Leslie Christian’s Sharp Focus on Risk and Flawed Asset Allocation

Leslie Christian’s Essay Series:

Originally published in Reimagine Money -

» Social Finance from an Investor’s Perspective

» Getting Serious about Long Term Investing

» Allocate your Risk Response

So many of us in sustainable finance talk about the need to “finance differently”. However, not many are underwriting or, more importantly here, understanding the green finance problem any differently than before.

As Scott Muldavin points out in his recent work, your intended decision drives the content of and the manner in which you underwrite green real estate investments.  Underwriting green does not have to be done in any “special” way. Your common, hardworking DCF analysis will do the job just fine.

Many governments and NGO’s understand the green finance “problem” as one of raising awareness and delivery logistics. Make consumers aware that a new behavior (like turning off the lights) will save them money and then pay them a few bucks (as an incentive or rebate) to adopt the desired behavior.

For investors perceive the “problem” as one of risk versus reward. They want to earn an appropriate risk-adjusted return for the sustainable property they are purchasing (or lending on). You get the picture.

We’re all in favor of green real estate, just as long as we don’t have to do (too much of) anything differently.

But does any of this address the real problem, or is it all just surface noise?

“It’s the global economy, stupid…”

I imagine that’s what James Carville might say if he read Leslie Christian’s recent essay series that been published in the Reimagining Money blog, over the past few months.

Instead of providing her take on the next couple of short term moves, Christian introduces the idea that we’re all playing the wrong game entirely.

She asks us to consider whether current day approaches are driven by basically faulty assumptions. Her point: limits on ecological resources mean that there are limits to economic growth. Ignoring the role that ecological limits play within our global economy opens us up to other risks (negative and positive) the financial community has never thought about. Risks that are already playing out every day throughout our markets and the world.

Rather than trying to measure the riskiness of a particular asset within the framework of a growth economy that looks a lot like the past century but with more players, perhaps we need to consider the riskiness of the global growth economy itself.

In her first essay, she lays out why “global growth thinking,” as reflected by Modern Portfolio Theory (MPT) and pretty much all of modern finance, is no longer a workable framework (if it ever was). The unquestioned expectation of perpetual growth leads many to analyze a particular asset or risk within a perpetually growing global economy. But they never question if the global growth economy itself is a problem.

Christian does — challenging MPT, then proposing a new risk framework for the 21st century, which positions social investing as a risk mitigant. And all that happens in just the first act.

In the two subsequent essays, she takes it to the next level. By the third essay, she calls you out, naming ostriches and other non-responsive market participants in denial.

The issues she raises are getting attention in financial circles. Pacesetter Vince Siciliano, CEO of New Resource Bank, commented on the second essay:

I welcome the discussion on limits to growth and the very real impact it should have on our lifestyle and investing decisions today. When we define the word “sustainability” we express a concern about future generations without acknowledging the inherent paradox of everyone around the world trying to live an lifestyle. The blunt question is whether we are willing to freeze (or shrink) our current standard of living to make room for others both now and in the future.

On the other hand, Leslie states that we crossed the tipping point on global resource use in the mid-1960s; I wonder how we prove that fact? The use of cradle to cradle thinking and sustainable technologies will enable us collectively to live much better on a global basis and that needs to be figured into the overall calculus.

Are we protecting ourselves with an umbrella in a hurricane?

Vince points out the need for more proof on the connection between ecological and economic limits. Actually, while I think the need for proof is prudent, it is quite plausible that Christian is at least half right. And that spells big trouble because modern finance can’t even address a part of the risks that she point to. So even if she’s partly wrong, there’s still a need for sustainable finance to redefine “financing and underwriting differently”.

So if you thought that any of Christian’s writing could be true, what would you do differently?

If you even partly accept the notion of ecological limits to growth that make the entire global economy riskier than we know:

• how much have you reduced your ‘risk’ by financing and investing in green real estate?
• what is the cost of waiting to implement your strategy?
• how much benefit will you gain by focusing only on “low hanging fruit” during your energy efficiency retrofit?
• are energy efficiency finance programs, such as PACE, really effective or are they too little too late?

Or do you think, as Vince Siciliano comments, that some of today’s new sustainability thinking — like cradle to cradle — can play such a significant role that you’ll be able to to avert the horrible future Christian suggests is waiting not only for the status quo but current day green investing, too?

Take a look at Leslie Christian’s essays, risk framework and recommendations.

Think about some of the markets where you currently seek investments.  Think about your underwriting.  Your network and clients. See any signs of ecological limits taking shape?

We do.

If you work with institutional investors, send the essays along and ask them what they think.

Then, share your experience and their reactions with the rest of us. We’d love to know if and how these ideas cause your conversations and more importantly, your investing, to differ.

Access all three of the essays here:

» Social Finance from an Investor’s Perspective

» Getting Serious about Long Term Investing

» Allocate your Risk Response

PACE inside baseball: Private-label securities to the rescue?

GSE’s bench PACE

If you follow the PACE saga — which we covered in February’s Pacesetter as well as in numerous posts before, you know that it’s attracted enough interest to keep us all hopeful about the prospects for a liquid secondary market for energy efficiency loans.

But, like any saga, there are always curveballs and intrigue to keep us wondering.

GSE’s (government-sponsored entities) Fannie Mae and Freddie Mac supplied the  action in this latest edition of PACEwatch.

They recently sent PACE financing back to the dugout, by declining the purchase of tax-lien secured energy efficiency loans on residential properties, citing concerns with repayment risk associated with the priority of the tax-lien over the senior mortgages.

No, folks,  the tax-lien-priority issue will not just get up and walk away on it’s own.  Market watchers quoted in the article point out that pricing in the theoretical risk and/or clearer underwriting to clarify the value improvements to the retrofitted properties could help the GSE’s and others buy into PACE-related debt.

IMHO, it’s going to take a solid mix of both approaches to get the secondary market comfortable with fund PACE paper.  Altering a senior mortgage’s status makes it tougher for the lender to price and re-sell their loans, even if retrofits improve property valuation. They’ll want compensation for what could be an important change to their contractual structure. It’s always been that way with modifications and I don’t think there’s anything wrong with a lender expecting to be paid a market return for agreeing to re-do a deal.

Additionally, requests to see, touch and feel (and standardize) the control of the retrofit value-creation process, beyond the theoretical math of energy savings is reasonable. Programs that dole out tax payer dollars without robust underwriting and performance measurement are setting themselves up for failure.  No matter how smart we become every economic cycle, a certain percentage of loans typically fail for the same old reasons.  “Failure to properly monitor” loans is one of the oldest, and most typical paths to default.

So, while I greatly wish to see lots more capital flowing towards PACE financing, I still think it’s prudent for any lender to request clarity on the loans they buy and to be paid the right price for the risk and underwriting.

Inside baseball: private-label securitizations to the rescue?

That being said, I suggest we keep our collective eyes on the private-label securities market as an alternative funding source.  Yeah, I know it’s been dead since the economic downturn, but that would be the alternative for PACE to build up a liquid secondary market as long as the GSE’s aren’t stepping up to buy energy loans.

And the idea’s not so far-fetched since the private-label market is now starting to show signs of life.  While the GSE’s are definitely big players in the residential mortgage secondary market, which reached $2 trillion at it’s height in 2006, private-label securities were responsible for as much as 56% of home mortgage securitizations during the same time frame.

Today’s WSJ details how Redwood Trust is taking a shot at offering ~$200 million in jumbo residential mortgages in a private-label sale. This will be the first sale of private-label mortgages in two years. Market watchers say that the timing seems good for private-label securitizations to make a comeback, now that the homeowner default surge that killed the market a couple of years ago has receded. Add to that, the currently tight underwriting guidelines in effect, which strengthens the credit quality of these loans, making them attractive to secondary market investors.

Note that this particular transaction is not a done deal yet, and Redwood may have to postpone the transaction if they can’t generate sufficient interest in the offering.

For us PACE fans, however, this is bit of side action is worth tracking. The private-label securitization market is another potential source of secondary market liquidity, if the GSE’s continue to reject energy efficiency finance.

I’m willing to bet, however, that private-label market will be just as tough on conforming documentation and tight underwriting guidelines. If investors are now able to buy into residential mortgage paper structured  with tight underwriting and and high credit quality, what will compel them to give that up for PACE-paper?

Nothing, I think.

Nonetheless, the game is not over and we’ve still got several more innings to go.