Key Points

With numerous stakeholders in housing finance, climate change will send significant stress down a long financial line, according to a Mortgage Bankers Association report.
The report said it could increase mortgage default, increase the volatility of house prices and produce significant climate migration.

Record-setting rain, floods and wildfires are examples of the rising risks to the U.S. housing market from climate change.

Mortgage lenders and investors are woefully unprepared not only to mitigate their risk but to even gauge that risk, according to a new report from the Mortgage Bankers Association’s Research Institute for Housing America.

“They are anxious to figure out what to do but not sure where to go to find out. They are unprepared but no longer unaware,” said Sean Becketti, author of the report and former chief economist at Freddie Mac.

There are numerous stakeholders in housing finance, including consumers, landlords, homebuilders, appraisers, mortgage originators and servicers, insurance companies, mortgage investors, government agencies, and the government-sponsored enterprises that issue mortgages (Fannie Mae and Freddie Mac). That means climate change will send significant pressure down a long financial line.

Not only is climate change putting more stress on the National Flood Insurance Program, it could increase mortgage default and prepayment risks, trigger adverse selection in the types of loans that are sold to the GSEs, increase the volatility of house prices, and produce significant climate migration, according to the report.

For instance, lenders who securitize their loans with the GSEs could face additional costs for representation and warranty insurance, which covers breach of contracts or warranties in large financial transactions, and higher risk as the GSEs revise their requirements in response to climate change.

More specifically, the GSEs might require lenders to perform additional due diligence to determine the need for flood insurance, and the lag in updating official flood maps may force lenders to incorporate additional sources of information on flood risk. As a result, the GSEs might not be allowed to buy loans on homes with higher flood risks.

In addition, the National Flood Insurance Program is in the midst of a major overhaul, which will change pricing for homeowners. That will affect home values and consequently the values of the mortgages that back those homes.

The biggest problem right now is uncertainty for mortgage stakeholders.

“They’re wondering what to do next more than anything else. There haven’t been any rule changes that affect the firms in the mortgage market, but they’re being contemplated,” said Becketti.

A climate foreclosure crisis?

Today, the mortgage market relies heavily on the insurance industry to gauge its risk.

But most mortgage industry risk models are focused on credit and operating risk.

“In the case of modeling for risk, the mortgage industry still predominantly thinks of protection in terms of property and casualty risk, which is underwritten and priced by insurance companies,” said Sanjiv Das, CEO of Caliber Home Loans. “The industry doesn’t model climate risk as much and mostly relies on models from FEMA or insurance companies.”

But the Federal Emergency Management Agency is already highly stressed due to the record volume of natural disasters in the past few years. If FEMA changes what it will back, mortgage lenders could be on the hook for losses.

In addition, borrowers displaced by natural disasters could default on their home loans.

Following Hurricane Harvey in Houston in 2017, mortgage industry leaders warned of a potential climate foreclosure crisis as the storm flooded close to 100,000 Houston-area homes. In Harvey’s federally declared disaster areas, 80% of the homes had no flood insurance because they weren’t normally prone to flooding. Serious mortgage delinquencies on damaged homes jumped more than 200%, according to CoreLogic.

The costs of estimated defaults are the centerpiece for banks, lenders, investors and mortgage servicers to assess profitability, as well as loan loss reserves and economic capital.

“If incremental defaults due to climate change turn out to be material for one or more of these stakeholders, regulators and investors are likely to require those stakeholders to quantify the impact of those incremental defaults and to gauge the sensitivity of those estimates to key assumptions,” Becketti said in the report.

Finally, mortgage bond investors, who are already asking for more information from lenders about climate risk, could also pull back, leaving the mortgage market with less liquidity.

This week, the Securities and Exchange Commission published a letter it has sent to public companies asking them to offer more information to investors about their climate risk. The letter details physical and financial risks from climate disasters, as well as risks from climate-related changes to regulations or business models. While it doesn’t name the specific companies receiving it, the banking industry is a likely recipient.

The question is, how do we best measure such risk? While there is now a new cottage industry of companies measuring all facets of climate risk to corporate America, as well as the housing market, there is no standard risk measurement for investors.

“Investors have built sophisticated risk models for default and severity but are novices when analyzing acts of God,” said Bill Dallas, president of Finance of America Mortgage.

“Today investors avoid these potential risks by simply not buying loans. As fires, hurricanes, earthquakes, volcanic eruptions, and torrential floods become more commonplace, investors will have to act more as actuarial insurers than mortgage lenders in order to build risk models that contemplate acts of God,” he added.

Heitman and the Urban Land Institute (ULI) developed a new research report focused on the risks that climate change poses to real estate and the measures that leading firms are taking today to mitigate those risks.

Climate Risk and Real Estate Investment Decision-Making explores current methods for assessing and mitigating climate risk in real estate, including physical risks such as catastrophes and transitional risks such as regulatory changes, availability of resources, and attractiveness of locations. It also highlights proactive measures by Heitman and other leading firms to stay at the forefront of mitigation strategies and accurately price risk into investment decisions. The report is based on insights from more than 25 investors and investment managers in Europe, North America, and Asia-Pacific, as well as existing research.

The real estate industry as a whole has recently begun the development of more advanced strategies to recognize, understand, and manage risks. The report found that, presently, the industry relies on insurance to cover the majority of the shorter term, financial-oriented risks related to climate change. However, insurance does not protect investors from devaluation or a reduction in asset liquidity. Combined with the likelihood of future changes in insurance availability and costs, is prompting a growing number of investors and investment managers to explore new ways to build climate risks into investment processes, including:

Mapping physical risk for current portfolios and potential acquisitions;
Incorporating climate risk into due diligence and other investment decision-making processes;
Incorporating additional physical adaptation and mitigation measures for assets at risk;
Exploring a variety of strategies to mitigate risk, including portfolio diversification and investing directly in the mitigation measures for specific assets; and
Engaging with policy makers on local resilience strategies.

Climate Risk shows that leading investment managers and institutional investors are at various points in the undertaking of resilience scans of their portfolios. These scans help to identify vulnerabilities and impacts resulting from sea-level rise, flooding, heavy rainfall, water stress, extreme heat, wildfires and hurricanes. This includes short-term considerations such as business disruption for building tenants as well as higher operating and capital costs caused by increased wear and tear on properties.

As a whole, the industry needs to understand the pricing impacts of physical climate risks, and how climate change is likely to have a bigger impact on valuation in the future as asset and market liquidity are affected, the report says. It identifies several steps to raise awareness, such as:

Improve analyses of climate risk in annual and quarterly reports. This helps create awareness among investment managers and investors and helps drive change.
Use big data to better understand patterns around changes in asset liquidity and value, and weather forecasting.
Work with the insurance industry to understand data and gain knowledge on how climate change is affecting premiums and coverage.
Engage with city leaders in vulnerable areas to support city-level commitment to and implementation of physical and transitional risk mitigation strategies.