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Articles Tagged with: Climate Risk

Quantifying the Impact of Climate Risk on Housing Finance 

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.

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Climate risk dashboard acute risk

These analyses can look at the exposure of an entire portfolio to all perils combined:    

Climate risk dashboard U.S.
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Or they can look at the exposure of a single geographic area to one peril in particular:

Climate risk dashboard Florida

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:

Climate risk pricing adjustments

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.

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Rising Rates; Rising Temperatures: What Higher Interest Rates Portend for Mortgage Climate Risk — An interview with Janet Jozwik  

Janet Jozwik leads RiskSpan’s sustainability analytics (climate risk and ESG) team. She is also an expert in mortgage credit risk and a recognized industry thought leader on incorporating climate risk into credit modeling. We sat down with Janet to get her views on whether the current macroeconomic environment should impact how mortgage investors prioritize their climate risk mitigation strategies.


You contend that higher interest rates are exposing mortgage lenders and investors to increased climate risk. Why is that?

JJ: My concern is primarily around the impact of higher rates on credit risk overall, of which climate risk is merely a subset – a largely overlooked and underappreciated subset, to be sure, and one with potentially devastating consequences, but ultimately one of many. The simple reason is that, because interest rates are up, loans are going to remain on your books longer. The MBA’s recent announcement of refinance applications (and mortgage originations overall) hitting their lowest levels since 2000 is stark evidence of this.

And because these loans are going to be lasting longer, borrowers will have more opportunities to get into trouble (be it a loss of income or a natural disaster) and everybody should be taking credit risk more seriously. One of the biggest challenges posed by a high-rate environment is borrowers don’t have a lot of the “outs” available to them as they do when they encounter stress during more favorable macroeconomic environments. They can no longer simply refi into a lower rate. Modification options become more complicated. They might have no option other than to sell the home – and even that isn’t going to be as easy as it was, say, a year ago. So, we’ve entered this phase where credit risk analytics, both at origination and life of loan, really need to be taken seriously. And credit risk includes climate risk.

So longer durations mean more exposure to credit risk – more time for borrowers to run into trouble and experience credit events. What does climate have to do with it? Doesn’t homeowners’ insurance mitigate most of this risk anyway?

JJ: Each additional month or year that a mortgage loan remains outstanding is another month or year that the underlying property is exposed to some form of natural disaster risk (hurricane, flood, wildfire, earthquake, etc.). When you look at a portfolio in aggregate – one whose weighted average life has suddenly ballooned from four years to, say eight years – it is going to experience more events, more things happening to it. Credit risk is the risk of a borrower failing to make contractual payments. And having a home get blown down or flooded by a hurricane tends to have a dampening effect on timely payment of principal and interest.

As for insurance, yes, insurance mitigates portfolio exposure to catastrophic loss to some degree. But remember that not everyone has flood insurance, and many loans don’t require it. Hurricane-specific policies often come with very high deductibles and don’t always cover all the damage. Many properties lack wildfire insurance or the coverage may not be adequate. Insurance is important and valuable but should not be viewed as a panacea or a substitute for good credit-risk management or taking climate into account when making credit decisions.

But the disaster is going to hit when the disaster is going to hit, isn’t it? How should I be thinking about this if I am a lender who recaptures a considerable portion of my refis? Haven’t I just effectively replaced three shorter-lived assets with a single longer-lived one? Either way, my portfolio’s going to take a hit, right?

JJ: That is true as far as it goes. And if in the steady state that you are envisioning, one where you’re just churning through your portfolio, prepaying existing loans with refis that look exactly like the loans they’re replacing, then, yes, the risk will be similar, irrespective of expected duration.

But do not forget that each time a loan turns over, a lender is afforded an opportunity to reassess pricing (or even reassess the whole credit box). Every refi is an opportunity to take climate and other credit risks into account and price them in. But in a high-rate environment, you’re essentially stuck with your credit decisions for the long haul.

Do home prices play any role in this?

JJ: Near-zero interest rates fueled a run-up in home prices like nothing we’ve ever seen before. This arguably made disciplined credit-risk management less important because, worst case, all the new equity in a property served as a buffer against loss.

But at some level, we all had to know that these home prices were not universally sustainable. And now that interest rates are back up, existing home prices are suddenly starting to look a little iffy. Suddenly, with cash-out refis off the table and virtually no one in the money for rate and term refis, weighted average lives have nowhere to go but up. This is great, of course, if your only exposure is prepayment risk. But credit risk is a different story.

And so, extremely low interest rates over an extended period played a significant role in unsustainably high home values. But the pandemic had a lot to do with it, as well. It’s well documented that the mass influx of home buyers into cities like Boise from larger, traditionally more expensive markets drove prices in those smaller cities to astronomical levels. Some of these markets (like Boise) have not only reached an equilibrium point but are starting to see property values decline. Lenders with excessive exposure to these traditionally smaller markets that experienced the sharpest home price increases during the pandemic will need to take a hard look at their credit models’ HPI assumptions (in addition to those properties’ climate risk exposure).

What actions should lenders and investors be considering today?

JJ: If you are looking for a silver lining in the fact that origination volumes have fallen off a cliff, it has afforded the market an opportunity to catch its breath and reassess where it stands risk-wise. Resources that had been fully deployed in an effort simply to keep up with the volume can now be reallocated to taking a hard look at where the portfolio stands in terms of credit risk generally and climate risk in particular.

This includes assessing where the risks and concentrations are in mortgage portfolios and, first, making sure not to further exacerbate existing concentration risks by continuing to acquire new assets in overly exposed geographies. Investors may be wise to go so far even to think about selling certain assets if they feel like they have too much risk in problematic areas.

Above all, this is a time when lenders need to be taking a hard look at the fundamentals underpinning their underwriting standards. We are coming up on 15 years since the start of the “Great Recession” – the last time mortgage underwriting was really “tight.” For the past decade, the industry has had nothing but calm waters – rising home values and historically low interest rates. It’s been like tech stocks in the ‘90s. Lenders couldn’t help but make money.

I am concerned that this has allowed complacency to take hold. We’re in a new world now. One with shaky home prices and more realistic interest rates. The temptation will be to loosen underwriting standards in order to wring whatever volume might be available out of the economy. But in reality, they need to be doing precisely the opposite. Underwriting standards are going to have tighten a bit in order effectively manage the increased credit (and climate) risks inherent to longer-duration lending.

It’s okay for lenders and investors to be taking these new risks on. They just need to be doing it with their eyes wide open and they need to be pricing for it.

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Webinar Recording: How Much Will That MSR Portfolio Really Cost You?

Recorded: June 8th | 1:00 p.m. ET

Accurately valuing a mortgage servicing rights portfolio requires accurately projecting MSR cash flows. And accurately projecting MSR cash flows requires a reliable forecast of servicing costs. Trouble is, servicing costs vary extensively from loan to loan. While the marginal cost of servicing a loan that always pays on time is next to nothing, seriously delinquent loans can easily cost hundreds, if not thousands, of dollars per year.

The best way to account for this is to forecast and assign servicing costs at the loan level – a once infeasible concept that cloud-native technology has now brought within reach. Our panelists present a novel, granular approach to servicing cost analytics and how to get to a truly loan-by-loan MSR valuation (without resorting to rep lines).

 

Featured Speakers

Venkat Mullur

SVP, Capital Markets, Ocwen

Paul Gross

Senior Quantitative Analyst, New Residential Investment Corp.

Dan Fleishman

Managing Director, RiskSpan

Joe Makepeace

Director, RiskSpan


Striking a Proper Balance: ESG for Structured Finance

The securitization market continues to wrestle with the myriad of approaches and lack of standards in identifying and reporting ESG factors in transactions and asset classes. But much needed guidance is on the way as industry leaders work toward a consensus on the best way to report ESG for structured finance.  

RiskSpan gathered with other key industry players tackling these challenges at this month’s third annual Structured Finance Association ESG symposium in New York City. The event identified a number of significant strides taken toward shaping an industry-standard ESG framework and guidelines.  

Robust and engaging discussions across a variety of topics illustrated the critical need for a thoughtful approach to framework development. We observed a broad consensus around the notion that market acceptance would require any solution to be data supported and fully transparent. 

Much of the discussion revolved around three recurring themes: Finding a workable balance between the institutional desire for portfolio-specific measures based on raw data and the market need for a standardized scoring mechanism that everybody understands, maintaining data privacy, and assessing tradeoffs between the societal benefits of ESG investing and the added risk it can pose to a portfolio. 

Striking the Right Balance: Institution-Specific Measures vs. Industry-Standard Asset Scoring 

When it comes to disclosure and reporting, one point on a spectrum does not fit all. Investors and asset managers vary in their ultimate reporting needs and approach to assessing ESG and impact investing. On the one hand, having raw data to apply their own analysis or specific standards can be more worthwhile to individual institutions. On the other, having well defined standards or third-party ESG scoring systems for assets provides greater certainty and understanding to the market as a whole.  

Both approaches have value.

Everyone wants access to data and control over how they view the assets in their portfolio. But the need for guidance on what ESG impacts are material and relevant to structured finance remains prominent. Scores, labels, methodologies, and standards can give investors assurance a security contributes to meeting their ESG goals. Investors want to know where their money is going and if it is meaningful.

Methodologies also have to be explainable. Though there was agreement that labeled transactions are not always necessary (or achievable), integration of ESG factors in the decision process is. Reporting systems will need to link underlying collateral to external data sources to calculate key metrics required by a framework while giving users the ability to drill down to meet specific and granular analytical needs.    

Data Privacy

Detailed analysis of underlying asset data, however, highlights a second key issue: the tradeoff between transparency and privacy, particularly for consumer-related assets. Fiduciary and regulatory responsibility to protect disclosure of non-public personally identifiable information limits investor ability to access loan-level data.

While property addresses provide the greatest insight to climate risk and other environmental factors, concerns persist over methods that allow data providers to triangulate and match data from various sources to identify addresses. This in turn makes it possible to link sensitive credit information to specific borrowers.

The responsibility to summarize and disclose metrics required by the framework falls to issuers. The largest residential issuers already appreciate this burden. These issuers have expressed a desire to solve these issues and are actively looking at what they can do to help the market without sacrificing privacy. Data providers, reporting systems, and users will all need to consider the guardrails needed to adhere to source data terms of use.   

Assessing Impact versus Risk

Another theme arising in nearly all discussions centered on assessing ESG investment decisions from the two sometimes competing dimensions of impact and risk and considering whether tradeoffs are needed to meet a wide variety of investment goals. Knowing the impact the investment is making—such as funding affordable housing or the reduction of greenhouse gas emissions—is fundamental to asset selection or understanding the overall ESG position.

But what risks/costs does the investment create for the portfolio? What is the likely influence on performance?

The credit aspect of a deal is distinct from its ESG impact. For example, a CMBS may be socially positive but rent regulation can create thin margins. Ideally, all would like to maximize positive impact but not at the cost of performance, a strategy that may be contributing now to an erosion in greeniums. Disclosures and reporting capabilities should be able to support investment analyses on these dimensions.  

A disclosure framework vetted and aligned by industry stakeholders, combined with robust reporting and analytics and access to as much underlying data as possible, will give investors and asset managers certainty as well as flexibility to meet their ESG goals.   

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Why Climate Risk Matters for Mortgage Loan & MSR Investors 

The time has come for mortgage investors to start paying attention to climate risk.

Until recently, mortgage loan and MSR investors felt that they were largely insulated from climate risk. Notwithstanding the inherent risk natural hazard events pose to housing and the anticipated increased frequency of these events due to climate change, it seemed safe to assume that property insurers and other parties in higher loss position were bearing those risks. 

In reality, these risks are often underinsured. And even in cases where property insurance is adequate, the fallout has the potential to hit investor cash flows in a variety of ways. Acute climate events like hurricanes create short-term delinquency and prepayment spikes in affected areas. Chronic risks such as sea level rise and increased wildfire risk can depress housing values in areas most susceptible to these events. Potential impacts to property insurance costs, utility costs (water and electricity in areas prone to excessive heat and drought, for example) and property taxes used to fund climate-mitigating infrastructure projects all contribute to uncertainty in loan and MSR modeling. 

Moreover, dismissing climate risk “because we are in fourth loss position” should be antithetical to any investor claiming to espouse ESG principles. After all, consider who is almost always in the first loan position – the borrower. Any mortgage investment strategy purporting to be ESG friendly must necessarily take borrower welfare into account. Dismissing climate risk because borrowers will bear most of the impact is hardly a socially responsible mindset. This is particularly true when a disproportionate number of borrowers prone to natural hazard risk are disadvantaged to begin with. 

Hazard and flood insurers typically occupy the loss positions between borrowers and investors. Few tears are shed when insurers absorb losses. But society at large ultimately pays the price when losses invariably lead to higher premiums for everybody.    

Evaluating Climate Exposure

For these and other reasons, natural hazards pose a systemic risk to the entire housing system. For mortgage loan and MSR investors, it raises a host of questions. Among them: 

  1. What percentage of the loans in my portfolio are susceptible to flood risk but uninsured because flood maps are out of date? 
  2. How geographically concentrated is my portfolio? What percentage of my portfolio is at risk of being adversely impacted by just one or two extreme events? 
  3. What would the true valuation of my servicing portfolio be if climate risk were factored into the modeling?  
  4. What will the regulatory landscape look like in coming years? To what extent will I be required to disclose the extent to which my portfolio is exposed to climate risk? Will I even know how to compute it, and if so, what will it mean for my balance sheet? 

 

Incorporating Climate Data into Investment Decision Making

Forward-thinking mortgage servicers are at the forefront of efforts to get their arms around the necessary data and analytics. Once servicers have acquired a portfolio, they assess and triage their loans to identify which properties are at greatest risk. Servicers also contemplate how to work with borrowers to mitigate their risk.  

For investors seeking to purchase MSR portfolios, climate assessment is making its way into the due diligence process. This helps would-be investors ensure that they are not falling victim to adverse selection. As investors increasingly do this, climate assessment will eventually make its way further upstream, into appraisal and underwriting processes. 

Reliably modeling climate risk first requires getting a handle on how frequently natural hazard events are likely to occur and how severe they are likely to be. 

In a recent virtual industrial roundtable co-hosted by RiskSpan and Housing Finance Strategies, representatives of Freddie Mac, Mr. Cooper, and Verisk Analytics (a leading data and analytics firm that models a wide range of natural and man-made perils) gathered to discuss why understanding climate risk should be top of mind for mortgage investors and introduced a framework for approaching it. 

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Building the Framework

The framework begins by identifying the specific hazards relevant to individual properties, building simulated catalogs of thousands of years worth of simulated events, computing likely events simulating damage based on property construction and calculating likely losses. These forecasted property losses are then factored into mortgage performance scenarios and used to model default risk, prepayment speeds and home price impacts. 

 

Responsibility to Borrowers

One member of the panel, Kurt Johnson, CRO of mega-servicer Mr. Cooper, spoke specifically of the operational complexities presented by climate risk. He cited as one example the need to speak daily with borrowers as catastrophic events are increasingly impacting borrowers in ways for which they were not adequately prepared. He also referred to the increasing number of borrowers incurring flood damage in areas that do not require flood insurance and spoke to how critical it is for servicers to know how many of their borrowers are in a similar position.

Johnson likened the concept of credit risk layering to climate risk exposure. The risk of one event happening on the heels of another event can cause the second event to be more devastating than it would have been had it occurred in a vacuum. As an example, he mentioned how the spike in delinquencies at the beginning of the covid pandemic was twice as large among borrowers who had just recovered from Hurricane Harvey 15 months earlier than it was among borrowers who had not been affected by the storm. He spoke of the responsibility he feels as a servicer to educate borrowers about what they can do to protect their properties in adverse scenarios.


Industry Virtual Roundtable: The Intersection of Climate Risk Management with Mortgage Loan & MSR Investing

April 14th | 2:00-3:15 p.m. ET

With both the public and private sectors increasingly making climate risk management a priority, attention in our industry is turning to what it means for mortgage loan and MSR investors.

Industry experts join RiskSpan and Housing Finance Strategies for a roundtable event where they engage in a discussion on the latest approaches and technology for mitigating climate risk management in mortgage portfolios.

The loan-level cash flows discussed in this webinar were generated using RiskSpan’s Edge Platform.

 

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Agenda (all times Eastern)

2:00-2:05 pm | WELCOME AND PROGRAM OVERVIEW 

Faith Schwartz, Founder & CEO, Housing Finance Strategies

2:05-2:20 pm | CLIMATE RISK’S IMPACT ON MORTGAGE FINANCE AND TOOLS TO MANAGE RISK

Janet Jozwik, Senior Managing Director and Head of Climate Risk, RiskSpan
Dan Raizman, Global Resilience Manager, Verisk Analytics

2:20-3:00 pm | PANEL DISCUSSION: CLIMATE RISK IN HOUSING FINANCE—RISK MANAGEMENT AND REGULATORY PERSPECTIVES

Faith Schwartz, Moderator
Mark Hanson, SVP, Freddie Mac
Kurt Johnson, CRO, Mr. Cooper
Sean Becketti, former Freddie Mac
Bernadette Kogler, CEO, RiskSpan

3:00-3:15 pm | QUESTIONS AND DISCUSSION OF POLLING RESULTS


Incorporating Climate Risk into ERM: A Mortgage Risk Manager’s Guide

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.

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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?


RiskSpan and Verisk Collaborate to Offer Climate Risk Analytics for Mortgage Finance

Mortgage analytics firm RiskSpan has collaborated with Verisk to create a first-of-its-kind solution for measuring and mitigating the risks of climate change to the housing finance industry. The collaboration unites RiskSpan’s Edge Platform for mortgage analytics with Verisk Extreme Event  Solutions’ proven set of models — relied on by leading insurance, re-insurance, corporate and government entities, to assess the risk from natural catastrophes and climate to a given location by providing a property-specific hazard risk metric.

“Verisk’s ground-up approach to property-specific risk analysis is the perfect complement to our loan-level approach to mortgage credit and prepayment modeling,” said Janet Jozwik, the managing director heading up RiskSpan’s contribution to the new partnership. “We are excited to layer Verisk’s unique property risk scoring into our existing credit and portfolio risk framework.”

“Our collaboration with RiskSpan will serve to greatly benefit the housing finance industry by adding critical data and analytics from Verisk’s catastrophe models during the loan screening process,” observed Roger Grenier, senior vice president of Verisk’s global resilience practice. “This added layer of portfolio management can help banks and financial institutions better understand the potential risk from extreme weather events to a given property.”

The risk to the housing finance industry from extreme events is significant. According to Verisk, 62 million residential locations are at moderate to extreme risk of flooding alone.

“We are thrilled to bring the powerful climate and hazard risk analytics of Verisk to our clients,” said Bernadette Kogler, chief executive officer, RiskSpan. “This alliance opens the door to a world of property-level data from the insurance industry that can have tremendous value for applications in the mortgage space.”

“The collaborative solution will bring together the best extreme event models, data and climate analytics to the mortgage finance industry,” concluded Bill Churney, president, Verisk’s Extreme Event Solutions unit. “With financial institutions facing increased pressure to factor climate risk into their decision making, we expect RiskSpan’s enhanced tools powered by Verisk to be a welcome addition to their risk management process.”

The collaboration offers two complementary products, including loan-level scoring and climate stress testing, with applications for loan screening, portfolio management, and financial disclosures.


About RiskSpan 

RiskSpan offers end-to-end solutions for data management, risk management analytics, and visualization on a highly secure, fast, and fully scalable platform that has earned the trust of the industry’s largest firms. Combining the strength of subject matter experts, quantitative analysts, and technologists, RiskSpan’s Edge Platform integrates a range of data-sets – structured and unstructured – and off-the-shelf analytical tools to provide you with powerful insights and a competitive advantage. Learn more at www.riskspan.com. 

About Extreme Event Solutions at Verisk

Extreme event solutions at Verisk (formerly AIR Worldwide) provides risk modeling solutions that help individuals, businesses, and society become more resilient to extreme events. In 1987, Verisk founded the catastrophe modeling industry and today models the risk from natural catastrophes, supply chain disruptions, terrorism, pandemics, casualty catastrophes, and cyber incidents. Insurance, reinsurance, financial, corporate, and government clients rely on Verisk’s advanced science, software, and consulting services for catastrophe risk management, insurance-linked securities, longevity modeling, site-specific engineering analyses, and agricultural risk management. Verisk’s extreme event solutions team is headquartered in Boston, with additional offices in North America, Europe, and Asia. For more information, please visit www.air-worldwide.com. For more information about Verisk, a leading data analytics provider serving customers in insurance, energy and specialized markets, and financial services, please visit www.verisk.com.

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Webinar: Geocoding Mortgage Data for ESG and Climate Risk Analysis

Recorded: February 16th | 1:00 p.m. ET

Geocoding remains a particularly vexing challenge for the mortgage industry. Lenders, servicers, and loan/MSR investors know the addresses of the properties securing their mortgage assets. But most data pertaining to climate and other ESG considerations is available only by matching to a census tract or latitude/longitude.

And if you have ever tried mapping addresses, you know this exercise can be a lot harder than it looks. Fortunately, a growing body of geocoding tools and techniques is emerging to make the process more manageable than ever, even with less than perfect address data.

Our panel presents a how-to guide on geocoding logic and its specific application to the mortgage space. You will learn a useful waterfall approach for linking census-tract-level, geo-specific data for climate risk and ESG to the property addresses in your portfolio.

 

Featured Speakers

Suhrud Dagli

Chief Innovation Officer, RiskSpan

Jason Huang

Manager, RiskSpan

Jason Lee

Software Engineer, RiskSpan


How Has the First “Social” RMBS Performed – And What’s So Social About It?

Now that six months have passed since Angel Oak issued AOMT 2021-2 – hailed as the first U.S. non-Agency RMBS to qualify as a social bond [1] – we can compare preliminary collateral performance to other deals. Angel Oak’s 2021-1, from the same shelf and vintage – but without the social bond distinction – provides an apt control group. To set the stage for this performance comparison, we’ll first reexamine the compositional differences – and significant overlap – between the two collateral pools. What we will show:

  • The pool compositions are highly overlapping, with marginally greater risk concentrations of self-employment and alternative documentation in the social securitization, and the same WA (weighted average) coupon
  • The social collateral has outperformed the benchmark credit-wise in the early going
  • The social deal has exhibited some lock-in, i.e., slower refinancing, providing some very preliminary evidence that the borrowers are indeed underserved, and that investors may be rewarded if the social collateral’s credit performance holds
  • However, the credit mix of the social collateral has drifted riskier – more so than the benchmark – meaning the strong early credit performance of the social deal could reverse, and ongoing surveillance is warranted

New Loans or New Label?


The Social AOMT 2021-2 Is Similar to AOMT 2021-1

Figure 1 shows AOMT 2021-1 vs. 2021-2 in the Collateral Comparison screen of Edge, RiskSpan’s data and analytics platform. Clearly, the two pools were similar at origination, with highly overlapping distributions of FICO, LTV, and DTI and many other similar metrics.

So What’s Different – And How Different Is It?

The distinguishing principle of a social bond under Angel Oak’s framework is that it provides affordable home mortgages to those who often can’t get them because they don’t qualify under the automated underwriting processes of traditional lenders because of the exceptional nature of their sources of income. [2]

Angel Oak says the specific characteristic hindering the borrowers in the AOMT 2021-2 deal is self-employment. [3] Self-employed borrowers make up 94.4% of the pool (with a median annual income of $227,803) [4], up marginally from 86.5% in the 2021-1 deal [5]. As Figure 1 shows, the proportion of low documentation by balance was up from 87.5% in 2021-1 to 97.5% in 2021-2.

Also, Figure 1 shows that 2021-2’s FICOs and LTVs are slightly worse on average with slightly more tail risk, and the cash-out proportion is slightly riskier.

Compensating marginally for 2021-2 are slightly lower ARM proportions (0 vs. 0.8% for 2021-1), lower WA. DTI, and a higher proportion of owner-occupied (90% vs. 85%), which many view as credit-positive.

In summary, RiskSpan calculates 1.83 average risk layers per loan for the social 2021-2, slightly higher than 1.78 for 2021-1.

Notably the WA coupons for the two pools are the same.


Figure 1: Edge’s Collateral Comparison Screen Showing AOMT 2021-1 (aka AOAK 2101) vs. 2021-2 (aka AOAK 2102) at OriginationSource: CoreLogic, RiskSpan


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In summary, it seems that most – though perhaps not all – of the loans that qualified for AOMT 2021-2 would have qualified for AOMT 2021-1 and other non-QM deals.

Kroll’s new issue report seems to acknowledge that what is new about 2021-2 is mostly the formal emphasis on the social benefits of the loans made, and less a change in the kinds of loans made: “While many of [Angel Oak’s] lending programs overlap meaningfully with other non-QM lender’s offerings, the actions taken by AOCA generally indicate management’s attention to ESG related matters. Specifically, AOCA’s SBF puts focus on the impact that credit availability for underserved borrowers can have.” [4]

A skeptical interpretation of the overlap between 2021-1 and the social 2021-2 collateral would be that the social claim is largely hollow. Another way of looking at it is that a financial market participant is finally taking credit for good work it has been largely doing all along. Angel Oak itself seems to take this latter view, saying, “Since 2011, AOCA has been implementing ESG principles within its non-qualified mortgage (non-QM) origination and securitization program to provide access to residential credit for underserved borrowers.” [2]

Either way, logical hypotheses would be that collateral performance will be similar between 2021-2 and 2021-1, with -2 showing (a) slightly more credit trouble and (b) slightly less able to refinance. Regarding the second hypothesis, logically it should challenge the premise that the deal serves underserved borrowers if its borrowers can refinance just as readily as others.

Early Performance of the Social Bonds


Let’s see how AOMT’s social 2021-2 has performed as benchmarked to 2021-1 during the first six and seven months, respectively, of available data.

Better Delinquency Trend Than the Benchmark

As Figure 2 shows, delinquencies opened higher for the social 2021-2 but have mostly cured. By contrast, delinquencies have trended up for 2021-1. So far, Angel Oak’s social origination is outperforming its non-social contemporary from a credit standpoint.


Figure 2: AOMT 2021-2 Delinquencies Began Higher, Have Mostly Cured; AOMT 2021-1’s Delinquencies Have Trended Up 60 day-plus delinquency share over time, AOMT 2021-2 vs AOMT 2021-1 Source: CoreLogic, RiskSpan


Significantly Better Credit Performance by the Social DSCR Investor Loans

A small slice of the deals driving outsized delinquencies in 2021-1 are the DSCR-based investor loans (Figure 3). In the social 2021-2, delinquencies among this cohort are zero. We plot the spreads at origination (SATO) of this cohort alongside delinquencies to show that the DSCR loans in 2021-2 had lower credit spreads by about 20bps. Perhaps the investor loans pooled into 2021-2 were managed to higher standards for DSCR, rent rolls or other attributes (their LTVs and ages are similar).


Figure 3: Delinquencies – and SATOs – Are Lower Among DSCR-Based Investor Loans in AOMT 2021-2 60 day-plus delinquency share and WA SATOs over time, AOMT 2021-2 vs. AOMT 2021-1, includes Detailed Doc Type = DSCR Investor Cash Flow.Source: CoreLogic, RiskSpan


Ironically, The Full Doc Loans Are the Social Deal’s Blemish

The slice of full doc loans in the social 2021-2 have a much lower WA FICO than the low doc loans in the same deal or either the low or full doc loans in 2021-1 (see the green dotted line in Figure 4). Correspondingly, these full doc loans have the highest delinquent share among the four cohorts in Figure 4 (green solid line). If this pattern holds, it highlights the viability of using tradeoffs to manage down the overall credit risk represented by loans with risky attributes.


Figure 4: AOMT 2021-2’s Full Doc Loans Are the Most Delinquent Doc Cohort from Either Deal 60 day-plus delinquency share and WA FICOs over time, AOMT 2021-2 vs. AOMT 2021-1 and Full Doc vs. Low Doc Source: CoreLogic, RiskSpan


Slower Refinances Than the Benchmark

While credit performance has been better for the social deal than we might expect, voluntary prepays so far (Figure 5) support our hypothesis that the social deal should prepay slower. Note that we plot voluntary prepays over loan age, and that all loans from this recent non-QM vintage have similar (and highly positive) refinance incentive. If the social deal’s refinances remain slower, that accomplishes two significant things: 1) it supports the claim that the social borrowers are indeed underserved; 2) if combined with sustained credit performance, it provides support in terms of financial risk and return for the price premiums that social bonds tend to command.


Figure 5: AOMT 2021-2 Is Refinancing Slower CRR over loan age, AOMT 2021-2 vs. AOMT 2021-1, July 2021-January 2022 Source: CoreLogic, RiskSpan


The Relative Refinance Slowness Is From the Large Balance Loans

The overall slowness of the social collateral in Figure 5 is driven by large loans. Figure 6 shows that, among loans <$417K, the prepay patterns of 2021-1 and 2021-2 are similar, while among loans > $417K, the prepays of 2021-2 are consistently slower. This may suggest that large loans with complex sources of income are particularly hard to underwrite.


Figure 6: The Social Deal’s Low-Balance Loans Refi Similar to Benchmark, But Large Balances Have Been Slower CRR over loan age, AOMT 2021-2 vs. AOMT 2021-1, bucketed by loan size, July 2021-January 2022 Source: CoreLogic, RiskSpan


 

Updated Collateral Mix


The Social Deal’s Credit Mix Has Drifted Riskier, Warranting Ongoing Monitoring

While the early performance of the social collateral is positive, Figure 7 provides reason for concern and ongoing watchfulness. Since origination, the composition of the social 2021-2 has drifted riskier in all respects except slight improvements in WA DTI and WA LTV. Its LTV tails, WA FICO, and FICO tails; proportions of cash-out, low doc, non-owner-occupied; and average overall risk layers are all somewhat riskier.

The drift for 2021-1 has been more mixed. Like 2021-2, it is safer with respect to WA DTI and WA LTV. Unlike 2021-2, it is also safer with respect to LTV tails, FICO tails, and cash-out proportion. Like 2021-2, it is riskier with respect to WA FICO; proportions of low doc and non-owner-occupied; and average overall risk layers.

We will continue to monitor whether this composition drift drives differential performance going forward.


Figure 7: Edge’s Collateral Comparison Screen Showing AOMT 2021-1 (aka AOAK 2101) vs. 2021-2 (aka AOAK 2102) updated to the Current Factor DateSource: CoreLogic, RiskSpan


Using Edge, you can examine prepay or credit performance of loan subsets defined by any characteristics, and generate aging curves, time series, or S-curves.

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