Retrofitting the mortgage

Even a casual reader of the business pages has noticed that banks and mortgage lenders are suffering because of the so-called subprime meltdown. During the recent housing boom years, lenders offered many innovative mortgage products that allowed buyers who didn’t meet strict lending ratios to buy houses that would have been out of their reach. Now, problems in that sector are dragging down lenders large and small.

Citigroup (NYSE: C), the largest U.S. bank, warned in early October 2007 that its thirdquarter earnings are expected to decline 60 percent, while Switzerland’s second-largest bank, UBS (NYSE: UBS), reported anticipated thirdquarter losses of up to $690 million. In late October, Merrill Lynch (NYSE: MER) said it would take a loss totaling $8 billion, $3.4 billion of which it attributed to mortgage losses. The mounting industry writedowns totaled more than $20 billion as of late October.

As the dust begins to settle, Sustainable Industries decided to take a look at what’s happening in the newly emerging green mortgage industry.

Today, green mortgages barely even register as a niche in the $10 trillion U.S. mortgage industry. The national Mortgage Bankers Association has conducted no research on the topic; mortgage industry analysts aren’t paying attention; and the big lenders’ offerings aren’t even promoted on Web sites. In part, experts say, that’s because green mortgage benefits need to be better understood by financial institutions and by consumers; there needs to be a widely accepted, clear set of standards for defining green housing; secondary markets for bundled green mortgages need to emerge; lending limits on federal energy-efficient mortgage programs need to be increased; and the mortgage insurance industry needs to play a role.

And particularly in the wake of the subprime meltdown, green mortgages need a track record that shows bankers the bottom-line benefits of lending green.

Right now, the green mortgage is primarily a variation on a nearly 30-year-old. In 1979, President Jimmy Carter put the federal government’s clout behind the idea that homebuyers should get an incentive for buying an energy-efficient house. By the mid-1990s, several banks had begun offering so-called energy-efficient mortgages.

The energy-efficient mortgage is the most popular and best understood of the green mortgage products. That’s because the benefits are clear and it’s easy for a lender to understand the payoffs, says Donald Simon, a partner with the Oakland, Calif., law firm Wendel Rosen Black & Dean.

Carsten Crossing Development is a LEED for Homes pilot project, with homes featuring integrated solar roofing tiles. Courtesy USGBC.

In a typical scenario, the borrower is looking to buy a property with a sale price that bumps up against the maximum amount the lender is willing to finance. But the purchase price includes lots of energy-efficient measures that could reduce the borrower’s cost to operate the house. In such cases, the lender might be willing to let the borrower take out a larger mortgage than usual because the borrower can use the energy savings to make a larger mortgage payment.

Or there’s the case of a borrower who is comfortably within the lender’s comfort zone but is able to negotiate a better interest rate because the energy savings make the loan a safer bet. Over the past few years, Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), Citigroup, Chase Manhattan (NYSE: JPM), Countrywide (NYSE: CFC) and other large financial institutions have taken their first tentative steps into the green mortgage arena by offering borrowers who meet environmental standards modest rebates or interest-rate reductions, typically in the range of $500 to $1,000 or a one-eighth to one-quarter reduction in the interest rate.

Other lenders, including some in Canada, offer programs where the lender purchases carbon credits or makes donations to an environmental organization of the borrower’s choice. Citizens Bank of Canada has a green mortgage package that gives borrowers a recycling box full of goodies such as compact fluorescent light bulbs, coupons, product samples and a rebate on a home energy audit.

“In its present loose definition, a green mortgage is a mortgage that uses all available, cost-effective methodologies to reduce the huge impact housing has on the environment,” says Tomek Rondio, CEO of San Francisco–based MortgageGreen, a provider of green mortgage products and services.

So far, despite the industrywide fallout, none of the big banks have announced plans to reduce or eliminate green mortgage offerings. And no one expects banks to stop making energy-efficient mortgages, or to stop looking for ways to attach an environmental label to their products. But sources do expect that, in the short term at least, lenders will be focused more on their core businesses than introducing innovative new loan products.

In the long run, however, green mortgage backers say they believe banks will see buyers of energy-efficient, sustainable houses as a better credit risk because they have more invested in their houses, and will consider green houses easier to sell because of a relative scarcity. As Simon puts it, truly green houses are a rare commodity buyers will be loath to surrender. “It is a product in the marketplace that is more desirable than the standard house,” Simon says. “People want to have a product that is actually consistent with their values.”

The primary challenge is demonstrating to the conventional mortgage industry that green mortgages have an inherent financial value proposition, Simon says. “A green building is a better economic decision because, above all other considerations, it costs less to operate,” he says. Making such a case, however, requires a track record. As more adventuresome, or values motivated, borrowers take the plunge that record will be established, sources agreed. The second need hearkens back to an earlier question—defining exactly what a green mortgage is and providing a standard measure that will tell a lender exactly why a house is green and what the expected payoffs are.

Bamboo flooring and efficient fireplaces and windows are visible reminders of green homes' high standards. Courtesy USGBC.

Commercial builders, lenders and borrowers have the U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) certification process, which is well-established in the commercial marketplace and provides a growing track record that reassures most lenders. Similarly, most LEED-certified buildings are owner-occupied, Simon says, which makes them less of a credit risk for lenders. After all, an owner has more invested—financially and emotionally—than a tenant who is paying a lease. Also, when the project involves a corporate headquarters building, the lender knows there’s a lot of collateral behind the loan.

But loans for LEED-certified buildings still lag far behind commercial loans for standard buildings. Wells Fargo announced in mid-July 2007 it had made $1 billion in loans for LEEDcertified commercial buildings since 2004. At the end of 2007’s second quarter, the bank was carrying $16.4 billion in commercial real estate loans on its books.

In the residential sector, a handful of smallbut- growing certification programs could help provide a way to measure the costs and benefits of building green, which in turn could show lenders there are valid reasons to offer preferential rates to green borrowers.

In 2005, the U.S. Green Building Council launched a pilot LEED for Homes project that certified 134 projects totaling 336 units through early October 2007. But in 2005 alone there were over 15 million residential mortgage loans made across the United States.

Then there’s Build it Green’s GreenPoint Rated program in California. Simon, who is the organization’s board president, says it provides California builders, buyers and lenders with clear guidelines on what constitutes a green house. Energy-efficient mortgages require some sort of inspection to ensure the house does meet lending criteria. GreenPoint’s program, according to its Web site, is compatible with both LEED for Homes and the federal government’s Energy Star program. The home energy rating system (HERS), which is now the standard in California, is gaining enough ground to create a un-met demand for inspectors who are certified to perform HERS inspections.

Lenders need standards to ensure they are making loans for real improvements and features that have a clear benefit, sources say, noting that, as the various private, state and national standards boards gain in visibility and clout, the green mortgage market should become less of a novelty and more of a straightforward business proposition. “It’s all about finances,” MortgageGreen’s Rondio says.

A financial track record would allow green mortgages to be bundled into mortgage-backed securities that could attract institutional investors. That’s important because it would give the whole idea legitimacy and attract the lenders and investors who could quickly take a niche idea mainstream. The socially responsible investment sector lacks a real estate investment option and would likely be an early buyer of green mortgage–backed securities, according to Simon.

Of more immediate concern, says Rick Williams, a certified mortgage planning specialist at Residential Pacific Mortgage in Santa Cruz, Calif., is the need to rewrite federal rules governing energy-efficient mortgages. Energy efficiency, nearly all industry experts agree, is likely to remain the cornerstone of any green mortgage offering.

Fannie Mae and Freddie Mac, the two federal home mortgage programs, run an energy-efficient mortgage program that gives borrowers a break on debt-to-income ratios when buying a home that meets energy-efficiency standards.

But the program is capped at $417,000 in the lower 48 states and $625,000 in Hawaii and Alaska, Williams says. There is movement in Congress to raise the limit to $625,000 throughout the United States, which would bring many more borrowers into the program. Another essential component of taking green mainstream is the participation of the mortgage-insurance industry. Canada Mortgage and Housing Corporation offers people with energyefficient homes a break on mortgage insurance. But the idea has been slow to catch on in the United States, Rondio says.

As more green mortgages are written, however, advocates expect to prove that green owners are a better risk than their conventional counterparts.

There are, however, plenty of green mortgage skeptics. Whether a financial industry reeling from its recent debacle with providing innovative lending products is ready to embrace an unproven concept remains to be seen. Even MortgageGreen’s Rondio admits “there’s no compelling reason right now to go green.”

But that’s what makes the field so exciting, true believers say. Rondio says he believes an industry shift is likely in the next five years driven by the combination of measurable, consistent standards and an overriding need to increase energy efficiency in the United States. Then, he says, green mortgage providers will compete on their ability to provide the most innovation for the dollar.

Oakland lawyer Donald Simon agrees. “The market is going to change really fast,” he says.