Can the Federal Mortgage Finance System Help Manage Climate Risk?
by Benjamin J. Keys
As climate change has increased both the frequency and severity of storms and hurricanes, and forecasts of sea level rise have become more urgent, property owners and those who provide credit to develop and invest in physical structures should be aware of the risks they face. Fannie Mae, Freddie Mac, and the FHA/VA mortgage lending programs make up the majority of the current mortgage landscape, and likely face dramatic exposure to climate-induced losses on the long-term (frequently 30-year) mortgages they insure. While these agencies bear climate risk, they are currently doing little to manage three climate-related risks to property: (1) acute storm events, (2) declining values from diminished access due to nuisance flooding, and (3) gradual inundation from sea level rise.
Instead, the burden of managing climate risk in the federal government has fallen disproportionately on the National Flood Insurance Program (NFIP), a program originally motivated by controlling floodplain use. Unfortunately, the NFIP is heavily in debt because of outdated flood maps, insufficient premiums for the riskiest areas, and problematic incentives to rebuild and re-insure in the most flood-prone areas. An alternative approach that broadens the management of climate risk to the federal mortgage finance system could alleviate some of the most problematic pressures on the NFIP, encourage physical adaptation, and foster managed retreat along America’s most vulnerable coastlines.
The U.S. mortgage finance system is unique among developed countries in the direct involvement of the government in the mortgage market, especially with Fannie Mae and Freddie Mac likely to remain in conservatorship for the foreseeable future. Mortgage-backed securities insured by the Federal Government (so-called “Agency MBS”) through Fannie Mae, Freddie Mac, or FHA/VA programs account for over 60 percent of the outstanding residential mortgage debt in the U.S., totaling $6.7 trillion.
This remarkable degree of exposure to residential property markets should spur action on climate risk from these large public mortgage insurers. Although disaster-related losses have not yet been significant for these agencies, loans in areas affected by hurricanes have greatly elevated delinquency rates well after the storms have passed, and climate-related risks are likely to rise sharply over the next 30 years. And yet, there has been relatively little public action on the part of the Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie, or the FHA/VA lending programs, to formally study their exposure to storm surges, increased nuisance flooding, and eventually permanent sea level rise. Both the NFIP and the government mortgage market bear the risks of climate change, but the large mortgage entities have thus far not addressed and acknowledged the degree of their exposure, or taken steps to accurately price and manage the risks of climate-related disasters.
A thorough investigation of risk exposure to climate change would in all likelihood indicate that these government agencies are actively insuring mortgages in every coastal neighborhood in the U.S., but not differentially pricing heightened flood risk in these communities. Interest rates for loans backed by these agencies generally vary by the size of the down payment and a borrower’s credit score, but very little else. The decision not to price flood risk by Fannie and Freddie is a political choice, and one that may not persist in our current political landscape.
In earlier research (Hurst et al. 2016), my co-authors and I found that Fannie Mae and Freddie Mac fail to price foreseeable regional default risk, such as that stemming from falling house prices or rising unemployment, which are to some degree predictable from year to year. We interpreted these results as suggestive of political barriers to regional risk-based pricing. However, our current political coalitions are unlikely to continue to support subsidizing building and re-building in exposed areas. In addition, the underwriting and lending decisions of Fannie Mae and Freddie Mac can be altered through its powerful regulator in conservatorship, the FHFA, rather than requiring the passage of legislation.
Another potential tool at the disposal of federal mortgage-insuring agencies is to further enforce the NFIP’s mandatory insurance purchase requirement. This rule mandates flood insurance for properties located in flood-prone areas if a mortgage on the property is made or held by federally-regulated lending institutions or guaranteed by federal agencies, including Fannie Mae and Freddie Mac. However, the degree of compliance with the mandate is little studied, and reviews of take-up rates suggest that it is not universal. By further enforcing compliance, and ideally linking flood insurance policy data to mortgage data, these agencies can help reduce adverse selection among the pool of insured properties while moving flood risk out of the mortgage system.
Accurately pricing loans’ regional climate risk at a local level, using the most sophisticated statistical models available, would sharply increase the cost of borrowing in many coastal communities. These rising mortgage costs would wisely promote managed retreat by steering lending and development away from the most exposed coasts. Furthermore, by offering discounted rates for properties that are elevated, or meet certain construction standards, the federal mortgage agencies can provide incentives to make remaining structures more durable and communities more resilient.
Fannie Mae and Freddie Mac are also central to the financing of multifamily housing development. Both agencies provide crucial mortgage support to the affordable housing space, and could use their influence in multifamily development and financing to direct investment and development away from at-risk areas that the NFIP does not sufficiently deter. The multifamily mortgage underwriting of these federal agencies can help private developers navigate away from the riskiest low-lying areas and promote affordability in a climate-conscious way.
In sum, the public obligation to address climate change at the federal level can be uniquely addressed through the governmental mortgage market. Mortgage pricing can reflect true expected losses, and incentives to repeatedly rebuild in the riskiest areas should be mitigated, amplifying the broader risk management mandate of the NFIP. The burdens of climate risk would fall more directly on those property owners willing to bear it, which will encourage adaptation and retreat. While there will undoubtedly be issues related to rising mortgage costs for at-risk communities if federal mortgage insurers adopt risk-based pricing, many of these communities need to actively address the risks of climate change sooner rather than later. These risks are instead being borne by the federal government and the American taxpayer. By pricing regional climate-related risk, the federal mortgage finance system could initiate the difficult discussions related to choices coastal communities face regarding adaptation and retreat.
Benjamin J. Keys is Associate Professor of Real Estate at the Wharton School