When Climate Change Leads to Mortgage Defaults: Viewpoint

Climate change poses risks to real estate that homebuyers may not be able to predict. As sea level rises, coastal properties, for example, may be subject to increased flooding and intensifying storm surges. First-time homebuyers often lack the expertise to evaluate these new risks, and thus tend to underestimate them and overpay for increasingly exposed properties.

Unfortunately, the risks they accept are not borne by themselves alone. Rather, our research has found, it is shared by mortgage lenders and, through the operations of Freddie Mac and Fannie Mae, American taxpayers.

Consider how most home purchases are arranged with long-term mortgages. While the conditions vary, a buyer of a $400,000 home may arrange a 5% fixed-rate, 30-year mortgage on $320,000, and agree to pay it back by making 360 monthly payments of about $1,700. If the lender holds this loan on its balance sheet, and climate change creates new expenses — from flooding, storms or wildfires — the borrower becomes more likely to default on the loan.

Consider that lenders originate an estimated $60-100 billion in mortgages on coastal properties, and it’s clear the potential aggregate impact of default due to climate change is significant.

Lenders can lower their risk, however, by exercising their option to sell loans to Fannie Mae and Freddie Mac, the government-sponsored enterprises that were created by Congress to improve access to mortgage lending. Fannie and Freddie have an important public mission, but lenders’ ability to sell them mortgages means that the risk of climate-related real estate expenses is easily relayed from homebuyers to taxpayers.

To gain some insight into the scope of this problem, we examined what happened in mortgage markets after 15 “billion-dollar” disasters, including Hurricanes Katrina ($119 billion) and Sandy ($73 billion). We found that natural disasters significantly raise the number of delinquencies, defaults and foreclosures. This is probably a consequence of the decline in flood insurance: When fewer homes are insured, less of the damage from storm surges and the like is repaired. Fewer homes are rebuilt. And many more homeowners default on their loans.

These mortgage defaults and payment delinquencies affect both lenders and Fannie Mae and Freddie Mac. In areas where natural disasters hit, we found, bank lenders transfer substantially more mortgages to the government-supported enterprises. And this increase is largest in neighborhoods where floods are “new news” — that is, where flooding has only recently become a regular occurrence. Indeed, lenders quickly learn where not to hold loans in their portfolios.

The existing rules of the mortgage-lending game actually maximize this risk to taxpayers, as Fannie and Freddie’s guarantee becomes a substitute for flood insurance. Simple reforms could discourage lenders from leaning so hard on the government-supported enterprises to absorb climate risks. The securitization fees (also called guarantee fees) that Fannie Mae and Freddie Mac charge lenders to take on their loans should be higher for properties at relatively high risk of flooding. And the fee structure should be designed to shift along with changes in risk and improvements in forecasting, as new climate-change scenarios materialize.

At the same time, when homebuyers neglect to buy the insurance that’s federally mandated in flood hazard areas, Fannie Mae and Freddie Mac should exercise their existing authority to transfer losses back to the lenders.

To make sure federal mortgage-market regulators have an accurate picture of flood risks, they should encourage the private-sector data-science industry to compete to provide the best possible forecasting algorithms. If mortgage lenders can steadily improve their understanding of climate risks, they can increasingly work those risks into their loan calculations, by asking for larger down payments and charging higher interest rates to borrowers buying vulnerable houses.

The risks of climate change keep growing, and homebuyers may never develop the expertise required to recognize them. But mortgage lenders have a responsibility to see what’s ahead. They should ensure that their customers know what they’re getting into, and that taxpayers are not unwittingly exposed.