Who ends up holding the bag when risky real estate markets collapse?

Ask the guy who predicted the Big Short

Dave Burt is worth listening to. Dave Burt was profiled by Michael Lewis in The Big Short because he "made millions off the subprime mortgage crisis." Burt saw then that synthetic securities based on tranches of mortgages were loaded up with junk that the market was not pricing correctly. By betting that the market would eventually wise up—by shorting those securities—Burt made an enormous amount of money.

Late last year, Burt's company, DeltaTerra Capital, announced a partnership with ICE, the financial powerhouse running the NYSE that also sells risk and data management products to investors. Burt and his ICE colleagues now see similar stripes of mispriced, little-understood risk running through municipal bond funds and mortgage-backed securities. Why? Because these debt-derived, abstracted instruments are failing to take even modest amounts of climate risk adequately into account.

"There's going to be plenty of big winners and losers along the way," Burt said in a recent public webinar, as the market gradually and then quickly wakes up to reality. He should know.

Burt's enthusiasm radiates off the screen as he talks about his work. He and ICE have something to sell to traders, credit analysts, and portfolio managers: a screening tool, based on bottom-up high-resolution climate data plus a host of credit analysis metrics, that will help investors in debt markets evaluate the climate-riskiness of their bids.

Burt calls the offering the "Klima Discount Factor" or "the Klima model" for short. Could be Greek, could be German; authoritative and katchy. He's been working on this for years. I can’t read his mind, but I imagine he’s trying to convey that the structural mispricing he’s focused on creates money-making opportunities for investors. I don’t think what Burt is doing is malign. Not one bit. He’s just telling the truth, using good data, to people who may be willing to pay for his insights.

The insurance industry is not leading the way. A part of ICE, formerly called "risq," tried to sell similar insights into the insurance/reinsurance marketplace a few years ago. Surely, ICE/risq thought, insurers recognize that climate change is real and want to have the capacity to price it into their financial models. But ICE couldn't make these sales as a structural matter. Why? Because the entire ecosystem of insurers and reinsurance companies uses existing computer models (called “catastrophe models” for short, or cat models) to make one-year-at-a-time decisions. Premiums get repriced annually. Reinsurers exit annually. No one has an incentive to care about how a portfolio of holdings will behave ten years from now. Without that structural incentive, there wasn't an appetite to pay for the screening products that could make those ten-year predictions far more accurate.

ICE says that this is why the "insurance gap," the difference between the total economic losses caused by various risks and the amount of those losses covered by insurance, is so huge in the US. The risks of extreme weather, those long fat tails of low-probability but high-loss events, aren't being adequately captured by the catastrophe models used by the insurance industry, which rely heavily on historical data to predict future events. The gap was up to $66 billion as of 2020 in the US, when we were just getting started.

ICE and DeltaTerra want to tell securities investors about risks. "Someone has to be holding the bag," Evan Korda of ICE said during that recent public presentation. Those losses will eventually be reflected somewhere in the world of financial instruments, and surely the people in that securitized area will be interested in having better information so they can get ahead of the market—as Burt did in 2008. Korda, the Senior Director of Sustainable Finance at ICE and his colleagues "followed the money," in Korda’s words, which led them to focus on the US mortgage market, mortgage-backed securities, and municipal bonds guaranteed by tax payments supposedly coming in the future from property-owners.

In those marketplaces, where mortgages last for 30 years and bonds usually mature in 10, there is (or should be) an appetite for long-range forecasting of risks. ICE is now selling modeling insights that are like the catastrophe models the insurance industry uses, but more richly evolved to take into account future fine-grained climate risks and adapted to fit the markets for structured credit based on real estate: muni bonds and MBSs.

Muni bonds and mortgages depend on a stable world. Those debts, the bonds and the mortgages, are backed up by profound assumptions that the world is basically a stable and predictable place. They exist and are invested in because their buyers believe that a home will stay in place and soldier on, that the people who own that home will keep paying taxes, and that securities spun off from those holdings can depend on those qualities. But where there is mispricing, Burt knows, there is the opportunity to bet against a temporarily blind marketplace: when all is revealed to those slower on the uptake, your bets will be in place and they will make you rich.

Because if you're really looking at what even modestly-tuned climate models say and if you remember how credit crises have played out in the past—the Great Recession of 2008, the S&L crisis of the 80s—you know deep in your bones, as Dave Burt does, that the stability on which these markets are based could be totally upended by climate either in the near term or, very likely, in the long term, and that someday everyone will figure that out.

Correlations are sending signals. Two things are already happening that signal to ICE the crash, the rapid come-to-Jesus boy-these-mortgages-are-risky moment, is coming. First, they're already seeing a link between physical climate risk and mortgage market fundamentals: Between 2012 and 2020, home prices appreciated less, or more weakly, after accounting for regional trends, affluence, and population density, in counties where physical climate risks (according to the Klima model) were higher. Discounts in home price appreciation clearly matter a lot to the property values that now underlie both the real estate market and the muni bond market.

Second, they have seen a strong correlation between physical climate risk and mortgage delinquency between 2006 and 2018, after controlling for all the things you'd look at when deciding whether to issue a mortgage in the first place. In the riskiest places, delinquency rates during that period were three times higher than baseline rates in other places. That's a powerful indicator that reality is already starting to catch up with the real estate marketplace.

Burt says that insurance issues are an even bigger threat to real-estate-based-debt than weak price appreciation and mortgage defaults are. For one thing, rising insurance premiums (or the departures of insurers altogether) are hitting homeowners nationwide, not just in Florida and California, and they drive big systemic weaknesses into real estate markets: current and future owners stop being able to afford houses; entire areas become less desirable; and defaults and write-downs infect the entire securitized marketplace (including municipal bonds).

ICE and Burt have a screen to sell. Using his Klima model, Burt says he can score bonds and securities using "base" (mid-range) and "bear" (worse) IPCC climate predictions plus a bunch of other very-high-resolution factors and insights. These insights will allow investors evaluating muni bonds and mortgage-backed securities to estimate and dis-aggregate their real climate risks—so if, say, a pool of real-estate related securities actually includes a single very-climate-challenged property that accounts for a significant part of the deal, investors will be able to see that risk.

In Burt's words, this can be "a quick check to avoid the landmine of insurance shocks [sudden increases in premiums, or the uninsurability of property] that are probably coming from one of those deals that are otherwise kind of invisible." To the mainstream market right now, these risks are largely unseen—just as the mis-rated, misunderstood, excessively-speculated-in risks in CDOs were unseen until they essentially toppled the global economy back in 2008.

When is the tipping point? How soon does this brittle structure give way? When do prices become real? Burt sounds magisterial. He's been through this credit devaluation cycle before, both in 2008 and by studying the late-1980s S&L crisis:

So right about now, you're starting to see it in [real estate] prices. And then there's going to be a little bit of a lag between price declines and mortgage defaults.... It's about five years once you start having those price moves before that's worked out [prices reflect the true risks]. But usually by actually two years into that five-year transition, the market's way onto the fact that those losses are coming. So I'd say a couple of years for this to play out in credit markets. Five years for it to play out on Main Street before it starts recovering.

That's all pretty soon: 2025 or 2026 is when things give way and it becomes very difficult to offload houses and buildings in risky places where mortgages are suddenly hard to get, much less insurance.

I bet you never heard of CDOs (Collateralized Debt Obligations) until you saw the movie.

Dave Burt is talking to people who deal in CRTs (Credit Risk Transfers), CMBSs (Commercial Mortgage Backed Securities), and Non-Agency RMBSs (Residential Mortgage-Backed Securities issued by private financial institutions rather than Fannie Mae or Freddie Mac). You haven't heard of those yet either. You will. I'll write about them soon. You probably don't know much about municipal bonds and the high-net-worth market they serve. (Here's what I wrote about munis last year.) Burt and ICE are planning to assist investors in shorting or simply avoiding climate-related-risks hidden in all these acronyms while continuing to invest.

Take a breath. At the moment, few people on Main Street, the people who actually own the real estate on which these exotic financial instruments are built, are aware of what's ahead. That's almost everyone.

They are likely to be the losers.