By Michael S. Derby 

Mortgage providers appear to have developed a strategy to continue lending in areas where climate-change-related flood threats are on the upswing, in a development that could be hiding a growing risk in home lending, according to new research.

Faced with risks related to destructive coastal storms, lenders are lowering the sizes of their mortgages to make sure the loans are eligible to be taken on by government-sponsored home lenders like Fannie Mae and Freddie Mac, a new paper distributed by the National Bureau of Economic Research says.

The paper, written by Amine Ouazad of HEC Montreal business school and Matthew Kahn of Johns Hopkins University, says the declining availability of flood insurance makes mortgage lending more risky in parts of the country. Reduced flood coverage means homeowners are more likely to default on their loans when faced with major storm damage to their homes.

Banks that provide mortgages understand that and know government housing lender guidelines "do not rely on the on-the-ground information of loan officers and may not take into account local climate risk as accurately as the local loan officer."

With risks rising, private home lenders "may have an incentive to sell their worse flood risk to the two main agency securitizers." The key, the paper said, is making conforming loans, or mortgages that don't exceed a size cap set by Fannie or Freddie if the government-sponsored enterprises are to buy them through securitization.

"After a billion-dollar event, lenders are significantly more likely to increase the share of mortgages originated and securitized below the conforming loan limit," the paper said. The increase "is larger in neighborhoods for which such a disaster is 'new news', i.e. does not have a long history of hurricanes," the researchers wrote.

By moving the risk of these vulnerable mortgages out of the private sector, government-sponsored home lenders increasingly serve as an "implicit insurer" and a "a substitute for the declining National Flood Insurance Program," the paper said.

For this and other reasons, these types of loans put more risk in the financial system, and it could get worse. That's because destructive storms are likely to become a bigger risk over time due to climate change. "Recent evidence suggests an increasing risk of natural disasters along the" East Coast, and recent work "predicts a doubling of category 4 and 5 storms by the end of the 21st century in moderate scenarios."

Dealing with the impact of climate change is a top issue for the financial industry and regulators, including the Federal Reserve. The central bank has said that as part of its stress-testing exercise to ensure banks are ready to navigate trouble, financial firms must take into account severe weather events. A recent San Francisco Fed paper said banks should get credit for lending that helps ensure resilience against climate change events.

Write to Michael S. Derby at michael.derby@wsj.com

 

(END) Dow Jones Newswires

October 01, 2019 16:22 ET (20:22 GMT)

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