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 










































SB 1326 (Petris)
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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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