The brewing conflict between President Trump and the state of California has captured headlines. The nation’s chief executive threatened to “defund”  the Golden State, while California politicos promise an ongoing legal insurrection against the administration.

Partially defunding high-speed rail or the increasingly speech-hostile University of California system are excellent political talking points for the Trump administration. However, both pale in comparison to the impact you would see if the federal government compelled California to pay its fair share of earthquake risk.

Unlike homes situated in areas of high flood risk, underwriting guidelines for the government-sponsored entities Fannie Mae and Freddie Mac do not require insurance to cover earthquake risk. In fact, earthquake is just about the only major peril—fire, windstorm, hail, smoke, explosions, theft, vandalism, civil commotion and riots—for which banks and the GSEs don’t require insurance.


This is a problem and a particularly acute one in California, the state that faces by far the largest preponderance of earthquake risk. Only 10 percent of Californians actually buy earthquake insurance, even though all of the state’s major population centers face significant risk. That fact alone might not be a problem if California policymakers were willing to make homeowners face the consequences of their recklessness, but they aren’t.

California is a borrower-friendly “nonrecourse” state, which means that when a mortgage borrower defaults, all the lender is entitled to recover is the property itself. That’s even true in the event an earthquake strikes an uninsured home. A California homeowner’s incentive is simply to walk away from the obligation. No matter how many hundreds of thousands of dollars might be outstanding on the loan, the lender could be left to foreclose on nothing more than a pile of rubble.

When the “big one” that every Californian knows to expect finally strikes, the rest of the nation will be on the hook for an avalanche of defaults. In a matter of seconds, tens of thousands of mortgages held by Fannie and Freddie could see their collateral destroyed. The GSEs, whose obligations are backed by American taxpayers, will have little recourse to regain their investments.

It’s therefore fair to say that Fannie and Freddie are implicitly insuring for free the homes of Californians who refuse to buy earthquake coverage for themselves. The scale of the earthquake subsidy to California is massive. Insurance broker Aon Benfield estimated in an August 2011 report to the Federal Reserve Bank of Atlanta that U.S. taxpayers currently are providing a $100 billion subsidy to the GSEs for the cost of their earthquake risk, about half of which can be attributed to California.

So long as Californians continue to lack any practical incentive to buy earthquake insurance, they will continue to pursue the risky development practices and public-policy decisions that have led to the current state of affairs. More disconcerting still, a major earthquake in California presents a real risk of triggering a shock to the nation’s entire financial system.

If there were ever an area worthy of a federal effort to check California, it would be to curtail its reckless willingness to unload its earthquake risk onto the other states. But what can be done?

For one, the Federal Housing Finance Agency, the regulator overseeing the GSEs, could propose rules requiring the GSEs to only purchase mortgages that carry earthquake insurance if the underlying property faces significant earthquake risk. Alternatively, the FHFA could order the GSEs to track the uninsured mortgage risk attached to mortgages in their portfolios, and to offer transparent disclosures quantifying for investors how much of that risk is embodied in the underlying collateral of mortgage securities the GSEs bring to market.

In this way, institutional investors like pension funds and foreign governments will be able to quantify their exposure to California earthquake risk and make more educated decisions about what sort of returns to demand on those investments.

President Trump’s twin concerns about “bad deals” and Californians running wild meet squarely in the state’s approach to managing its earthquake risk. It is well past time for the residents of the Golden State to pay for their own risks.

Image by Jerry Lin

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