Why it could be important to include rapidly accelerating climate risks in Fannie Mae and Freddie Mac's "sustainable housing" mission

"We need to harden our financial institutions"

From May 2022

As torrential rain pummels South Florida this week, let's take a moment to remember this month’s Senate Budget Committee hearing ("Riskier Business: How Climate is Already Challenging Insurance Markets"). 

During the hearing, Prof. Ishita Sen (whose co-authored paper about credit ratings of insurers I wrote about a few weeks ago) said:

"We need to stop subsidizing building in risky areas...Not only do we need to harden our homes, but we also need to harden our financial institutions, our banks, and our insurance companies in order to make them withstand really large climate shocks that are for sure coming their way."

To the extent areas of increased climate risk may be reflected in pockets of repriced real estate in the US, those pockets have the potential to infect other areas of our financial system. After all, it was foreclosures in Las Vegas, Phoenix, and a handful of other locations that led to a cascade of global effects in 2008. (You can think of insurance companies as leading the way to "hardening" by repricing their products: Today, Oklahomans confronting severe thunderstorms, hailstorms, and tornadoes face some of the highest home insurance costs in the country.) 

If we wanted to steadily, prudently reduce risks to homeowners in America that are being caused by out-of-date building codes, inadequate land-use policies, and under-capitalized insurers, one possible area to examine would be the rules that Fannie Mae and Freddie Mac use to screen the mortgages they agree to guarantee. Using this power wisely has the potential to affect much of the housing market, because these Government Sponsored Enterprises (GSEs) support about 70 percent of the mortgage market (as of 2023, according to the National Association of Realtors).

To its great credit, the Federal Housing Finance Agency (FHFA), set up by Congress after the 2008 crisis with extraordinarily broad powers to run the GSEs “with all the powers of the shareholders, the directors, and the officers,”* has made clear by its actions and statements that it is aware of climate risks—just look at the major meetings it keeps holding about the insurance industry and the economic risks of climate change generally.

But even though the FHFA arguably has the legal authority to do it, changing the GSEs' rules won't be easy. There are difficult tradeoffs involved. 

Henry Lu, a joint HBS/HLS student who took a course with me this past term, wrote a terrific paper (one I hope he publishes soon so I can link to it) titled "The Role of the Federal Housing Finance Agency (FHFA) to Reduce Systematic Mortgage Risk and Improve Homeowner Climate Resiliency." He's got a list of proposed reforms—and when I can link to the paper I'll explore each suggestion in turn.

In the meantime, here's a question that could frame a mission-driven focus on adaptation risks: What does "sustainable housing" mean?

The FHFA's mission is to make sure the GSEs fulfill their mission "by operating in a safe and sound manner to serve as a reliable source of liquidity for equitable and sustainable housing finance and community investment throughout the economic cycle." That language of "sustainability," sprinkled throughout the FHFA's most recent "Housing Mission Report," so far has meant affordable and available housing for both owners and renters, as far as I can tell.

There are a host of challenges to this mission already. Interest rates are high, housing stock is in short supply, and prices are climbing, 

But doesn't "sustainable" housing connote lower-risk housing? Housing covered by adequate insurance (issued by adequately capitalized insurers) that the buyer can afford to pay for over decades? Housing built according to codes that take the next few decades of climate change into account? Housing built well away from riverine or coastal flooding? Housing that is energy-efficient, so that spiraling energy bills don't drive residents to default on their loans? Absent this kind of "sustainable" planning, there could be more defaults that could end up on the GSEs' balance sheet—which could affect their safety and soundness.** At the least, such planning would help focus attention on the risks to housing posed by accelerating climate change.

The timelines here are difficult and perhaps impossible. Home insurers reprice their products yearly, making it difficult to for the GSEs' processes to predict whether particular homeowners will be able to afford insurance over the long term. Enforcing modern building codes as a requirement for guaranteeing a mortgage would govern only newly-originated mortgages, not existing loans.*** Accurately pricing true physical climate risk, upfront, into mortgage costs would be fiendishly difficult and might introduce new forms of unfairness into home markets that are already extremely difficult.

The immediate reaction to this kind of planning is that it makes housing more expensive. (When the FHFA mused about considering updated building codes, the National Association of Home Builders said exactly that.)

But is a house or rental unit truly affordable, truly "sustainable," if the weather coming at it over the next few decades hasn't been taken into account?

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*This is all from the Housing and Economic Reform Act (HERA), at 12 U.S.C. § 4617(b)(2)(B). The FHFA also has rulemaking authority. As long as what FHFA does is within the lawful scope of what the GSEs are allowed to do, no court can second-guess these actions. As Mr. Lu's paper informs me: "12 U.S.C. § 4617(f) declares 'no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator or a receiver,' effectively preventing any judicial challenge so long as 'the Agency’s action is a lawful exercise of its authority as conservator of the Enterprises.'"

**HERA was an amendment to The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, and the FHFA is supposed to "regulate the GSEs for prudential safety and soundness."

***And even if updated housing code adherence is required, it’s tough to ascertain in a standardized manner whether it is actually happening. Inspectors need to be trained and certification protocols need to be established in order for the GSEs to take in this information in a useful, coherent way.