The S-Curve

Mortgage Weather Hazard Risk: A Three Body Problem

Andrew Davidson

At the recent AmeriCatalyst ‘Going to Extremes’ Climate, Housing and Finance Leadership Summit, I presented a session on how risks related to weather-related losses impact the housing finance system.

Until recently, weather-related losses were almost fully segmented from the risks borne by investors in mortgages and mortgage-backed securities. Most mortgages require that borrowers retain property insurance, so mortgage investors for the most part assumed that insurance or government assistance would cover property damage and protect the value of the mortgage collateral.

A few large weather events such as hurricanes Katrina, Irma and Sandy as well as wildfires in California led the mortgage market to recognize that delinquency immediately following a major weather event may not be indicative of a borrower’s ability to make mortgage payments over longer time horizons. Thus, the mortgage market introduced more flexible forbearance for weather-related delinquencies. Still, mortgage investors assumed, for the most part, that homes would be insured and weather-related losses would be small and easily diversified.

The recent spate of insurance firms exiting property insurance markets in Florida and California and rapid increases in premiums for borrowers who can purchase insurance has raised the specter that mortgages may be exposed to weather-related losses and that fewer homes may be eligible for mortgage financing.

While the structure of the housing finance system is quite complex, the issues associated with weather-related losses can be understood by focusing on three main players.

  • The Borrower
  • The Lender
  • The Property Insurer

The Borrower seeks leverage and stable cost of housing and is willing to take on long-term risk of changes in the value of the home and maintenance cost. Borrowers often do not have the resources to cover significant damage to their homes or sustained loss of employment income. Risk management is to default on the loan if they do not have sufficient income and the home value declines below the amount of the loan

The Property Insurer is willing to take on diversified hazard risks in exchange for an actuarially sound premium. When there are losses, the borrower/homeowner files a claim and is reimbursed for the costs to restore the home. Insurance is provided on an annual basis, and the insurer has no obligation to keep prices the same or renew insurance. Risk management for the insurer is annual repricing or withdrawal from a market if regulators do not allow them to charge the premiums they request.

The Lender is seeking investments that exceed their cost of funds. The mortgage market is willing to provide funding and take on interest rate/prepayment risk. The market has various mechanisms to cover and distribute credit risk, many of which involve segmenting the various risks to investors with specific investment objectives. Risk management for non-payment by the borrower in the mortgage market is foreclosure. Thus, the mortgage market cannot provide stable homeownership for weather-related losses and generally, mortgage investors are not interested in taking on property hazard risks. As a result, the mortgage market uses “forced place insurance” when a borrower’s property insurance lapses or is not renewed.

There are roughly $13 trillion of mortgages outstanding in the US. These generate approximately $900 billion of annual payments of principal and interest. Of that amount, approximately $60 billion, or about 50 basis points per year, goes to the providers of credit guarantees like FHA, Fannie Mae and Freddie Mac and private insurance. Coincidently, the amount of homeowners’ insurance premiums is in the same ballpark as the guarantee fees, with the median issuance premium around 40 basis points on the replacement value of the structure. The value of the loan and the value of the structure both represent somewhere around 50% to 70% of the total value of the property.

Both insurance and mortgages provide stability for home ownership and allow borrowers to shed risks that would otherwise make homeownership unstable and unaffordable.

While both mortgage guarantee fees and property insurance are designed to cover losses, the mechanism for addressing losses is very different. Insurance provides money to the homeowner to continue living in the house, while guarantee fees are used to cover losses associated with foreclosure, that is, removing the owner from the house.

Mortgages serve to provide borrowers with long-term stability in the cost of homeownership. Property insurance, on the other hand, does not provide long-term stability as insurance is repriced annually and firms that are unable to operate profitably due to inability to adjust premiums to current levels of loss exit the market.

The change in the costs of property insurance due to more frequent weather events has upset the functioning of the housing finance system. Increased insurance costs and the potential for unavailable insurance have the potential to shift the risk of weather events to the mortgage market and the mortgage credit guarantees. However, the mechanism of the mortgage market to address losses, that is, foreclosure, is not suited to the problem of properties needing repairs to be livable.

Even if insurance is available, rapid increases in the cost of insurance may cause borrowers to default on loans when they can no longer afford the mortgage payments and the increased insurance costs. Additionally, higher insurance costs may decrease the value of homes, increasing the frequency and severity of loss.

Moreover, insurance that merely covers losses may be a disservice to the borrower and their communities. Houses that are restored, possibly to updated building codes, may still be subject to future losses and unaffordable insurance. Money spent on higher insurance premiums is money not spent on making properties and communities more resilient.

As mentioned earlier, one bright spot has been that the mortgage market has recognized that forbearance is a better solution for borrowers who are delinquent on their loans due to weather-related disruptions. And that often by waiting for the borrower to receive insurance payments or otherwise find financing for repairs, foreclosure and the associated losses can be avoided.

While the mortgage market can accommodate some degree of loss from weather events, we believe that it would be better to recognize the need to restructure the delivery of property insurance and find a solution that provides longer-term certainty for property insurance to the borrower and avoid the use of foreclosure as a method of addressing weather-related loss.