When people speak of the risk climate poses to housing, they typically do so in qualitative and relative terms. A Florida home is at greater risk of hurricane damage than an Iowa home. Wildfires generally threaten homes in northern California more than they threaten homes in New Hampshire. And because of climate change, the risk these and other perils pose to any individual geographical area are largely viewed as higher than they were 25 years ago.
People feel comfortable speaking in these general terms. But qualitative estimates are of little practical use to mortgage investors seeking to fine-tune their pricing, prepayment, and default models. These analytical frameworks require not just reliable data but the means to translate them into actionable risk metrics.
Physical risks and transition risks
Broadly speaking, climate risk manifests itself as a combination of physical risks and transition risks. Physical risks include “acute” disaster events, such as hurricanes, tornadoes, wildfires, and floods. Chronic risks, such as sea level rise, extreme temperatures, and drought, are experienced over a longer period. Transition risks relate to costs resulting from regulations promulgated to combat climate change and from the need to invest in new technologies designed either to combat climate change directly or mitigate its effects.
Some of the ways in which these risks impact mortgage assets are self-evident. Acute events that damage or destroy homes have an obvious effect on the performance of the underlying mortgages. Other mechanisms are more latent but no less real. Increasing costs of homeownership, caused by required investment in climate-change-mitigating technologies, can be a source of financial stress for some borrowers and affect mortgage performance. Likewise, as flood and other hazard insurance premiums adjust to better reflect the reality of certain geographies’ increasing exposure to natural disaster risk, demand for real estate in these areas could decrease, increasing the pressure on existing homeowners who may not have much cushion in their LTVs to begin with.
Mortgage portfolio risk management
At the individual loan level, these risks translate to higher delinquency risks, probability of default, loss given default, spreads, and advance expenses. At the portfolio level, the impact is felt in asset valuation, concentration risk (what percentage of homes in the portfolio are located in high-risk areas), VaR, and catastrophic tail risk.
VaR can be computed using natural hazard risk models designed to forecast the probability of individual perils for a given geography and using that probability to compute the worst property loss (total physical loss and loss net of insurance proceeds) that can be expected during the portfolio’s expected life at the 99 percent (or 95 percent) confidence level. The following figure illustrates how this works for a portfolio covering multiple geographies with varying types and likelihoods of natural hazard risk.
These analyses can look at the exposure of an entire portfolio to all perils combined:
Or they can look at the exposure of a single geographic area to one peril in particular:
Accounting for climate risk when bidding on whole loans
The risks quantified above pertain to properties that secure mortgages and therefore only indirectly to the mortgage assets themselves. Investors seeking to build whole-loan portfolios that are resilient to climate risk should consider climate risk in the context of other risk factors. Such a “property-level climate risk” approach takes into account factors such as:
- Whether the property is insured against the peril in question
- The estimate expected risk (and tail risk) of property damage by the peril in question
- Loan-to-value ratio
The most prudent course of action includes a screening mechanism that includes pricing and concentration limits tied to LTV ratios. Investors may choose to invest in areas of high climate risk but only in loans with low LTV ratios. Bids should be adjusted to account for climate risk, but the amount of the adjustment can be a function of the LTV. Concentration limits should be adjusted accordingly:
Conclusion
When assessing the impact of climate risk on a mortgage portfolio, investors need to consider and seek to quantify not just how natural hazard events will affect home values but also how they will affect borrower behavior, specifically in terms of prepayments, delinquencies, and defaults.
We are already beginning to see climate factors working their way into the secondary mortgage markets via pricing adjustments and concentration screening. It is only a matter of time before these considerations move further up into the origination process and begin to manifest themselves in pricing and underwriting policy (as flood insurance requirements already have today).
Investors looking for a place to start can begin by incorporating a climate risk score into their existing credit box/pricing grid, as illustrated above. This will help provide at least a modicum of comfort to investors that they are being compensated for these hidden risks and (at least as important) will ensure that portfolios do not become overly concentrated in at-risk areas.
