Residential Fracking Puts Lenders In A Gassy Hole

by Michael Kling
on May 16, 2012 No Comments
Categories : E-Features

Many homeowners are earning extra income by signing leases with natural gas companies to allow hydraulic fracturing combined with horizontal drilling on their properties. This activity is commonly known as fracking – and for many lenders, it is also known as trouble.

For starters, a homeowner who signs a fracking lease without the approval of his or her lender is in violation of the mortgage terms and could be considered in default. The lender can demand that the borrower pay off the mortgage or terminate the lease.
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In order to protect the collateral, mortgage requirements prohibit commercial activities and the storage of hazardous materials on the property.

‘Provisions in gas leases permit the very things that the standard mortgage prohibits,’ says Elisabeth N. Radow, a New York attorney specializing in real estate and environmental issues and chairwoman of the hydraulic fracturing committee of the League of Women Voters of New York State.

But that's not the only problem. The gas leases may not meet secondary mortgage market requirements regarding setbacks from buildings and property lines. This is especially complicated because fracking is a multi-step process, involving trucking in water and toxic chemicals, setting up surface operations, creating long-term easements, drilling, and storing gas and hazardous waste on-site, among other activities.
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‘It's not just sticking a straw in the ground to get the gas out,’ says Radow, who notes that mortgage underwriting guidelines predate fracking and, thus, do not take into account the multi-step process. ‘We need to update our underwriting guidelines. To preserve the secondary mortgage market, it should be incumbent on people underwriting the loans to understand what the drilling process is.’

However, insurance – or the lack of it – may be the largest problem. Space leases typically require tenants to buy general liability insurance naming the landlord – in this case, the homeowner – as an additional insured with an indemnity covering costs for uninsured damage. But gas leases do not have this requirement. Standard, pre-printed gas leases do not provide for insurance from the gas company, unless it is negotiated into the lease, so homeowners become potentially responsible for the activity.

Alas, homeowners insurance does not cover industrial activity or fracking damages. If there is an accident, the homeowner's home insurance company may get pulled into a lawsuit but refuse to pay the claim and decide to drop the insurance, saying the activity was excluded from coverage and not permitted.

Furthermore, if the property's well water is contaminated or the property otherwise becomes unlivable due to drilling activity, the homeowner may decide to stop paying and default on the loan.
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Radow observes that homeowners have little or no recourse against companies, even if they somehow manage to win in court, as a company's own disclosures typically admit it is under-insured.

‘According to gas industry filings with the Securities and Exchange Commission, it is clear that the industry is under-insured,’ Radow continues. ‘The industry states there are any number of accidents that can happen in this inherently risky process, including fire, explosions and uncontrollable flowing of well fluids. A current report from Insurance Thought Leadership points to under-insurance for well blowouts of both producing wells and capped and abandoned wells. If damage occurs from an abandoned well, whose responsibility will that be?’

As of now, there is no known funding source to pay for uninsured fracking-lifecycle damages. Radow points out that if the funding source is not identified, the secondary market could be left to foot the clean-up bill. And since the federal government dominates today's secondary market, the tab is ultimately sent to taxpayers.

‘There are many unanswered questions here,’ says Radow. ‘This is not just an energy question. With the inherently risky gas drilling expanding across 30 or more states, including peoples' backyards and most homeowners having a mortgage, this is a question of national concern.’

Several states are taking their own initiative in regard to the intersection of homeownership and fracking. The North Carolina legislature is currently studying whether to legalize fracking locally; approximately 80 leases have been signed with natural gas explorers to drill on properties across the state. However, North Carolina Assistant Attorney General Lynne Weaver has warned state officials that borrowers who sell or lease drilling rights on their property could put their lenders at significant financial risks that include devalued properties and the potential for environmental hazards.
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In Maryland, Attorney General Douglas F. Gansler issued a warning to homeowners about signing gas leases and created educational publications for homeowners.

‘Marylanders need to protect themselves from unintentionally putting their homes and farms at risk,’ Gansler said. ‘If a mineral rights lease is on the table, take it to your bank or mortgage lender first and have them sign off on it.’

The issue has also reached Congress. Rep. Raul M. Grijalva, D-Ariz., is urging the Federal Housing Finance Agency (FHFA) to audit mortgage portfolios in order to find how many of the agency's mortgages have gas leases and how many violate investor guidelines, as well as to consider if additional guidance is needed for lenders and borrowers.

‘It is clear to me that we cannot wait any longer, and a strictly hands-off 'buyer beware' attitude is no longer appropriate,’ said Grijalva in a letter to FHFA Inspector General Steve Linick. Compounding the problem, Grijalva continued, is that leases are often not properly filed with any public agency, so their terms and even how common they are is difficult to determine.

An FHFA spokesperson responded to Grijalva's letter by saying the government-sponsored enterprises would ‘continue to monitor developments at the local level and among their servicers, who address leasing issues as part of their responsibilities.’

Michael Kling is a former editor of Secondary Marketing Executive and a financial journalist based in Stratford, Conn.

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