A report has raised concerns that stakeholders in the U.S. mortgage market, including lenders, investors and insurers, are woefully unprepared for accelerating climate change and the risk it brings.
Not only are lenders and others unprepared to mitigate their risk, but according to the report from the Mortgage Bankers Association's Research Institute for Housing America, they’re not even capable of adequately gauging the risk they face.
“They are anxious to figure out what to do but not sure where to go to find out,” said Sean Becketti, author of the report and a former economist at Freddie Mac. “They are unprepared but no longer aware.”
The world of housing finance involves a lot of players, not just mortgage originators and servicers. The consumers, landlords, home builders, appraisers, insurance firms, mortgage investors, government agencies and the government-sponsored enterprises Fannie Mae and Freddie Mac all play critical roles.
The report says climate change will send significant pressure down a long and complex financial web.
The most significant pressure will be increased mortgage default and prepayment risks, resulting in adverse selection of the type of loans sold to GSEs. It will also lead to more volatile home prices and lead to significant climate migration, the report says.
Lenders that securitize their loans with the GSEs will face additional costs for representation and warranty insurance that covers breach of contracts or warranties in large financial transactions. They will also face higher risk due to the GSEs revising their requirements in response to climate change.
For example, the GSEs may insist lenders perform extra due diligence to determine whether flood insurance is required on a home loan. The lag in updating official flood maps will likely force lenders to use additional sources of information. Due to this, GSEs may not be allowed to buy loans on homes determined to be at high risk of flooding.
Meanwhile the ongoing overhaul of the National Flood Insurance Program will result in altered pricing for homeowners, affecting both home values and the value of the mortgages on those homes.
Becketti said the biggest problem now for mortgage stakeholders is the level of uncertainty. “They’re wondering what to do next more than anything else,” he said. “There haven’t been any rule changes that affect the firms in the mortgage market but they’re being contemplated.”
One reason for the uncertainty is that the mortgage market relies on outdated models to gauge its risk. The majority of those models are focused on credit and operating risk, the report points out, which are underwritten and priced by insurance firms or the Federal Emergency Management Agency.
The problem with FEMA and some insurers is they’re already highly stressed due to the record number of natural disasters over the previous few years. If, as expected, FEMA alters its risk models, lenders would find themselves on the hook for more losses, the report said.
Of course, borrowers who’re displaced by natural disasters are highly likely to default on their home loans too.
In 2017, after Hurricane Harvey struck Houston mortgage industry leaders warned of a potential climate foreclosure crisis. Almost 100,000 homes were flooded, yet 80% of those properties had no flood insurance because the area wasn’t deemed to be prone to flooding. CoreLogic data shows that serious mortgage delinquencies on damaged homes rose by 200% that year.
Banks, lenders, investors and mortgage servicers alike all use the cost of estimated defaults as a key factor in assessing profitability, 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 wrote.
There’s also a danger that mortgage bond investors could also pull back from the mortgage market, leaving it with less liquidity. Many have already began asking for more information from lenders about climate risk.
For example the Securities and Exchange Commission last week published a letter sent to public companies asking them to provide more information to investors about their climate risk. It’s especially interested in what physical and financial risks might arise from climate disasters, as well the risk from climate-linked changes to regulations and business models. The letter doesn’t name the specific companies it was addressed to, but it’s likely that the banking industry is one recipient.