One of the major types of Mortgage risks that the industry faces in the 21st century stems from climate change. Mortgage lenders operate not on a real-time basis, but keeping in mind a 30-year loan tenure on an average. At the pace of current climate change trends, this could mean a significant amount of Risk due to climate and disaster-related foreclosures. To navigate this, the industry needs better data models and a different approach on the holistic, macro level.

What are the Mortgage Risks Arising from Climate Change?

When it comes to the financial service sector, real estate investments and the lenders who fund them are uniquely vulnerable to climate change. According to the Global Commission on Adaptation, the impact of rising seas and storms alone could cost urban centers in coastal areas $1 trillion per year by 2050.  Financial institutions are starting to recognize weather-related disasters as an important mortgage risk that has to be factored into lending decisions.

1. Shrinking market

The mortgage industry has typically relied on home insurance data to assess the value of a property as collateral. However, recent climate change trends mean that certain properties are rendered uninsurable. This shrinks the mortgage market and limits the sale of such properties to only cash buyers.

2. Reputational risk

Mortgage businesses that lend money to purchase vulnerable properties can be exposed to broader reputational risks. For example, the borrower might hold the mortgage provider responsible for funding a property purchase without fully assessing its long-term viability and resilience to climate change.

3. Data model obsolescence

While weather-related disasters were traditionally factored into insurance underwriting processes, climate change is a different beast. It can cause floods in locations that have not seen such an event in over 100 years, for example. This renders current data models defunct and further increases mortgage risks.

4. Inventory reshuffling

Climate change trends will also reshape construction policies and the available real estate inventory. Already, a combination of high interest rates and demand outpacing availability has led to a dip in the number of originations in the US. With stricter construction policies, mortgage providers could see a further dip in volumes.

5. Climate change migration

Another mortgage risk arising from climate change is the risk of migration. The volatility of house prices and soaring temperatures in certain parts of the country is already causing some homeowners to migrate; others are choosing to rent rather than buy, mindful of future migration needs. Mortgage business models need to adapt accordingly.

As you can see, climate change presents a complex and multi-faceted challenge for the mortgage industry, one that is yet to be fully quantified.

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How to Quantify Mortgage Risk related to Climate Change

It is clear that the industry needs to quantify climate risk and build this data into their credit models when evaluating borrowers and properties. However, this proves difficult because:

• Climate scenarios are diverse and simulations are infinite: When it comes to the future of the world’s weather patterns, the range of possibilities is enormous. Further, this future is constantly changing due to the actions of governments, corporations, and communities. Predicting these actions and their effects is a mammoth task.
• There is no standardization: To assess default risk, mortgage providers use credit scores and different indicators of indebtedness. To find interest rate risk, they look at previous rates and patterns of change. But there is no clear consensus about what constitutes climate risk and the metrics to measure it.
• Climate change is a historic event with no precedence: Quantifiable risk is always based on past precedence – which is why, after the 2008 financial crisis, the industry struggled to estimate the losses of such magnitude. Similarly, in the case of changing weather patterns, human judgment and empirical observations collected over time are among the key tools.

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Navigating Climate Risks: Potential Solutions

There are a number of ways mortgage providers can prepare for and mitigate the impact of climate risks. The first step is to quantify it, by understanding the physical risk exposure of real estate assets. Fortunately, regulatory overhauls like the new changes to the FEMA National Flood Insurance Program have made climate change and ratings methodologies more accessible.

Another potential solution is to increase the down payment amount for coastal and high-risk areas instead of writing them off, as uninsurable. This will increase the loan to value ratio (LTV) by reducing the amount that needs to be borrowed. Another operational change that can help is reducing the length of the standard 30-year mortgage to reflect the fast-changing nature of global weather patterns.

Mortgage providers can also consider selling their high-risk portfolios to the secondary market, thereby transferring the majority of the mortgage risk to government-backed entities like Freddie Mac and Fannie Mae.

Read More: Key Risks Impacting Your Mortgage Operations and How to Mitigate Them

Towards Smarter Data Models for a Climate-Sensitive World

Ultimately, the solution for a resilient mortgage business lies in building smarter data models that not only quantify climate risk but also correlate them with new and existing types of mortgage risk when evaluating property value and borrower credit worthiness.

For example, the energy costs associated with an old property may soon become a factor during its valuation. But this requires smarter, more sophisticated data models and also information-gathering systems that can work across stakeholders and systems. For now, mortgage providers can get started by strengthening their business intelligence capabilities and integrating tools designed for big data.

Speak with our experts at Nexval to understand your exposure to climate risk today.

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