The Public Policy

Fannie, Freddie, and the Big One

We're on the hook for earthquake damage.

By 1.17.14

FEMA
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Twenty years ago today, the 6.7-magnitude Northridge Earthquake struck the San Fernando Valley 20 miles northwest of downtown Los Angeles, killing 60, injuring 7,000, and damaging more than 82,000 buildings. The price tag for the quake was a record $20 billion in property damage, only about half of which was insured.

The two decades since Northridge have seen significant efforts to mitigate earthquake risk through retrofitting, as well as the creation of a state agency in California dedicated to providing earthquake insurance to all who seek it. Alas, despite those steps, there is significant evidence that not only are we less prepared for a major quake today than we were in 1994, but that the financial brunt of any such disaster would mostly fall squarely on the shoulders of U.S. taxpayers.

On the mitigation front, California understandably has led the nation, making several upgrades and improvements to statewide retrofit requirements that were first adopted in 1978. In cities like Los Angeles and San Francisco, building and zoning codes are even more stringent. However, a 2003 study by the Association of Bay Area Governments determined that most Bay Area retrofits surveyed in the wake of 1989's 6.9-magnitude Loma Prieta Earthquake were incomplete. A 2006 investigation by Contra Costa Times reporters Jessica Guynn and Thomas Peele surveyed 35 retrofitted houses along the Hayward Fault in the East Bay, determining that only 11 would withstand the shaking of a high magnitude temblor.

Outside of California, other cities that face significant earthquake risk – including places as disparate as St. Louis, Seattle, Las Vegas, Honolulu, Memphis, Salt Lake City, and Charleston, S.C. – lag far behind in mitigation. Scientists also continue to discover new seismic threats. California state geologists recently discovered a previously unknown branch of the Hollywood Fault, a 10-mile fracture below Los Angeles that is believed capable of producing a 7.0-magnitude quake. The U.S. Geologic Survey also recently uncovered a fault crossing Spokane, Wash., in a northeast direction near where the city experienced 105 sub-4.0 quakes in 2001.

Not only are we falling short in mitigating the risk of earthquakes, but an even bigger problem is how few property owners are financially prepared for the consequences. The California Earthquake Authority – a publicly managed, but mostly privately funded, pool of insurance companies chartered by the state in 1996 – now covers roughly 75 percent of California policyholders who have earthquake coverage. Unfortunately, only about 9 percent of at-risk Californians actually purchase the coverage, down from more than 20 percent at the time of Northridge. In other states exposed to earthquake risk, coverage is typically sold through optional endorsements on homeowners policies, and take-up is similarly low.

The source of the problem is a profoundly stupid loophole in the rules governing which mortgages the government-sponsored enterprises Fannie Mae and Freddie Mac are allowed to assume. While the Federal Housing Finance Agency, the GSEs' regulator, requires mortgages to maintain property insurance coverage for most standard perils—fire, windstorm, flood, hail, smoke, explosions, theft, vandalism, civil commotion, and riots—there is a big glaring exception when it comes to earthquake coverage.

The result is that, should a significant quake strike, the GSEs would find themselves holding the mortgages of tens of thousands of destroyed properties that have no insurance coverage. The best estimates are that the GSEs carry about $130 billion of exposure to a 1-in-250 year earthquake, of which there is 0.4 percent chance in any given year. What that means, effectively, is that U.S. taxpayers are currently serving as the world's largest earthquake insurer.

Over the longer term, the odds show that it is a matter of when, not if, a major earthquake will strike in the United States. The USGS assigns a 99.7 percent chance of a magnitude 6.7 quake (equal to Northridge) and a 46 percent chance of a magnitude 7.5 earthquake (45 times stronger than Northridge) hitting at some point in the next 30 years. The insurance company Fireman's Fund estimates that if the 1906 San Francisco earthquake (estimated to be about magnitude 7.8) were to occur today, the loss would be as much as $60 billion, making it the costliest natural disaster in history. According to USGS estimates, a 7.8 quake striking Southern California's San Andreas Fault could produce an unthinkable $200 billion in damage, and much of that would be uninsured.

The most straightforward solution to protect taxpayers would be simply to change the rules to require that mortgages bought or guaranteed by Fannie or Freddie, or issued by lenders with protection from the Federal Deposit Insurance Corp., must maintain earthquake coverage if the property is in a seismic zone. Such a shift would actually make earthquake coverage the single largest insured catastrophe peril in the United States, dwarfing all hurricane risks combined. 

Alternatively, Fannie and Freddie themselves could issue catastrophe bonds or purchase earthquake coverage directly from the global insurance and reinsurance markets. Reinsurance broker Aon Benfield has estimated that coverage to protect the GSEs from the risk of a 1-in-250 year earthquake would cost the GSEs about $30 billion. That figure is, of course, nothing to sneeze at, but it sure beats continuing the current hidden $100 billion subsidy the GSEs enjoy for their earthquake risk. American taxpayers shouldn't be forced to bear the risk that hundreds of billions of dollars of property value could literally come crashing to the ground in the blink of an eye.

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