Why rising home insurance costs have consequences for the trillion dollar structured credit world

Physical climate risk isn't just the insurance industry's problem. The rest of us will end up paying the bill. The question is when.

For many homeowners, their home is their largest asset, their mortgage is their largest liability, and—for some—rising home insurance costs, driven by accelerating climate change, may make hanging onto that home much less affordable.

You can think of this value loss in properties, this repricing, as an early domino in a systemic cascade. A huge part of the financial system that will start reflecting physical climate risk is made up of structured credit, in which assets—mortgages, credit card debt, car payments—are rolled up into pools. Then these assets back up securities, many of which are issued by private actors.

This market, which includes trillions of dollars in mortgage-backed securities and credit-risk transfer bonds, may not yet be fully factoring in how these financial instruments might be affected by physical risks accompanying climate change. That's the central insight from a recent webinar hosted by ICE ("Climate and insurance risk for lenders and securitized investors"), featuring Ben Keys, Dave Burt, and Malea Figgins.

Just as in the subprime mortgage crisis, buried in these structured financial instruments are loans for properties that will likely end up repricing because of climate effects—including, crucially, the skyrocketing costs and increasing unavailability of insurance facing those properties, and the consequent difficulties owners have in selling. Researchers can predict the percentage of borrowers who will likely default on their mortgages in this context, because they have reams of data underlying models forecasting how stressed borrowers behave.

From Zillow, Dec. 17, 2024. Houses for sale in zip code 33950: Punta Gorda, Florida, and the surrounding areas of Charlotte Park, Solana, Acline, and Cleveland. Area was affected by Hurricanes Ian, Helene, and Milton.

These loans—the assets backing the structured credit instruments—will decline in value, leading to losses in tranches (slices) of mortgage-backed securities and credit-risk transfer bonds, particularly on the lower end of the investment-grade scale. Which means the investors who bought these financial instruments, looking for higher-risk but higher-reward places to park their money, will lose as well.

Let's assume you're an investor looking for returns that are higher than Treasury bonds. You see that there are some residential mortgages that have been taken out by borrowers with good credit scores and stable income—so-called "Prime" loans. Inside the pool of these prime loans is a layer of loans that has been assigned a "BBB" rating by a credit rating agency, but the security is still investment-grade. You buy.

You receive periodic payments of interest and principal as the underlying mortgages are paid off, and the return on your money is nearly two percent higher than a comparable Treasury investment. There's a risk involved, sure, but, hey, it's an investment-grade security, it's relatively liquid and safe—and two percent, in this time of narrow spreads, is not nothing.

What you probably don't know, according to Dave Burt of DeltaTerra’s presentation during this webinar, is that his research shows there is a very substantial risk that a substantial slice of those BBB loans (even though they are for well-qualified buyers) will lose at least 10 percent of their value because of climate-driven repricing. Even though the insurance-cost shock won't faze most of those borrowers (because they have resources), after just 2.3 percent of default-driven losses are absorbed by investors in lower-rated tranches your investment will lose value.

You'll be safer if you invested only in AAA-rated mortgage-backed securities. Burt says, though, that although AAA-rated loans for both homes and commercial properties are "pretty well-protected" from these losses, there are some exceptions--if, for example, you're looking at a security backed by a single commercial asset (called a "single asset, single borrower" deal), if that "loan goes sideways, there's only one loan to support the structure." And, he points out, "whenever there's issues [weakness and risk] going on below the stack [in lower-rated tranches of many-layered deals], that can cause significant mark-to-market losses in the near term." In other words, your AAA-rated MBS may be affected by the jolt of climate-driven repricing in the lower-rated ranks that he is predicting.

You'd also be safer if you invested in "non-qualified" mortgage loan-backed securities—loans to borrowers with dodgy credit ratings and income—rated BBB. Why? Because these are structured to require 12.8 percent of default-driven losses to be absorbed by others before your investment is touched. But substantial physical climate risk is lurking inside those "prime 2.0 BBB" loans. Here's Burt's overall chart telling this story:

Ever since the 2008 crisis, individual borrowers have been more deeply scrutinized for their credit-worthiness. But although it's clear that credit risk now includes—or should include—climate risk, it's not clear that this additional element of risk is being integrated by all actors along the chains of financial engineering that are built into the US financial system.

Malea Figgins, a vice president and fixed-income analyst at TCW, said during the webinar that "integrating climate risk is just good risk management as fiduciaries of our clients' capital." Figgins said other MBS research (she didn't name the source) that came out after Hurricane Helene looked only at disaster-caused damage. Usual methods of assessing risk in secured credit instruments look at immediate risks like hurricanes, and don't take into account long term climate risk caused by the gradual impacts of flooding and wildfire. That's what the DeltaTerra research does, in Figgins's view.

Figgins also pointed out that it is not just mortgage-backed securities that will be affected by physical climate risks. "Personal loans, credit cards, card payments, all of these get securitized" into asset-backed securities, and extreme weather may affect a borrower's repayment of these loans, she said.

Systemically, this matters in the same way that the securitization of subprime mortgages mattered to the 2008 financial crisis. It was the softness of tranches of rotten loans contained within bundles of mortgage-backed securities, and the bets that had been made against those loans, that led to the meltdown. When these bets suddenly had to be paid off, there was a sudden liquidity crisis that froze financial systems around the world.

But the bettors, the people who bought protection against the collapse of these securities, did not create the crisis. The underlying fundamentals of loans were mispriced because credit risk—at that point, the credit risk of borrowers—was not being taken into account by the housing finance system. Now that credit risk includes physical climate risk to properties.

Borrowers in climate-pummeled regions who have low-interest mortgages will want to hold onto those loans, Ben Keys pointed out during the webinar, and early retirees who recently bought in risky areas may want to keep their options open, believing there could be another COVID-work-from-home uptick in home values. “How does this market actually realize the losses and over what timescale?” Keys asks.

That’s the key question for much of our financial system.