intent but also the exact language of the contract has to be reasonable similar so that there is a similar default timing and credit remedies are reasonably similar. The enhancement has to be within a range of again, conformity.
Last issue of concern to a lender is going to be well I don't want to be stuck holding this loan while the borrower and its contractor are "duking" it out as to whether the borrower got what it intended to pay for, that's where measurement and verification come in, it's also from a political standpoint necessary when we're using money to be able to prove the benefits that were achieved through the use of that money.
Next Slide: Elements of Volume
A characteristic of a secondary market is volume and you definitely need the size and the volume in the scope of this market. An ___ liquid market is characterized by very few buyers, few sellers, few transactions. As you increase the number of buyers, increase the number of sellers and increase the number of transactions, you begin to get what's called price transparency and we begin to see the similarities in pricing of various types of risk. The market then begins to take shape around that transparency. So we need a certain level of volume to create and tradable market, we need a sixe that's necessary to attract private capital and this goes back to the risk evaluation issues in terms of private capital. When ___come in they don't, in a secondary market they're not going to want to do the intense underwriting due diligence that's necessary if they were an originator so they need to be able to have a large enough potential payoff from the investment to support the due diligence that they're going to have to do in any event and that is in the range of approximately $15 million dollars a month.
So the question is: how can your governmental entity best support the development of volume needed to reach this launch feat? Direct loans are of course the way weâ€™ve done it for years but as we've seen the market has not responded to the small scale of where the programs are now and there is clearly never going to be enough public dollars to overcome the homeowner and business owner inertia to reach the necessary scale. So perhaps a more efficient use of public funds is to provide credit enhancement to loans made by private lenders. By agreeing to share in whatever costs are, excuse me, whatever losses are incurred by the lender, the lender's losses are capped and this provides a critical level of certainty required for the lender to even venture into this space. But its losses are a ___ number not an infinite number while leaving some pain if the___ has not been sufficiently diligent in its underwriting. So this will allow public funds to support a much larger amount of private funding; this is called leverage and will enable your program to support at least for and possibly as much as 10 times the number of loans and the amount of loans that would otherwise be possible through direct lending.
Next Slide: Role of Credit Enhancement
Ok. Credit enhancement is required in the market right now because in the energy efficiency loan space there is very little data on loan performance since there have been so few loans. As the size and scale of the energy efficiency market grow, loan market grows there will be less need for general credit enhancement and more need for more targeted enhancement for certain buckets of loans. Credit enhancement is simply a fancy term for sharing the risk or in cases of hundred percent guarantees or full loss reserves allowing the lender to escape credit risk entirely. Enhancement is provided by insurance, sub debt, loan loss reserve and there's almost an infinite form of credit enhancement.
Next Slide: Obstacles
Of course nothing worth doing is easy; there is a hiccup that is currently being worked out related to an OMB general directive. But the larger difficulty is in coordinating the development of this loan template and insuring conformity over a large number of essentially _____ entity. DOE can be used as a clearing house as you develop your program and we can advise you on various approached that have worked or not worked in other communities and we can try to facilitate communications on a broad scaled among you as you develop your programs. There will also be a memo available and posted on this site in the near future which will have additional information.
Thank you for your attention and Howard will describe some of these concepts in more detail.
Next Slide: Specialized Financiers
Jeanine thank you very much. We will now move to Howard Banker, I'm going to note that once again there are, there is the question box at the bottom right hand corner of your screen. I see a couple of questions that have come through and I'm going to note first off that the, there's been a question that says, has a template been developed for a standard loan term, for standard loan terms and conditions that would provide a conforming loan product and that's a perfect question to tee up Howard Banker's presentation which will deal with at least for one market segment, for one target market will deal with the very issue so Howard take it away.
Thank you Matthew.
So I'm Howard Banker and I manage Energy Program Consortium and National Association of State Energy Officials, finance working group.
What I thought we would try to do here is to present two examples of secondary market models. Again to underline Janine's good point, the key to secondary market, the key to accessing capital market dollars is to know how much leverage dollars you need to apply to attract whatever the amount of private capital you're seeking. An additional description of a conforming product is that the security instrument that is the main feature of the loan being made and whether the loan is being made to a person or a corporation or a partnership or to a city government or to whom ever. The security instrument is loan document or documents that the borrower signs.
Part of a conforming loan model is that the security instrument is the same in which ever state or municipality or locality or tribal area or wherever it is being offered it is the same document across the board. So alone in Oregon is the same as a loan in New York, is the same as a loan in Florida and this is what the investors must see as being a part of whatever the security offering is going to be.
Finally what we're going to talk about as we look at these models is what is from the investor's perspective, the risk of buying your investment instrument. So if I'm buying a bond, what do I have to worry about? Then besides what I have to worry about how are you the issuer of the bond going to offset my risk? So many of the folks on the call have been exploring these questions as they set revolving loan funds and other approaches being either able to make the direct loans for Energy efficiency or to leverage capital markets and secondary markets, have a place to sale your loans into and that is the bottom line.
A secondary market is a place where a loan made in Oregon, Florida, New York or anywhere is able to be sold so that the maker of the loan gets cash back and then can go on to make another loan.
Please change the slide.
Next Slide: State Housing Finance Agency (not actual)
So something that perhaps some of you might be aware of and an existing example of a secondary market, in every state is a state housing finance agency bond. What I'm going to present to you here is what one of these from an academic standpoint looks like and then what the leverage issues are and then what the risk factors are and how these are overcome. So when we say issuer of a security for a housing finance agency they sell a bond. When a bond or a security instrument of that type is sold there are fairly substantial costs involved with the issuance of the bond. So opinions of counsel and rating each and see opinions and ____ analysis and accounting review, so all of these and other expenses are generally called issuance expenses and either they are paid upfront by the issuer and then recovered when the bond or the security instrument is sold or if it's an ordinary kind of bond issue and everybody knows this will be purchased it may then be built into the bond issue itself. So whether it's paid for upfront or it's paid for after the issuance of the bond there are upfront expenses which have to be paid. These can range anywhere from 2% up to 8% of the cost of the actual total cost of the bond itself, so we're talking significant money.
Another important part of accessing secondary market is understanding aggregation. That's the third bullet point on this slide says and again in our example, state housing finance agency an _ _ _ uses its own or borrow funds as a warehouse line of credit. So if the HFA is gonna issue a bond for, let's use an easy number, a $100 million, but they're not going to issue the bond until they have a hundred million dollars in purchase loans. Then that means they need the cash to buy those loans and hold and that's what aggregation is, it's the purchase of and the retention of purchase loans until such time as a security can be issued.
So warehouse lines of credit can be taken from banks and large financial institutions and sometimes the issuer themselves uses their own funds to aggregate these loans then hold them until they reach enough scale to allow a security to be issued.
Jeanine's good example about $15 million is ___ the minimum threshold give the sense of what the warehouse line of credit or whatever, equity, whatever the issuer is going to use to permit them to purchase loans before they're able to actually package them and sell them.
Please let's change slides.
Next Slide: Loan Collateral
So our HFA now wants to issue a security. It's aggregated a number of loans, we'll say $100 million and, ok so what then is in the security that the investor is going to be asked to buy? Well the primary component of a mortgage back security which is what a state housing finance agency is issuing are loans made to consumers, generally home buyers and those loans are up to 95% of the appraised value of the home. So the first thing is, what's the loan type and what is the risk factor of each of the loans so when you say it's a mortgage then it's a secured loan and it's up to 95% of the appraised value of the home and so the investor understands then what the principle loan instruments are in the loan.
The second bit of collateral is not just that there are loans in the security but that each of the loans comes with a mortgage insurance policy which ensures the investor that if the loan is to default the very top 35% of this loan and again I'm using this just as an example, it can be differences but the top 35% of the loan is covered by an outside insurance company. So that if that particular borrower were to default on their 95% loan even if the foreclosure did not recover the entire loan amount at least the top 35 was covered by an insurance policy and then whatever else was recovered in the auction of that property after foreclosure would be paid. Again from an investor's perspective, this is very solid collateral.
Finally, the investor wants to know what is the loan underwriting that goes with each of these loans, is it wild and free or is it conservative so just to make it simple, I've said here conservative loan underwriting. But that would be something the opposite of what the recent subprime ____ indicated was going on with a great many of these mortgage back securities.
So this is the loan collateral that's making up this bond which is being sold to investors. Then actually what is being sold is $100 million bond and in that $100 million bond that, again this is an example, would be 95 million in loans and 5 million in cash so we can call the cash additional collateral. The cash collateral is in there for several reasons and I'll mention a couple of them, one is it's a back stop. So in additional to all these really conservative loans with a lot of mortgage insurance on them, there's even extra cash in the security instrument in the bond so that is a payment is not made or if a glitch in the system ___, there's still plenty of cash in there to cover the investor's risk.
Next page please.
Next Slide: Additional Collateral for HFA Security
Believe it or not there's even additional collateral when an HFA issues the bond. An HFA (housing finance agency or housing finance authority) is a state corporation, an affiliated state corporation and it's, it has its own rating so a rating agency reviews the state HFA and issues a rating of the strength of that HFA. So an investor looks at these and their letter and number rating so the better the rating the higher the rating the stronger, the safer the HFA is and therefore the lower the interest rate the HFA will have to pay when they're selling the security bond to investors.
In addition the security itself is rated by a rating agency so the rating agency may say this particular security is even better than the one this HFA issued in 2007 and for whatever reasons and all the following reasons. So both the state issuer of the bond and the bond itself is rated by a rating agency. Now some cynics among us, myself included I suppose, would say that for real what is the value of a rating agency? We've seen what they've done, they were signing off on all kinds of corrupt mortgage back securities but in the investment market for institutional investors they are often required to have a rating agency rating placed on an investment, a bond or any other kind that they can purchase. Many institutional investors, especially including union pension funds cannot purchase any security instrument that has not been rated and has a high rating, insurance funds the same. Some of them have a capacity to borrow, to buy security instruments that are not rated but is a very, very small percentage of what they're able to purchase so while we may or may not believe in the rating agencies, fortunately for trying to access institutional investors, weâ€™re going to have to find a way to secure ratings of the security instruments weâ€™re issuing.
Finally the payments of all the loan payers are handled by what are called a master servicer. There are several but not an infinite number of master servicers so when an investor is looking at this bond that they're thinking about buying they will want to know about the master servicer that is handling the payments from the consumers into the security instrument; and then from the security instrument into their little investor hands is a master servicer that is capable and competent ___ ___ perhaps themselves have been rated or at least presented with a report of some kind of oversight report that they are in fact a competent and capable master servicer.
Finally in this example a state HFA bond it's a tax exempt instrument so an additional consideration of collateral for the investor is that the interest that they will receive as part of the payments on this bond issue are tax exempt so that is of interest to many investors if the same risk factors were present in an exempt issue as into a non-exempt issue the fact that they're going to get a savings on the tax that they would have to pay on the interest earnings theyâ€™re gonna receive from this would drive them into the tax exempt issues. While it may not be completely proper to call that additional collateral the fact that it is a benefit to the investor will use it in that way to say that a tax exempt treatment of the interest is additional collateral for the purchase of this investment.
Please the next slide.
Next Slide: EPC/NASEO/DOE EE Loan Security
So those, the previous, the one just presented the HFA bond are made up of first time homebuyer mortgages is a fairly traditional uncomplicated, unsophisticated kind of security issue. A bond is something everybody knows and institutional investors whether they're buying the bond from Mississippi or Alaska or Hawaii or Maine, when they purchase the bond because they've purchased so many of these they almost know exactly what they're looking at and they, the pricing of these instruments says then fluctuates within a very narrow field, everybody know what you're talking about, everybody know what they're looking at, they're fairly similar, they're almost exactly the same and they're as conforming as conforming can be.
So let's compare a new issue of a loan security, one that we're designing has not yet been issued and kind of go through the same approach in presenting this to you just as we did with what kind of plain vanilla state HFA bonds for mortgage back security looks like. One we have here is, this will be a security which will purchase unsecured energy efficiency loans made to residential consumers. So, again the fundamental difference is the loans themselves are not secured by property; an unsecured loan is in effect a promise by the borrower to pay. If the borrower doesn't pay there isn't all too much collateral to go after. In our effort here with this unsecured loans security an investment bank will issue the security and much like a state housing finance authority or state housing finance agency would issue a bond, here and investment bank will issue a bond. As we said there are issuance costs but because this bond issue has never been done before and therefore investors will not recognize it and this will be relevant to many of you on the call because if you're making these kinds of unsecured commercial, unsecured residential consumer loans and you wish to sale them into this security that we're developing then the issue for us and for you is since none of these have ever been issued the investment bank that is gonna sale this things wants to be paid upfront because whether or not it's issued they're going to incur opinion counsel, opinion letters and rating reviews and all the rest of it. So that would have to be shared prior to the issuance of the security.
So the way this is been structured to cover those expenses is that the states that are participating will pay their ____ ____ a ____ depending upon how much they're going to sell into his security and this issuance cost will be supported by some foundations.
Finally just as we talked about the warehouse line of credit for the mortgage back security that's the state HFA issue, here the warehouse line of credit will be accomplished in one or two different ways. One is there are some states that are participating in this effort that themselves will use their own ARRA or EECBG or public benefit fund dollars or ____ dollars to function as a warehouse line of credit so that they will purchase these loans and hold them until the group of states together has in total approximately 20-25 million in these loans and they can then gather all the loan assets together and sale them. The warehouse line of credit will be accomplished using the kind of funds we just talked about.
Second use of warehouse line is there are a couple of banks that are participating in this effort that have agreed themselves to make the loans and hold them on their balance again until such time as enough loans have been aggregated and then sale those loans into the security directly.
Next slide please.
Next Slide: Loan Collateral
So ok, just as we reviewed the HFA bond-what's in this? Well, first of all they'll be loans of up to $25,000 and those are unsecured loans so again unlike the secured loans which come with a large kind of mortgage insurance policy, these are unsecured loans while at smaller size much greater risk.
This particular security that we are developing and will be issuing soon is allowed to purchase secured loans up to $50,000. Some states we're working with have conforming loan products that can be made ____ into this and they're secured basically second mortgage loans up to $50,000. What we've discovered is that the average energy efficient loan size is approximately $8500 in the residential mortgage so that's just a bit of information there while the loans will be up to 25 and in some cases secured loans up to 50 in fact the average loan size will be $8500. This is important to an investor cause it means that they'll be lots and lots and lots of little tiny loans which makes them nervous, on the other side of lots and lots and lots of little tiny loans which makes them nervous it also means that if a loan or three or five or even ten go bad, one loan going bad doesn't cause a big red light to go on the investor panel. So the fact that the loan sizes are small can be considered an additional collateral benefit.
On the underwriting side, as we said in the mortgage back security example that was very ___ conservative underwriting, here we have moderate underwriting and specifically the way these loans are underwritten are using the borrower's FICO score and how much debt they already have against how much income they possess and some of them use utility payment histories either in support of or in exchange for a FICO credit score kind of analysis. There is underwriting of the borrower and there are then going to be denials of borrowers but the investor at least understands what the underwriting criteria is.
Finally that there are as Jeanine mentioned in investors being worried about, they don't want to get in the middle of fight between a borrower and a contractor if work was not done properly so another bit of the and we'll call it loan collateral, is that these loans possess a great deal of consumer protection and warranties and contractor oversight so that in effect what we're saying to the investor is you donâ€™t have to worry about this, any little ___ or poor contractor work because our system covers those concerns.
Just as in the state bond issue what that looked like was a $100 million of which $95 million was loans and $5 million was cash in this structure what we've proposed is 80% of the security will be loans and 20% will be cash. And ___ minute if I can bore you a little bit about this notion of senior and subordinate tranche, so what that means is a tranche is a special fancy word for "part". So what part of the security am I buying? So when we say senior that would mean that we would work to sale this security to an institutional investor, let's say Calvert. Calvert would buy not the entire security but Calvert would buy the top 80% of the security, that's the senior tranche. So the way that works is all the loan payments go only to pay the senior tranche, so what that does is that accelerates the payments to the senior tranche investor owner and it pays them off faster, so the senior junior or senior subordinate tranche structure is designed to accelerate the payments to the senior investors and then after the senior investor is paid in full then all the remaining loan payments go to the junior investors or the subordinate investors. So this is an important additional collateral tool because it says to the investor even though this is a 10 year security you are going to be paid in full within 5 years because weâ€™ve accelerated your payment, so that sounds better to them. They're concerned about a 10 year but they might buy something that's 5 years.
Next slide please.
Next Slide: Additional Collateral for EE Security
So what else do we have for the investors? Well behind door number 1 is that is unfortunately and unrated security, what rating agencies require to rate something is an example against which this issue, what does this issue resemble? The fact of the matter is there have been so few if any energy efficient security issue that there's almost nothing to compare it to. So the problem with that is if we let a rating agency are these unsecured loans the other kind of unsecured securities which to them means credit cards are ___ loans then the investors are going to demand an extremely high premium on the purchase of this security. What we're saying is we'll present you information which is in effect unrated quality data review but because the rating agencies have nothing to compare this to of like kind, this will be an unrated security and it will be a private place, so instead of trying to sale 5 investors to each share in that 80% of the security issue, we'll find one good investor to purchase the entire security.
Other actual and very real additional collateral is that 20% and so that is made up of a 10% loan loss reserve and then an additional 10% of cash that the state or the participating states and municipalities are going to contribute into the security.
A master servicer will handle the receipt of loan payments and again it will be a master servicer that investor are used to and accepting of, competent and capable and so that they'll be comfortable with the notion that somebody that knows what they're doing is going to be delivering their payments to them.
What we've thought is to make this more useable in our space, in our energy efficiency space is have banks be able to service the loans they make and to have utility companies service loans that banks make, on-bill servicing. That's an important component of an Oregon, Oregon loan product and we want to introduce utility on-bill servicing into the secondary market space and the issuing of the security in allowing that having that as an inclusion will let us do that.
Can I mention that the senior tranche gets all the loan payments until theyâ€™re paid in full and then the subordinate tranche gets their loan payments after the senior is paid in full? This is a fairly traditional kind of a security issue that has a senior and subordinate tranche. From a state perspective, from a city and municipality a county or any other sovereign entity the key difference here with this structure is that some of you are in and utility companies do this, is basically use money to buy down the interest rate of the loan that is made to consumers. That's a fine thing to do, the problem with that is that you don't get that money back, that discount fund and it's often 10%-15% to sometimes 20% of the loan amount is gone-good bye. In this kind of structure instead of spending your money as a discount the state or the municipality or the, whatever the sovereign entity is, invests those dollars into the security and assuming the security performs as predicted you get your money back and you get your money back with some interest which is another new idea that public dollars should not just be thrown as collateral to attract capital markets but should be presented as additional collateral that is recovered.
That basically wraps up my comments so I very much look forward to any questions, thank you.
Thank you very much Howard and maybe before we go into some broader questions if you could just spend just minute or two or a few seconds perhaps talking about a couple of definitions I think that it would be helpful to, you're referring to subordinate tranche senior and so on and I think that's not necessarily familiar word to all of the people in this audience. Maybe if you could kind of offer a bit of a definition when you're talking about a tranche what you refer to.
Ok, so if the security that we're selling to an investor is $100 security the investor will say I'll buy the senior tranche and I'm only gonna buy the top $50 of that. So in effect then what the investor is saying is here's $50 and I get the top part of that security. I have first rights to any finds that come into that come back from that security. So they're buying the senior part so one way, another way to say tranche is "part", Iâ€™m buying the senior "part" of that security and I get first "dibbs" in anything that goes wrong.
So there's a couple of other questions that have come in and this one I'm going to throw out to Howard and then Jeanine we'll see if you have some comments.
The questions is, "What is more important in the current market, scale or conformity, and is there an opportunity for co-mingled funds at this time that provide greater scale but with less conformity?" Then the second part of it, "What are the trade offs of a co-mingled approach given that the data needed to distinguish between loan types and terms does not yet exist?"
So I'll put that in - how important is it that you have a bucket that includes only for instance residential versus a bucket that's lighting fluid, some mix of residential or commercial or residential and large commercial loans?
I'm afraid that I have some bad news for the questioner and for others, without conformity there is no scale and in ___ market's talking about scale 25 million to the capital markets almost doesn't exist. It's so little that the brain damage that they incur looking at all the components of a $25 million, they would spend as much time on a $250 million issue as theyâ€™re gonna spend on a $25 million issue. They absolutely will not entertain; I will be happy to be proven wrong but my experience in this space is they will not entertain the mixing of different assets, classes and types in the same security. Again it's brain damage, understanding the different risk factors for the different asset classes in the security makes it too complicated and difficult for them to want to participate, either that or they will charge you so much for giving it a review that the amount you will get back will almost be self defeating.
So you must have conformity to prevent the aggregation of enough loans to even turn the lights on for the capital markets and our experience $25 million is about the minimum that we need __ ___ and secondly that has to be conformity in both asset type and class. So what that means is we're focused on unsecured loans and but commercial loans or secured residential loans are secured commercial loans or different asset classes that doesnâ€™t mean we can't do these things simultaneously but you generally cannot mix them in the same security. As to data, it is very hard to come by data for the reasons we've begun our efforts and this ____ about unsecured loans is because there is data about that. Fannie Mae has been buying these loans for 10 or 12 years, there's a great many states that issue these loans in a conforming way and that is the most magnificent part of this is that the performance on these loans is extraordinary. The default rates are less than 3% and when we have and you do present this data to investors this changes the discussion because they think of unsecured asset class like they do on credit cards or auto loans and those are a mess. So when we say people residential owners that borrow energy efficient loans only to fall 2% of the time it helps reduced the price conversation.
Jeanine did you have any additional thoughts on this question?
Well Howard's exactly right, there are very, to go back to my analogies of apples and oranges - there aren't fruit purchasers, there are apple purchasers and there are orange purchasers and those are two different markets and the prices in those markets are different. Just because you have a large bushel of apples and a very small crate of oranges you don't just throw the oranges into the apples and have one slightly larger market, they're just two smaller markets. There's, he's absolutely right the name of the game here is risk, that's why we're talking about secondary markets because that's exactly what the secondary markets are geared to address is risk mitigation. You can't mitigate the risks that you can't understand and separately quantify. When you mix it all up you canâ€™t separately quantify it.
Great. This next question goes to Howard more specifically and it's about the EPC/NASEO program and the question is, "Which banks have agreed, if you can release that information, I've agreed to participate in this NASEO conforming loan program?"
Sure, there are four and they're not all banks. One is AFC First Financial in Pennsylvania, Peter Krajsa is the President, they are a bank. Another is EFS (Energy Finance Solutions), they're in Wisconsin, they're an affiliate of WECC (Wisconsin Energy Conservation Core) they're a CDFI, a financial intermediary and then there is View Tech which is a finance company, licensed in California, they're based in Los Angeles and the three of those are Fannie Mae seller servicers. Finally there is ShoreBank Cascadia Enterprise based in Oregon and while they are not a Fannie Mae seller servicer because their loans are serviced by the utilities in Oregon, we thought that that was an important addition to make to this effort.
Another question that came up is the question about the source of the data or actually somebody who would like to see the data about the default rates on these loans and actually I'll just answer that quickly and if Janine or Howard you have additional perspectives but that data that's, Howard mentioned is less than 3% default rates in general actually the default rates are tending to be on a 3 year old loan from in Pennsylvania unsecured loan, it's a 1.5%. When you look at many of the programs across the country there a number of programs, particularly some of those that are run through utility service bill programs where you'll have Â½ to 1% rates so that data is the result of or the source of that data is basically looking at the loan programs that have been out there. The other big piece is of course the Fannie Mae program where the three Fannie Mae qualified lenders have been selling loans into Fannie Mae for a number of years and so that data is also included in this, actually relatively conservatively stated less than 3% number.
Unfortunately, we don't possess the Fannie Mae data; they have so far at least refused to share it with us, but from the states that sell into the, or support the sale of loans into that program we've gained the information that Matthew just, Matthew, ___ and others have been working on but we don't actually possess the loan performance data that an investor will consider so to date we've only been able to use the few different states that have similar conforming products and _____ __ that so we have that loan data.
Let me just add a caveat here and that is that this is, this performance is across the board. Even the utility programs tend to have extremely low default rates but if I were a banker and looking at this numbers, these number, I would look at them and think ok, it's a tiny, as large as it is, it's still at tiny program compared to the amount of data I would need to be able to generalize loss rate to a larger market. I would look at these and I think these are your early adopters; these are the people who believe in energy efficiency, they're less likely to default. They're also the people who have the, sufficient cash flow to even think about doing energy efficiency right now, that's as we know, that's getting tighter and tighter. So I'm just not sure how much this excellent performance data is going to translate as we move into greater adoption numbers. I'm just putting that out as a caveat, something that I think it's realistic to expect the default rate to increase as we increase penetration rates into the general market.
Thank you Jeanine. There's another question, "Has there been any thought yet to performing surveillance on these new securities in order to be able to report ongoing, on an ongoing basis on the performance of the security and underlying loans? Both financial loan performance and the energy savings performance that those loans have enabled?"
Yeah, that means that's built into the security design - we've done that; both the energy use and the individual loan performance, as well as the security performance is built in as a cost to the issuance of the security because these early first users, these all, early first investor purchases of these securities have better perform really well to demonstrate that we don't need 20% leverage to issue a security.
Howard, can you talk briefly about which states you were talking about some states that are participating in this program? Can you talk briefly about which states are participating?
Sure, the one set of expressed interest are New York, Pennsylvania, Wisconsin, California and Oregon. We are open, we are absolutely open to other states but our goal is to have a security issued in the next quarter and so if your state or municipality or sovereign entities is interested to participate, we're happy to talk to you and we would look forward to your participation in this second security issuance, an ongoing one.
Great. Another question and this goes back to the discussion of default rates on unsecured loans is, "Could a good proxy for the estimate of a default rate on these energy efficiency unsecured loans be utility bill payment history?"
There's been mixed evidence about that. Under the Fannie Mae program and the ___ of that design implement that ___ that program is working with us. It turns out that if utilities have noâ€¦ let's call it skin in the game, their collection efforts around these financing tools are less than exemplary. Because of the loan is this particular case is an unsecured loan if you don't act quickly on a default payment you stand a very good chance of losing the loan asset as to say this becomes uncollectible. Fannie Mae tried on bill servicing and it didnâ€™t work out so well, so now some states are using on the on bill the PACE model using utility payments as the supplementary credit review approach to borrow or FICO score and other kind of credit analysis and that is fine but I will only say that the ___ ____ at using utility payments as a supplement has been a problem for the secondary market and secondly because they are now such a high rate of default on utilities, usually people when theyâ€™re queuing up their payments if they're having trouble if they've recently lost their job or something bad has happened, a family member is become sick and they decide which ones to pay or not to pay often utility bills fall to the bottom of that list because often there are a great many protections, consumer protections in different states around the payment of utility bills so just using utility bills sounds like a good idea and it might be a good idea but at least in the near term that experience is not always the best.
I'll add something to that which is that it's interesting, Howard brings up the concept of the skin in the game and I think it's a very important concept in general for these programs that the different players have some skin in the game including the player in an on bill program including the utility that's actually doing the collections. So a number of utility run energy efficiency loan programs in which the utilities are providing the capital and therefore have quite a bit of skin in the game those programs tend not to use FICO scores but tend to use utility bill payment history as a proxy for a credit score. Often the credit analysis ____ and the default rate rather have tended to show very, very low, low default rates. So there's, I guess I would say thereâ€™s different issues, there's a measure of the ability to pay and that's a debt to income consideration. Thereâ€™s a willingness to pay and that's a credit score on the other side there's a willingness and ability to collect and on each one of those there needs to be some kind of consideration.
I am going to thank everybody for their participation in this call today, I think it was, it's been very helpful and Jeanine and Howard thank you very much for your participation.
You should all see on your screen at the moment a list of upcoming webinars, these webinars are going to be taking place over the course of the next three weeks or so and then we will have other ones announced in the near future. The next one is going to be focusing on the KeyStone HELP program, you did hear a little bit about that program mentioned today and that's on the 28th, on the 4th of February the community energy challenge in Whatcom County Washington is going to be profiled, on the 11th of February the next one will be a profile of the Portland program that again you heard that one mentioned as well.
I'd like to thank you all very, very much for your participation in this webinar; we look forward to your participation in future webinars and hope you all have a good day. Thank you very much.