United States: Impact Of Climate Change On US Residential Mortgage Servicing

Whether or not climate change is real and represents an existential threat and, if so, regardless of the reasons for it, the number and severity of domestic natural disasters appear to be on the rise. And, if you are a mortgage servicer dealing with disaster-related damage to mortgaged properties and the related mortgagor defaults, it probably does not matter why. What matters the most is whether the servicer bears the risk of loss resulting from borrower defaults arising out of natural disasters and that exceed property insurance proceeds, even though the servicer has no beneficial ownership interest in the loan.

As we detail below, the credit risk of loss following a mortgagor default resulting from a natural disaster rests in part with the servicer when the loan is pooled to back securities guaranteed by the Government National Mortgage Association ("Ginnie Mae")-the most common form of ownership of government-insured or -guaranteed loans. And the servicer morphs into the actual holder of the loan following an early pool buy-out. If the frequency and severity of natural disasters continue to increase due to climate change or mere random acts and property-related insurance proves to be insufficient to cover the costs of property repair and rebuilding, the appetite of servicers to service government-insured or -guaranteed loans and acquire the related servicing rights could well be materially diminished. A reasonably likely consequence of this diminished appetite could be lessened availability or increased costs of government-insured or -guaranteed residential mortgage loans.

Impact of Climate Change on Financial Services

The US government has investigated and reported on the risks climate change poses to financial services. Most recently, the Commodity Futures Trading Commission ("CFTC") issued a report documenting these risks and how to manage them.¹ The CFTC found that "[c]limate change poses a major risk to the stability of the US financial system and to its ability to sustain the American economy" and that such impacts are already occurring.² Specifically, the CTFC identified risks that included disorderly price adjustments in various asset classes, the potential inability of market participants to adapt to rapid changes in policy that will be necessary for a large-scale transition to a net-zero emissions economy, and limitations in the availability of credit and financial products.³

With regard to real estate, the CFTC noted that climate change is already affecting and will likely continue to have an increasing impact on real estate values.⁴ The Commission cited several studies showing depressions in certain housing markets because of flooding and wildfire risks.⁵ Flooding, wildfires, or other natural disasters in a large region could result in a swift increase in mortgage delinquency and prepayment rates, similar to the current impact of the COVID-19 pandemic.⁶ Recent studies suggest that lenders are passing along riskier mortgages to government-sponsored entities in order to reduce the risk on their own books.⁷ The US government, and accordingly US taxpayers, will ultimately have to pay if these risky mortgages default.⁸ The CFTC identified several financial assets that have significant exposure to climate change impacts, including: mortgages, mortgage-backed securities, government-sponsored enterprise credit risk transfer securities, and real estate investment trusts, among other assets.⁹ Further, estimates place more than half of mortgaged properties at risk of climate-change exacerbated flooding outside of current recognized flood zones, meaning that these properties are at a higher risk of being underinsured and accordingly at higher risk of default.¹⁰

State governments are also considering the impacts of climate change on the financial industry. On October 29, 2020, New York's Department of Financial Services ("DFS") issued guidance providing background information on climate risks and outlining DFS's expectations for regulated financial institutions in New York to manage financial risks from climate change.¹¹ The letter notes that residential homes in New York City with $334 billion of reconstruction value are at high risk of storm surges. In addition, the letter cites a study finding that current climate data show 70% more (14.6 million) properties in the United States are at substantial risk of flooding than the current Federal Emergency Management Agency classification of 8.7 million properties, indicating that these additional properties could have insufficient flood insurance.¹² In response to these impacts, among others, DFS now expects all regulated banking organizations to start integrating the financial risks from climate change into their governance frameworks, risk management processes, and business strategies and to start developing their approach to climate-related financial risk disclosure.¹³ DFS also expects all regulated non-depository financial institutions to conduct a risk assessment of the physical and transition risks of climate change and to start developing strategic plans to mitigate such risks.¹⁴ The agency also noted that it is planning on issuing further guidance on this issue, including integrating climate-related risks into its supervisory process.¹⁵

Mortgage issuers and insurance companies have already started changing their lending and insurance practices regarding environmentally risky properties as a result of these risks. Lenders have virtually refused to mortgage environmentally risky properties worth too much for federal mortgage backers to accept, but have continued making loans secured by similar, lower-priced homes that meet the requirements of government insurers.¹⁶ Lenders then quickly pass the loans, along with their risks of damage, to federal mortgage backers. Similarly, insurers have raised rates or outright refused to provide insurance for properties at high risk for natural disasters.¹⁷ Despite attempts to withdraw policies and raise rates, however, some states have enacted laws and regulations that either subsidize the cost of affordable insurance or provide a state option, called Fair Access to Insurance Requirements Plans.¹⁸ Yet even if there is hazard or flood insurance, it may be insufficient in amount or claims may be rejected or delayed if there are questions of what actually caused the damage during a natural disaster.

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Footnotes

1. CFTC, "Managing Climate Risk in the U.S. Financial System" (Sept. 9, 2020), https://www.cftc.gov/sites/default/files/2020-09/9-9- 20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20- %20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf.

2. Id. at i.

3. Id.

4. Id. at 16-17.

5. Id.

6. Id. at 31.

7. Id.

8. Id.

9. Id.

10. Id. at 36.

11. Letter from Linda A. Lacewell, Superintendent, DFS, to the Chief Executive Officers or Equivalents of New York State Regulated Financial Institutions (Oct. 29, 2020), https://www.dfs.ny.gov/industry_guidance/industry_letters/il20201029_climate_change_financial_risks.

12. Id.

13. Id.

14. Id.

15. Id.

16. Jesse M. Keenan & Jacob T. Bradt, "Underwaterwriting: from theory to empiricism in regional mortgage markets in the U.S.," Climatic Change (June 2020).

17. Abrahm Lustgarten, "How Climate Migration Will Reshape America," New York Times (Sept. 17, 2020).

18. Id. In some instances, state governments have also mandated that residential insurance companies provide relief to policyholders for damages caused by natural disasters. See, e.g., our October 2, 2020, blog post CA Department of Insurance Asks Residential Insurers to Provide Relief to Policyholders Who Suffered Loss in Wildfires authored by Kara Baysinger, Stephanie Duchene, and Philip A. Goldstein, available at https://www.mayerbrown.com/en/perspectives-events/publications/2020/10/ca-department-ofinsurance-asks-residential-insurers-to-provide-relief-to-policyholders-who-suffered-loss-in-wildfires.

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