PART 2: LOCATION! LOCATION! LOCATION! What’s at Risk: Climate change’s potential on all things mortgage — lenders, servicing rights and mortgage-backed securities

By Douglas Page

What makes a house in a woodsy California town captivating – it’s a primal sanctuary returning people to nature – also comes with exorbitant risk: The possibility of a whipped-up wildfire.

“The characteristics of a place that heighten its risk of wildfire damage are often simultaneously the very environmental amenities that draw people to live there,” said the Federal Reserve Bank of Cleveland in a 2021 report. “As a result, it is not clear whether local wildfire destruction would be significant enough to alter the draw of such regions.”

A survey, conducted by a Stanford University doctoral candidate and professor, confirms that, saying most people aren’t about to pick up for areas less prone to burning.

Published last year, it looked at more than 1,100 California residents living in areas where a wildfire is a possibility, asking them if they intended to move after the 2020 wildfire season. Only about a third, the study’s authors wrote, said yes.

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Why the fires?

The cause, says a paper published in August by the Federal Housing Finance Agency (FHFA), which oversees the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Corporation (Freddie Mac), is due to “an ever-expanding Wildland Urban Interface (WUI),” which is defined by the U.S. Fire Administration as a the “line, area or zone where structures and other human development (meets) or (intermingles) with undeveloped wildland or vegetative fuels.’”

Across the country, the FHFA says, between 1990 and 2010, the WUI increased about 33% to nearly 300,000 square miles and added more than 46 million homes with an estimated market value of $1.3 trillion. The FHFA estimates nearly 100 million people live in the WUI.

The Golden State, says a study from California Polytechnic State University, saw the largest number of houses built in the WUI, with 4.4 million of them. What’s driving the growth in the WUI, reports the University of California Los Angeles’s Institute of the Environment and Sustainability, is the state’s high cost of housing, which “increased pressure to develop on the urban fringe.”

The UCLA study also noted that California’s Proposition 13, passed in 1978, which restricts annual real estate tax increases, makes “local governments depend on the construction of more homes to boost revenue.”

The National Park Service, part of the U.S. Department of the Interior, says 85% of all wildfires are caused by people due to leaving campfires unattended, burning debris, equipment malfunctions, discarding cigarettes and arson.

Downed power lines, says California’s Public Utilities Commission, also ignite wildfires. 

“Utility infrastructure has been responsible for less than 10% of reported wildfires,” said the state’s utilities commission. “Historically, fires attributed to power lines consist of roughly half of the most destructive fires in California history.”

In addition, climate change increases ocean temperatures and, sometimes, makes for less rain, resulting in ground vegetation becoming dry enough to burn.

With U.S. residential real estate worth so much – Redfin values it, in the aggregate, at nearly $47 trillion, making it one of the most expensive assets in the country, if not the world – even more than the market capitalization of the companies making up the Standard & Poor’s 500, which, in comparison, is about $37 trillion, a lot’s at stake should climate events, whether it’s a hurricane, a tornado or a flood, strike.

According to the Federal Reserve Bank of St. Louis, U.S. households, as of this year’s second quarter, hold about $13.8 trillion of residential mortgage debt. But with the increase in housing prices, Lending Tree reports, U.S. homeowners are sitting on near record amounts of equity in their homes, close to $29 trillion, down from nearly $32 trillion – a record – in the second quarter of last year. 

The Mortgage Bankers Association (MBA), the Washington, DC-based national association representing the real estate finance industry, at of the end of this year’s second quarter, reported that delinquencies on mortgage loans on “one-to-four unit residential properties decreased to a seasonally adjusted rate of 3.37%,” meaning that the vast majority of U.S. households with a mortgage, nearly 97%, are paying the monthly bill on time. 

In addition, the MBA reported, less than 1% of all households with a mortgage were in foreclosure at the end of the second quarter.

“We’re seeing an increase in auto loan delinquencies, but mortgage delinquencies are historically low,” said Rick Sharga, CEO of Trabuco Canyon, Calif.-based CJ Patrick & Co., a consultancy to the real estate industry. “People are doing the math and following the logic.”

Given that U.S. residential real estate is an asset in a class of its own, and often a critical component of someone’s wealth, how could homeowners, whether in California or elsewhere in the United States, and those in the real estate industry, like lenders, banks, mortgage servicers and investors, be impacted by climate change? SD METRO spoke with executives in the know to find out what is and could be in the offing.

Mortgages and the GSEs

“What if Fannie Mae and Freddie Mac’s risk officers decide it doesn’t make sense to buy mortgages from Northern California, in the town of Paradise, because it all burned down?” asked Sharga, referring to the 2018 Camp Fire that killed 85 people, making it one of the state’s deadliest fires. “The secondary market for mortgages could dry up faster than the frontline lenders in terms of not wanting to take on this risk.

“Alternatively, and this is probably a more likely scenario, they start building in risk-based pricing into the loans they’re buying or the mortgage-backed securities they’re going to buy, which will reduce the capital that banks can recoup for selling those assets. If that happens, it makes the whole mortgage market tighter and, conceivably, increases mortgage (interest) rates for your average buyer,” he added.

One of the reasons Golden State homeowners are having property insurance difficulties, Sharga says, is because their home values increased sizably.

“If you’re insuring a property and the value’s gone up 40% over the last two years, you probably need to ratchet up the premiums in order to accommodate that increase,” he said. “It’s hard to point directly at the natural disasters or the weather events and say that’s 100% of the reason everything’s changing, but they’re certainly part of it.”

Given the recent actions by homeowners insurance companies – pulling out or reducing their footprint in California – Sharga sees something similar with another industry critical to real estate.

“If you’re a lender or a banker, you may take a look at certain regions and decide they represent too high a risk and opt not to lend there anymore,” he said. “Do you make a loan where there might not be an insurer available to insure that property?

“We’re not there yet, but when you start putting these factors in place (fewer insurance companies and extreme weather events), you can see where it comes down to that,” Sharga continued.

California Insurance Commissioner Ricardo Lara recently announced a plan to make the Golden State more hospitable to insurance companies, which he says will be effective by December 2024.

David Burt, CEO of Natick, Mass.-based DeltaTerra Capital, which advises institutional investors on climate change risks, disagrees with Sharga.

“Ninety percent of the mortgages that are within the conforming balance size limit are guaranteed by the GSEs,” he said, adding it’s unlikely banks will stop originating mortgages where hurricanes, wildfires or other weather risks are likely.

Burt comes with a storied background. He was one of the few, CNBC reported, to recognize “the housing market was on the brink of collapse in 2007” and helped two protagonists in Michael Lewis’s book, The Big Short, “bet against the mortgage market in the lead up to the 2008 financial crisis.”

Three years ago, he testified before a special U.S. Senate committee investigating the economics of climate risk, predicting that damages from climate events will be “58% higher than the amount collected by insurers to cover it.”

Homeowners Insurance

Sharga says state government-started or supported insurance companies, like the California FAIR Plan or Citizens Property Insurance in Florida, often the insurer of last resort for Sunshine State residents, could become the norm.

“The insurance companies are in business to make money, and if they’re in a market where they don’t believe they’ll be able to turn a profit because of escalating costs of damage, somebody’s got to pick up the slack, and typically, the only entity big enough to do that is the government,” he said. “Would I be surprised if the federal government leveraged something like FEMA (Federal Emergency Management Agency) and started issuing state-by-state policies? Not at all.”

Burt sees another problem.

“The state is capping the insurance premium chargeable by the private market,” he said. “In order to do that, they serve as the backstop.

“There’s probably not enough money being collected to pay for the damages (when a catastrophe strikes). So, it’s a lot of passing the buck right now and, ultimately, the homeowners will pay for it,” Burt added.

A paper published by the Federal Reserve in March 2021 supports Sharga and Burt, saying if there are fewer private insurers providing coverage for climate events, “state and local governments could face pressure to provide coverage or absorb losses for areas affected by natural disasters.”

Exacerbating the problem, the Fed’s paper says, could be people leaving areas prone to climate events.

“Coupled with a potential reduction in the tax base from emigration, governments could face increasing fiscal pressures and become less able to service their debt,” the Fed wrote. “This reduced ability to service debt could result in a higher probability of municipal bond defaults and knock-on consequences for municipal debt markets broadly.”

Climate Change on Mortgage Servicing Rights

Could extreme weather problems devalue mortgage servicing rights (MSRs) which banks and other lenders sometimes sell to raise capital to make additional loans? MSR owners service mortgages, including collecting payments and, often, taxes and insurance, on each account they manage. 

“It’s a hot-button issue,” said Eric Nokken, a director at Oakdale, Minn.-based Wilary Winn, which values MSRs and advises banks. But, he adds, MSR valuations are mostly based on a combination of interest rates and prepayment speeds.

Climate change, Sharga said, can alter MSR valuations because “it factors in a significant amount of more risk than your basic vanilla portfolio of MSRs.”

Robert Chrisman, a California Mortgage Bankers Association board member, agrees.

“Blame it on climate change. Blame it on whatever,” he said. “The fact of the matter is that it’s having an impact on borrowers’ mentality, on lenders’ pricing and on insurance premiums and investor interest in buying pools of loans made up of mortgages from those states.”

Chrisman declined to say how much MSRs have or will devalue due to climate change but offered an observation similar to Sharga’s:  

“MSRs base their value in part on how long the company will collect those premiums,” he said. “If that appears to be shortened, then MSR investors are going to pay less of a premium because the odds of them not having the loan on their books for a regular length of time is diminished.”

Further, Chrisman said, it’s possible to sell custom-designed MSRs.

“If they are afraid of fire risk or hurricane risk or earthquake risk or whatever, they can buy pools of loans made up of places like the Dakotas or Missouri or wherever there’s not those risks,” he said. “It may be that MSR buyers are shying away more and more from locations that are either uninsurable or present an undue risk to their future cash flows.”

Janet Jozwik, a senior managing director at Arlington, Va.-based RiskSpan, which analyzes mortgages, says the mortgage industry is looking differently at climate change.

“Two years ago, people in the mortgage industry were like, ‘Oh, this is predominantly an insurance industry issue,’ but now people in the mortgage industry are taking it much more seriously,” she said. “The people we’ve talked to seem more concerned about hurricanes than wildfires because hurricanes, unlike wildfires, have a much broader impact.”

In a report on its website, Riskspan suggests any climate or weather event has the potential to impact homeowners and real estate investors alike.

“Even in cases where property insurance is adequate, the fallout has the potential to hit investor cash flows in a variety of ways,” the report said. “Acute climate events like hurricanes create short-term (homeowner) delinquency and prepayment spikes in affected areas.

“Chronic risks such as sea level rise and increased wildfire risk can depress housing values in areas most susceptible to these events. Potential impacts to property insurance costs, utility costs (water and electricity in areas prone to excessive heat and drought, for example) and property taxes used to fund climate-mitigating infrastructure projects all contribute to uncertainty in loan and MSR modeling,” the Riskspan report continued.

Burt says weather events can change homeowner behavior, including bringing about mortgage default.

“But the other thing that’s more impactful is asset devaluation risk,” he said. “It’s really unclear what that does to prepayment fees.

“It becomes much harder (for the homeowner) to take advantage of lower interest rates should one come about. The lower the optionality of the borrowers, the higher the values of MSRs because it keeps people in their homes and their current mortgages,” Burt added.

Michael Lau, CEO of Denver-based Pingora Asset Management, an MSR investor, says geography and weather events can impact MSR valuations. 

“You look at a portfolio of loans and let’s say it’s got a 50% concentration in California and Florida,” he said. “You’re going to haircut the California ones because those homeowners tend to prepay faster.

“You also have to pay interest on California accounts that are escrowed, which you don’t have in every state. In Florida, you have a lot of fraud. And you do think about hurricanes in Florida and wildfires in California,” he added.

But there are worse concerns, he says.

“What you really think about is flood,” he said. “It’s not so much the wind and the rain. It’s flood because most people are woefully underinsured for flood. There’s the National Flood Insurance Program but it’s got a limit ($250,000) on how much it will pay out. 

“MSR valuations will come down because of higher costs, but it’s going to be gradual. It’s getting a lot of press when these insurance companies pull out of states, and I’ve got to believe there’s some folks in Washington starting to pay attention to this and starting to think about what we’re going to do,” Lau added.

Mortgage-Backed Securities

Since most residential mortgage-backed securities (RMBS) are guaranteed by the GSEs, whether it’s Fannie Mae, Freddie Mae or the Government National Mortgage Association (Ginnie Mae), John Bastoni, a senior trader with San Diego- and Boston-based Breckinridge Capital Advisors, says that while climate change is a concern, the risk, at least for the GSE-backed RMBS he trades, doesn’t keep him awake at night.

“We take climate risks seriously,” he said. “We do price it into our models but, at the end of the day, it’s manageable to us. 

“We can certainly sleep at night,” he added.

RMBS are an asset-backed security often secured by a collection of mortgages and an asset, often a house.

Bastoni describes the GSE-backed $7 trillion RMBS market as relatively safe. The idea behind allowing banks to sell their mortgages, and, thus, help create RMBSs, is that it will recapitalize the banks for the loans they made, enabling them to make even more loans.

“Typically, what happens if a property is destroyed, whether it be from a natural disaster, is that it becomes a prepayment to MBS investors,” he said. “The agency will buy the loan out of the pool.”

That results, he said, in getting his principal returned.

“I might lose a month or two of interest but, in the end, that’s a minor concern,” he said. “The timing of those cash flows might be altered and that’s going to change my return profile, but I’m not facing any credit losses because the agency guarantees that.”

“(GSE-backed) MBS offer investment grade credit quality and a yield-to-maturity of almost 5%, based on the Bloomberg MBS Index as of June 30, 2023,” Blackrock reported at the end of August. 

In the non-agency RMBS space – which isn’t backed by any of the GSEs – it’s a different story. Bastoni described the non-agency MBS market as being valued at close to $1 trillion.

“There’s no guarantor,” he said. “There’s no GSE backing those loans, so if I buy a pool of 10 securities and one of them gets destroyed, I could face a loss of 10% of my principal.”

Bastoni added that Breckinridge doesn’t invest in the non-agency RMBSs, but he says the GSEs are talking more about climate change.

“We’ve seen them (the GSEs) start to disclose more climate and ESG (environmental, social and governmental) related metrics on their bonds in the past couple of years,” he said. “So, it’s picking up, not just in the investor universe but also on the issuer side.”

In addition, he said, he’s seen the GSEs become more forthcoming with some of the data they’ve kept behind the scenes.

“Usually, when you look at an MBS pool, you’ll get a state breakdown,” he said. “So, you’ll look at a pool that might have 100 loans in it, and you might get a state breakdown that says 20% Florida, 20% Texas and 20% Massachusetts, and loans located maybe on coastal areas of Florida might a little bit riskier than loans located inland.

“We are trying to get more granular with the data that we get from them,” he added.

As for how climate change impacts the pricing of RMBS, Bastoni said, “The market’s been slow to adopt any sort of pricing concessions for climate change. We do that right now but it’s really proprietary.”

Breckinridge uses a combination of proprietary software and market sources for their analysis, says Kristin Wetherbee, a company spokeswoman.

DeltaTerra Capital recently announced it will collaborate with Intercontinental Exchange, a global provider of financial technology and data services, to offer climate-adjusted credit risk analytics for investors of residential and commercial mortgage-backed securities.

“The ‘Klima’ models and analytics are an important toolkit providing transparency into whether markets are adequately factoring in future insurance costs and other climate-related fundamental drivers when buying and selling property, loans, and related securities,” Burt said.

The companies will integrate ICE’s “Physical Climate Risk Data,” with DeltaTerra’s “Klima” financial risk models.

In a separate statement, Burt said, “By incorporating our market risk models and property risk estimates at the foundational level of climate risk analysis, rather than bolting financial relationships onto broad climate averages, we can develop and offer a much richer understanding of true system risks.”

The plan is to offer the service initially to agency credit risk transfer (CRT) and commercial mortgage-backed securities (CMBS) investors. Other types of non-agency RMBS will be covered in the very near future, said Min Pefanis, a spokeswoman for DeltaTerra Capital.

Douglas Page can be reached at dpage@sandiegometro.com