Mortgage market is unprepared for climate risk, says industry report
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Jenna Fountain carries a bucket down Regency Drive to try to recover items from their flooded home in Port Arthur, Texas, September 1, 2017.
Getty Images Record-setting rain, floods and wildfires are examples of the rising risks to the U.S. housing market from climate change.| AFP | Getty Images
Record-setting rain, floods and wildfires are examples of the rising risks to the U.S. housing market from climate change.
Mortgage lenders and investors are woefully unprepared not only to mitigate their risk but to even gauge that risk, according to a new report from the Mortgage Bankers Association’s Research Institute for Housing America.
They are eager to know what to do, but don’t know where to look. Sean Becketti (author of the report, former chief economist at Freddie Mac), said that although they are not prepared for what lies ahead, it isn’t impossible to be aware.
Housing finance involves many stakeholders, such as homeowners, landowners, appraisers, appraisers and mortgage originators, servicers and lenders, insurers, investors in mortgages and government-sponsored entities that issue them (Fannie Mae, Freddie Mac). Climate change is expected to cause significant financial stress over a long period of time.
Climate change will not only increase stress on the National Flood Insurance Program but it can also increase prepayment and mortgage default risks and trigger adverse selection in loans being sold to GSEs. This could lead to significant climate migration and volatility.
The GSEs might charge lenders for rep and warrant insurance, which covers the breach of financial contracts, warranties, and other risks. There could also be higher costs for those who securitize loans with them.
In particular, lenders might be asked to conduct additional research to establish the need to insure flood risks. Additionally, delays in the updating of official flood maps could force lenders into adding additional flood information sources. GSEs may not be permitted to purchase loans for homes at higher flood risk.
In addition, the NFIP is in the midst of a major overhaul, which will change pricing for homeowners. This will have an impact on home values, and consequently the value of mortgages backing those homes.
Uncertainty for mortgage lenders is the biggest issue right now.
The biggest problem right now is uncertainty for mortgage stakeholders. Becketti said that there hasn’t been any change in rule to affect firms involved in the mortgage market, but it is being looked at.
Climate foreclosure crisis
The insurance industry is a major source of risk assessment for the mortgage market.
However, most models of risk in the mortgage industry are focused on operating and credit risk.
“In the case of modeling for risk, the mortgage industry still predominantly thinks of protection in terms of property and casualty risk, which is underwritten and priced by insurance companies,” said Sanjiv Das, CEO of Caliber Home Loans. The industry does not model climate risk as well and mainly relies upon models provided by FEMA or other insurance companies.
FEMA, the Federal Emergency Management Agency is already stressed by the unprecedented number of natural catastrophes that have struck the country in recent years. Mortgage lenders may be held responsible for any losses if FEMA alters the way it backs.
Additionally, homeowners who have been displaced from natural disasters might default on their homes loans.
Following Hurricane Harvey in Houston in 2017, mortgage industry leaders warned of a potential climate foreclosure crisis as the storm flooded close to 100,000 Houston-area homes. Harvey-related disaster zones were declared federally and 80% of affected homes didn’t have flood insurance as they aren’t usually prone to flooding. CoreLogic reports that serious mortgage defaults on homes damaged by flooding rose more than 2000%.
Banks, lenders, investors, mortgage servicers and banks use estimated default costs as a key component to determine profitability. They also need loan loss reserves, economic capital, and financial capital.
Becketti stated in the report, “If climate change causes incremental defaults that are material to any of these stakeholder(s), regulators or investors will expect those stakeholders to estimate the impacts of incremental defaults and compare those estimates with key assumptions.”
After Hurricane Harvey, homes in flood are seen near Lake Houston.
Win McNamee | Getty Images
Finally, mortgage bond investors, who are already asking for more information from lenders about climate risk, could also pull back, leaving the mortgage market with less liquidity.
This week the Securities and Exchange Commission published a copy of a letter it has sent to public companies asking them to offer more information to investors about their climate risk. This letter details the financial and physical risks of climate catastrophes as well as those that could be caused by changes in regulations or business model. It doesn’t identify specific recipients but the banking sector is likely to be.
How can we measure this risk best? While there is now a new cottage industry of companies measuring all facets of climate risk to corporate America, as well as the housing market, there is no standard risk measurement for investors.
Bill Dallas of Finance of America Mortgage said that although they have sophisticated risk models for severity and default, investors are still novices at analysing acts of God.
Today, investors can avoid such potential risks by not purchasing loans. Investors will need to be more actuarial lenders than mortgage lenders as fires and hurricanes, volcano eruptions, earthquakes, tsunamis, and floods are more frequent.
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