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Risky Business

Financial system needs to be more resilient in face of disasters

Lew Sichelman headshot
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Lew Sichelman
Risky Business

Vacation home buyers, it seems, are following the advice of Admiral David Farragut, who is credited with saying “Damn the torpedoes, full speed ahead” during the Civil War Battle of Mobile Bay.

Historians doubt that Farragut actually said those words when he ordered his fleet into a harbor awash with mines, which were called torpedoes back in the day. But that’s not the point, at least not here. The point, or rather the question, is who owns all the risk when buyers ignore all those warnings about climate change and move into regions or even neighborhoods susceptible to floods, wildfire, hurricanes and other natural disasters?

A new report from the Mortgage Bankers Association tries to answer that question. We’ll get to how the MBA sees it in a moment. First, a look at the rush to risky places, as reported by the Redfin real estate brokerage firm, which found that second-home purchases rose some 40% in spots at higher risk for floods, severe storms or excessive heat over the past two years.

The Redfin analysis found that more people have been moving into than out of those counties with the largest share of homes at high risk from natural disasters. Some aren’t aware of the potential for disaster, but others don’t give a fig.

“House hunters from out of town ask about climate change because they’re very concerned about flooding, but most of them don’t change their minds,” says Miami Redfin agent Cristina Llanos. “They hear horror stories of hurricanes, but generally still move forward. People want to talk about it but it typically doesn’t make or break their decision.”

Heat Top Risk

Breaking it down, the brokerage found that heat is the most common risk facing second-home buyers. More than nine out of 10 second homes purchased in the past two years face high heat risk. Next comes high storm risk, which hovers over more than three-quarters of second homes bought in the past two years. One in four face high flood risk, while about one in five face high fire risk and high drought risk.

Not only have vacation home buyers (and those who invest in them) taken up residence in these hot environmental locations, so has severe weather — to the tune of roughly $121.4 billion in property damage over the last five years, reports ValuePenguin. Flash floods caused $49.1 billion in property damages, said the LendingTree-owned consumer advice website. That’s followed by hurricanes, which caused $36.1 billion in damages, and tornadoes, which caused $7.1 billion in damages.

That’s a lot of shekels. But that pales in comparison to what home owners, insurers and mortgage stand to lose should the next big one hit. The latest from CoreLogic shows that nearly 7.8 million houses — primary or otherwise — are at risk of storm surge damage. Their combined reconstruction cost: $2.3 trillion. Worse, 33 million houses with nearly $10.5 trillion in construction costs are at risk of hurricane-force winds.

Obviously, owners of houses and multi-family properties “bear the burden” of paying for the risks, according to the MBA’s aforementioned white paper (https://newslink.mba.org/wp-content/uploads/2022/07/24055-Research-Climate-Change-2022-White-Paper.pdf). So, of course, do their insurers. But perhaps one in four owners self-insure, meaning they have no insurance other than their own bank accounts.

Homeowner Responsibility

Even when owners have insurance, they may not have enough to keep from digging into their wallets for more than their deductibles. “The only scenario where an insurer won’t cover a homeowner or business for extreme weather damage is when they do not have sufficient insurance coverage,” says ValuePenguin’s Divya Sangameshwar. “It is the homeowners’/business owners’ responsibility to know what their level of coverage is, the kinds of perils their existing policy covers, and purchase additional coverage to cover perils that aren’t included in their basic policy.”

Beyond owners and their insurers, though, others in the housing continuum also share some of the hazard, according to the MBA’s report, “Who Owns Climate Risk in the U.S. Real Estate Market.” And according to the 21-page paper, “the ways in which responsibility ... is distributed among the various market players is heavily dependent on whether the property owners do or do not have a mortgage and whether that mortgage is held in a lender’s portfolio or is sold into the secondary market.”

Before going further, I know there are some who don’t believe in climate change. But let’s assume for the purposes of this treatise that it is real. And if that’s the case, the MBA points out, the mortgage market “serves as a de facto insurance coverage.”

While owners take on all the physical risk, mortgagors take on some of the transition risk of moving to a lower-carbon economy as well as counterparty and operational risk, according to authors Jamie Woodwell, Mike Fratantoni and Edward Seiler, all of whom are MBA staffers. And if the loan is sold to the government sponsored enterprises, insured by the Federal Housing Administration, securitized by the Government National Mortgage Association or finds its way into a private-label security, transition and counterparty risk transfers to those entities. Operational risk, on the other hand, generally remains with the servicer. (Woodwell is the MBA’s vice president of research; Fratatnoni, its chief economist, and Seiler, executive director of its Research Institute for Housing America.)

Extreme weather icons

Going Commando?

Owners of the 30 million or so owner-occupied properties without a mortgage make their own insurance decisions. But when they go commando, Uncle Sam often comes to their rescue, in some way or fashion, to ease the burden of climate-related disasters with grants, loans and other form of support. Even when they have insurance, though, owners could be left high and dry if their insurer pulls out of the market, as some have done recently in Florida, or goes under, as a few have in Florida as well. And then there’s increased risk of higher taxes and changes in housing values, all of which also is assumed by the owner.

At the same time, some 48 million owners have some form of mortgage which requires them to maintain insurance. If they don’t, lenders have the authority to “force-place” coverage. When a property is held in the lender’s portfolio, the report outlines, owners still retain a portion of the physical risk. But some of the transitional risk equal to the loan amount shifts to the lender in a second position behind the borrower. Moreover, the servicer “must establish policies and procedures to monitor and act” on insurance issues should they arise. Consequently, servicers assume some operational risk.

When the loan moves into the secondary market — some 36 million are sold or securitized — the physical risks don’t change, nor do the transition risk. But the lender sheds its share of the risk it would have otherwise assumed had it held on to the mortgage, and the servicer continues to own some operational risk associated with monitoring and managing the risk taken on by others.

De Facto Insurance

Why the need to lay this all out? Because, the authors point out, “regulators will need to pay increased attention” to what many believe — sorry, naysayers — lies ahead with respect to climate change. Their report, they say, has “broad implications for where risk management and regulation can have the most significant impact.”

As they see it, the mortgage market “plays a de facto form of insurance ... taking on the risk from an attachment point of the owner’s equity in the property through to a detachment point of the property’s value.” And they think regulators should “lean into” the fact that the market has been able to distribute that risk across multiple parties.

Looking ahead with respect to credit risk, the MBA staffers suggest that the best regulatory approach “may simply be to ensure that lenders are doing the blocking and tackling their businesses require.” When it comes to market risk, they warn, rule makers must avoid anything that suddenly impairs a property’s value. And as far as operational risk is concerned, they argue that regulators should “help to lead” industry-wide discussion about how to optimize relief efforts for borrowers.

Above all, perhaps, the paper implores regulators to “push for efforts that will help the (financial) system as a whole become more resilient in the face of disasters.”

This article was originally published in the NMP Magazine September 2022 issue.
Lew Sichelman headshot
Lew Sichelman,
National Mortgage Professional Contributing Writer

Lew Sichelman has been covering the housing and mortgage sectors for 52 years. His syndicated column appears in major newspapers throughout the country. He also has been the real estate editor at two major Washington, D.C., dailies and spent 30 years on the staff of National Mortgage News, formerly National Thrift News.

Published on
Aug 31, 2022
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