BILL ANALYSIS SENATE JUDICIARY COMMITTEE S Charles M. Calderon, Chairman B 1995-96 Regular Session 1 3 2 6 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) Page 3 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 (more) SB 1326 (Petris) Page 4 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 (more) SB 1326 (Petris) Page 5 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 (more) SB 1326 (Petris) Page 6 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 (more) SB 1326 (Petris) Page 7 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 (more) SB 1326 (Petris) Page 8 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 (more) SB 1326 (Petris) Page 9 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. (more) SB 1326 (Petris) Page 10 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. (more) SB 1326 (Petris) Page 11 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 (more) SB 1326 (Petris) Page 12 prefunded its deductible with a surety bond. The total cost to unit owners is $16.41 per month. (more) SB 1326 (Petris) Page 13 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 (more) SB 1326 (Petris) Page 14 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 ********** (more)