During the Trump administration, Fannie Mae and Freddie Mac appeared to studiously avoid weighing in on the potential effects of climate change on the value of their more than $7 trillion of securitized mortgages.
After all, the former president was a well known climate skeptic and the GSEs perhaps wanted to avoid his ire, especially as expressed on his favorite social media weapon, Twitter.
But it’s a new day, a new dawn and a new administration in Washington.
So, early in 2021, the GSEs wasted no time in putting out an all points climate SOS, asking all and sundry to pass along any information and analysis they might have on climate and the mortgage market in general. But most importantly, climate as it relates to Fannie and Freddie’s mortgage portfolios specifically.
One response stands out, and not just because of its stark climate warning, but also because of the report’s author and the outsized and famous role he and colleagues played in the mortgage finance crisis of 2008, a crisis in which the GSEs, of course, also had an outsize role.
Featured prominently in “The Big Short,” the film in part told the story of how David Burt and his colleagues at Cornwall Capital – Burt was a consultant to Cornwall – warned in 2008 that the residential mortgage market was a tsunami waiting to happen. It fell on deaf ears.
Burt and company, though, put their money where their mouths were, making out when the mortgage market eventually did implode, almost taking the world’s financial system down with it. And now, through his DeltaTerra Capital, a research house, Burt has again been eyeing the housing market, this time through a different lens: climate change.
Burt is warning of a climate driven mortgage mispricing event, an event that he says approaches the 2008 residential mortgage disaster in its scale, estimating losses could be two-thirds as large.
The mispricing risk
“My decision to step away from fixed income portfolio management and form DeltaTerra was driven by my team’s previous research into deep real estate mispricing issues related to climate risk,” Burt explains in the introductory missive to DeltaTerra’s response to the climate SOS.
“The mispricing issues have continued to grow as structural inefficiencies and poorly aligned incentives have confounded rational pricing mechanisms for the increased risk of property damage as the climate warms.”
Amine Ouazad, assistant professor of economics at management education specialist HEC Montreal, pointed out just one way poorly aligned incentives work against Fannie and Freddie, and the taxpayer, when it comes to contributing to increased risk in the GSEs mortgage portfolios.
Banks can use the GSEs as, basically, a substutute for flood insurance, Ouazad said, because banks can always exercise the option of selling their high climate risk mortgages – the mortgages that are most exposed to climate change, in this case flooding – to Freddie Mac or Fannie Mae, he says.
Primarily because their core mission – established in 1930s New Deal legislation creating the GSEs – is to expand homeownership, Fannie and Freddie cannot factor disaster [climate] related risk, for instance living in a flood zone, into their mortgage pricing in the way that the commercial banks originating these loans can, according to Ouazad.
Ouazad says there are ways to address the mispricing arising out of poorly aligned incentives surrounding the way the GSEs do business, such as the one described above. But unless mounting mispricing is addressed, like increasing securitization fees to compensate for additional risk, mispricing of up to $100 billion a year in coastal properties, for example, will continue, he says.
This will effect the financial stability of the GSEs, he says.
The Klima Model
Over the last two years, Burt, his colleagues and partnering firms have been building a new analytical framework, the “Klima” model, to measure climate risk and the extent of the residential mortgage climate mispricing.
DeltaTerra’s Klima work draws heavily from the insights of their climate services partner, risQ and their sister geospatial real estate analytics firm, Level11, DeltaTerra explains in its report, one of almost 60 DeltaTerra says were submitted to the FHFA and the GSEs in response to the climate data SOS, or the Request for Input, RFI.
RisQ and Level11 principal Chris Hartshorn said Burt’s reputation preceded him, particularly as word spread about DeltaTerra’s search to quantify the extent that ignorance about climate change might lead to a significant mortgage market mispricing event. So, Hartshorn approached Burt with the idea that risQ and Level11 and DeltaTerra’s efforts might be complementary – suggesting a collaboration, which became a commercial partnership.
RisQ and Level11, which have subsisted on grants until recently, have 15 clients, including names like financial information powerhouse Intercontinental Exchange.
The way Hartshorn explains the Klima model buildout, the entirety of the map of the U.S. was sliced up into roughly football field sized grid chunks. Data was pulled from myriad public sources on demographics like income and on things like historical housing price data among many, many other things.
Then came the hard, labor intensive and highly proprietary task of identifying each loan in the more than $7 trillion of mortgages contained in myriad GSE securitized MBS pools, refining the location and characteristics of millions of individual housing loans whose credit risk is backstopped, through the GSEs, by the U.S. taxpayer in securitized MBS pools.
The upshot, according to DeltaTerra and Hartshorn, is that Klima’s database covers micro data on over 80% of individual mortgages that are securitized in GSE MBS pools, linking that micro data to the macro data pulled from public sources and to the proprietary climate change model embedded in Klima.
Signaling abrupt repricing
DeltaTerra’s Klima model is signaling an “abrupt repricing [very likely in the near future] of real estate properties exposed to acute natural hazards,” and DeltaTerra warns that climate is the most dangerous risk factor the single family mortgage market and the GSE mortgage portfolios currently face.
Klima examines “acute natural hazards” such as wildfires, inland and coastal flooding, as well as greater frequency of extreme weather events, and concludes that large numbers of residential mortgages are in need of “rational repricing” because of failure to properly account for climate change.
Such a repricing, for example just from flood and wildfire alone, would wipe out as much as $1.9 trillion in real estate value from high climate at risk properties, the effects to begin to be felt over the next two years with market adjustment continuing to work out over a period of perhaps ten years, according to Klima.
A bailout number
In the aggregate, the climate-driven mortgage mispricing will approach the 2008 disaster in its scale, with losses possibly two-thirds as large, DeltaTerra estimates. The “cost” of the 2008 Fannie and Freddie “bailouts” was $189 billion.
Those terms – “cost” and “bailout” – were more often than not used by the press at the time to describe what was really in effect an acquisition, a $189 billion acquisition of the GSEs’ mortgage portfolios by the newly created Federal Housing Finance Authority, FHFA, itself created by Congress to manage the federal government’s “conservatorship” of the GSEs.
The upshot is that the federal government now controls the GSEs, even going so far in recent years as to unilaterally “sweep” GSE books and deposit the proceeds at the Treasury.
A week ago, in a complete victory for the federal government, the Supreme Court ruled that the federal government had the right to “sweep” GSE books and that the five-year term of the FHFA chief is at the discretion of the president, striking down the part of law creating the FHFA that stipulated once an FHFA chief is appointed his five year term cannot be interrupted, not even by the president.
The FHFA acquired the conservatorship of GSE mortgage portfolios at the point of uppermost panic as markets melted down in 2008, so it should come as no surprise that what was widely characterized at the time as a disaster for the taxpayer – thus “cost” and “bailout” – was in reality a financial bonanza.
As it turns out, $189 billion was one of the great bargains of the age. So far in the course of FHFA’s conservatorship, the GSEs have thrown off annual free cash in aggregate totaling a multiple of that $189 billion.
Thus, the GSEs appear to be relatively well capitalized as they face waves of climate driven mortgage repricings. DeltaTerra agrees, pointing out, however, that as climate increasingly stresses the mortgage markets they will be less able to deal with any unforeseen stressor events in the future.
