Mortgage Lenders and Climate Risk

The real estate debt market is a critical system that supports all real estate, including both commercial lending and home mortgages. Typical real estate lending works by the borrower pledging a piece of real estate (homes, buildings, and land) as collateral for a loan to purchase the property. Therefore, lenders (the banks and credit unions) and secondary markets (RMBS and CMBS) that have a stake in these assets are vulnerable to sudden market shifts within real estate. For the banking and mortgage systems, climate change poses an existential risk to the collateral used to support loans.

Climate change has the potential to cause distress to the mortgage market through extreme weather events, changing ecosystems, loss of resources, and economic disruption. As demonstrated by the subprime mortgage crisis in 2007, major disruptions to the viability of the mortgage market can have cascading consequences for the global economy. Many mortgage lenders acknowledge these growing risks and have sought out climate risk management solutions. Loss of revenue and reduced asset value can be a major problem for banks, so they have been working quickly to evaluate climate risk in their lending practices.

The Mortgage Market and Risk

Loans are a key part of the financial system that allows banks and lenders to earn interest from borrowers in need of financial backing for property purchases, and provide borrowers funding to fuel economic growth. Backing loans is the main source of bank income and financing mortgage market securities can be very lucrative for investors.

But the mortgage market is inherently risky, and especially vulnerable to natural disaster. Lending institutions and investors are backing a physical property that could be defaulted on, destroyed, or rapidly lose value at any time. For this reason, the mortgage market seeks to evaluate the individual risk and reward of each property, compared with the amount that they stand to lose if something goes wrong.

Loans are sold on the primary and secondary loan markets:

  • Primary Mortgage Market: Within the primary mortgage market, borrowers can obtain a loan from a primary lender which includes banks, mortgage brokers, mortgage bankers, and credit unions. Mortgage brokers and bankers act as intermediaries between borrowers and lenders.
  • Secondary Mortgage Market: Because mortgages are a long term investment, usually between 10 and 30 years, the secondary mortgage market is used to sell mortgages before they are fully paid. Investors buy financial products backed by those mortgages. Up to two-thirds of U.S. loans are sold in the secondary market through securities such as:
  • Residential mortgage backed security (RMBS): These securities are backed by the interest paid on loans for residences such as mortgages, subprime mortgages, and home equity loans. The risk of default is inherent to these types of investments, but managed by grouping together many similar loans.
  • Commercial mortgage backed security (CMBS): Investment products that are backed by commercial properties, not residential real estate. CMBSs are known as a more risky and complex investment than RMBSs because of the individual nature of each commercial or multifamily property.

When there is a serious economic downturn, loans resold in the secondary market can be a source of risk for lending institutions and investors if borrowers default on their loan and the reclaimed collateral is less valuable than the loan. The financial risk for a RMBS or CMBS within the secondary loan market is shared by the issuer (usually a bank) and the investors. Financial institutions use default models to determine the default probability of a borrower based on their credit history.

Loan to Value (LTV): This measurement compares the amount of a mortgage with the appraised value of a property. It is used to assess the amount of financial exposure that a lender will take on when taking on a loan. Loan assessments with a high LTV are treated as high risk loans, and therefore there will be a higher interest rate on that property if a mortgage is approved. A good LTV ratio is generally 80 percent or lower.

  • Example: If a borrower applies for a $100,000 loan to purchase a $175,000 house, the LTV is 57.1 percent (amount divided by appraised value).

When the LTV ratio on a property is too high, that property has a higher chance of default. If a lending institution backs a loan with an amount that is too close to the appraised value, in the event of a foreclosure, they may lose money if the home cannot sell for enough to cover the amount of the mortgage.

  • Example: A $100,000 loan on a property valued at $120,000 is issued, but a flood causes major water damage to the property. The mortgage loan defaults and the home is foreclosed at a price of $60,000. The lender and investors lose $40,000 of the original loan amount.

A major natural disaster or financial crash can expose lenders and investors in the mortgage market to the sudden loss of value of thousands of properties at once. However, the financial effect of disaster can be partially mitigated if the properties have insurance that covers damages. Additionally, increased demand for loans in the wake of disaster for rebuilding and reinvestment in homes and properties can alleviate the effects of loan losses, if not cancel them out entirely according to a study by the Federal Reserve Bank of New York.

Despite these factors, areas that have been consistently exposed to damage from extreme weather events can lose value or experience issues with insurance rates and coverage. Banks that overextend the amount of their lending can incur significant income deficits if too many of the properties they back are affected. For this reason, it is important to pay attention to the loan to deposit ratio to determine the total amount of financial exposure.

Loan to Deposit Ratio (LDR): The comparison of a bank’s total amount of loans with its total deposits over the same period of time. This metric is used to assess a bank’s liquidity; if the ratio is too high, it can indicate that a bank does not have enough liquidity to pay for unexpected expenses when they arise. If the LDR ratio is low, the bank could be missing out on profits. An ideal LDR is usually between 80 and 90 percent.

Climate Risk Management in Mortgage Banking

The disruption from both physical and transitional risks of climate change will affect the mortgage market. Extreme weather events are some of the most prominent causes of home damage, especially floods, rising sea levels, fire, and severe storms (physical risk). But economic shifts will also be brought about by the need for decarbonization, new energy resources, climate regulations, and climate innovations (transition risk). The properties and resources financially affected by climate are often called “stranded assets”.

  • Stranded Assets: Assets that have been subject to devaluations, write-downs, and conversion to liabilities are called “stranded assets”. This term describes the economic fallout resulting from a severe weather event, such as flood or fire, that causes temporary or permanent damage to assets within its path. Stranded assets can also be related to transitional risks, such as the vulnerability of oil and gas sectors to a possible green energy economic transition.

Mortgage insurance programs are particularly vulnerable to climate change, but the mortgage market consists of many different stakeholders that might be put under stress. Consumers, homebuilders, landlords, mortgage investors, insurance companies, governmental agencies, and government-sponsored mortgage issuers are all key parts of the mortgage system and are thus exposed to climate risk.

Below are several ways in which the threat of climate change could introduce shocks into the mortgage system, based on five broad categories of financial risk to lenders (market risk, credit risk, liquidity risk, operational risk, and reputational risk):

1. Market Risk: Property values decline suddenly due to severe weather events and climate-related economic disruption.

  • The increase in frequency and severity of floods, fires, and hurricanes has already caused massive property damage across the U.S., and is increasing year after year. Lenders often have a significant stake in the damaged property that is left behind. Less dramatic, but still dangerous, climate effects like drought and heat could also cause markets to permanently shift away from certain real estate areas.

2. Credit Risk: Climate change reduces the ability of borrowers to repay loans. The rate of default increases and banks are unable to recover the value of loans.

  • Transitional climate risk can cause severe disruption in markets and income sources. Many loan borrowers could see their finances strained and be unable to continue their mortgage payments, resulting in an increased default rate.

3. Liquidity Risk, 4. Operational Risk, and 5. Reputational Risk: Bank’s access to profitable low-risk loans declines due to wide-spread climate risk and trust in the secondary loan market decreases. Legal and regulatory compliance fees increase for climate-sensitive assets.

  • Each of these factors pose a problem for the stability of the banking system based on the ability of lenders to make stable profits. A serious financial shock from climate change has the potential to reduce investment in mortgage-backed securities. This scenario would leave the market with less liquidity and less stability.

Finally, insurance companies or government agencies could reduce insurance coverage for at-risk properties. No natural disaster has yet been the cause of widespread RMBS/CMBS or municipal bond disruption. This is partly due to billions of federal disaster aid and the proceeds of flood insurance programs. The Federal Emergency Management Agency (FEMA) has come under strain in recent years from record numbers of natural disasters. If FEMA were to reduce coverage of properties in high-risk flood areas, mortgage lenders would still be responsible for covering their stake in those properties, even if they rapidly decline in value or are damaged by natural disasters.

Solutions and Regulation

Banks are already making changes to reduce their risk exposure and considering wide-scale shifts to how and where they loan. These include:

  • Increasing the down payment for coastal and high-risk areas, therefore decreasing the LTV ratio
  • Selling high-risk mortgages to the secondary market, so that risk is primarily held by government-backed mortgage buyers like Fannie Mae and Freddie Mac
  • Reducing the length of the standard 30-year mortgage to better reflect the quickly-changing nature of climate risk

Awareness of the many ways that climate change could disrupt key players in the mortgage market has caused regulator policies for managing climate risk to grow quickly. Financial regulatory safeguards are usually put in place to limit the chance of harmful crises and boost resiliency. More guidance and clearer regulatory standards are needed to safely manage the many ways physical and transition risks will affect the U.S. economy.

Accurate Climate Risk Measurement and Data

Companies, financial institutions, and consumers can help protect themselves from risk by measuring and managing their exposure to climate risks and building climate exposure into their financial decision making. Understanding physical risk exposure of assets within a real estate portfolio is a great first step for managing climate risk. Banks need access to reliable, data-based risk scenarios to determine the range of risk they will potentially be exposed to.

ClimateCheck’s tools can be used to screen a portfolio of physical assets. ClimateCheck data is based on future climate risk extending to 2050 in five year increments, more than covering the length of a standard 7-year commercial loan or a 30-year residential mortgage. The type and severity of exposure to extreme weather are both key factors for their potential to become a stranded asset.

Changes to Government Regulation

As part of the Biden Administration’s approach to climate change, the Department of Housing and Urban Development (HUD) addressed issues with its mortgage insurance and guarantee programs. The department intends to increase resources for climate resiliency projects and mitigation efforts in vulnerable areas. HUD has allocated millions to the states for help in managing the impact of future natural disasters, especially on low and moderate income areas.

The FEMA National Flood Insurance Program has recently undergone major changes as a result of climate change. The program currently provides $1.3 trillion in coverage across America. A new ratings methodology introduced in 2021 made insurance policy prices more accurately and equitably reflect a property’s risk of flood. The rating still bases property risk on elevation within flood zones on the Flood Insurance Rate Map, but changes included:

  • More Flood Risk Variables: flood frequency, flood types (river overflow, storm surge, coastal erosion, heavy rainfall), and total distance from water sources; taking into account all water sources increases the accuracy of the flood risk rating
  • Cost to Rebuild: the value of the home; more valuable homes in areas of risk pay increased premiums

Conclusion

The mortgage market is only one piece of the financial system, but its exposure to the risks of climate change is particularly dangerous. The mortgage system is based on long-term investments in physical assets and therefore the quick and devastating power of natural disasters can upset the financial balance lenders rely on. The good news is, banks and other lenders are already making adjustments to how they look at climate risk and the types of properties that they extend lending to. Climate change will increase the frequency and severity of natural disasters, requiring lenders to implement climate risk into their portfolio management.