MW Your home insurance costs more in high-risk areas. Your mortgage should, too.
By Stijn Van Nieuwerburgh and Parinitha Sastry
Fannie Mae and Freddie Mac don't factor climate change into rates. More frequent floods, hurricanes and wildfires raise systemic default risk.
When mortgage rates are too low in high-risk areas, it encourages building in dangerous locations and having people move there. Taxpayers' climate exposure gets worse.
Last September, Tampa, Fla. narrowly avoided Hurricane Helene, a fortunate miss for a metropolitan area home to 3 million people. The last time Tampa was directly hit by a hurricane was a century ago, in 1921, when just 10,000 people lived there.
What happened in Tampa is part of a broader trend in the U.S. of people moving into climate harm's way. People move for all sorts of reasons: jobs, family, sunshine or low taxes. Unfortunately, climate risk and extreme weather rarely make their list. Consequently, Americans have been moving into locations prone to flooding, hurricanes and wildfires. As the impact of climate change creates more intense natural disasters, many houses in climate-risky areas will become stranded assets.
For many issues, economists and policymakers can rely on market factors to restrain demand. Prices serve to signal scarcity. But these basic rules are blunted in the realm of housing finance. Fannie Mae (FNMA) and Freddie Mac (FMCC), the two mortgage giants known as government-sponsored enterprises (GSEs) and owned by taxpayers since 2008, regularly purchase and guarantee mortgages. But they do not differentiate for risks - like climate risk.
This uniform pricing has its roots in history. Prior to the creation of the GSEs, most mortgage banking was hyper-local, making lenders vulnerable to local shocks, be it a natural or economic disaster. The GSEs were created by Congress to promote liquidity in the mortgage market nationwide. By pooling mortgages from around the country, the GSEs could diversify local shocks, allowing them to require less compensation for mortgage default risk than local lenders. This diversification dividend, in turn, was passed through to homebuyers in the form of lower interest rates.
When all locations are about equally likely to face mortgage defaults, uniform risk pricing is sensible and the risk-sharing benefits are powerful. However, there are limits. One such limit was made abundantly clear in 2008, when the entire country experienced house price declines at the same time. A shock of this nature cannot be diversified. It created massive losses for the GSEs and required a taxpayer bailout. Similarly, the risk from persistent changes in weather patterns can create large aggregate losses in a number of different regions at the same time.
Borrowers in climate-safe areas implicitly subsidize the mortgage rates of borrowers in high-risk areas, like those in Florida.
A key point is that some places are much more likely to get hit by natural disasters than others. Take Florida, for example - out of the nearly 300 hurricanes that have hit the United States since the 1850s, about 120 have made landfall in Florida. In the government-backed mortgage market, a uniform price means that borrowers in climate-safe areas implicitly subsidize the mortgage rates of borrowers in high-risk areas, like those in Florida. It's no longer risk-sharing when the payments only go in one direction.
When mortgage rates are too low in high-risk areas, it encourages building in dangerous locations and having people move there. The taxpayers' climate exposure gets worse over time.
Staring rising risks in the face, what should policy focus on? The first leg of the policy must be to make mortgage interest rates for new loans reflect the full cost of the climate risk. This will provide the proper signal to potential buyers about the climate risks of each location they are considering, helping to stem the flow of people to climate-risky areas.
The second leg of the policy must focus on better adaptation of existing real-estate and infrastructure assets to reduce risks. Evidence suggests that even small-scale investments in weatherizing properties, such as using fortified roofs in properties prone to hurricanes, or more mindful landscaping in areas prone to fires, can yield major improvements in resiliency. These government-sponsored enterprises can create financial incentives for households to undertake these investments by offering price discounts for mortgage borrowers who make such improvements.
If another massive hurricane hits while the U.S. is mired in a recession, property insurers may not be able to pay out the full brunt of the damage.
The potential calamity of not adjusting rates or reducing risks is stark. While the GSEs have faced limited losses from climate events in recent years, things could change quickly if a catastrophic weather disaster were to strike during an economic downturn.
If another massive hurricane hits while the U.S. is mired in a recession, property insurers may not be able to pay out the full brunt of the damage, at a time when mortgage defaults would already be higher than baseline. Right now, the GSEs' combined net worth is roughly $140 billion, and they back a collective $7.6 trillion in mortgages. If just one major hurricane hits Florida and causes an increase in default by 2%, it would wipe out 10% of the GSEs' equity.
Such a default rate is not too far off from what occurred in 2017 after Hurricanes Irma, Harvey and Maria. The GSEs' equity cushion may need to be bolstered if it is to withstand rising disaster intensity and increasing numbers of borrowers in risky areas. Whether or not the Trump administration privatizes the GSEs, they are too big to fail, and the taxpayer bears the climate tail risk.
Most Americans' biggest source of wealth is tied up in their home. To protect these investments, it's time to adapt by building more resilient homes in safer locations and deter building in climate-risky areas via a price mechanism that more accurately signals the real dangers. Adjusting the GSEs' mortgage pricing is a natural way to do so. Homeowners insurance payments are the other natural mechanism but represent only about 5% of the mortgage payment, making interest rate adjustments more potent than changes in insurance premiums. In addition, mortgages are usually 30-year contracts, while insurance contracts are yearly. Lenders and homeowners have incentives to reduce risks over the long run in a way that insurance companies may not.
Mortgage policy today needs to adjust to reflect mounting risks over the 30-year horizon of a typical mortgage. With taxpayers on the hook for two-thirds of U.S. mortgage debt, Fannie Mae and Freddie Mac are a good place to start. A proactive policy that reduces risks in the U.S. mortgage market is something that both Republicans and Democrats should be able to agree on.
Stijn Van Nieuwerburgh is the E. Kazis and B. Schore professor of real estate at Columbia Business School and co-director of the Paul Milstein Center for Real Estate. Parinitha Sastry is an assistant professor of finance at Columbia Business School.
More: Fannie Mae CEO reveals what's really behind rising mortgage rates
Also read: A crisis-era mortgage strategy is making a comeback - and this time it's bailing out buyers
-Stijn Van Nieuwerburgh -Parinitha Sastry
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
December 14, 2024 11:27 ET (16:27 GMT)
Copyright (c) 2024 Dow Jones & Company, Inc.
Comments