Some banks are cutting their own climate-change exposure by selling riskier disaster-area mortgages to taxpayer-supported entities.
That puts the health of the mortgage market at risk, a potential repeat of the financial conditions at the root of the banking crisis a decade ago, a research paper published in September argues.
The number and total value of flood insurance policies has been declining since 2006, meaning that households that purchased a property in coastal areas especially may be at increased risk of defaulting on their mortgages, the academic paper said. Commercial banks, including two of the largest U.S. mortgage lenders, JPMorgan Chase
and Wells Fargo
, have the ability to price mortgages for flood risk, and by design they can securitize some of these loans, thereby spreading the risk to more parties.
But one of the more active ways banks unload climate-change and flooding risk is by reselling mortgage loans to Fannie Mae
and Freddie Mac
, which desire the liquidity, the paper says. These entities are the mortgage guarantors that are under tax-supported government control, though have been tagged by the Trump administration for a shift to the private sector. By rule, primarily because their mission is to expand homeownership, Fannie and Freddie cannot factor disaster-related risk, for instance living in a flood zone, into their mortgage pricing in the way that the commercial banks originating these loans can.
Absent change, the mispricing is only going to be aggravated, the paper notes, with $60 billion to $100 billion in new mortgages issued for coastal homes each year.
The researchers, Amine Ouazad, a professor in the department of applied economics at HEC Montreal, and Matthew Kahn, a professor at Johns Hopkins University, say their findings show “a potential threat to the stability of financial institutions.”
That harkens back to the start of the subprime lending crisis of 2008. On the plus side, the number of climate-change-linked mortgages is believed to be smaller than the pool of risky subprime mortgages that tainted the system 10 years ago. On the other hand, damaged properties could be lost forever to flooding, wind and storm surges, meaning there’s no underlying physical asset behind these compromised mortgages.
Freddie Mac’s then–chief economist Sean Becketti in 2016 wrote that “the economic losses and social disruption [of rising seas on coastal housing] may happen gradually, but they are likely to be greater in total than those experienced in the housing crisis and Great Recession.”
It is, he wrote at the time, “less likely that borrowers will continue to make mortgage payments if their homes are literally underwater.”
The paper’s authors studied the behavior of mortgage lenders in areas hit by hurricanes between 2004 and 2012, with at least $1 billion in damages. They found that, after those hurricanes, lenders increased by almost 10% the share of coastal mortgages offloaded to Fannie and Freddie.
The researchers found that the odds of an eventual foreclosure rose by 3.6 percentage points for a mortgage originated in the first year after a hurricane, and by 4.9 percentage points for a mortgage originated in the third year.
The researchers also pointed out a different risk for banks: that some markets will be better insured or even better prepared than others for rising climate risk. That means that lopsided prepayment risk, potentially costing the banks money, is a real factor, too.
The Mortgage Bankers Association did not immediately respond to a request for comment on the researchers’ findings.
The biggest challenge at work here, according to researchers Ouazad and Kahn, is that there’s little incentive to make borrowing for homeownership more difficult, meaning costlier for homebuyers, even when it comes to shouldering climate-change risk.
That’s in large part because Americans put so much emphasis on home ownership for reasons of status and wealth building. Lenders and government-sponsored enterprises play a key role in providing the capital to allow households to bid and purchase this place-based wealth, totaling $27.5 trillion in value and $10.9 trillion of debt as of the first quarter of this year. Fannie and Freddie, with their added liquidity in a huge mortgage market, essentially make possible the popular 30-year, fixed-rate mortgage.
“Place-based asset purchases such as real estate are likely to be exposed to increasing risk in a world confronting ambiguous climate change,” the authors wrote. “Standard financial arguments would argue that such risk, if idiosyncratic, can be diversified away. Yet a host of politically popular subsidies and institutions encourage households to invest in homes as their primary source of wealth.”
Separate research released in October showed that the number of people threatened by climate change-triggered flooding is about three times higher than previously thought. The jump is not because of more water than earlier projections showed but because the land, especially in Asia and the developing world, is several feet lower than what space-based radar has calculated, according to a study in the journal Nature Communications.
Climate-linked risks are shaping some pockets of the real-estate market. Startups are selling more climate-risk data to the industry, measuring everything from carbon emissions to extreme heat and sea-level rise. Some of the players include Four Twenty Seven Inc., which this year was acquired by the credit-ratings firm Moody’s, and a 3-year-old firm called Jupiter, which converts flood, fire, heat, drought, cold, wind and hail events into risk modeling for real-estate assets, including in such high-population coastal areas as New York and Miami.
That arm of the home-buying-and-selling industry may be changing with the times. But the worrisome lag, as the Ouazad and Kahn paper suggests, lies with the multitrillion-dollar lending market and an increasingly exposed Fannie and Freddie.
This article was first published in late September and updated on Oct. 30, 2019.