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Are Lenders Responding to Risks Fast Enough?

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Are Lenders Responding to Risks Fast Enough?

By: Adam M. Matheny

We Don't Want to be on Thin Ice

Lenders are keeping a close eye on risk exposure due to climate change, and they’re responding by dumping their riskier properties on taxpayer-supported organizations. This has industry experts concerned, since a continued trend in this vein could put the mortgage market itself on thin ice. No one wants a repeat of the financial crisis that rocked the country a decade ago.

Climate change is only one aspect of the problem. Since 2006, fewer and fewer properties have been covered by flood insurance each year. Not only that, but the policies that are purchased are for lower values than before. Even if we weren’t already concerned about rising waters and more (and more dangerous) storms, this would be troubling news. Combined, it’s more than troubling—it’s a clear sign that people who have purchased property along the coast may be at a higher risk of defaulting/foreclosure.

There are a few different ways that banks can approach this risk. For example, some banks have the ability to assess flood risk and price mortgages accordingly; they can also securitize loans which is instrumental in spreading the risk among a greater number of parties. This helps prevent defaults from having a devastating effect on one sector; instead, they’ll have a more minor impact amongst several.

However, some banks don’t have these capabilities, and even amongst those that do, they may choose an easier out: reselling mortgage loans to the tax-supported, government-controlled Freddie Mac and Fannie Mae.  Neither of these entities can price mortgages according to flood risk, by design, because they were developed with the express purpose of increasing homeownership in the United States. They are more limited in this regard, and in regards to any risks of natural disaster, unlike commercial banks.

There are any number of issues with this, from the mispricing of mortgages to consolidating mortgages with a high risk of disaster-related defaults in one place—a place that is tax-payer supported, no less.

More than one expert considers these practices to represent a serious threat to financial stability.

2008 All Over Again?

How much does this situation actually resemble the crisis experienced in 2008? Well, the pool of sub-prime mortgages that weakened the system in 2008 was significantly larger than the number of mortgages currently threatened by climate-change related disasters. But that doesn’t necessarily mean much, for a few reasons:

  • Properties that are at risk due to disaster may be completely destroyed—lost forever. At least in the case of sub-prime mortgages, there were still physical assets remaining.
  • Climate-change isn’t going away. There might be fewer properties affected now, but even if the change is gradual, there could eventually be more homes affected than during the 2008 crisis.
  • People are more likely to default, even if the property can be salvaged, if they believe it’s only a matter of time before there’s another surge or storm. Those that could save their homes during the 2008 crisis went through great lengths to do so—don’t’ expect that kind of motivated response from those whose homes are destroyed by the changing climate.

And the danger isn’t theoretical. According to researchers who studied lenders that served areas already hit by hurricanes in recent years, these lenders have been offloading mortgages to Freddie Mac and Fanny May in increasing numbers. Furthermore, the odds of an eventual foreclosure rise when a mortgage is initiated in the first year following a hurricane, by nearly 4 percent… and keep rising, with a 5 percent increase in mortgages which are initiated during the third year following a hurricane.

What Can Be Done?

The simplest solution—making borrowing with the intent of purchasing a home more difficult overall, and especially in areas that will be affected by climate change—isn’t one that is very attractive to lenders.

Americans really want to purchase their own homes, and the mortgage market keeps growing, as a result. Freddie Mac and Fannie Mae help it grow by increasing liquidity in the market. As long as Americans equate home ownership with status and wealth, and pursue lenders to achieve it, lenders are going to answer the call—they have very little immediate incentive not to. This is problematic for families as well as the economy at large—because it means that a majority of households prioritize “place-based” wealth. Place-based wealth will be among the most threatened by climate change.

The forecasts are getting more dire, as well, not because sea levels are rising faster than anticipated, but because early measurements regarding the height of coastal lands were inaccurate.

Ultimately, lenders are going to need to address this issue if they don’t want to contribute to another financial crisis. And if they do not, state and federal governments may need to look for other ways to ensure the lending market doesn’t outpace its ability to recover from climate change.

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