How Can Mortgage Lenders, Servicers and Investors Prepare for Climate Change Risk?

An estimated one in three Americans experienced a weather-related disaster this summer, including hurricanes, tornados, flash flooding and fires. Hurricane Ida barreled into Louisiana on August 29 and made its way Northeast, killing an estimated 82 people, and setting the stage for one of the costliest U.S. mainland hurricanes on record. Meanwhile, July ranked as the hottest month since record-keeping began. California’s Dixie Fire, which began that month, consumed nearly 725,000 acres, making it the second largest such event in state history. 

“The human and personal toll of these weather events is catastrophic and tragic,” said Mark Garland, SitusAMC Managing Director, Analytics and Head of MSR Valuations. “Recent headlines really highlight just how much of the mortgage borrower population could potentially be at risk from these natural disasters. They present enormous financial and operational risks for mortgage stakeholders and our servicing clients.” 

Mortgage lenders and investors need to better weigh and prepare for the risks of climate change, according to a new report from the Mortgage Bankers Association’s Research Institute for Housing America. Climate change could ignite a wave of impacts, the report notes, including: 

• increasing mortgage default and prepayment risks,
• greater volatility in housing prices, 
• major climate migration, 
• and adverse selection in the kinds of loans that are sold to the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. 

The frequency of severe weather events has increased over the last four decades, according to data collected by the National Oceanic and Atmospheric Administration (NOAA). Since 1980, the U.S. has seen nearly 300 events that each caused at least a billion dollars in damage, with total costs exceeding $1.975 trillion. The average annual number of weather events over that period was 7.1. From 2016 to 2020, disasters averaged 16.2 events per year. 

Climate events will reverberate through the mortgage ecosystem and its stakeholders. “Firms will be pressed by regulators and investors to provide more quantitative estimates of the climate-related risks they face,” the MBA report said. “It is apparent that better and more standardized predictors of environmental risks will be needed.” 

Gauging Risk 

To determine the risk of natural disasters and model the potential impact on their portfolios, lenders and servicers must recognize, map and quantify geographic segments where exposure is most likely to occur. “Establish placeholders to account for loan-level risks of loss and determine where the greatest potential is for an incident of default,” said Kathryn Ferriman, SitusAMC Vice President, Reverse Mortgage Valuation and Analytics. “It’s almost like an actuarial exercise that an insurance company would do.” 

Ferriman recommends institutions begin with a deep dive on their geographies, identifying the kinds of disasters that have fallen into those zones using Federal Emergency Management Agency (FEMA) data. “You can overlay six sigma events on the servicing portfolio and drill into counties to get a better level of detail,” she said. “Conduct market-level risk assessment and stress-testing. Think of it as a scenario exercise: build the boundaries of what could and couldn’t happen and posit more and less significant scenarios to dial in the impact.” 

A number of large real estate investors are already moving down this path, according to a recent report from the Urban Land Institute (ULI). They are mapping for physical risks in current portfolios, exploring physical adaptation and mitigation measures for owned assets, integrating climate consideration in due diligence processes, and diversifying portfolios to safeguard investments. 

“The most climate-aware investors are increasingly taking a hard line on local climate risk,” noted Ed Walter, ULI Global Chief Executive Officer, in the report. “They are looking beyond the individual asset and assessing a city’s preparedness for climate change, but the models and metrics they need are still in their infancy. Benchmarking cities for climate risk and resilience is a challenge, and I anticipate significant progress from the industry on obtaining this much-needed data.” New startups are deploying predictive data and frameworks to forecast climate-change risks on real estate as far out as 50 years. 

Financial and Operational Stress Testing 

For servicers, risk analysis requires thinking through both financial and operational impacts. “Servicers must have the liquidity to front payments for consumers affected by disasters, often for an extended period of time,” Garland explained. “Disasters are also very labor-intensive, over and above normal servicing operations. A huge number of boots on the ground are needed to contact homeowners, understand the impact to properties, and help administer repairs.” SitusAMC helps clients model cash flow needs and costs to service segments of the portfolio potentially impacted by disaster. 

A recent RedFin analysis found $628 billion worth of homes in California face high fire risk, and more than 23.7 million properties are at risk of flooding. Meanwhile, flood risk may be as much as 70 percent higher than suggested by FEMA, which lacks the resources to continually update its maps. While homeowners in FEMA-designated flood zones are required to purchase flood insurance, properties outside of recognized flood zones are more likely to be underinsured. This puts their owners at higher risk of mortgage default. 

But these developments are not deterring home buyers. In fact, home values in high-risk areas continue to rise. “Since 2013, homes with high flood risk have sold for about 7 percent more on average than homes with low flood risk,” the Refin report said.  “This is likely due to the lure of luxury waterfront properties, a demand that only intensified with the pandemic and the ability to work remotely.” 

Nevertheless, that trend may be unsustainable. FEMA, which provides flood coverage for more than 5 million homeowners, revised its National Flood Insurance Program (NFIP) to factor in the impact of climate change, and pricing for it. The new methodology will increase premiums for more than three-quarters of home owners, and higher insurance costs could depress home values. “Increases this century in insurance claims generated by climate change are likely to stretch the NFIP to the breaking point, facing homebuyers, lenders, GSEs and governments with a host of difficult questions,” the MBA report noted. “The current government approach to disaster recovery may become too expensive to sustain in future.” 

On September 22, the Securities and Exchange Commission published a letter that it sent to public companies, reminding them of certain climate-change disclosures required by the SEC’s 2010 Climate Change Guidance. They include “the material effects of transition risks related to climate change that may affect your business, financial condition, and results of operations, such as policy and regulatory changes that could impose operational and compliance burdens, market trends that may alter business opportunities, credit risks, or technological changes.”

The upshot: Climate change analysis is likely to become mainstream. “The guidance indicates that some climate change disclosures are already required, even without specific new regulations,” Garland said. “I would expect the guidance to be a catalyst for expanded climate reporting going forward.”

To understand the potential impact of climate disasters on mortgage portfolios, connect with Mark Garland at markgarland@situsamc.com or discover SitusAMC’s offering here.