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Climate Change Impacts to the US Mortgage Industry

Mayer Brown
03/11/2021

Climate change could have serious impacts on the mortgage industry, and stakeholders should take action now. That is the recent urgent message from federal regulators and mortgage industry stakeholders.

In September 2021, the Mortgage Bankers Association’s (“MBA’s”) Research Institute for Housing America (“RIHA”) released “The Impact of Climate Change on Housing and Housing Finance.”1 That report discussed the impact of climate change on the mortgage industry, strategies to mitigate those impacts, and how the industry can measure the risk of climate change. Then, in October, the White House issued “A Roadmap to Building a Climate-Resilient Economy,”2 a report on US climate-related financial risk, including how the federal mortgage guarantors/insurers are addressing that risk. Additionally, the Department of Housing and Urban Development (“HUD”),3 the Department of Veterans Affairs (“VA”),4 and the Department of Agriculture (“USDA”)5 recently issued climate action plans explaining each agency’s efforts toward mitigating and adapting to climate change. Most recently, on October 21, 2021, the Financial Stability Oversight Council (“FSOC”) released its “Report on Climate-Related Financial Risk.”6

These recent reports and initiatives are the latest in a movement by regulators and other mortgage industry stakeholders to measure and mitigate climate change-related risk. The reports consistently recommend that regulators and industry actors begin taking steps to identify and measure this risk.

RIHA’s Report on the Impact of Climate Change on Housing and Housing Finance

Dr. Sean Becketti, head of portfolio analytics at Freddie Mac, prepared RIHA’s report. It provides an overview of climate change, its causes, and its potential impacts on the industry. The report also addresses how industry participants can measure their exposure to climate change and adopt mitigation strategies. Specifically, the report cites evidence of global warming and predicts that its impacts will worsen over time, increasing risks to, among other things, the US housing stock and the housing finance system. One of the most significant risks is flooding. While floods are one of the most common natural disasters impacting housing, flood insurance requirements are based on largely outdated flood risk maps. Further, Dr. Becketti predicts that some residential areas may eventually become uninsurable due to worsening flooding and sea level rise. He also points out that independent estimates of flood risk suggest that the National Flood Insurance Program currently excludes two-thirds of at-risk properties. Accordingly, while we know floods create a significant risk to housing and housing finance, there is likely an increasing number of homeowners in flood-prone areas at risk.

The report explains that increased risks from climate change (such an insufficient flood insurance coverage) will likely stress the mortgage and insurance industries’ ability to distribute and manage risks. Mortgagors and investors in government-sponsored enterprise (“GSE”) mortgage-backed securities face the risk of losses from defaults and prepayments of mortgages in areas significantly impacted by flooding and other natural disasters. Such losses may cause insurers to increase rates, and lenders to increase interest rates and fees. Further, although the GSEs currently shift some risk of losses to private investors through credit-risk transfer securities, higher default risk due to climate change may cause investors to increase prices or exit the market.

The RIHA report recommends that stakeholders in the mortgage industry, and even those outside it, begin making the mortgage industry more resilient to climate change now. Generally, the world can slow global warming by reducing, worldwide, the concentration of greenhouse gases in the atmosphere. For instance, the world generally can replace fossil fuels with carbon-neutral, renewable energy and improve land use through reforestation.

Even if the world eventually achieves such reduction, however, the report argues that additional global warming is virtually guaranteed. Adapting to inevitable climate change should include making buildings more resilient and modifying our infrastructure. For example, the first level of homes can be built a couple of feet above base elevation, and utility lines can be contained in a protective column to protect against water damage. The US government also may need to consider how it will continue to fund the National Flood Insurance Program, as damage from flooding and rising sea levels may deplete existing funds and homeowners seek relief from local, state, and federal governments.

In addition, the mortgage industry can begin to adapt to climate change by accounting for and disclosing climate-related risk in financial statements. Industry participants should also quantify the expected costs of future weather events, both from physical damage and risk of default; climate change mitigation activities; and changes needed to comply with any new regulations and laws. The report also recommends that risk managers and modelers incorporate climate risk indicators in mortgage risk models. Measuring these risks will be difficult, because models cannot rely on historical data for anticipated future changes.

White House Report on Building a Climate-Resilient Economy

As mentioned above, the federal government has also taken significant steps over the past year to identify financial-related climate risks and begin mitigating against these risks. In the past few weeks, the US Department of the Treasury (“Treasury”) announced that it has launched a study on the impact of climate change to US households and communities.7 The Securities and Exchange Commission (“SEC”) issued a sample letter to public companies illustrating comments the SEC may issue regarding climate-related disclosures.8

The White House also released a “A Roadmap to Build a Climate-Resilient Economy.” The report outlines the risks climate change poses to the US economy and financial system, provides a climate risk accountability framework for the federal government, and lays out a roadmap toward executive action to address climate-related risk. Generally, those actions include promoting the resiliency of the financial system to climate-related financial risks, incorporating climate-related financial risk into federal financial management; using federal procurement to address climate-related financial risk, protecting life savings, and pensions from climate-related financial risk; incorporating climate-related financial risk into federal lending and underwriting; and building resilient infrastructure and communities.

The White House described some of the specific measures that federal insurers/guarantors are taking to incorporate climate-risk into federal lending and underwriting. In line with the approaches suggested in the RIHA report, one such measure is a joint effort by the HUD, the Office of Management and Budget, USDA, and VA to identify potential options for incorporating climate-related considerations into the agencies’ underwriting standards, loan terms and conditions, and asset management and servicing procedures. Such options will include ensuring mortgagees have necessary information about climate risks.

The White House also outlined the measures that each insurer/guarantor is taking independently to manage its own risk. HUD is working to improve the quality and integration of climate-related data and assess loss mitigation outcomes related to climate events. The department is also finalizing a rule allowing for the use of private flood insurance with Federal Housing Administration-insured mortgages secured by properties in flood zones. In addition, HUD has implemented several program-specific policies to its Community Development Block Grant Disaster Recovery Fund and multifamily housing programs try to increase resilience to flooding through new residential construction standards. The White House recognized that HUD may need to revise some of its underwriting standards to ensure the financial integrity of future loans and loan guarantees while continuing to support affordable housing in rural areas. The VA has implemented a process to provide more accurate data, so that it can better evaluate the impact of climate change to its home loan program.

Climate Action Plans

As another part of the Biden Administration’s efforts to address climate risk, about 20 federal agencies released climate action plans over the past few months, including HUD and VA, which both addressed risks to their mortgage insurance and guarantee programs. In its climate action plan, HUD noted that its mortgage insurance programs are particularly vulnerable to climate change because of increased defaults and loss severities due to physical damage, disruptions in borrowers’ ability to pay, and declining property values in certain communities. HUD concluded that it must increase resources for grantees and stakeholders to implement climate resiliency efforts, particularly by improving climate resources and continuing to invest in areas vulnerable to climate change impacts. HUD has already allocated funds for grants to state and local governments that will be used to lessen the impact of future natural disasters, half of which must benefit low- and moderate-income persons. In addition, HUD has obligated nearly $1 billion to flood mitigation projects in the northeastern United States. The VA similarly recognized the risks climate change poses to homes financed through its home loan program. As noted above, the agency will start to obtain better data on the impact of climate change to specific locations as well as other data relevant to climate and financial risks.

FSOC’s Report on Climate-Related Financial Risk

In response to an Executive Order, FSOC released its “Report on Climate-Related Financial Risk” on October 21, 2021. FSOC is made up of members who head the following organizations: Treasury, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau, the SEC, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Federal Housing Finance Agency (“FHFA”), and the National Credit Union Administration.

The report summarizes climate-related financial risks, reviews current efforts by its members to incorporate climate-related financial risk into their regulatory and supervisory activities, highlights the challenges to measuring and disclosing such risk, and provides recommendations. Although FSOC members ramped up efforts to address climate-related risks of the past year, the report concluded that members still had a substantial amount of work ahead to strengthen the financial system against climate change.

Just as the RIHA and White House reports did, FSOC’s report similarly recommended that its members quantify the potential physical and transition risks climate change poses to the US financial system. The physical risks include property damage to homes, which will impact their value and the mortgages those homes secure. The report noted that several data points are needed to quantify risks to households, including local estimates of exposures and projected damages based on geographic location and climate trends, data on physical characteristics of property and structures, data on credit and insurance exposures, and data on replacement costs. FSOC also recognized that more fully understanding the physical and financial risks of climate change requires additional scientific data and analysis.

FSOC’s report pointed out that GSEs are exposed to several different types of climate-change-related risk, according to the report. Of course, physical damage to properties may result in direct financial loss to the GSEs (even in light of their efforts to disperse some of this risk, as explained above). In addition, changes to public policy and technology could lead to higher building costs and higher home ownership costs. Although FSOC’s report is limited to impacts directly affecting its members (here FHFA), we note that such impacts will affect the entire industry. Investors may also begin demanding certain types of mortgage-backed securities over others, such as green bonds offered by the GSEs. The report points out that global green bond issuance, which reached a high of $269.6 billion in 2020, is set to exceed $450 billion in 2021. Recognizing and evaluating all the potential risks will require complex modeling and assumptions about climate change. FHFA may consider implementing climate-related stress tests and scenario analyses for the GSEs.

FSOC members have already begun addressing climate risks. FHFA has issued a Request for Input on climate and natural disaster risk9 and added a natural disaster assessment for the GSEs in the 2021 Conservator Scorecard. Further, FHFA is identifying and closing data gaps and analyzing its data to link climate change, flood risk, and other disaster-related data with existing insurance, mortgage, and property data. FHFA seeks to use this data to define, identify, and measure climate-related financial risk to the GSEs, while considering disparate impacts to historically underserved communities.

FSOC also recommended that its members: (1) build capacity and expand efforts to address climate-related risks, including through the efforts of two newly established committees; (2) identify and share climate related-data and methodological gaps; (3) enhance public climate-related disclosures in a way that is consistent with each member’s mandates and authorities; and (4) assess and mitigate climate-related risks that could threaten the stability of the financial system.

Conclusion

These latest reports continue a trend toward identifying, measuring, and addressing potential risks to the mortgage industry due to climate change and natural disasters.10 Regardless of the causes of climate change, these reports indicate that the federal government will be taking further steps to measure, mitigate, and adapt to climate change, and some of these steps will impact the mortgage industry. Further, because the impacts of climate change are expected to worsen, mortgage industry participants may need to consider ways to measure, disclose, and incorporate climate-related risk into their risk management strategies.

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