Mortgage Finance in the Face of Rising Climate Risk

Matthew Kahn (Johns Hopkins) with Amine Ouazad

Abstract:

Recent evidence suggests an increasing risk of natural disasters of the magnitude of hurricane  Katrina and Sandy. Concurrently, the number and volume of flood insurance policies has been  declining since 2008. Hence, households who have purchased a house in coastal areas may be at  increasing risk of defaulting on their mortgage. Commercial banks have the ability to screen and  price mortgages for flood risk. Banks also retain the option to securitize some of these loans. In  particular, bank lenders may have an incentive to sell their worse flood risk to the two main  agency securitizers, the Federal National Mortgage Association, commonly known as Fannie  Mae, and the Federal Home Loan Mortgage Corporation, known as Freddie Mac. In contrast with  commercial banks, Fannie and Freddie follow observable rules set by the FHFA for the purchase  and the pricing of securitized mortgages. This paper uses the impact of one such sharp rule, the  conforming loan limit, on securitization volumes. We estimate whether lenders’ sales of  mortgages with loan amounts right below the conforming loan limit increase significantly after a  natural disaster that caused more than a billion dollar in damages. Results suggest a substantial  increase in securitization activity in years following such a billion-dollar disaster. Such increase  is larger in neighborhoods for which such a disaster is “new news”, i.e. does not have a long history of hurricanes. Conforming loans are riskier in dimensions not observed in publicly  available data sets: the borrowers have lower credit scores and they are more likely to become  delinquent or default. A structurally estimated model of mortgage pricing with asymmetric  information suggests that bunching at the conforming loan limit is an increasing function of  perceived price volatility and declining price trends. A simulation of the impact of increasing  climate risk on mortgage origination volumes with and without the GSEs suggests that the GSEs  may act as an implicit insurer, i.e a substitute for the declining National Flood Insurance Program.