BILL ANALYSIS
SENATE JUDICIARY COMMITTEE S
Charles M. Calderon, Chairman B
1995-96 Regular Session
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SB 1326 (Petris)
As introduced
Hearing date: May 16, 1995
Civil Code
GEH:md
COMMON INTEREST DEVELOPMENTS
EARTHQUAKE INSURANCE REQUIREMENTS
LENDER DISCLOSURE
HISTORY
Source: California Association of Realtors
Related Pending Legislation: SB 1325 (Polanco); AB 1975 (Knowles);
SB 1327 (Johnston); AJR 23 (Hauser); SB 266
(Rosenthal); SB 58 (Lewis);
SB 8X (Campbell)
ANALYSIS REFLECTS AUTHOR'S AMENDMENTS TO BE OFFERED IN COMMITTEE
KEY ISSUES
1. SHOULD THE LEGISLATURE DECLARE THAT FREDDIE MAC'S EARTHQUAKE
INSURANCE UNDERWRITING REQUIREMENT FOR LOANS SECURED BY
CONDOMINIUM UNITS HAS BEEN "ARBITRARILY IMPOSED" AND IS
UNWORKABLE, EXTREMELY EXPENSIVE AND DIFFICULT?"
2. SHOULD LENDERS ISSUING A MORTGAGE SECURED BY A CONDOMINIUM UNIT
BE REQUIRED TO MAKE SPECIFIED DISCLOSURES CONCERNING FREDDIE
MAC'S EARTHQUAKE INSURANCE UNDERWRITING REQUIREMENT?
PURPOSE
The purpose of this bill is to require lenders issuing a mortgage
secured by a condominium unit be required to make specified
disclosures concerning Freddie Mac's earthquake insurance
underwriting requirement. The purpose of the bill is also to
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express the Legislature's disapproval of this earthquake insurance
requirement.
What is Freddie Mac?
Freddie Mac's formal name is the Federal Home Loan Mortgage
Corporation. It was created by Congress on July 24, 1970 ( 12
U.S.C. 1451 et. seq.) to provide stability in the secondary market
for residential mortgages by increasing the liquidity of mortgage
investments and improving the distribution of capital available for
residential mortgage financing.
Freddie Mac's principal activity consists of the purchase of
conventional residential mortgages from primary lenders. It is
allowed to purchase residential mortgages whose principal balance is
$203,000 or less, and it holds about one out of every six
residential mortgages in the United States. Freddie Mac finances
its purchases of mortgages by sales of guaranteed mortgage-related
securities, primarily mortgage participation certificates.
Congress has also created the Federal National Mortgage Association
("Fannie Mae"), which also purchases residential mortgages from
primary lenders and packages them as securities. Although Freddie
Mac and Fannie Mae at one time dealt in different markets, they are
now essentially competitors in the same business.
General authority over Freddie Mac and Fannie Mae is vested in the
Secretary of Housing and Urban Development (HUD). (12 U.S.C. 4541)
The Office of Federal Housing Enterprise Oversight (OFHEO) in HUD is
specifically charged with regulating these enterprises to ensure
that they engage in safe and sound financial practices. (12 U.S.C.
4513).
Although created by Congress, Freddie Mac (like Fannie Mae) is a
stockholder-owned corporation. Courts sometimes consider it to be a
governmental entity, and sometimes they consider it to be a private
entity, depending upon the context. Compare McCauley v. Thygerson
(D.C. Cir. 1984) 732 F.2d 978 (holding that Freddie Mac is not part
of the federal government for purposes of the Federal Tort Claims
Act) with Mendrala v. Crown Mortgage Company (7th Cir. 1992) 955
F.2d 1132) (holding that Freddie Mac is a governmental entity for
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purposes of applying the doctrine that promissory estoppel cannot be
asserted against a governmental entity).
In finding that Freddie Mac was a governmental entity, the Mendrala
decision emphasized the fact that Freddie Mac is statutorily
authorized "to make and enforce such bylaws, rules, and regulations
as may be necessary or appropriate to carry out the purposes of this
chapter." (12 U.S. 1452(c)). It is also authorized to impose various
requirements on classes of sellers or servicers of
mortgages" (12 U.S.C. 1454(a)(1)).
Pursuant to this statutory authority, Freddie Mac has issued a set
of requirements for loans which it purchases. These requirements
are set forth in the Single-Family Seller/Servicer Guide ("the
Guide"). Primary lenders which want to sell their home loans to
Freddie Mac must impose the requirements set forth in the Guide upon
the borrowers to whom they issue home loans.
Freddie Mac's new earthquake insurance requirement
On February 15, 1995, Freddie Mac issued Bulletin 95-2, announcing
that, as of July 1, 1995, the Guide will be amended to provide that,
in specified areas of California, condominium units used to secure
loans must be in condominium projects which are covered by
earthquake insurance.
Under the Davis-Stirling Common Interest Development Act,
condominium projects are governed by homeowner associations.
(Section 1350 et. seq. of the Civil Code) Associations are granted
broad powers to maintain and repair the areas of the project which
are owned in common by all of the unit owners. These poweres
include the ability to impose fees and assessments on unit owners to
pay for such maintenance and repair. The commmon area controlled by
the association includes the structure of the project; the separate
interest of unit owners is basically the air space inside of their
unit.
A condominium project would meet the new Freddie Mac requirements if
the association purchased earthquake insurance whose limit was equal
to 100 percent of the insurable replacement cost of all fixtures,
improvements, alterations, and equipment within both the common
areas of the project and the individual condominium units. The
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policy need not include fixtures, etc. in individual units if the
association's governing documents require unit owners to
individually insure their units against earthquakes.
Associations would also be required to "prefund" the insurance
policy's deductible, in one of the following ways:
1) By establishing a cash reserve designated for the exclusive use
of paying the earthquake policy deductible;
2) By maintaining condominium unit owner's earthquake insurance on
all units in the project, including coverage for loss
assessments which may be imposed by the association upon unit
owners to cover costs incurred by the association.
3) Any other method which fully prefunds the deductible; for
example, surety bonds.
This requirement applies to condominium units in "high-risk" and
"moderate-risk" areas of the state. These areas are identified by
zip code, and they encompass most of the Bay Area, Los Angeles,
Orange County, San Diego, and Humboldt County.
In "high-risk" areas, the requirement applies to all condominium
projects. In "moderate-risk" areas, the requirement applies to
certain types of condominium projects, as determined by a matrix
developed by a risk management firm. The matrix factors in the type
of material used in construction of the project, its height, the
date of construction, whether there is an underground parking lot,
etc. As a practical matter, it appears that most projects in
moderate-risk areas will be required to have earthquake insurance.
There is also a provision for obtaining site-specific waivers from
the requirement for projects in either high- or moderate-risk areas.
Fannie Mae has not adopted any earthquake insurance requirement for
condominium loans.
Earthquake insurance requirements under present state law
Under Section 10081 of the Insurance Code, no policy of "residential
property insurance" may be issued in California unless the named
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insured is offered coverage for loss or damage caused by
earthquakes.
It is the practice in the insurance industry to issue commerical
loans to associations for their condominium project. This practice
was validated by a state Court of Appeals in Marina Green Homeowners
Ass'n v. State Farm (1994) 25 Cal.App.4th 200. The court held that
the statutory duty of an insurer to offer earthquake insurance in
residential insurance policies did not apply to insurance issued to
condominium homeowner associations to cover the common interest in
the project's structure.
The Marina Green court did hold that policies offered to individual
unit owners to insure their separate interest were required to
include earthquake coverage.
Real estate and lender disclosure requirements under present law
Existing law, Sections 1102 and 1102.6 of the Civil Code, require a
seller of real property to disclose to a prospective buyer various
facts about the condition of the property, and a statutory form
established for such disclosure. Cities and counties also have the
option of requiring an additional statutory form.
The Alquist-Priolo Earthquake Fault Zoning Act (Section 2621 et.
seq. of the Public Resources Code requires the State Geologist to
inform cities an counties about the locations of surface rupture
faults. Section 2621.9 requires property owners to inform
prospective buyers if the property is located within an identified
earthquake fault.
The Seismic Hazards Mapping Act (Section 2690 of the Government Code
et. seq.) requires the State Geologist to compile maps of earthquake
fault zones, landslide hazards, dam inundations, and the effects of
tsunami and seiche. Section 2694 requires a seller to
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inform prospective buyers if the property is within a seismic hazard
area.
All of these disclosure requirements may be satisfied by including
the necessary information when filling out the statutory forms, or
in the real estate contract and receipt for deposit.
Lenders are required by a number of federal and state laws to make
disclosures to a prospective borrower concerning the exact terms and
conditions of the loan. These required disclosures include the
federal Truth in Lending Statement.
Proposed legislation
This bill is an urgency statute declared to be necessary for the
immediate preservation of the public peace, health or safety. The
bill states that the facts constituting the necessity are that an
institutional third party purchaser has "arbitrarily imposed" a new
requirement which "will impose an unworkable, extremely expensive,
and difficult insurance requirement."
The bill further states that "homebuyers and sellers need to be
informed of their options as soon as possible in order to avoid
significant loan defaults and to determine what options are
available when the new requirement becomes operative."
The operative language of this bill requires a lender, when issuing
a mortgage secured by a separate interest in a common interest
development which may be sold to an institutional third party, to
disclose all of the following to a potential borrower "as soon as
reasonably practical:"
1) That the lender or institutional third party in question
requires earthquake insurance.
2) That not all lenders or institutional third parties require
earthquake insurance.
3) That all of the units and all of the common areas in the common
interest development may require earthquake insurance.
4) That lenders or institutional third parties may also require
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that a common interest development maintain, or demonstrate an
ability to maintain, financial reserves in the amount of the
earthquake insurance deductible.
The bill defines "institutional third parties" as Freddie Mac,
Fannie Mae, and similar institutions, whether public or private.
COMMENT
1. Should the Legislature express its disapproval of Freddie Mac's
earthquake insurance underwriting requirement?
a) Freddie Mac's argument in favor of its requirement
After Freddie Mac purchases a home mortgage loan, if the
borrower defaults, it is Freddie Mac, not the original
lender, which must foreclose on the property in order to
recapture the principal. If a borrower defaults because the
borrower cannot afford to repair earthquake damage which was
not covered by insurance, Freddie Mac's foreclosure rights
are not very meaningful because of the depreciation in value
of the collateral due to the earthquake damage.
This problem is particularly acute with condominiums
because of the nature of their governance. Unless most of
the unit owners or at least most of the owners on the
association board have significant equity in their units, it
is not likely that the association will vote to assess unit
owners the costs of repairing earthquake damage, since the
necessary assessment will often be more than the equity held
by many unit owners. The same economics apply to the
initial decision to carry earthquake insurance.
Condominiums are also structurally more likely than
detached homes to suffer earthquake damage, for a variety of
reasons.
According to Freddie Mac, after the Northridge
earthquake, 13 homeowner associations have dissolved (or are
dissolving) because of a lack of earthquake insurance, or
because of an inability to find their deductible. As a
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result, 450 condominium unit owners have lost their homes
and their equity.
Freddie Mac reports that 50 percent of its losses from
the Northridge earthquake resulted from defaulting
condominium owners, even though condominiums constituted
only 10 percent of their loan portfolio in the region
affected by the quake.
In response to questions about why it has singled out
California, Freddie Mac states that it is investigating the
need for similar requirements in other select parts of the
country. It cites research that there is a 60 percent
probability of a 7.5 earthquake hitting San Francisco in the
next 30 years, and a 47 percent probability of a 7.0
earthquake hitting the Los Angeles area in the next five
years. This California-only requirement "responds to the
immediate California reality first."
b) Arguments against Freddie Mac's policy
The sponsors of this measure, the California Association
of Realtors (CAR), compare Freddie Mac's earthquake
insurance requirement to the dinosaur park in the movie
Jurassic Park. They argue that, like the scientist who
created that park, Freddie Mac will produce unintended chaos
and catastrophe as a result of employing a seemingly simple
scientific model:
"[A] closer look at the implications of Freddie Mac's
new policy unveils a more complex, and highly disturbing
reality that threatens to create havoc in the California
real estate market."
CAR's first argument is that the policy unfairly singles
out California and uses "a new earthquake risk assessment
model that is based on an untested scientific methodology."
In questioning the methodology, CAR belittles the fact that
1200 of the zip codes Freddie Mac places in high-risk and
moderate-risk zones have no population at all; they include
only post office boxes or high rise office buildings.
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Another CAR-sponsored bill, SB 1327 (Johnston) would
prohibit the use of earthquake risk assessments of
condominium projects for loan underwriting, unless the
analytical assumptions and methodology used have been
approved by the state Insurance Commissioner.
In arguing that California has been unfairly singled
out, CAR has provided a chart showing that 9 of the 10 worst
earthquakes (measured by Richter scale magnitude) in United
States history were outside of California. Seven were in
Alaska.
CAR's second argument is that imposing a requirement on
condominiums sets a dangerous precedent:
"If Freddie Mac's new risk assessment of California zip
codes becomes the norm, this could cause the overall market
to revisit its current risk assessment of California
properties, resulting in further slippage of California home
prices. The California housing market could experience
foreclosures, short sales, and loss of wealth for its
citizens."
CAR's third argument is that the policy will
disproportionately impact minorities. This issue is
discussed in detail in the analysis for SB 1325 (Polanco),
which is also to be heard in the Judiciary Committee on May
16th.
c) Is condominium earthquake insurance meeting Freddie
Mac's requirements available?
CAR's over-arching argument against Freddie Mac's policy
is that it is a ruse designed to cover up Freddie Mac's
intention to pull out of the California condominium market.
This belief is based on the argument that Freddie Mac's
earthquake insurance requirement will be virtually
impossible to meet, and that therefore Freddie Mac will not
be buying any condominium loans in the areas covered by the
requirement, which represent the vast majority of the
state's populated areas.
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Freddie Mac vehemently denies that it desires to
pull-out of the California condominium market. It contends
that many condominium projects will be able to meet its new
requirement. In support of this proposition, it cites a
statement by the Community Associations Institute that
"about 68 percent of all condominium associations in
California already earthquake insurance."
Freddie Mac does acknowledge that this insurance would
not necessarily meet the prefunded deductible requirement,
but indicates that the statistic debunks the myth that
earthquake insurance is generally impossible to find.
CAR's argument focuses on this prefunded deductible
requirement, arguing that it is highly unlikely that any
association will be able to set aside a cash reserve equal
to the amount of its earthquake insurance deductible. They
argue this would essentially require unit owners to make a
double downpayment.
Freddie Mac concedes this point, but argues that CAR is
ignoring the provision in its policy allowing deductibles to
be prefunded by purchasing condominium unit owners policies
which will cover loss assessments imposed by associations,
or by other means such as surety bonds.
Under the recent Marina Green decision, supra, insurers
offering homeowner policies to condominium unit owners are
required to offer the unit owners earthquake coverage for
their separate interest. However, it is not clear if the
scope and amount of coverage required to be offered would
meet the criteria of the unit owner policy option for
meeting Freddie Mac's prefunded deductible requirement.
Nevertheless, Freddie Mac claims that associations will
be able to meet the prefunded deductible requirement. It
cites a Long Beach association which has acquired an
earthquake insurance policy and a condominium unit owners
policy meeting the prefunded deductible requirement. This
policy is costing unit owners' $22.98 per month for each
$100,000 increment of coverage.
Also cited is an Escondido association which has
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prefunded its deductible with a surety bond. The total cost
to unit owners is $16.41 per month.
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d) Appropriateness of the language in the bill's urgency
clause
On the basis of the debate summarized above, the
committee may wish to consider whether it is appropriate for
the Legislature to make the statements proposed in this
bill's urgency language: that Freddie Mac's policy has been
"arbitrarily imposed"; that the policy is "unworkable,
extremely expensive, and difficult."
SHOULD THE NECESSITY FOR AN URGENCY BE STATED IN LESS
PROVOCATIVE LANGUAGE?
2. Requiring lenders to make disclosures about the earthquake
insurance requirement
There does not appear to be any dispute about the fact that it
would be desirable for condominium buyers/borrowers to be
informed as to possible earthquake insurance requirements, and
their options regarding such requirements.
The only dispute is over who should be required to make these
disclosures. Freddie Mac argues that, since sellers and agents
are already required by law to disclose whether a property is in
certain earthquake hazard zones, it only makes sense that they
should be required to disclose that being in such a zone may
mean that a condominium must be covered by earthquake insurance.
Freddie Mac also argues that the disclosure should happen as
soon as possible, and imposing the obligation on the seller or
agent would facilitate such early communication.
CAR argues that, since the earthquake insurance requirement is a
term and condition of the loan, the lender should be responsible
for the disclosure, just as it is responsible for all other
required disclosures about the terms and conditions of the loan.
Acknowledging Freddie Mac's point that the disclosure should
happen as soon as possible, the author is proposing to amend the
bill in committee to require the lender to ensure that the
disclosure be made as "as soon as reasonably practical." Since
prospective buyers often contact a potential lender before
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making an offer, this requirement might result in earlier
disclosure than would a requirement that sellers or agents make
the disclosure.
To be sure, both Freddie Mac and CAR are protecting certain
interests in asserting their respective positions about who
should make the disclosure.
Freddie Mac is unhappy that CAR is proposing a whole package of
bills attacking their new requirement, and this bill may provide
an appropriate opportunity to argue that CAR's members
should have a requirement imposed upon them.
CAR appears to be less interested in informing buyers/borrowers,
than it is interested in influencing lenders. It hopes that
requiring the lender to make the disclosure will encourage
lenders to not abide by Freddie Mac's requirement, and will
instead make uninsured condominium loans and sell them to Fannie
Mae.
Posturing aside, a policy argument can be made for either
position.
Support: California Association of Realtors
Community Associations Institute
Opposition: Freddie Mac
Prior Legislation: None Known
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