How climate change could spark the next home mortgage disasterNovember 30, 2020
With its lively parks and colorful bungalows, Hialeah, Fla., has been the gateway to the American middle class for thousands of Cuban immigrants.
Hialeah was the place where home ownership, an unattainable goal under the Communist regime of their homeland, became a reality. And as in many American communities — rich and poor, of every ethnic makeup — the American dream for families in Hialeah was helped along by the taxpayer-funded mortgage giants, Fannie Mae and Freddie Mac. Their willingness to purchase the loans on homes in the area provides local lenders with a steady flow of cash to invest in the community.
But behind the vibrant life in Hialeah is a troubling reality: flooding. Heavy rains overran the streets this year, last year — almost every year. And the problem is projected to get worse: Some scientists fear the city could be underwater within the lifetimes of some current residents.
Despite that grim prognosis, the federal government keeps pumping mortgage money into Hialeah, as it does in hundreds of other communities now facing grave dangers from climate change. Fannie Mae and Freddie Mac hold the majority of home mortgages in some Hialeah neighborhoods. More significantly, federal taxpayers hold greater than 60 percent of mortgages on homes in some areas outside the specially designated federal floodplain, according to an analysis of federal data by Amine Ouazad, an associate economics professor at Canadian business school HEC Montréal.
That’s important because being outside the so-called “100-year floodplain” means homes aren’t required to carry flood insurance. Thus, if the homes are damaged sufficiently that their owners can’t afford to fix them, and must abandon the property, the federal government gets stuck with the house. That’s a relatively small risk in a time of rising real estate values, when families can use their home equity to take out repair loans, but a potential economic disaster if home prices start to plunge and owners can’t find ways to make repairs on houses that are worth far less than their outstanding debt. And there are compelling reasons to believe that climate risks are starting to catch up to the real estate market in Hialeah and beyond.
Buyers and lenders are now able to assess the risks of climate change damage by using simple apps — a technological revolution that is placing a warning label on millions of properties from seaside New England to low-lying areas vulnerable to hurricanes across the Southeast to the arid, fire-prone hills of California. And once buyers start refusing to pay top dollar for such homes — and insurers stop underwriting policies on them — the more than trillion-dollar Fannie-Freddie portfolio could take an enormous hit, big enough to knock the economy into recession or worse.
“It just has not reached that level of concern. And it never does, right?” Clifford Rossi, a former senior risk officer at both Fannie Mae and Freddie Mac, told POLITICO. “It never reaches the point of people really kind of being forward-thinking about this until the crisis is upon you or about to hit you in the face.”
POLITICO interviewed federal officials in charge of housing policy, decision-makers at major U.S. banks, former chief operatives at Freddie Mac, Fannie Mae and the Federal Housing Finance Agency, investors in fixed-income securities like mortgage pools, analysts building new products that measure climate risk, think tank experts and academics to understand the political, scientific, technical and social complexities that have left the taxpayer-backed mortgage market suspended in time, unwilling or unable to prepare for the inevitability of property- and wealth-destroying climate change.
Hialeah is just a tiny part of a much larger risk pool, but it encapsulates the conundrum facing policymakers. Homeownership rates in the city are relatively low, at less than 46 percent. Meanwhile, Fannie Mae and Freddie Mac have a congressionally approved mandate to put more people, especially those from traditionally underserved backgrounds, in homes of their own.
Officials at the FHFA, which oversees Fannie Mae and Freddie Mac, maintain that taxpayers are protected by flood insurance requirements. Parts of Hialeah, though, don’t fall into the floodplain, a result of outdated maps that do not consider future flood scenarios arising from climate change — a problem that, policymakers maintain, is replicated in communities across the country. But pricing climate change into mortgage terms would wreak havoc in the real estate market — a hit that, while protective of taxpayers in the long run, runs counter to the missions of the relevant agencies. Turning off the mortgage spigot in communities affected by climate change would disproportionately affect people of color, whose neighborhoods are more likely to be plagued by violent weather.
The result, many current and former federal housing officials acknowledge, is a peculiar kind of stasis — a crisis that everyone sees coming but no one feels empowered to prevent, even as banks and investors grow far savvier about assessing climate risk.
“At some point, it’s going to crystallize and everyone’s going to pull out” of homes facing climate risks, said Ed Golding, a former Freddie Mac executive who ran the Federal Housing Administration during the Obama administration. “It will be a crisis that will have to get everybody to react.”
For now, however, “There’s a tendency not to want to address these hard issues and we allow a lot of capital to go in” to at-risk neighborhoods, added Golding, who is now executive director of the Massachusetts Institute of Technology Golub Center for Finance and Policy.
Fannie Mae did not respond to multiple requests for comment. Freddie Mac referred POLITICO to FHFA.
The mortgage giants appear to be taking fledgling steps to understand the true cost of climate-threatened loans on their books. In June, Fannie Mae hired a vice president of climate-risk analytics. The agency previously issued a request for proposals to analyze climate exposure to homes that are outside the 100-year floodplain, and therefore do not require flood insurance coverage, which was first reported by POLITICO.
Fannie Mae and Freddie Mac’s regulator, FHFA, is also trying to fully comprehend the climate challenge: POLITICO first reported in October that the regulator convened a workshop on natural disaster risks to mortgages and that it was standing up an internal team on the issue. Several start-up analytic companies that use publicly available data to develop more sophisticated, fine-scale climate risk scenarios say they have peddled their wares in meetings with FHFA, Fannie Mae and Freddie Mac.
Nonetheless, some current and former federal housing officials who were interviewed by POLITICO said that they interpret the charters that formed Fannie Mae and Freddie Mac as preventing officials from deciding, on their own accord, to stop buying mortgages in areas at high climate risk: Such a decision would have to be made by Congress and the president.
Others who occupied the same positions said the exact opposite.
“The short answer is they could if they wanted,” said Ed DeMarco, who ran the FHFA for much of the Obama administration.
Fannie Mae was founded in 1938, near the height of the Great Depression, to provide an injection of federally backed dollars into the mortgage market, empowering banks to give home buyers the loans they needed to boost the real estate market.
The idea was simple: Banks would lend to families in their own communities and, provided they followed certain underwriting criteria, would be eligible to sell the loans to Fannie Mae shortly thereafter, thereby clearing their balance sheet to make more loans.
The agency helped fuel the post-World War II housing boom that greatly expanded the middle class. In 1970, the federal government created Freddie Mac as a private company to serve much the same function. Eventually, the two giants would take control of roughly half of all home mortgages in the country.
With explicit missions to promote the American dream of homeownership — and prodded through the years to expand opportunities to traditionally underserved racial and ethnic communities — Fannie Mae and Freddie Mac simply aren’t geared to choke off those opportunities to combat a future of more floods, stronger hurricanes and faster-spreading fires.
As with most aspects of climate change, there’s a lack of certainty: Mortgage assessors can’t say exactly when and exactly where life- and property-destroying events will occur, even if they know the risks of them will increase.
A further reason for caution is that any actions taken by the two mortgage giants would be highly disruptive in themselves: A refusal to buy mortgages on homes in certain areas would potentially choke off lending in those areas, driving down housing prices. For those already owning homes in those areas, equity could disappear overnight. Some owners, realizing their homes were worth less than their mortgages, might simply refuse to pay, triggering foreclosures and igniting some of the forces that created the financial crisis of 2008-2009.
But failing to take preventative action in anticipation of climate changes risks a far greater downturn.
“The problem is they’re not seeing where the puck is going. How do you price into that moving target?” said Dave Stevens, who was assistant secretary of housing and federal housing commissioner at the Department of Housing and Urban Development during the Obama administration and was senior vice president for single-family lending at Freddie Mac. “If you believe the maps about the sea level rising, why isn’t that being considered?”
Weighing those climate-fueled dynamics would take Fannie Mae and Freddie Mac into the political minefield of place-based pricing. The companies’ charters discourage such distinctions in order to create a national mortgage market. Maintaining a largely homogeneous market helps to combat redlining policies that have deprived predominantly Black neighborhoods of access to credit, while also ensuring that rural communities have the same access to credit as urban areas that have far more lenders.
While those factors work against assessing the risk of climate change to would-be homeowners, they don’t prohibit such a system. Yet FHFA, Fannie Mae and Freddie Mac have internalized the tricky politics of place-based pricing as an insurmountable obstacle.
There are reasons for that. In the early 1990s, Fannie Mae and Freddie Mac tried to raise the price of mortgages on properties in California neighborhoods with a high risk of earthquake damage, only to backtrack in the face of furious opposition from Golden State leaders. More recently, DeMarco, the former FHFA director, recalled pushing to charge higher fees for homes in states with a judicial foreclosure process to reflect the longer, costlier timelines. FHFA dropped its plan amid a fierce backlash from Congress.
Some critics note that Fannie Mae and Freddie Mac already maintain some forms of risk-based pricing. The lenders charge banks higher rates — known as “guarantee fees” — when a borrower’s credit history signals a greater default risk. Some calculations made through so-called loan-level price adjustments are place-based in practice, if not name, noted Richard Green, director of the Lusk Center for Real Estate at the University of Southern California and former principal economist at Freddie Mac. Condominiums and co-ops, for example, carry higher fees than single-family homes, which disadvantages more densely populated cities relative to the suburbs, he said.
Mortgage experts, however, point out that those variables are more closely related to objective metrics about the borrower or home. Factoring climate change into the agencies’ price structure would require more subjective judgments about which communities are vulnerable to devastating weather events and whether those communities are likely to invest in infrastructure such as flood walls to reduce the risk.
“Anybody who believes in science knows that global warming is only going to cause increases in future risks for major storms,” said Stevens, the former Freddie Mac official, who also was president of the Mortgage Bankers Association trade organization. “I think the key is, what’s predictive here?”
Making those decisions would put the mortgage giants in a position to write off whole communities. Susan Wachter, a real estate and finance professor as the Wharton School of the University of Pennsylvania, said that to truly discourage people from locating in climate-sensitive areas, borrowing costs would need to rise so sharply that they would spur a “death spiral,” creating a self-fulfilling narrative that cuts off investment in entire regions. Those higher borrowing costs could also present equity concerns, as many Black communities are situated in low-lying areas as a result of racist historical policies.
Other forms of risk pricing, such as amortizing a climate-risk surcharge across all borrowers, would create a capital buffer against losses but wouldn’t change behavior about where people live. Wachter and other mortgage experts contend the worst effects of climate change are simply too distant to price into lending for individual homes, arguing instead to signal risk by requiring steeper insurance policies that operate on shorter timelines.
Raffi Williams, a spokesman for FHFA, noted that Fannie Mae and Freddie Mac do indeed utilize flood insurance requirements.
“Fannie Mae and Freddie Mac’s losses after major flood events, like Hurricane Harvey in 2017, have been small, in relative terms,” he said in a statement. The mortgage giants “are proactively assessing potential risks and exposures from natural disasters and focusing on ensuring that disaster-related policies are adapted to the situations we face,” he continued.
The main vehicle for such efforts, however, is the National Flood Insurance Program, which requires that every federally backed home in the 100-year floodplain carry flood insurance. But floodplain managers and climate change experts maintain that the program significantly underestimates the risks. The maps it relies on are outdated — likely omitting millions of at-risk homes — and the program is billions of dollars in debt.
“That we are rapidly growing places that are just right there in the bull’s-eye of climate change just doesn’t make any sense,” said Green, of USC, who believes Fannie Mae and Freddie Mac should price for climate risk.
The mortgage giants have already made an implicit decision to distort the market by not pricing climate risk, noted Jesse Keenan, an associate professor at Tulane University’s School of Architecture who has studied climate risks in real estate. They extend more financing to climate-vulnerable borrowers than the properties are worth. Thus they put taxpayer dollars and American lives in the crosshairs of extreme weather and storms.
FHFA is increasingly coming to that realization.
FHFA has brought in experts to discuss climate risk in the mortgage market, Keenan said, noting he and other colleagues have met with the regulator. In a June 30 proposal to release Fannie Mae and Freddie Mac from the federal government’s watch — a goal of Republicans who want the government out of the mortgage market — FHFA noted the lenders suffer from “gaps in risk coverage,” such as climate change.
Fannie Mae and Freddie Mac carry “risks relating to uninsured or underinsured losses from flooding, earthquakes, or other natural disasters or radiological or biological hazards. There also is no risk-based capital requirement for the risks that climate change could pose to property values in some localities,” the proposal said.
In other words: Fannie Mae and Freddie Mac have no designated financial buffer for offsetting climate-related losses to their lending portfolio.
“Why do this? What’s their motivation?” Keenan said of FHFA’s decision to advertise such vulnerabilities in its privatization proposal. “I think they see the writing on the wall.”
But plans to privatize Fannie Mae and Freddie Mac have languished for years, and few people close to the situation expect any movement on the proposals in the near future.
This sets up the possibility that banks would deliberately sell off mortgages in areas with climate risks to Fannie Mae and Freddie Mac — which can’t refuse them, given the mandate to provide market liquidity — while keeping the sturdier loans on their own books.
“In general, private entities are being more nimble and protecting themselves better than the federal government,” said an official at a major U.S. bank, who requested anonymity to discuss proprietary information about how the financial institution evaluates risk.
Banks such as Wells Fargo, Morgan Stanley, Citigroup and Bank of America acknowledged in response to questions from Sen. Elizabeth Warren (D-Mass.) that they are using new tools and services to gauge climate risk to their portfolios. That includes working with companies such as Jupiter Intelligence and Four Twenty Seven, two climate analytics firms that measure portfolio risks to drought, flood, wildfires and other perils.
Jupiter Intelligence CEO Rich Sorkin said banks are using his firm’s services to “understand the safety of a mortgage asset over the mortgage’s expected life cycle.” Sorkin added that his company has seen “a huge uptick in interest” from insurance, asset management and real estate companies.
Four Twenty Seven founder Emilie Mazzacurati told POLITICO that her company, too, has mortgage lenders as clients and has worked with real estate and mortgage associations, noting that some lenders are already steering away from properties in certain regions due to climate risks.
Morgan Stanley, for example, has contracted with analytics firm Cloud To Street to survey flood risk across the United States. The firm’s founder, Bessie Schwarz, said she did not know how the bank planned to use its findings. She worried aloud, however, that the general public would remain in the dark about climate risks while well-heeled financial institutions benefited from detailed knowledge.
“As climate change happens, as catastrophes are getting more extreme, as the stress gets more extreme, access to this kind of information about your risk about — if a risk is about to come — I do think in many ways that’s just a public good,” Schwarz said. “People have a right to understand that stuff.”
Generally speaking, though, average families lack information about climate risks before they buy homes. And it’s not clear whether Fannie Mae and Freddie Mac have purchased the sophisticated data many lenders now use to better assess potential climate damage, said Lindsay Owens, a fellow at the Great Democracy Initiative and a former Warren aide.
Nonetheless, private-sector lenders have been slow to make significant changes to their business models, the U.S. bank official said. But the bank has done the legwork — it has the analytics and data in place — to determine which mortgages are most exposed to climate change.
And if the bank ever becomes convinced of the inevitability of climate change in certain places, it could simply flip any loans in those places to Fannie Mae and Freddie Mac, which would be obligated to buy them. That means taxpayers would be guaranteeing the risk rather than private lenders.
“That is certainly a theoretical lever we could pull as a company where we could always securitize an area we don’t want to be in,” the official said. “We don’t do that today … but that is certainly something I have contemplated.”
Currently, the mortgage market is cross-subsidized: Borrowers in New Mexico are implicitly subsidizing Florida homes through the securities of mortgage pools Fannie Mae and Freddie Mac sell to private investors.
Those securities are opaque, and for good reason, mortgage experts argue: They exist to generate more cash flow to keep lending fluid. Fannie Mae and Freddie Mac — in effect, taxpayers — guarantee the principal on those investments even if hurricanes or wildfires wipe out the homes.
“Until those loans that are in zip codes that have flood risk trade at a discount to other loans, [Fannie Mae and Freddie Mac] won’t care,” said Chris Whalen, an investment banker. “But since there’s a guarantee to credit risk, [investors] don’t care.”
Nonetheless, a growing number of investors are developing tools and methods to decipher which securities contain greater concentrations of mortgages in areas vulnerable to floods, storms and wildfires to either short or snub those specific offerings. The fear is that, if the properties are destroyed, Fannie Mae and Freddie Mac would indeed pay off the mortgages immediately. But that would deprive investors of the benefits of interest over the longer term.
Asset managers and financial security companies are hiring companies like risQ, which fingerprint mortgage-backed securities for geographic data that can illuminate which pools contain an abnormally large number of mortgages in climate-vulnerable zones.
Some firms are building in-house capabilities to do the same thing. Breckinridge Capital Advisors, a Boston-based investment manager, created a tool for assessing mortgage-backed securities’ risks to climate events. Its metric assumes mortgage prepayments will occur faster as disasters wipe out homes that Fannie Mae and Freddie Mac immediately pay off, thus changing the calculation for investors counting on interest-accruing securities that pay increasing returns over a longer period.
“The investment community is wanting to get more granularity and understanding as to where their risks are,” said risQ Chief Commercial Officer Chris Hartshorn. “Right now, these assets have been priced irresponsibly.”
Mortgage investors already have, at least implicitly, said the same. As Hurricane Harvey barreled down on Texas in 2017, securities that Fannie Mae and Freddie Mac sell to private investors in what’s known as a “credit risk transfer” went haywire, spiking 150 basis points — or 1.5 percent — amid fears that the storm would obliterate entire communities. When the credit risk transfer market settled after Harvey, the Association of Mortgage Investors, a trade group representing mortgage securities buyers, asked Fannie Mae and Freddie Mac to remove mortgages vulnerable to climate change from those offerings.
That spike occurred because, unlike with most of the mortgage-backed securities that the mortgage giants sell, private buyers take the loss on credit risk transfers if mortgages default. The idea is to relieve taxpayers of the risk of having to cover for potential losses, putting it on private investors instead. But that solution can only work for so long, especially given the pressure investors have put on the mortgage giants to remove loans on properties at risk of climate change from those offerings, said Rossi, the former Fannie Mae and Freddie Mac risk officer.
Rossi called the letter “a clarion call” that investors were skeptical of the risks the mortgage giants were taking on from climate-exposed properties — so Fannie Mae and Freddie Mac took the loans out of the credit risk transfer pool, he said, letting climate-vulnerable mortgages pile up on their own books.
“In a still relatively low-risk environment relative to the rest of their portfolio they can get by pulling those loans out and putting them aside,” Rossi said. “But over time, that’s going to pose challenges for them.”