Can Bank in Subordinate Position Make Loan if Not on Flood Policy?

Inquiry/Issue

The Bank wishes to make a business loan that will be secured by a third lien on the customer’s primary residence. The mortgage will be behind a large financial institution’s first residential mortgage, with a balance of $343,000, and a Home Equity Line of Credit (“HELOC”), with $400,000 available. The subject property is in a flood zone and the Bank has provided all necessary flood disclosures to the customer. The customer has provided the Bank with proof of insurance coverage in the amount of $250,000. When the Bank asked the customer to have it listed as additional insured on the policy, the primary lien holder denied the request. Can the Bank go to closing or will it be unable to take the property as collateral?

Response Summary

The Bank can go to closing, as there is no requirement for it to be listed on the flood insurance policy. However, unless it takes certain steps, it can expect to face increased scrutiny and possible criticism from its Federal regulator for not being listed on the policy as a loss payee. In order to avoid this, it must (1) document that it has obtained a flood search using the Standard Flood Hazard Determination form and provided the borrower with a timely Notice of Flood Hazard; (2) document that the customer provided proof of flood insurance coverage in the proper amount before the loan was made; (3) document that the first lienholder has prevented the Bank from being listed on the flood policy as a loss payee; (4) demonstrate that it is a moot question as to whether the Bank is listed on the policy, from the standpoint of coverage; and (5) document that it is periodically reviewing the situation and the outstanding balance of the loans being secured by the property.

Response Detail

There is no requirement under the Flood Rules for the Bank to be listed on the flood insurance property as an insured party. If the Bank otherwise fulfills the legal and regulatory requirements of the rules, it should be able to close the loan under the circumstances described.

The Bank should be aware, however, that the Federal regulators will expect it to be listed on the flood insurance policy. The examination procedures of the FDIC, for example, ask a question:

[D]oes the institution have the borrower obtain a policy, with the institution as loss payee, in the correct amount prior to closing?

FDIC Compliance Manual, V-6.10.

At the very least, the Bank should expect increased scrutiny and possible criticism from a compliance standpoint, for inadequate monitoring, and from a safety and soundness standpoint, for failing to ensure coverage of the Bank in the event of loss.

In order to make this loan, the Bank must address those aspects within the context of the Flood Rules and the special circumstances attending to the loan.
Under the Flood Rules, a bank must require flood insurance for the term of its loan under the following conditions:

• The bank is making, increasing, extending, or renewing a loan secured by improved real estate or a mobile home that is affixed to a permanent foundation.
• The property securing the loan is improved real property located in a special flood hazard area.
• The community in which the property is located participates in the National Flood Insurance Program.

The amount of flood insurance required must be at least equal to the lesser of (1) the outstanding principal balance of the loan, (2) the maximum amount under the NFIP, or (3) the total value of the property (land and improvements) minus the value of the land.

If these requirements are not fulfilled, the financial institution is not allowed to make the loan. 12 CFR §339.3(a).

The federal regulators have provided guidance as to what a bank should do when it will become a junior lien holder on a property located in a special flood hazard area. For example, it might have the borrower do the following:

• Inform the agent of the intention to obtain a loan involving a subordinate lien.
• Obtain verification of the existence of a flood insurance policy.
• Check whether the amount of insurance covers both loans.

After obtaining this information, the insurance agent should increase the amount of coverage, if necessary, and issue an endorsement that adds the junior lien holder to the existing policy. Loans in Areas Having Special Flood Hazards: Interagency Questions and Answers Regarding Flood Insurance, Q. 36.
That is what should happen. In this case, however, the first lienholder will not cooperate and, indeed, seems to be actively preventing the customer from having the Bank listed as a loss payee on the policy. Whether that will stand the first lienholder in good stead with its own Federal regulator, should this become known to the regulator, is a question. In the meantime, however, the Bank must complete the following:

• Document that it has obtained a flood determination using the Special Flood Hazard Determination Form and provided the customer with a timely Notice of Flood Hazard.
• Document that the customer provided the Bank with proof of flood insurance coverage in the proper amount before the loan was made.
• Document, as by a memorandum to file or other documentation, that the first lienholder has prevented the Bank from being listed on the flood policy as a loss payee.
• Demonstrate that, for the purposes of the Flood Rules, it is a moot question as to whether the Bank is listed on the flood policy as loss payee, since the Bank’s interest in the property will be outside the coverage of the policy.

With regards to the last point, the “outstanding principal balance of the loan” includes not only the amount of the loan being made, but also the outstanding balance of any existing loans secured by the property, which in this case would be the residential mortgage loan and HELOC.

For the purposes of this analysis, we will assume that the business loan will be in the amount of $100,000 and that the Replacement Cost Value of the property (i.e., the customary way of measuring the insurable value of residential property) is $1,000,000. The principles will remain the same and the Bank can follow them with the actual amounts and values. If these factors are arranged as per the regulatory formula of the Flood Rules, they will appear as follows:

• Property value:                     $1,000,000
• Loan balance:                            843,000
• Insurance limit:                           250,000

The amount of insurance coverage available will be the lesser of these three factors, or in this case, $250,000, the limit on available flood insurance for residential properties.

Whether or not there are advances on the HELOC, the balance of the residential mortgage loan of $343,000 substantially exceeds the amount of insurance coverage available. Thus, the Bank would not enjoy any coverage under the flood insurance policy whether it was listed on the policy or not. If the HELOC was borrowed in full, the Bank’s exposure would simply be that much greater.

Given that the residential mortgage loan will be paid down and that the HELOC balance will fluctuate, the Bank must also demonstrate that it is aware of the situation and monitoring it. There should be a periodic review conducted by the Bank indicating the outstanding balance of the loans being secured by the property, which should be documented by a memorandum to the file. The Bank must also obtain continuing proof of flood insurance coverage during the term of its loan.

If the Bank follows these steps, it should fulfill the requirements of the Flood Rules and satisfy the expectations of its Federal Regulator.

This entry was posted on Monday, April 6th, 2015 at 1:30 pm.