Archive for November, 2011

Mortgage Lenders Are Becoming Increasingly Concerned With Gas and Oil Leases Associated With Hydraulic Fracturing

Tuesday, November 15th, 2011

Fee Simple ownership of land in the United States generally consists of both the “surface” rights and the “mineral” rights associated with the property.   As hydraulic fracturing becomes more prevalent, landowners are often attracted to the potential financial gain that could be realized by entering into a gas and oil lease that allows an extraction company the right to drill on their land.  Gas and oil leases typically allow the extraction company the right to explore and extract “minerals” below the land.  These leases also allow the extraction company to engage in other related activities, such as drilling and storage of waste materials on the surface of the landowner’s property.  In return, the extraction company will agree to pay the landowner royalties based on the amount of natural gas or other minerals extracted from the land.  It is estimated that  American landowners have signed more than one million of these gas and oil leases.

Recent reports indicate that mortgage lenders are becoming increasingly concerned with the growing number of gas and oil leases on mortgaged land.  In most instances, a mortgage is secured by both the “surface” and “subsurface” rights to the land.  As a result, the terms of the mortgage generally include the requirement that the landowner: (1) obtain prior permission from the lender before entering into a lease; (2) protect the property from damage, and (3) prohibit the storage of hazardous materials on the land.  Some mortgages also include a rider specifically prohibiting the landowner from leasing mineral, oil or gas rights.

A landowner may be able to seek permission from the mortgage lender before entering into a gas and oil lease.  This typically requires that the landowner complete a standardized form with the lender and provide a copy of the proposed gas and oil lease.  It is then within the discretion of the lender whether it will grant the requisite permission.  When deciding to grant permission, lenders generally take into account the following factors: (1) whether the lease is customary in the area: (2) whether the lease will prevent the use of the property as a residence; (3) whether the lease will materially affect the value of the property; or (4) whether the activity contemplated in the lease will expose residents to serious health or safety hazards.  Mortgage lenders may also require the landowner to pay additional sums toward the balance of the loan before approving the lease or require the extraction company to indemnify the landowner for damage resulting in the devaluation of the property.  A failure by a landowner to obtain permission from the mortgage lender prior to entering into a lease may be deemed a breach of the mortgage requirements and could give the lender the right to demand immediate payment of the mortgage or to foreclose on the property.

The potential implications from a breach of the mortgage may not be limited to the landowner.  Approximately 90 percent of all mortgages are sold by primary lenders to secondary lenders like Fannie Mae and Freddie Mac.  The primary lenders often guarantee that the mortgage complies with standard mortgage rules and underwriting requirements.  These secondary lenders then either hold the mortgage or convert the income from the mortgage into mortgage-backed securities and guarantee the performance of the securities to their investors.  If a mortgage does not comply with standard mortgage rules and requirements, these secondary lenders may refuse to acquire the mortgage from the primary lender or hold the primary lender responsible if the mortgage is acquired without knowledge of the lease.  Title insurance is also a common requirement related to mortgages and may include specific exclusions for certain types of commercial or hazardous activity.  This too can lead to additional exposure to primary and secondary lenders.

There is also no reliable data to support what impact a gas and oil lease may have on the value or marketability of land.  As some recent reports have suggested, a lease may actually enhance the value of a property and the additional income may make mortgage repayment more likely.  On the other hand, the lease may decrease the value of the property or make the property less marketable.  Primary and secondary lenders typically require comparable sales and an analysis of the marketability of the property from an appraiser before issuing a mortgage.  Property appraisers have recently expressed concerns that issuing an appraisal on a property that is subject to a gas and oil lease is often difficult because comparable sales of similar properties are unavailable in many areas.

Recent news articles have also suggested that the increase in gas and oil leases related to hydraulic fracturing may negatively impact the entire mortgage lending industry and could prolong the mortgage industry’s recovery from the subprime mortgage problem.  Fearful of these concerns, some mortgage lenders are now considering revising their underwriting requirements to address these issues.  There has also been discussion that mortgage lenders may be more reluctant to grant permission to landowners interested in signing a gas and oil lease or may refuse to issue a mortgage on a property already subject to a lease.

These issues have generated recent concern among lawmakers.  In September, the Congressional Research Service issued a memorandum to Congresswoman Carolyn Maloney of New York identifying the guidelines utilized by Freddie Mac and Fannie Mae when there is a request to create a gas and oil lease on a mortgaged property.  The New York Times also reported that Congressmen Edward Markey of Massachusetts and Maurice Hinchey of New York recently requested that Freddie Mac and Fannie Mae advise how they plan to address any potential breaches related to gas and oil leases on mortgaged property.

The potential impact of gas and oil leases on mortgaged property has been the subject of a number of recent news reports.  The discussion above merely summarizes some of those issues.  With hydraulic fracturing operations expanding, the concern over gas and oil leases will likely only garner more attention from the mortgage industry, insurers and lawmakers.  We will continue to monitor these issues and provide updates in future additions of this Digest as they develop.



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