Climate risk is becoming impossible to ignore in the mortgage space.

President Biden’s May 2021 Executive Order makes clear that quantifying and mitigating climate risk will be a priority for the federal government’s housing finance agencies (HUD, FHFA, FHA, VA). It’s just a matter of time before the increased emphasis on this risk makes its way to others in the eco-system (Government-Sponsored Enterprises, Servicers, Lenders, Investors). The SEC will be coming out with climate-related requirements for the securities markets. In early 2021, a proposed rule amendment “to enhance registrant disclosures regarding issuers’ climate-related risks and opportunities” was added to their regulatory agenda with an expected release in 2022. Other agencies, including the OCC, are issuing draft guidance, or requesting feedback on climate-related risks.  Boards are taking notice, and, if you haven’t heard from yours on the topic, you will soon.

But where can you start?

Bear in mind there are a couple of critical questions you need to think about regarding your organizational response to climate risk. Most executives and boards are now familiar with the concepts of physical and transition risks of climate change, but how will these risks manifest in your organization through business, asset, regulatory, legal, and reputation risk? How will these risks impact residential housing prices, attractiveness of communities, building codes, insurance costs, and zoning laws, and the valuation of mortgages and other financial instruments that are a derivative value of residential properties and the economic strength of communities? What will be the response from homeowners, insurers, builders, investors, and public policy of local, state, and federal governments that could impact asset valuation? It’s not an easy problem to solve!

A growing body of academic literature has developed around home price dynamics, mortgage performance, and the general perception of climate risk as a market influencer. Published findings focus primarily on the effect of physical risks on mortgage performance and home prices. A recurring theme in the literature is that while individual climate events can be highly disruptive on local real estate and mortgage markets, values tend to rebound quickly (Bin and Landry, 2013) with the specter of another such event not appearing to weigh down prices significantly. On top of that, short-run effects of supply issues and competitive effects, such as attractive housing features and locations, complicate housing price dynamics. People still want to live on coasts and rivers, in hot and dry desert locations, and in earthquake- and wildfire-exposed areas that are prone to natural catastrophes and increasing impacts from climate change. So attractive are these areas, the marginal effect of a home being in an area that is projected to be underwater may actually increase home prices, without controlling for distance to the shore. This may be a consequence of the premium value associated with waterfront views (Baldauf et al., 2020). But just because impacts so far have been minimal, does not mean future impacts will follow the same trend.

While prices have rebounded quickly after events in the past and housing prices still command a premium for waterfront views, there is evidence that buyers are starting to discount values for coastal properties exposed to sea level rise (Bernstein et al. 2018).  In the future, where there is increasing chances that climate change will cause permanent change to usable land due to any number of hazards without effective resilience improvements, there may be a smaller or no rebound in prices leaving the holders of exposed real and financial assets with a loss. Or, conversely, the value of waterfront homes may even begin to experience a rapid decline if mortgage holders begin to suspect that the value (and usability) of their properties could decline substantially over the life of their mortgages.

Further discussion of the academic literature and a bibliography can be found in the note at the end of this article.

Significant uncertainty exists about how climate change will occur, over what timeframe these changes will occur, how all levels of government will intervene or react to chronic risks like sea level rise, and how households, companies, and financial markets will respond to various signals that will create movements in prices, demographics, and economic activity even before climate risk manifests. What is known is that global temperatures will continue to warm over the next 50 years regardless of the actions people and governments take, and the impacts of that warming will accumulate and become more severe and frequent over time, requiring a definitive action plan for dealing with this issue.


Little differentiation in scenarios in 20 years. Risks will manifest differently over different timeframes.


 

The standards by which organizations will be expected to deal with climate risk will evolve as the climate continues to change and more capabilities are developed to address these issues. An important first step is the need to contextualize these risks with respect to other risks to your business. One immediate need is to address near-term board and regulatory reporting requirements, as well as voluntary public disclosure, as pressure by stakeholders to understand what actions are being taken by companies to address climate change builds.

There is no easy answer, but we offer a way to bring the issue into focus and plan for a thoughtful response as the risks and standards evolve. We are tackling the problem by understanding the risks the organization faces and evaluate those through scenarios and sensitivity analysis. We recommend against over-engineering a solution; instead, design a framework that allows you to monitor and track risk over time. We propose a practical approach, one that’s incrementally phased and integrates risk management through time, enabling pause, adjustment, assessment, and changes in course as needed.


Suggested Approach for Incorporating Climate Risk into ERM


We present five key components to consider when incorporating a climate and natural hazard risk dimension into an existing ERM framework.

Evaluate the Risk Landscape

As a starting point, evaluating the risk landscape entails identifying which climate-related risks have the potential to affect investment return. Climate-related financial risks can be categorized into physical and transition risks.

Physical risks can be acute or chronic. Acute physical risks include extreme events like hurricane, floods, and wildfire. Chronic physical risks refer to a property’s exposure to sea level rise, excessive heat, or drought, for example. Investors who understand these terms and scenarios – including how uncertainty is modeled, emphasizing the directional relationship and order of magnitude of changes rather than exact quantification — are at a competitive advantage.

Transition risks and the secondary effects of physical risks can arise from changes in policy, legal, technology, or market actions that come about from a movement to reduce carbon emissions.

Some important and guiding questions for both physical and transition risk include:

What are the acute and chronic physical hazard types that pose a financial risk?

How will these risks manifest as potential financial loss to mortgage investments?

How material are the possible losses?

How might these risks evolve over time?

Note that climate science continues to evolve, especially as it relates to longer-term impacts, and there is limited historical data to understand how the effects of climate change will trickle into the housing market. Risk assessments must be based on a range of scenarios and include plausible narratives that are not bound by historical observations. The scenario approach applies to studying both acute and chronic physical risks, and the scenarios used in assessing acute or chronic risks may be conceptualized differently.

Select Climate-Related Risks that Impact Mortgage Finance

Visualizing the exposure of various mortgage stakeholders to different forms of climate risk can be accomplished using a table like the following.


Figure


Establish Risk Measurement Approach

Quantifying the financial impact of physical and transition risk is critical to evaluating a portfolio’s potential exposure. From a mortgage loan perspective, loan-level and portfolio-level analyses provide both standalone and marginal views of risk.

Translating hazard risk into a view of financial loss on a mortgage instrument can be accomplished within traditional mortgage model estimations using 1) a combination of property-specific damage estimates from natural hazard and climate risk models, and 2) formulated macroeconomic scenarios guided by academic research and regulatory impacts. And because chronic effects can affect how acute risks manifest, a more nuanced view of how acute risks and chronic risks relate to one another is necessary to answer questions about financial risk.

Mortgage investors can better understand natural hazard risk measures by taking a page from how property insurers account for it. For example, the worst-case “tail loss” potential of a given portfolio is often put in context of the type of events that are at the tail of risk for the industry as a whole – in other words, a 1-in-100-year loss to the portfolio versus a loss to portfolio for a 1-in-100-year industry event. Extending this view to mortgages entails considering the type of events that could occur over the average life of a loan.

To address chronic and transition risk, selecting appropriate macroeconomic scenarios also provides a financial view of the possible impact on a mortgage portfolio. These scenarios may be grounded in published climate projections, asset-specific data collection, or different scenario narratives outlining how these risks could manifest locally.

Defining a Risk Appetite Framework

Inventorying the complete range of potential climate-related risks provides structure and organization around which risks have the largest or most severe impact and creates a framework for ranking them by appropriate criteria. A risk appetite and limit framework defines the type and quantity of natural catastrophe and climate change risk that an enterprise is willing to hold in relation to equity, assets, and other financial exposure measures at a selected probability of occurrence.  The operational usefulness of these frameworks are enhanced when defining the appetite and limits in reference to the risk measures the company selects in addition to straight notional values.

The loss exposure for a particular risk will drive operations differently across business lines based on risk preferences. From the viewpoint of mortgage activities, these operations include origination, servicing, structuring, and pricing. For instance, it may be undesirable to have more than $100 million of asset valuation at risk across the enterprise and apportion that limit to business units based upon the return of the asset in relation to the risk generated from business activity. In this way, the organization has a quantitative way for balancing business goals with risk management goals.

The framework can also target appropriate remediation and hedging strategies in light of the risk priorities. Selecting a remediation strategy requires risk reporting and monitoring across different lines of business and a knowledge of the cost and benefits attributed to physical and transition risks.

Incorporate Findings into Risk Governance

Entities can adapt policies, processes, and responsibilities in the existing ERM framework based on their quantified, prioritized, and articulated risk. This could come in the form of changes to stakeholder reporting from internal management committees, board, and board committees to external financial, investor, public, and regulatory reporting.

Because regulatory requirements and industry best practices are still being formed, it is important to continuously monitor these and ensure that policies align with evolving guidance.

Monitor and Manage Risk Within Risk Appetite and Limits

Implementation of an ERM framework with considerations for natural catastrophe and climate risk may appear different across different lines of businesses and risk management processes. For this reason, it is important that dashboards, reporting frameworks, and exposure control processes be designed to fit in with current reporting within individual lines of businesses.

A practical first step is to establish monitoring specifically to detect adverse selections issues—i.e., ensuring that you are not acquiring a book of business with disproportionately high levels of climate risk or one that adds risk to areas of existing exposure within your portfolio. The object is to manage the portfolio, so risk remains within the agreed appetite and limit framework.  This type of monitoring will become increasingly critical as other market participants start to incorporate climate risk into their own asset screening and pricing decisions. Firms that fail to monitor for climate risk will ultimately be the firms that bear it.

All of this ultimately comes down to identifying natural catastrophe and climate risks, quantifying them through property and loan-specific modeling and scenarios, ranking the risks along different criteria, and tailoring reporting to different operations in the enterprise with an eye for changing regulatory requirements and risk governance policies. An enterprise view is needed given climate risks correlate across multiple asset classes, and where it is determined that differences in risk tolerance are desired, the framework described provides a coherent and quantitative basis for differences.  Successfully negotiating these elements is more easily described than actually carried out, particularly in large financial institutions consisting of businesses with widely divergent risk tolerances.  But we appear to be reaching a point where further deferral is no longer an option. The time to begin planning and implementing these frameworks is now.

GET STARTED

Note on academic research and works referenced

Some empirical research has been conducted examining outcomes following natural hazard events, specifically their impact on mortgage loan performance. Kousky et al. (2020) show evidence that property damage from an extreme event increases short-term mortgage delinquencies and forbearance rates. This effect is mitigated by the presence of flood insurance, which enables borrowers to use insurance proceeds to pay off loans or sell damaged homes once they’ve received compensation and move away from the impacted area. A rebound effect, observed in home prices, occurs in loan performance as well. Delinquencies, while elevated just after the disaster, tend to quickly revert to pre-disaster levels (Fannie Mae, 2017). Extending beyond single-event analysis, delinquencies in hurricane-prone areas have been shown to be higher than delinquency rates in other areas, controlling for other risk factors (Rossi, 2020). The projected rise in hurricane intensity and incidence can therefore lead to higher default risk, which in turn leads to higher losses to investors in mortgage credit risk.

Studies on chronic risks like sea level rise reveal the risk to have a moderate effect on housing prices, stratified by climate “denier” and climate “believer” borrowers (Baldauf et al., 2020). All else equal, areas with owners who perceive a climate threat to their properties may demand a discount on prices. Similarly, Bernstein et al. (2018) show housing price discounts of up to 7% for counties more worried about sea level rise than unworried counties. Risk perception for climate change is subject to a number of biases (Kousky et al., 2020). As such, distortion created by these biases can contribute to inaccurate home pricing. Evidence suggests that regulatory floodplain properties are overvalued, but pricing is inconsistent. Borrowers who are well-informed and sophisticated may fully reflect flood risk information in their pricing (Hino and Burke, 2021). These effects can vary by consumer disclosure requirements as well, which lead to discussion about information gaps on climate risk.

Yet, there is notable research on the salience of events, where house prices following the occurrence of an extreme event have been shown to have persistent effects on home prices. Ortega and Taspinar (2018) show a permanent price decline in the 5 years following Hurricane Sandy for properties in flood zones, regardless of the damage experienced. While properties damaged by the hurricane showed a rebound in home prices right after the event, all properties affected by the storm converged to the same home price penalty. Eichholtz et al. (2019) primarily study commercial real estate properties in New York, with corroborating studies in Boston and Chicago, and find negative price effects from flood-risk exposure post-Hurricane Sandy due to sophisticated investors adjusting their valuations downward. Increased attention to climate change from the occurrence of extreme events may cause long-term price effects as communities begin evaluating the possible risks they face after weathering a catastrophic event.


For further reading, see:

Markus Baldauf, Lorenzo Garlappi, Constantine Yannelis, Does Climate Change Affect Real Estate Prices? Only If You Believe In It, The Review of Financial Studies, Volume 33, Issue 3, March 2020, Pages 1256–1295, https://doi.org/10.1093/rfs/hhz073

Eichholtz, Piet M. A.; Steiner, Eva; Yönder, Erkan “Where, When, and How Do Sophisticated Investors Respond to Flood Risk?,” June 2019. PDF

Bernstein, Asaf and Gustafson, Matthew and Lewis, Ryan, Disaster on the Horizon: The Price Effect of Sea Level Rise (May 4, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=3073842 

Bin, O., & Landry, C. E. (2013). Changes in implicit flood risk premiums: Empirical evidence from the housing market. Journal of Environmental Economics and Management, 65(3), 361–376. HYPERLINK “https://protect-us.mimecast.com/s/SL58C5ylW5F05NOpXUzgQhi?domain=doi.org

Hinoa and Burke, The effect of information about climate risk on
property values (March 18, 2021). PDF

Ortega, Francesc and Taspinar, Suleyman, Rising Sea Levels and Sinking Property Values: The Effects of Hurricane Sandy on New York’s Housing Market (March 29, 2018). Available at SSRN: https://ssrn.com/abstract=3074762 or http://dx.doi.org/10.2139/ssrn.3074762

Clifford Rossi. “Assessing the impact of hurricane frequency and intensity on mortgage default risk,” June 2020. PDF

Markus Baldauf, Lorenzo Garlappi, Constantine Yannelis, Does Climate Change Affect Real Estate Prices? Only If You Believe In It, The Review of Financial Studies, Volume 33, Issue 3, March 2020, Pages 1256–1295, https://doi.org/10.1093/rfs/hhz073

Carolyn Kousky, Howard Kunreuther, Michael LaCour-Little & Susan Wachter (2020) Flood Risk and the U.S. Housing Market, Journal of Housing Research, 29:sup1, S3-S24, DOI: 10.1080/10527001.2020.1836915

Carolyn Kousky, Mark Palim & Ying Pan (2020) Flood Damage and Mortgage Credit Risk: A Case Study of Hurricane Harvey, Journal of Housing Research, 29:sup1, S86-S120, DOI: 10.1080/10527001.2020.1840131

Verisk 2021: How Current Market Conditions Could Impact U.S. Hurricane Season 2021

RiskSpan 2018: Houston Strong: Communities Recover from Hurricanes. Do Mortgages?