The big one

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By David Chernick, Kyle Mrotek , Paul Anderson | 01 November 2009

The looming risk of an earthquake-triggered mortgage crisis in California

A major California earthquake could cause tens of billions of dollars in mortgage defaults in San Francisco alone, where subprime exposure is even less than in other parts of the financially troubled state.

One of the scariest aspects of any crisis is not knowing how much worse it can get. The current crisis is no different. The sudden realization of vulnerability can lead to a predilection for imagining worst-case scenarios or a willful ignorance of urgent realities. What's needed instead is a frank accounting of the ongoing risks and well-founded plans to deal with them.

It is in this spirit that we highlight the risk of yet another financial crisis lurking in California that has received precious little attention: A major earthquake would leave many California population centers susceptible to a wave of mortgage defaults rivaling those we've seen to date. Because only 12% of California homeowners carry earthquake insurance and private mortgage insurance does not cover damaged properties, mortgage investors would be left in the rubble holding abandoned, damaged properties and defaulted loans.

A tremor of 7.9 on the Richter scale in San Francisco—the same magnitude as the 1906 San Francisco Earthquake—today could cause $120 billion or more in insured property losses alone.1

California has unique vulnerabilities

California is well known for its earthquake-prone population centers, with the San Andreas Fault running much of the length of the state, in addition to an extensive network of other fault lines. But earthquake potential is only the catalyst in this chain reaction of risks.

The estimated property losses from an earthquake of this size would lead to billions more in losses from residential mortgage defaults in San Francisco.2 The dearth of earthquake insurance coverage creates an immediate possibility of huge losses that aren’t insured, and many homeowners may walk away rather than rebuild. We derived this estimate by applying our mortgage performance forecasting model (developed for mortgage-backed security and portfolio valuation) to a database of San-Francisco-area mortgages and publicly available data from sources like the U.S. Census and the U.S. Bureau of Labor Statistics. The model relies on historical performance, loan level underwriting characteristics, and economic forecasts.

Not only does this estimate exclude commercial property loans, business loans, and other credit defaults that could result from earthquake damage, but San Francisco also has even less mortgage default exposure than other earthquake-prone cities. The balance of subprime Alternative A-paper (Alt-A) home mortgage loans in San Francisco is estimated to be less than one-fifth that of Los Angeles, and roughly half of San Diego's. These southern California housing markets have also been hit with more dramatic price declines.

In some cases, the mortgage losses would be even greater than the property damage. For example, suppose an earthquake causes $75,000 in structural damage to a $600,000 home. If the homeowner holds a $550,000 mortgage but does not have earthquake coverage, the earthquake would put him underwater on the home and make him much more likely to walk away. But only some of the home's value is recoverable. Mortgage owners are currently experiencing credit losses in excess of 50% of the loan balance when borrowers walk away. So the mortgage owner might face approximately $250,000 in credit losses resulting from $75,000 in property damage.

The potential default losses are in addition to the ongoing stream of defaults driven by the economy. Economists are predicting a second wave of foreclosures—mostly on adjustable-rate mortgages,3 but with a surprising number of prime mortgages as well, arising from otherwise creditworthy borrowers who have lost their jobs.4

California has taken some of the hardest hits from the financial crisis and its ensuing recession. Unemployment rose to 11.9% in July—the state's highest rate since before WWII and the fourth-highest in the nation.5 California home prices have also declined at a rate more than double the U.S. average6 With four of the 10 U.S. cities hit hardest by foreclosures,7 the state has the second-highest percentage of subprime loans and the highest percentage of Alt-A loans. California also has one of the top ten rates of subprime and Alt-A foreclosures and late payments.8

And the damages and foreclosure risk aren't limited to structural damage from a quake itself. Water supplies could be seriously threatened, for example. Most population centers rely on water shipped from other parts of the state using levees that are, in some cases, more than 100 years old. A series of dry years has compromised the state’s water supply, but an earthquake could cause major levee failures in some of the state's most important water transportation infrastructure.9

Earthquakes pose a unique set of risks for mortgages

Many homeowners would not otherwise be at risk for mortgage default, but uninsured earthquake damage would represent an extra-large drop in home values relative to mortgage debts—a key factor in the likelihood of foreclosure. This shake-up in loan-to-value (LTV) ratios could drive many borrowers who are on the edge of default—and even many who seem to be far from it—over the cliff.

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Although private mortgage insurance (PMI) typically protects investors against borrower default when the LTV is more than 80%, PMI policies exclude coverage for loans on properties with physical damage arising from earthquakes, among other perils. Thus, mortgage owners could end up bearing significant default risk from earthquakes or other uninsured natural disasters. Also, homeowners with more equity are more likely to buy earthquake coverage, leaving the more leveraged borrowers more likely to walk away.

Earthquakes are unique among natural disasters from the perspective of property insurance for several reasons. Unlike coverage for wind damage from hurricanes, which is required in a typical homeowner policy, mortgage companies don't require earthquake coverage near fault lines. People tend not to voluntarily buy earthquake coverage because it's expensive, it has large mandatory deductibles, and earthquakes often do not factor in a homebuyer's decision-making process. They are not as frequent as hurricanes, and don't occur in distinct locations like tornadoes, so people unknowingly tend to take more risks.

A perfect storm

Excessively leveraged borrowers, tight credit, and continuing job losses potentially place California's population centers in the crosshairs of a perfect seismic and financial storm. The solution? Both investors and consumers should seek a better understanding of their individual exposure to earthquake risk. Natural catastrophes have often outstripped the ability of insurers to adequately manage the risk, and in this case a layer of mortgage risk makes the situation more dire.

Dave Chernick is a consulting actuary with the Milwaukee office of Milliman. His area of expertise is in personal lines property and casualty insurance, including auto and homeowners. His experience includes ratemaking, data analysis and forecasting, catastrophe management, and pricing hurricane and earthquake perils.

Kyle Mrotek is a principal and consulting actuary with the Milwaukee office of Milliman. He has performed extensive work for mortgage/financial guaranty insurers, mortgage lenders, investors, and government agencies on credit-risk-related issues such as reserving, pricing, credit enhancement, and portfolio credit risk management.

Paul Anderson is a consulting actuary with the Milwaukee office of Milliman. He is experienced in numerous aspects of personal lines actuarial work, including catastrophe management; pricing hurricane, earthquake, and wildfire perils; incorporating reinsurance costs into rates; and data analysis and forecasting.

1 Milliman projection to 2009 based on AIR Worldwide Corporation 2005 damage estimate.

2 These losses are net of any expected value recovered by the bank on the foreclosed property through salvage or resale.

3 "Option-ARM Mortgages Turning Worse Than Subprime." The Wall Street Journal. July 10, 2009.

4 "Job Losses Push Safer Mortgages to Foreclosure." The New York Times. May 24, 2009.

5 U.S. Bureau of Labor Statistics.

6 "California Home Price Declines 41% on Foreclosures." Bloomberg, March 25, 2009.

7 "Where Foreclosure Has Hit the Hardest." BusinessWeek.

8 Federal Reserve Bank of New York.

9 Popular Mechanics interview with UC Davis Geology Professor Jeff Mount.