Mold could mean double jeopardy for lenders.

The pandemic of mold litigation spreading in the commercial and residential real estate industries has compelled lenders to protect their mortgage portfolios, but that may not be enough.

Lender liability concerns have now spread to other loan categories as state legislatures have stepped into the equation, making it possible for multiple lender exposures and potential losses from just one instance of mold contamination.

First, the insurance industry exited the scene by underwriting exclusions for mold within property-casualty policies in all but a handful of states.

In response, the lending community began considering changes to its mortgage loan documents, stipulating new terms (for example, mold inspections and use of mold-resistant building materials). Now, however, laws like those in California, which make developers and contractors responsible for structural defects within the first ten years of occupancy, could mean millions in liability losses for each case of mold contamination.

The new context of this law has paralyzed many California builders, sending ripples through the lending community.

"It's gone from single to potential double jeopardy for lenders," said Charles Perry, a member of the mold working group for the Mortgage Bankers Association.

"Instead of just worrying about mold's financial impact on the collateral supporting the mortgage industry, especially new construction, lenders now have to additionally guard against the weakening of their business loans to builders and contractors.

"If builders who borrow money for their business are hit with mold-related suits under the California law, they can be held liable for ten years post-construction, therefore affecting their own financial status and the relationship with their lender. And this is just the beginning--we've heard that seventeen other states are considering similar legislation."

The MBA's mold working group is working to formulate recommendations to members about changing their loan criteria to protect against the possibility of moldy mortgages. If mold dramatically decreases property values, it could force these loans into a "non-performing" category. That classification causes a negative chain reaction from ratings agencies, regulatory authorities, and shareholders.

"As a former lender, some of the recommendations I support include requiring mold inspections before, during and after construction as well as making new construction loans contingent on the use of mold-resistant building materials wherever possible," said Perry, who is also the principal of Environmental Assurance Group.

"Especially in light of the multiplying liability issues, should we not always attempt to prevent the presence of mold? Who would refute that? As bad the current problem is for lenders, it isn't as bad as what we could see if other states follow California's lead on mold liability for developers and builders."

According to Perry, the conditions under which mold occurs are: the existence of spores, moisture in the air, a normal temperature range, and the presence of a food source like paper. Since temperatures, airborne spores, and moisture are issues dealing with Mother Nature, the only controllable variable is the food source--primarily products containing cellulose.

Cellulose is the organic material found in paper, which accounts for approximately 80% of the surface area of a building. Organic products have been major factors in buildings and construction for decades: carpets, ceiling tiles, insulation, and paper-faced wallboard.

"When it comes to products with organic content, there are only two kinds--those with mold and those that will have mold," said Perry.

"As a science-based consultant recently told me, 'Water plus paper equals problem.' Paper-faced dry wall is the most common element of any post-50's structure, and unfortunately, it makes a great home for mold."

Faced with moldy collateral, mortgage lenders have three options. They can try to cure the problem by bringing in a mold inspection and remediation team or simply leveling the structure. However, either cure is expensive and, unlike most remediation, this kind of cleanup holds no guarantee that the mold will be permanently eliminated. The third option is to actually prevent the likelihood of mold by setting down specific new requirements in their mortgage guidelines, especially their construction lending practices.

"Who is ultimately holding the financial bag for construction and permanent mortgages along with business loans to builders?" said Perry.

"The lender typically holds 80% or more of the risk in these loans (since 20% is typically invested by the borrower).

"Therefore, the smart lenders will work even faster to protect themselves by initially preventing the existence of mold."