BACKGROUND

That climate change poses a growing—and largely unmeasured—risk to housing and mortgage investors is not news. As is often the case with looming threats whose timing and magnitude are only vaguely understood, increased natural hazard risks have most often been discussed anecdotally and in broad generalities. This, however, is beginning to change as the reality of these risks becomes increasingly clear to an increasing number of market participants and industry-sponsored research begins to emerge.

This past week’s special report by the Mortgage Bankers Association’s Research Institute for Housing America, The Impact of Climate Change on Housing and Housing Finance, raises a number of red flags about our industry’s general lack of preparedness and the need for the mortgage industry to take climate risk seriously as a part of a holistic risk management framework. Clearly this cannot happen until appropriate risk scenarios are generated and introduced into credit and prepayment models.

One of the puzzles we are focusing on here at RiskSpan is an approach to creating climate risk stress testing that can be easily incorporated into existing mortgage modeling frameworks—at the loan level—using home price projections and other stress model inputs already in use. We are also partnering with firms who have been developing climate stress scenarios for insurance companies and other related industries to help ensure that the climate risk scenarios we create are consistent with the best and most recently scientific research available.

Also on the short-term horizon is the implementation of FEMA’s new NFIP premiums for Risk Rating 2.0. Phase I of this new framework will begin applying to all new policies issued on or after October 1, 2021. (Phase II kicks in next April.) We wrote about this change back in February when these changes were slated to take effect back in the spring. Political pressure, which delayed the original implementation may also impact the October date, of course. We’ll be keeping a close eye on this and are preparing to help our clients estimate the likely impact of FEMA’s new framework on mortgages (and the properties securing them) in their portfolios.

Finally, this past week’s SEC statement detailing the commission’s expectations for climate-related 10-K disclosures is also garnering significant (and warranted) attention. By reiterating existing guidelines around disclosing material risks and applying them specifically to climate change, the SEC is issuing an unmistakable warning shot at filing companies who fail to take climate risk seriously in their disclosures.

Contact us (or just email me directly if you prefer) to talk about how we are incorporating climate risk scenarios into our in-house credit and prepayment models and how we can help incorporate this into your existing risk management framework.  

The impacts of climate change on housing and holders of mortgage risk are very real and growing. As the frequency and severity of perils increases, so does the associated cost – estimated to have grown from $100B in 2000 to $450B 2020 (see chart below). Many of these costs are not covered by property insurance, leaving homeowners and potential mortgage investors holding the bag. Even after adjusting for inflation and appreciation, the loss to both investors and consumers is staggering. 

When it comes to climate concerns for the housing market, sea level rise and its impacts on coastal communities often get top billing. But this article in yesterday’s New York Times highlights one example of far-reaching impacts in places you might not suspect.

Chicago, built on a swamp and virtually surrounded by Lake Michigan, can tie its whole existence as a city to its control and management of water. But as the Times article explains, management of that water is becoming increasingly difficult as various dynamics related to climate change are creating increasingly large and unpredictable fluctuations in the level of the lake (higher highs and lower lows). These dynamics are threatening the city with more frequency and severe flooding.

The Times article connects water management issues to housing issues in two ways: the increasing frequency of basement flooding caused by sewer overflow and the battering buildings are taking from increased storm surge off the lake. Residents face increasing costs to mitigate their exposure and fear the potentially negative impact on home prices. As one resident puts it, “If you report [basement flooding] to the city, and word gets out, people fear it’s going to devalue their home.”

These concerns — increasing peril exposure and decreasing valuations — echo fears expressed in a growing number of seaside communities and offer further evidence that mortgage investors cannot bank on escaping climate risk merely by avoiding the coasts. Portfolios everywhere are going to need to begin incorporating climate risk into their analytics.

As hurricane (and wildfire) season ramps up, don’t sleep on the increase in prepayment speeds after a natural disaster event. The increase in delinquencies might get top billing, but prepays also increase after events—especially for homes that were fully insured against the risk they experienced. For a mortgage servicer with concentrated geographic exposure to the event area, this can be a double-whammy impacting their balance sheet—delinquencies increase servicing advances, prepays rolling loans off the book. Hurricane Katrina loan performance is a classic example of this dynamic.