PACE Financing: A Brief Overview

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This week I decided to take some time to write about one of the financing structures I find the most interesting – Property Assessed Clean Energy (PACE).  PACE is an innovative structure that makes it possible for owners of residential and non-residential asset classes to obtain relatively low-cost, long-term financing for projects that leverage energy efficiency, water conservation, seismic strengthening, and renewable energy sources (such as solar, wind, and biofuels). PACE is a program authorized at the state level and implemented at the municipal and county levels that allows coordination with private capital providers to offer financing to property owners for qualifying improvement projects. This post will provide a quick breakdown of how PACE programs are structured and how PACE fits in a typical capital stack for a commercial real estate transaction.

PACE Program Structure

PACE was originally introduced in California in 2007 as a form of assessment financing to fund improvements to “qualifying properties,” namely properties that reduce energy and water usage, leverage a renewable energy source, enhance the resiliency of a structure, and which are ultimately considered a public good. There are currently 36 states that have approved the PACE structure in the U.S., below is a breakdown of how a PACE program is implemented through legislation and funded via a private capital source.

  • State legislature must approve PACE legislation.
  • Counties and/or cities are able to “opt-in” to the PACE based on the program implemented at the state level.
  • The source of private capital (typically a fund) will essentially underwrite the PACE financing as a loan to ensure eligible borrowers have adequate repayment capacity.
  • Once underwritten, the PACE transaction is submitted for program approval. Upon receipt of approval, the transaction is funded (typically through bond proceeds).
  • Post-funding, the transaction is recorded by the county/municipality as an additional line item added to the property’s tax assessment. The PACE assessment is collected bi-annually or annually with the normal tax assessment and then remitted to private capital source for repayment.

To put it simply, PACE is originated as a debt instrument and assessed as an addition to property taxes. Though the PACE assessment is structured similarly to a mortgage, repayment is filtered through the county or municipality. However, unlike a mortgage, a deed of trust is not filed as part of the recording process for the transaction. Therefore, PACE financing is ultimately tied to the property and not the borrower. If the borrower decides to sell the property, they are required to provide documentation recording the PACE assessment, but they are not required to pay off the assessment. The assessment remains with the subject property until it is repaid.

PACE in the Capital Stack

In commercial real estate transactions PACE is typically utilized to replace expensive mezzanine debt (or equity, depending on the size/scope of the transaction). A typical financing structure or “capital stack” is comprised of (1) a senior bank note and equity from partners/investors or (2) a senior bank note, mezzanine debt, and equity – depending on project/sponsor level constraints. Moreover, mezzanine debt tends to carry a shorter time horizon of 5-10 years. As discussed above, PACE financing is structured like a mortgage with a time horizon of 25-30 years.

Stretching out the time horizon can make the project bankable as the payments over a longer period can reduce debt service burdens. Mezzanine debt is relatively expensive, usually priced at a rate of 10-15%. In addition to a longer maturity, PACE financing is priced more competitively, around 5.5-7%. Finally, PACE financing usually accounts for a larger amount of the capital stack than you would see with mezzanine debt. The illustration below captures the benefits described in this section and provides a side by side view of a typical mezzanine structure compared to a PACE structure.

Source: CleanFund

Though not applicable to all transaction types, PACE provides a competitive alternative to equity and mezzanine financing when developing or retrofitting a property with energy efficiency in mind. Moreover, this type of financing strikes a good balance between financial flexibility and renewable energy incentives which makes it attractive to a large base of developers – hopefully expanding the reach of sustainable development at the urban level.

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Credit Creation Theory

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As discussed in my previous post, this week I will be focusing on specifically on the credit creation theory of banking. Dr. Werner ultimately makes the case that this is the most compelling theory of banking because it most accurately depicts how the current financial system functions at the transactional level. I tend to agree with his assessment and find the credit creation theory to be a helpful lens through which to view the current financial system. Moreover, if you accept the tenets of this theory, deficits in monetary policy and banking regulations start to appear. This post will focus on the concept of money, how it is circulated and the logic of credit creation.

The Concept of Money & How it is Circulated

Money within an economy can take several forms. The most common forms are notes, coins, and credit. Precious metals such as gold and silver are also prominent forms of money. However, only about 3% of the money in circulation is derived from cash or coins. The overwhelming majority of the money in circulation, ~97%, is comprised of credit originated by banks. This credit is derived from bank deposits and circulated through the economy in the form of loans. A bank effectively creates credit money when generating a bank deposit that is a consequence of fulfilling a loan agreement with a borrower. When the debt instrument is executed, the bank deposits the agreed upon sum into the borrower’s account.

Credit money represents the total amount of money that is owed to banks by borrowers and it only remains valid so long as the bank is solvent. Though it is intuitive to assume that as a loan is paid back to a bank the money supply would expand, the opposite is actually true. Bank deposits basically represent an IOU between a commercial bank and their clients (represented by both individuals and organizations). Again, when a commercial bank lends money, they are technically creating a deposit in another account. Moreover, when individuals deposit their money in a bank they are technically serving as a creditor to the bank, which in turn reserves the right to deploy the depositors’ capital as they see fit. This dynamic is important to understand in order to grasp the credit creation theory of banking at a high level.

The Logic of Credit Creation

As mentioned previously, the dominant theories of banking have been the intermediation theory and fractional reserve theory. These are the theories that are most often taught in college level business, economics, and finance courses. Credit creation theory is seldom considered in academia, however the Bank of England recently published a paper which recognizes the credit creation theory as useful and practical. The theory proposes that individual banks create money and do not solely have to draw upon existing deposits. Instead, the banks create deposits with each loan they originate. As a result, banks are not actually constrained by their deposit activities. By virtue of the bank’s lending, new purchasing power is created which did not previously exist.

The argument for credit creation theory works like this – banks act as the ‘accountant of record’ within the financial system, which enables them to create the fiction that the debtor has deposited money at the bank. The general public is unable to distinguish between money that a bank has created through debt instruments and money deposited at the bank by individuals. Moreover, banks’ ability to create credit money has had significant impacts in the economy – as stated previously, ~97% of all transactions taking place in the economy are considered non-cash or credit transactions. These transactions are settled with non-cash transfers within the banking system as a whole. Ultimately, this theory makes the case that banks are capable of creating an endless supply of money through their lending activities. When viewed from this perspective, current and past financial crises, as well as interventions from the Fed begin to make sense.

As always, if you found this information valuable please like, share, and subscribe to my content.

The Three Theories of Banking: An Overview

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I have already published a few posts regarding the Federal Reserve and the credit facilities it has developed in an attempt to mitigate the financial crisis resulting from the COVID-19 pandemic. However, I thought it would be beneficial to take a step back and explore a more fundamental topic – how does banking work? This is a topic that I’ve been interested in discussing for a while and I think now is a great time to explore it. The answer to the question of how banking works is more complicated than many realize. Moreover, it is still a topic that remains open to debate within the realm of economics.

One of the most compelling arguments that I’ve come across stems from the work of German economist Richard Werner. He provides three mutually exclusive theories of banking, ultimately making the case that one in particular is the empirically correct way to understand how banking works in practice. The three theories put forward by Dr. Werner are the financial intermediation theory, the fractional reserve theory and the credit creation theory.  It is important to grapple with these theories because the way banking is conceived of and carried out in practice will ultimately have profound implications for how banking policies, monetary policies, and bank regulations are implemented. For the purposes of this post, I will be focusing on the three theories of banking presented above and how they are unique from each other.

Financial Intermediation Theory

This is the presently dominant theory of banking. It holds that banks are merely financial intermediaries, undiscernible from other non-bank financial institutions: they gather deposits from clients and use them to make loans. Put another way, banks are “borrowing” money from their depositors in the short term and using that money to make long term loans to borrowers. This theory of banking is publicized by highly ranked economics journal and has also been lauded by well known economists such as Keynes and Mises, with Mises being one of its earliest proponents. The more recent views of this theory, as put forth by the likes of Ben Bernanke, double down on the notion that banks are simply financial intermediaries, one among many, with the power to create credit or money. The key distinction here is that banks and other financial intermediaries do not create money, they can only repurpose existing funds – effectively swapping one asset for another.

Fractional Reserve Theory of Banking

This theory of banking also makes the case that each bank serves as a financial intermediary, but it takes a more nuanced approach than the former. For example, this theory disagrees with the collective notion that banks are solely financial intermediaries, indistinguishable from others, incapable of creating money. Rather, it argues that “together” the banking system does create money through the process of depository expansion. This process is also referred to as the “money multiplier” process. While each bank serves as a financial intermediary, the banking system as a whole is capable of creating new money. Fractional reserve banking effectively means that banks can lend in excess of their reserves, while the total amount outstanding must remain equal to total deposits. Typically, banks are only required to hold 8-10% of their outstanding loan balances in reserves. An important caveat here is that, just like in the financial intermediation theory, banks cannot make loans without having depositors. The nuanced part of this is that banks are only required to allocate a small percentage of their deposits to reserves, while lending out the rest. These new loans become inevitably create multiple new deposits throughout the financial system, which has the aggregate effect of creating new money.

Credit Creation Theory

The third theory of banking is at odds with the other two theories presented above. Unlike financial intermediation and fractional reserve approaches, the credit creation theory asserts that banks are not financial intermediaries in any sense. Rather, each bank is said to be capable of creating credit and money out of nothing whenever it executes a bank loan contract or purchases an asset. From this perspective, banks are not required to gather deposits or allocate reserves in order to lend. This theory posits the opposite – that banks create deposits whenever they originate a loan. The argument being made here actually has less to do with finance and more to do with the law. When a bank originates a loan, what takes place legally is the execution of a legal document. This legal document is a “debt instrument” that the bank is technically purchasing from the borrower under a particular set of conditions (i.e. the sum being purchased by the bank now, will be repaid in the future with interest). Through this purchase, the bank creates a deposit and records it as such on its books. Therefore, at the end of the transaction, money has been created that did not exist prior.

Conclusion

This concludes my brief overview of the theories of banking. Most are probably familiar with the financial intermediation and fractional reserve theories, especially if they have taken contemporary courses in finance, economics, or business. What I found the most interesting in Werner’s work was the notion of credit creation, as it was, for me, a novel concept with some interesting implications. In future blogs I will focus more on this topic and expand on more on the credit creation theory. As always, if you found this information valuable please like, share, and subscribe to my content.

A Glimmer of Hope – Mortgage Refinancing in the Wake of Coronavirus

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The financial markets have experienced unprecedented levels of volatility resulting from the Coronavirus pandemic. These swings in the market have prompted equally unprecedented responses from the Federal Reserve and U.S. Treasury with the aims of providing relative stability to the financial system. I have written extensively about the responses taken by the Fed over the last month, providing mostly overviews and critiques of certain credit facilities. Moving forward, I’d like to highlight something that has emerged as a financial silver lining amongst the chaos – increased utility from and demand for mortgage refinancing.

A significant result of the turmoil we’ve seen in the financial markets has been rate cuts. The Fed cut rates to near zero at the beginning of the pandemic to quell the market and incentivize borrowing. The lower rates have generated a boon in demand for mortgage refinancing. According to the Wall Street Journal average jumbo loan rates dropped to their lowest levels since 2011 – 3.58%. Given the current circumstances, it is likely that rates will remain low. Excessive demand for mortgage refis may result in minor rate hikes, but in general the incentives to refi will remain intact.

Moreover, given the combination of massive losses of income, low rates, and a boon in home equity over the past 10 years, families and individuals will be looking to cash in on the equity they’ve accumulated. Home equity can provide a much needed buffer for households that have experienced a reduction or complete loss of income. Fortunately, given the low rate environment and demand for mortgage backed securities (MBS) enhanced by the Fed, households find themselves in an opportune position to access the capital they need. However, the current state of affairs presents a dynamic situation. Prospective borrowers should familiarize themselves with potential disruptions in the process as well as easy to make, but avoidable mistakes. A few examples of each will be presented below.

Potential Disruptions

I read a great article from Brookings that explored several potential disruptions and also laid out a set of policy solutions for each. I highly recommend reading it if you’re interest in more than a cursory overview of the mortgage space. For the sake of this post, I’ve isolated the two disruptions I considered to be the most important for prospective borrowers to be aware of – verification of employment and closing.

First, mortgage refis currently require some form of employment verification; this is a difficult requirement to meet in the current environment when so many employers have been forced to shut down in the midst of the pandemic. Fortunately, Fannie Mae and Freddie Mac have provided some flexibility to the situation by allowing employers to verify employment status via email. Moreover, this requirement can also be met with a paystub or bank statement and the lender can wait to obtain verification up to loan closing. This step is key and all lenders will want to maintain it as part of their underwriting process to some degree. Moreover, Fannie and Freddie have both required lenders to engage in due diligence to ensure continuity of income during the pandemic as a condition to guarantee the loan. Conventional lenders will have more flexibility to address repayment capacity, but since a significant portion of mortgage lending incentives are provided through Fannie and Freddie, this may present a significant pitfall for prospective borrowers. This is particularly true for those who are self-employed.

Second, the closing process for these loans is complicated in the current environment because many homeowners will be unwilling to allow a notary into their home to physically execute closing documents. Conversely, many notaries are likely to resist entering a stranger’s home. A majority of states do not allow e-notarizations, but fortunately this is changing. Currently, 23 states allow for virtual signings, with New York being the most recent addition as of March 20th.  Additionally, there are an increasing amount of Fintech lenders adopting the e-notarization standard as the default for closing loans – Figure Technologies is an excellent example.

Mistakes to Avoid

The two most important considerations prior to initiating a mortgage refi are getting appraisal ready and making sure your credit situation is lean. First, make sure that your home is appraisal ready before engaging a lender. Since the appraisal will ultimately determine how much equity you can withdraw from your house, it is imperative that everything is in order prior to ordering an appraisal. If you’re considering home improvements or in the midst of completing them, make sure they are completed in advance. The house should not be under construction at any point during the appraisal process. Ultimately, the key is to ensure your home is as immaculate as possible to maximize the valuation at the time of refinance.

Second, make sure your credit situation is pristine. Do not open a new auto loan, line of credit, etc immediately before or during the mortgage process. New debt creates several issues that can impact your ability to qualify. This is especially important during the pandemic, as repayment capacity will be heavily scrutinized. Moreover, as lenders gear up to process a slew of refi requests, they will inevitably run into problems with capacity. In normal times, lenders would just hire and train new loan officers, but the pandemic has inhibited hiring in a majority of sectors, not just mortgage lending. As capacity is stretched thin, lenders will likely place a premium on borrowers with the best credit situation. The more you can do to enhance your repayment capacity, the better.

This wraps up my post on mortgage refinancing in the wake of Coronavirus. As always, if you found this information valuable please like, share, and subscribe to my content.

Secondary Market Corporate Credit Facility: Analysis and Consequences

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Earlier this week I wrote about the Primary Market Corporate Credit Facility (PMCCF). Today, I will follow up with an analysis of its counterpart – the Secondary Market Corporate Credit Facility (SMCCF). The SMCCF and PMCCF both aim to support the flow of credit to large firms. The key difference between the two is that the SMCCF supports liquidity in existing markets, while the PMCCF is designed to support new bond and loan issuances. Similar to the PMCCF, the SMCCF will take the form of an SPV that will purchase existing individual corporate bonds as well as corporate bond portfolios in the secondary market.

The facility works like this – the Federal Reserve Bank of New York (FRBNY) will lend to the aforementioned SPV on a recourse basis and the FRBNY’s loans will be fully secured by the entirety of the assets held by the SPV. Finally, the Treasury will seed the SPV with $10 billion using the Exchange Stabilization Fund, the FRBNY will in turn leverage the $10 billion investment to purchase existing bonds and bond portfolios in the secondary markets. I will highlight what I consider to be the most important aspects of the SMCCF and discuss potential consequences of the facility below.

Key Aspects

The SMCCF will mirror the guidelines of the PMCCF when it comes to the purchase of individual corporate bonds – they must be BBB or better by a major NRSRO. Specific to SMCCF is that the bond being purchased must have a remaining maturity of five years or less to be eligible. Moreover, the SMCCF will be purchasing eligible bonds at fair market value in the secondary market. The rationale here is that the FRBNY will, through the SPV, mitigate existing volatility and provide stability in the credit markets by insuring there remains a buyer for existing corporate debt.

In addition to individual corporate bonds, the SMCCF will purchase corporate bond portfolios which (for now) are only limited to exchange traded funds (ETFs). This is, in my opinion, the most profound point of departure we’ve seen the Fed take over the course of the pandemic and it is certainly unprecedented. The investment objective here is to provide broad exposure to the market for U.S. investment-grade corporate bonds. The specifics are presented below:

  • The SMCCF can purchase up to 10% of an issuer’s maximum bonds outstanding at any time between March 22, 2019 and March 22, 2020.
  • The SMCCF can purchase up to 20% of the assets of any one ETF as of March 22, 2020.
  • Finally, and this is a key provision, the SMCCF will not purchase shares of ETFs at a price that materially exceeds the estimated net asset value of the ETF’s underlying portfolio. This is supposed to mitigate substantial losses, should the portfolios buckle.

Both eligible purchases under the SMCCF will have tangible impacts in the secondary markets, but my primary focus for this piece will be to drill down on the former. As stated previously, the Fed making direct investments in the corporate bond portfolios is certainly a new frontier that is sure to result in a slew of consequences, both intended and unintended.

Consequences of the SMCCF

In my opinion, the most interesting consequence has been the market’s reaction to the announcement of the new facility. Companies have started issuing massive sums of corporate debt in anticipation of the SMCCF and the HYG Fund (a corporate bond ETF) experienced its most significant single day spike in value since 2009 late last week (depicted below).

Source – ETF.com segment: Fixed Income: U.S. – Corporate, Broad-based High Yield

Again, keep in mind that this spike was wholly attributed to the Fed’s announcement. The facility has yet to be implemented and therefore no bonds or shares of bond ETFs have been acquired by the Fed through the SMCCF. In my post about the PMCCF, I expressed concern that it was effectively a bailout for imprudent firms, that it sent the message that bad behavior is acceptable. The same is true of the SMCCF, as it will provide liquidity for existing corporate bonds that would otherwise collapse. However, the speculation that it will drive in bond portfolios such as the HYG Fund is far more concerning.

Facilitating artificial growth in the corporate bond markets is dangerous because these credit facilities are effectively propping up what can be objectively considered poor investments in overleveraged firms. In doing so, they are overriding a fundamental truth – firms that egregiously mismanage money are ultimately supposed to fail. This is no longer the case, so long as a firm is large enough to issue corporate debt they will be empowered to do so. This will maintain a status quo that routinely punishes other firms and investors for making prudent financial decisions.

Conclusion

Finally, I think it is important to mention that all of this is occurring in the midst of record high unemployment filings. Each week the numbered of unemployed expands, demonstrating profound strife in the real economy. However, this inconvenient truth appears to have no bearing on the stock market as stocks once again begin to rise in the midst of these new Fed credit facilities. I mentioned above that the HYG Fund experienced it’s largest single one day valuation spike since 2009 last week – this occurred after unemployment filings were recorded in excess of 6 million. The most recent filings, adding an additional 5.2 million to initial jobless claims, are presented below.

Source – YCharts: US Initial Jobless Claims

Unfortunately, these figures once again coincide with an uptick in equity futures. Below is a graph chronicling activity within the NASDAQ Composite index over the course of today, signaling an ever-expanding chasm between Wall Street and Main Street.

Source – Yahoo Finance: NASDAQ GIDS Real Time Price

As always, thank you for taking the time to read my thoughts. If you found this information valuable, please be sure to like, subscribe and share with others. Additionally, please feel free to weigh in on these topics, I’d love to see what others are thinking!

Financial Content

When it comes to financial content, it’s very important to identify legitimate sources, especially since the content you choose to consume on a regular will constitute your daily news cycle. In this post I will present a few of my favorite finance publications and make the case for why you should incorporate some (or all) of these sources into your feed. These are great sources whether you’re just getting acquainted with finance, an active practitioner, or somewhere in between.

Quality over Quantity

There is only so much information we can actually consume and retain over the course of a day. Therefore, when it comes to staying on top of financial topics I place a lot of weight on finding a handful of quality sources, rather than stuffing my feed with as much information as possible. The way I see it, if you try to process too much information at once without getting your bearings straight, you won’t retain much at all. In the sections that follow I am going to make the case for some of my favorite outlets, but ultimately I would argue that this is an exercise anyone who has an interest in finance should go through. Once you take the time to find outlets you’re reviewing on a daily/weekly basis, you’ll know you’re hooked.

The Wall Street Journal

Okay, this first one is pretty obvious – but it is an absolute staple. The Wall Street Journal remains a journalistic authority on all things related to the financial sphere and it should be a part of any aspiring financier’s daily feed. The reason I’m so invested in the WSJ is that it is arguably the most comprehensive daily resource for financial news in the U.S. and abroad. Having the WSJ as part of your daily feed will certainly keep you in the know when it comes to the most relevant financial, political, and business-related news. The quality and consistency of their content is well worth the price of admission (~$40/month).

Hidden Forces

Hidden Forces is a podcast hosted by Demetri Kofinas that facilitates conversations with prominent (and often contrarian) thinkers in the realms of technology, finance, social science, and occasionally, the hard sciences. The thing I love about this podcast is that you are always provided with something new and challenging to consider at the end of each interview. While the guest list is somewhat varied, I think it’s fair to say that a majority of the guests are experts in a finance related domain. This show is a particularly good resource for those interested in developing a greater understanding of the forces at play in financial markets. This is a free podcast, however there are subscription services available that range from $10-20/month if you’d like to have access to longer interviews and more comprehensive content (such as transcripts and show notes).

American Affairs Journal

American Affairs is a quarterly journal of public policy, political thought, and economic thought. It was founded in 2017 with the aim of providing an outlet for people who consider conventional partisan platforms ill-equipped to address contemporary public policy challenges. Although this journal is geared towards public policy, a considerable amount of their publications address financial and economic topics. The reason I recommend this publication so highly is because it is one of the few truly contrarian outlets that I have come across. The articles are always well written and I can all but guarantee that the arguments presented in American Affairs are arguments you will not be introduced to anywhere else (and it only costs ~$20/year).

Conclusion

Though different in regards to their respective mediums, I decided to showcase these three outlets because of a common thread between them – each of these outlets explores financial topics through the lenses of other disciplines. The addition of these perspectives allow for a more nuanced understanding of the forces that influence and dictate the outcomes we observe in the financial system. Ultimately, the argument I wanted to make is that finance is an interdisciplinary topic; the more exposure you can get to a wide range of perspectives, the better.

Finance is the Means

All money is a matter of belief.

— Adam Smith

To many, finance is a nebulous term. It’s a term that gets thrown around quite often in our vernacular and it is something most of us take for granted. But what is finance? And more importantly, why should one care about finance? I decided to start this blog because I believe these are questions that are worthy of consideration. This inaugural post is about addressing these questions at a high level and establishing a foundation for this blog. Inevitably, all questions in finance, regardless of technicality, revert to these fundamental questions. Therefore, this post will serve as the point of departure for a myriad of interrelated topics and discussions.

So, what is finance? Let’s begin with a literal definition – finance means to “make an end.” This definition implies that all finance is supposed to serve the function of settling agreements. Essentially, finance can be thought of as a vehicle used for the purpose of transferring resources from one actor to another. How is this done? The simplest way to describe a financial system is that it serves as an intermediary for the transfer of purchasing power, and these transfers take place through transactions. More specifically, these transfers determine the allocation of assets and liabilities over space and time – often under conditions of risk and uncertainty. Put more directly, finance is the art and science of money management.

Why is this important? It’s important because finance permeates – it has an impact at the personal level, at the business level, at the state level, the national level, and most importantly, the global level. Finance is in many ways, the tie that binds. At levels small and large, the ability to effectively manage and deploy capital is essential because this is the means by which we facilitate material outcomes. Moreover, the financial system in which we are all participants is increasingly globally integrated. The implication of this is that we are all connected in unprecedented ways – personally, financially, and politically.

Ultimately, the point I intend to make here is that finance is a far-reaching concept with tangible impacts. For better or worse, we are all participants in a global financial system that dictates certain elements of our lives. The less one knows about this system, the more likely one is to be swept up in it. Conversely, the more one knows about the system, the more capable one is to act within it.