November 14, 2012
A former colleague, Barry Goldberg, raises an important financial issue relating to the devastation that Hurricane Sandy left in its wake.
Massive flood, storm and fire casualties on homes with underwater mortgages may make for an odd set of incentives for borrower and RMBS investor.
A Fannie/Freddie form of mortgage contains language like this:
“In the event of loss, Borrower shall give prompt notice to the insurance carrier and Lender. . . . Unless Lender and Borrower otherwise agree in writing, any insurance proceeds, whether or not the underlying insurance was required by Lender, shall be applied to restoration or repair of the Property, if the restoration or repair is economically feasible and Lender’s security is not lessened.”
Homeowner has no financial incentive to rebuild — in all likelihood she would still be underwater. If the owner of the mortgage believes in good faith that restoration is not economically feasible, then it will accelerate the balance of the loan and direct the insurance proceeds to be applied to sums owed pursuant to the mortgage.
Take this example:
Homeowner purchases home for $250,000.
The house is now worth $150,000.
The mortgage is for $200,000.
The insurance policy is for $200,000.
The homeowner (mortgagor) would be incentivized to abandon the property in a non-recourse jurisdiction and the owner of the mortgage (mortgagee) would be incentivized to take the proceeds from the insurance policy, foreclose and sell the property as a tear down. It looks, from this simple example, like the mortgageee would be better off financially as a result of the massive casualty.
I would be interested to hear from others who have seen how this plays out in reality, given real players and real documents.