"It's like two mortgages"

Why rapidly rising insurance costs are making some mortgages potentially toxic for our entire financial system, and what to do about it

At the heart of the Great Financial Crisis in the fall of 2008 was the collapse of a housing bubble that was driven by toxic mortgages. Lenders like Countrywide and Indymac made loans with exotic terms to people who didn't understand what they were getting into. No downpayment! Pay when you can! The banks didn't care because they immediately packaged up the loans into securities and sold them to Wall Street. When a cascade of foreclosures hit, trillions of dollars in toxic loans that had been embedded throughout the financial system by way of those securities caused a meltdown. The whole thing was avoidable, but no one in the private sector had an incentive to slow the machine and the regulators failed to act.

Today, existing mortgages for homes in areas that are threatened by rising waters and wildfire were handed out, overwhelmingly by nonbanks (which are subject to little oversight), to people who probably didn't understand what they were getting into. In particular, they may not have understood that their property insurance costs might climb steeply. 

Regulators at the federal level could lower systemic risks by looking more carefully at climate data and refusing to allow Fannie Mae and Freddie Mac to soak up mortgages from too-risky areas where they can already tell buyers won't be able to afford homeownership in the future. But stopping the circus will have a big effect on lower-income would-be homeowners living in those areas.

The solution? Face the risks and plan now for multi-year transition processes. Ripping off the band-aid will be very painful, but will avoid far greater misery later on.

The hidden costs of homeownership. Nicole Friedman of the Wall Street Journal wrote about the climate-driven hidden costs of homeownership a couple of weeks ago, quoting an anguished owner in New Orleans who is struggling with high-cost wind and hail insurance. His monthly payment for insurance and taxes is now higher than his principal and interest payment for his mortgage. "'It's kind of like having two mortgages in one,'" he said. 

Remember the operatic drama of Lee County, FL, I wrote about last week, where local officials are decrying the "hostage-taking" and "revenge politics" of federal increases in flood insurance rates? In May 2021, investment research and consulting firm DeltaTerra told the Federal Housing Finance Agency that Lee County, which includes Ft. Myers and Cape Coral, was the metro area with the highest, concentrated risk of a swift real-estate repricing in the whole country. It had high flood risk, a big insurance gap, and home prices there weren't yet reflecting those realities. Well, Hurricane Ian hit in September 2022, and Lee County was deeply affected. 

Then Florida said that, as of this year, anyone who wants to buy insurance from Citizens, the state's insurer of last resort (which itself is a thicket of concentrated risk, because it's promising thin payouts to the riskiest properties in the state), also has to buy flood insurance. 

Imagine you're a homeowner of modest means in Ft. Myers. Maybe you're outside an official flood zone, so when you got your mortgage you didn't have to buy flood insurance. You can't find anyone to sell you ordinary property insurance, because regular insurance companies are fleeing, so you have to buy from Citizens. And then you suddenly learn that, on top of that, you have to spend $10,000 on federal flood insurance. You're a new federal flood insurance customer, so you're not grandfathered into any slow transition to more realistic rates. You have to pay those more realistic rates right away. 

You try to sell your house, but it sits on the market and you can't stay afloat financially. Maybe you default on your loan. Maybe you walk away. Now multiply this kind of scenario many times over. 

Many of these loans are toxic. They're toxic for reasons different from the risky pre-2008 loans were, but the effect is the same: They're creating risks at all levels. Unlike the 2008 crisis, the houses on which these loans are written will never fully bounce back. Their value has likely been permanently reduced. The pipeline of available homes in risky areas—say 20 percent of the country—is becoming full and stagnant. We saw this same kind of signal in the lead-up to the 2008 crisis. Importantly, these loans are actually creating risks for would-be homeowners whose credit ratings and lives will be ruined when paying to stay in these homes becomes impossible. 

This isn't an insurance crisis. It's a "maybe the risks are too high to make homeownership affordable" crisis. It's a "homes are flooding and burning to the ground" crisis. 

Who's in charge? We may be facing a series of mini financial crises in pockets of risky real estate around the country (likely replicated around the world—more on that later) as markets reset to reflect actual risks. The banks have no real incentive to call the circus to a halt, because they sell their loans to Fannie Mae and Freddie Mac (nickname for those two: the Enterprises.) The Enterprises hold about $7 trillion of the $13 trillion in mortgages that are outstanding in America. Result: a ton of risk sitting on federal books. Some of that risk is now shared with the private sector in the form of "credit risk transfer" bonds (CRTs), which I've written about before.

So why haven't the signals of climate risk at local levels mounted up into a loud, blaring alarm horn at the federal level? Why are the thresholds the Enterprises use for ingesting loans staying the same? What's disciplining this entire story? 

Pre-2008, the idea was that markets would discipline mortgages. Banks would be wary of lending money to people who couldn't pay them back. Fannie Mae and Freddie Mac themselves were publicly-owned, non-governmental companies, formed in the mid-1930s to facilitate a national mortgage market. They were accountable to actual shareholders, which arguably made them leery of risks. 

Since 2008, the Enterprises been in conservatorship, and the Federal Housing Finance Agency (FHFA) tells them what to do.* They are effectively public entities. So their discipline has to come from the FHFA. It doesn't look as if the CRT market is providing much of a constraint; investors love CRTs, and they cover just about $2 trillion of the $13 trillion market.

Credit standards have been tightened at the Enterprise level, so the people down the chain getting mortgages are better credit risks these days. If the FHFA moves to change the threshold for climate risks, its acts may be perceived as redlining all over again, because lower-income neighborhoods are, as you probably know, disproportionately exposed to climate issues. 

This is quite a puzzle. But it's one that has to be solved. We can't afford to repeat the crisis of 2008. Surely we know better. At the least, we should stop handing out mortgages to people who a few years from now will not be able to afford them.

*Under the Housing and Economic Recovery Act of 2008, the FHFA as conservator is allowed to “operate” the Enterprises “with all the powers of the[ir] shareholders, [] directors, and [] officers,” and to “conduct all business” of the Enterprises—including by “transfer[ring] or sell[ing] any asset[s] or liabilit[ies]” and “perform[ing] all functions” of the Enterprises “in the name of” the Enterprises. Additionally, “by regulation or order,” FHFA may “provide for the exercise of any function by any stockholder, director, or officer” of the Enterprises. The Department of the Treasury is the main shareholder in the Enterprises and keeps them solvent.