Integrating climate risk into mortgage lenders' risk assessment

Climate risk will expose mortgage lenders to important default rates from homeowners

According to a recent study from the Financial Regulation Blog at Duke University, natural disasters can substantially increase default rates for mortgage lenders, including Government-Sponsored Enterprises (i.e., Fannie., Fannie Mae and Freddie Mac), resulting in sizeable financial losses. Indeed, if mortgage borrowers experience unexpected damages to their homes because of a natural disaster, they will prioritize the repair of such damages rather than the payment of their mortgage, if forced to choose. Moreover, as borrowers further delay the payment of their respective mortgages, the probability of them defaulting increases significantly, as they fall further and further behind their financial obligations. Ultimately, climate change can cause substantial disruption in the housing market as mortgage borrowers are no longer able to honor their mortgage payments (because of severe damages to their homes), leaving mortgage lenders on the hook financially. 

Forbearance used by mortgage borrowers in the event of a natural disaster is a risk for mortgage lenders, who will face liquidity strains and financial losses

Homeowners with a federally backed mortgage whose homes are affected by natural disasters can use forbearance and other forms of payment relief which can cause liquidity strains for mortgage servicers. Indeed, homeowners are eligible to reduce or suspend their mortgage payments for up to a full year, during which time they will not incur late fees and avoid the risk of foreclosure. Ultimately, homeowners unable to pay their mortgage due to extreme weather events can cause significant losses for mortgage servicers, who are contractually responsible for advancing loan payments to secondary market investors, regardless of whether the borrower is making payments on time or not.

Prepayment risk: a unique concern for mortgage lenders and holders of mortgage-backed securities in the event of a natural disaster 

After extreme weather events, homeowners can use disaster insurance to pay down their mortgages early. As a result, mortgage prepayment rates can increase after natural disasters because insured homeowners use insurance proceeds to pay down debt or because the knowledge of forthcoming insurance payments means they can more quickly sell their homes to investors. In this scenario mortgage-backed securities (MBS) are affected because full insurance in disaster-prone areas could thus substantially lower the value of MBS. Indeed, when mortgage borrowers prepay their mortgage the principal value of the underlying security shrinks, as does the value of a monthly fee that mortgage servicers retain, better known as “servicing strip”. Ultimately, this situation causes a reduction in the mortgage value for holders of MBS, as they experience both an early return of principal and a decrease in interest income.

Mortgage lenders who provide loans in areas at risk of natural calamity are increasing securitization, transferring the risk to the secondary market

The lack of climate-related information and the potential for extreme-weather events can lead to an increase in securitization volumes. In the years following natural disasters, mortgage originators are more likely to approve mortgages that can be securitized. The securitization of risky mortgages allows mortgage originators, especially local lenders who may have a more granular understanding of risks, to transfer climate-related risks to the secondary market. According to the National Bureau of Economic Research “in the aftermath of natural disasters, lenders are more likely to approve mortgages that can be securitized.” Moreover, the authors conclude that the probability of securitization by mortgage lenders increases by up to 19.3 percentage points in areas affected by “billion-dollar” disasters. Ultimately, lenders not only expand their lending growth in recovery areas after extreme weather events, they also increasingly sell those loans on the secondary market. 

The federal government has begun addressing the impact of climate change on low-income homebuyers

As the country’s mortgage industry faces growing challenges, with homebuyers struggling to pay off their mortgages due to unexpected damages from natural disasters, federal authorities have decided to step up their efforts in addressing the consequences of climate change on mortgage borrowers. The Biden administration has begun addressing this issue by instructing the Department of Housing and Urban Development (HUD) to identify ways to incorporate climate related considerations into the origination of mortgages for low-income borrowers. As a result, the HUD has advocated for a mortgage payment relief program for low-income communities who are the most impacted by climate change. The mechanism put forward guarantees low-income mortgage applicants an insurance policy stipulating that in the case of a natural disaster, which causes damages to their homes, they will receive federal assistance to enable them to continue honoring their mortgage payments. Ultimately, this proposal benefits both mortgage borrowers and lenders, as borrowers can mitigate the risk of foreclosure, by continuing to pay their mortgages through federal aid in the case of a natural disaster, while lenders can avoid a significant devaluation of their mortgage portfolio, as mortgage payments continue to inflow from borrowers.

The mortgage industry has experienced an evolving regulatory environment in relation to flood insurance

Since the enactment of the National Flood Insurance Act (1968) and the Flood Disaster Protection Act (1973), federally regulated lending institutions have been faced with a series of regulations relating to flood insurance. For example, the Flood Insurance Reform Act of 2004 forced lending institutions to provide greater transparency to mortgage borrowers on the risk of physical destruction, from natural disasters on properties. The regulation sought to encourage mortgage borrowers to subscribe to an appropriate flood insurance policy. More recently, market standards for flood insurance processes in syndicated lending, which were enacted through the Biggert-Waters Flood Insurance Reform Act of 2012 have been amended. Since February 8th, 2022, mortgage lenders are required to “accept flood insurance policies that meet the definition of private flood insurance”. The legislation stipulates that any insurance policy that is issued by an insurance company that is— (i) licensed, admitted, or otherwise approved to engage in the business of insurance in the State or jurisdiction in which the insured building is located must be admitted by mortgage lenders. In addition, lenders are subject to providing mortgage borrowers with “compliance aid” designed to list appropriate flood insurance policies. Ultimately, mortgage lenders must adapt to an evolving regulatory environment in relation to flood insurance.

The inexistence of an asset-level resiliency assessment that evaluates the specific vulnerabilities of a property poses a challenge for mortgage lenders

While a growing number of mortgage lenders have incorporated climate risks in their risk assessment process through up-to-date risk models, most do not include property specific data. According to a recent Financial Stability Report on The Implications of Climate Change for Financial Stability, the risk models used by mortgage lenders do not include an on-the-ground assessment of a property’s physical condition. This poses a long-term challenge as specific vulnerabilities and estimates of potential damages on a property are not measured by mortgage lenders. The incorporation of an asset-level resiliency assessment can enable mortgage lenders to evaluate particular vulnerabilities on a large sample of properties, determine if such properties can withstand future aggravations (i.e. natural disasters) and ultimately assess if risk mitigation measures will be necessary to prevent property damages and expensive replacements from homeowners.

The absence of correlation between providers of climate risk models poses a risk management obstacle for the mortgage lending industry

In a recent study from Fannie Mae on the industry’s tackling of climate change analyzing multiple climate risk models across a sample of providers, large discrepancies are found between the risk models of different providers. According to the findings, providers fail to put forward similar estimations on weather projections, even in a particular geographical area. For example, estimations on the increase in temperature by 2030 for the state of California vary substantially from one provider to another. In addition, providers do not necessarily place emphasis on the same climate risks. For example, some providers put a higher degree of emphasis on the risk of mortgage defaults, while some risk models put more weight on the risk of price volatility in the housing market. Ultimately, this creates a significant challenge for the mortgage industry as it creates a low correlation between the overall risks of climate change identified by providers on the housing market.

The reliance from mortgage lenders on the insurance industry to mitigate climate risks poses a long-term financial risk for mortgage lenders

Despite beginning to articulate and build climate risk-management frameworks, the mortgage market still relies heavily on the insurance industry to protect itself from the impact of climate risk. Today, an overwhelming number of risk models used by mortgage lenders only concentrate on credit and operational risk. According to the Mortgage Bankers Association’s Research Institute for Housing America, mortgage lenders don’t model climate risk enough and mostly depend on risk models from Federal Emergency Management Agency (FEMA) or private insurance companies. However, the Federal Emergency Management Agency, is facing growing financial pressure because of the record number of natural disasters, over the last couple of years. Consequently, if FEMA or other private insurance companies decide to review their respective policies and alter what it covers (i.e., reduction in the rate of reimbursement to homeowners for damages caused by natural disasters), mortgage lenders could be faced with severe financial liability (as homeowners are no longer able to pay their monthly mortgage). Ultimately, mortgage lenders need to invest more aggressively in their internal risk management divisions to mitigate potential losses from climate change.

Assist in the development of a robust climate risk model by identifying which climate hazards are the most relevant for your mortgage portfolio

Our recognized four step approach will produce an efficient climate risk model adapted to the specific characteristics of a lender’s mortgage portfolio:

1. Analyze a large sample of mortgages from a lender’s portfolio

• Break down a lender’s mortgage portfolio across geographical and financial criteria (e.g., the principal amount of the loan issued and its geographical destination)

2.  Define the appropriate weight of each risk variable in your climate risk model

• Ensure that the weight of various risk variables is accurately defined (e.g., mortgage lenders with greater exposure to coastal properties will have a strong emphasis in their climate risk model on the risk of hurricanes and rising sea levels)

3. Test the strength of the newly crafted climate risk model

• Evaluate the performance of the new climate risk model on a lender’s mortgage portfolio based on predefined scenarios (e.g., does the risk level for coastal properties increase on the new climate risk model following a hypothetical announcement of a hurricane by public officials?)  

4. Implement the new climate risk model

• Provide the new climate risk model to the relevant risk management team and undergo a risk assessment of the mortgage loan portfolio

Provide access to Sia Partners climate analysis team  

Our recognized climate analysis team and experts will enable you to successfully tackle climate related obstacles in the financial industry:

1. Assist in the implementation of ESG regulations for your lending institution

• Climate change has paved the way for new regulations and stricter compliance measures for financial institutions

2. Assist in the development of an ESG data acquisition strategy

• ESG Data has become inevitable in the financial sector, particularly for sustainable investment decisions

3. Access our comprehensive climate analysis survey which outlines the best practices in the financial industry to tackle climate risk

• Sia Partners has collected significant data from leading financial institutions (GSIB’s/Foreign Banks/Regional Banks) regarding their strategy and insight on how to tackle climate risk