In his pivotal 2021 paper, The Impact of Climate Change on Housing and Housing Finance, Sean Becketti outlined the impact of climate change on the Housing Finance Industry for the first time. Becketti’s report includes a summary of Intergovernmental Panel on Climate Change (IPCC) findings, a section on Physical Risks, a section on Transition Risks, a section specifically on flood risk and its impact on the Housing Finance Industry, and most importantly, sections which address risk management and resilience, which highlight the possibility of Systemic Risks which may not be reflected in current market valuations. My comment, not Becketti’s: Read that again – we are not currently pricing for climate risk throughout the housing finance lifecycle. There are serious implications for this.

Becketti begins with a summary of the four climate scenarios outlined by the IPCC, which range from a scenario based on “high future greenhouse gas emissions” to a scenario in which “stringent measures to mitigate the growth of greenhouse gas emissions.” Becketti summarizes the scientific predictions which emerge from these scenarios as follows:

“In all these possible futures, the consensus projections of the scientific community are unsettling. Sea levels will rise, flooding will increase, and other extreme weather events will become more destructive and more frequent. The second half of the 21st century will see increases in food insecurity as the result of reductions in marine and freshwater populations and declining agricultural productivity. Many land- and water-based species will face extinction. Reliable water supplies will become scarcer. Human health will suffer, especially in poorer regions where the infrastructure lacks resilience to climate change.” (p. 1)

Physical Risks, Transition Risks, & Flood Risks

The rest of the paper focuses on the Housing Finance Industry, and the types of climate change related risks it inevitably faces. Becketti begins with Physical Risks, which are “familiar acute risks — floods, hurricanes, etc. … and chronic risks such as secular increases in temperature or sea level.” Becketti notes that “Physical risks are easier to gauge than transition risks, and acute physical risks are more-easily identified than chronic physical risks….”

Becketti relies on research by the Task Force on Climate-Related Financial Disclosures (TCFD) as he examines Physical Risks, noting that the “TCFD recommends that firms address three chronic physical risks in their financial disclosures: (1) changes in precipitation patterns and extreme variability in weather patterns; (2) rising mean temperatures; and (3) rising sea levels.” Based on the TFCD research, the Housing Finance Industry faces the following impacts associated with those forms of physical risk:

• Property Damage: Existing assets may be written off and retired early due to damage

• Insurance: Increased Insurance premiums will be higher and high-risk assets may become uninsurable

• Costs & Revenue: Firms may face increased operating costs, as well as lost revenue due to decreased production capacity 

Transition Risks are less obvious; they stem from “all the changes firms may be required to take to adapt” as various climate related events unfold. Examples of Transition Risks outlined by Becketti include:

• Policy: Government regulations will incur higher costs and greater litigation risk

• Technology: Changes in building codes will require builders to adopt new technologies 

• Market: Abrupt changes in energy costs may destabilize property valuations 

• Reputation: Public opinion related to environmental issues may impact profits

Becketti then delves deeper into climate related risk and analyzes flood risk, which for him “highlights many of the most significant housing-specific risks … [and] provides a perspective on the thorny questions of risk sharing.” Becketti begins by point out that even in the present, FEMA’s out of date flood maps may not mandate insurance for all properties in high risk areas, and claims, “Independent calculations published in 2018 estimate that an accurate update of the SFHAs would include roughly 40 million people (12 percent of the population) in the high-risk areas…. According to these calculations, far too few properties are required to have flood insurance today.”

He goes on to discuss chronic flooding due to sea water rise, and highlights some of the potential consequences:

• According to the Risky Business Project predicts that by 2050, between $66 billion and $160 billion worth of real estate may be below sea level, and as much as $238 billion and $507 billion by the century’s end.

• The Union of Concerned Scientists (UCS) estimates that around 2.5 million properties with a cumulative value of over $1 trillion could be subject to chronic flooding by the end of the century.

• A 2019  analysis by the First Street Foundation predicts an increase in the average annual dollar loss (AAL) of 61 percent between 2021 and 2051, and suggests that NFIP rates may be far too low to cover these properties.

Systemic Risks

After reviewing Physical and Transition Risks, Becketti identifies what amounts to a third risk category for the Housing Finance Industry, Systemic Risks. He claims that “Climate change impacts additional housing-specific risks… these risks may not be immediately obvious….” The major forms of Systemic Risk that impact the Housing Finance Industry include “mortgage default and prepayment risk, adverse selection, house price risk and climate migration.” 

• Mortgage Default Risk: An increase in mortgage defaults can be expected as a result of climate related natural disasters. Becketti notes, “To the extent climate change increases defaults via increases in flooding and other natural disasters, GSEs and portfolio lenders may have to increase their loan loss reserves…. The guarantee fees (Gfees) charged by the GSEs to cover losses from mortgage defaults may be too blunt an instrument if natural disasters increase…. “

• Mortgage Prepayment Risk: “If climate-related increases in natural disasters boost mortgage defaults, they also will increase prepayment rates. These changes would imply changes in hedging behavior by servicers, GSEs and investors….”

• Adverse Selection and Moral Hazard: The inability of GSEs to leverage property-level climate risk indicators may expose them to adverse selection in some transactions, although this can be mitigated via geographically diversified mortgage pools.

• House Price Risk: It is likely that property in high-risk ares is overvalued, and may not reflect the likely potential for climate-driven property damage in these areas.

• Climate Migration: Climate migration is not new; from the Dust Bowl of the 1930s to Hurricane Katrina in 2005, we have many examples of natural disasters leading to wide scale migration.

Resilience of Housing Finance

Finally, after drawing attention to the possibility of Systemic Risks, Becketti analyzes the resilience of the Housing Finance Industry in terms of property insurance losses and mortgage defaults. In the area of property insurance, Becketti highlights the political impact of these losses, predicting that Congress may be forced to choose between funding insurance losses or restructuring NFIP, and that “Affected homeowners are likely to seek some form of relief from local, state, and Federal governments, confronting these governments with difficult choices.” (p. 24)

Becketti then turns to losses associated with increased mortgage defaults, noting “These losses will be borne by portfolio lenders — who account for about a quarter of recent first lien originations — the Federal government via FHA/VA (roughly 15 percent), and the GSEs (between 55 and 60 percent). The growth of credit-risk transfer (CRT) programs at the GSEs can shift some of these losses to private investors.” Becketti then analyzes the potential responses available to the various stakeholders, which can be used to limit losses due to mortgage defaults:

• Portfolio Lenders: Lenders may raise interest rates and fees or refuse mortgages.

• GSEs: GSEs are limited in ability to adjust acquisition fees and prices, in order to compensate for losses due to mortgage defaults; but can use CRT programs to shift some losses to private investors.

• Federal Government: The federal government will face similar losses as GSEs, but it is less constrained in its ability to compensate.

• CRT Investors: Investors will reprice investments in response to default risk, and if spreads widen the CRT market may cease to function.

Overall, Becketti’s paper represents a significant step in the initial attempts to understand the nature of the climate related risks which impacts the Housing Finance Industry. It is especially important because it goes beyond the well known categories of Physical Risks and Transition Risks, in order to examine Systemic Risks specific to the Housing Finance Industry, and raise questions about its long-term resilience. We’ll be discussing all forms of climate related risk, including Physical Risks, Transition Risks, and Systemic Risks, at AmeriCatalyst’s “GOING TO EXTREMES” Climate, Housing and Finance Leadership Summit at the Gaylord National Harbor (Washington DC) on April 18 and 19, 2024.

Sources:
“The Impact of Climate Change on Housing and Housing Finance”,
RESEARCH INSTITUTE FOR HOUSING AMERICA SPECIAL REPORT
Authors: Sean Becketti | September 2021