luistaker94
New Member
John Macomber, a senior lecturer in the finance unit at Harvard Business School, believes we may be on the verge of a collapse in housing prices and an ensuing financial crisis — this time caused by our failure to acknowledge and confront climate change. In a phone interview and a written email exchange, he shared his reasoning and what the incoming Biden administration can do to prevent this scenario.
You’ve been warning for years that America’s housing market has been ignoring the risk of perils associated with climate change. Do you believe we are approaching a correction?
Yes. Damage from climate change has accelerated faster than many people anticipated. In USA in 2020, there were 16 weather/climate disaster events with losses exceeding $1 billion each (some much larger). The average from 2015 to 2019 was 13.8 such events. The average for the 40 years prior to 2020 was 6.6. What’s more, we are seeing risks we didn’t foresee just a few years ago. We’ve been rightly worried about coastal flooding from sea-level rise but in the last several years there’s also been an increase in river flooding from rain and huge damage from wildfires.
Among other issues, we haven’t faced the tough question of whether people should be restricted from building or rebuilding in these places that are, in the example of California, natural fire corridors that have been recognized for centuries. Instead, in California we’ve required utilities to bring power to homes in these dangerous areas, and now the state is mandating that insurance companies renew fire policies at below-market rates. Similarly, in parts of the east coast, private insurers have long since exited the homeowner flood risk market and instead the coverage is provided with deeply subsidized premiums by state agencies relying on the National Flood Insurance Program.
This is a classic market distortion.
Indeed. It encourages people to make or maintain housing investments that are exposed to more danger than they realize. For now, governmental entities absorb the extra cost of these risks when they repair or rebuild these homes (using the tax receipts from other property owners, by the way).
Insuring, repairing, and rebuilding properties that really are uninsurable has artificially inflated home prices by papering over this risk pricing gap. In the short run many parties benefit from propping up housing prices, but with increased exposure to peril and further tightening of government budgets this cash-hemorrhaging system cannot endure. The question is whether it’s going to settle out slowly or settle out fast. My concern is that all of a sudden it just snaps and there’s this giant reset that leads to a real disruption in housing prices.
Take us through that scenario.
The optimistic scenario is that a gradual sea level rise or a slight increase in fires will lead to gradual declines (or relatively slower appreciation) in house prices. The broader system has time to adjust.
The greater worry is that insurance premium support will suddenly dry up, and at the same time mortgage underwriters will start to factor in the substantial danger of these exposures. The result will be a dramatic consequent rise in insurance premiums, coupled with a reduction in mortgage loan-to-value ratios (and at worst the complete inability to buy fire and flood insurance at all, or to refinance a mortgage). Housing prices will plummet in these areas. For many homeowners the equity in their property is their biggest asset. It’s a real problem if that asset declines in value or even goes negative (if you owe more on your house than its risk-adjusted value).
This scenario will result in a second circle of trouble. Most American municipalities get the bulk of their revenue from property taxes. Property taxes are tied to the value of homes and commercial real estate. If home values fall, then property tax receipts fall without a simultaneous reduction in a city or town’s expenses, so their ability to service their municipal bonds becomes imperiled. That could lead to the ratings of the bonds being downgraded. That puts cities and towns under cost-cutting pressure, which then leads to other stresses on government services. It also increases their cost of borrowing, with both factors leading to a downward spiral.
A knock-on effect will be a potential decline in the ratings and value of certain bonds. Tax-advantaged fixed-income instruments, such as municipal bonds, are a big part of many people’s retirement portfolios (and many insurance companies’ reserves). I argue, then, that this aspect of climate risk touches everyone’s pocketbook.
The 2008 correction in housing prices spread throughout the financial system. Is there concern this could happen again?
Yes. You won’t be surprised to hear that the really dangerous amplification is from algorithms and risk transfer in sophisticated financial products. Homeowners buy their property/casualty and fire/flood insurance policies through brand-name companies, such as Allstate or Progressive. But these companies often don’t retain all of the exposure to pay for loss events. In particular, they don’t mind being exposed if say one house burns down – the other premiums collected cover that cost.
But if an entire county or part of a state gets hit hard by a hurricane, they can’t cover losses to all of those homes on their own. They often contract, in bulk, with another tier of insurers called reinsurance companies. These firms include giant but lesser-known companies like Swiss Re, Munich Re, and General Re. Those international firms attempt to spread their exposure across the globe and across many categories of peril like tornado, hurricane, earthquake, wind, and flood.
In addition to diversifying the risks, the reinsurers also can slice off some of the risk into insurance-linked securities — including weather derivatives sometimes known as “catastrophe bonds.” The probability of an event happening and the likely cost of the event are rated by several specialty companies then bought and sold by financial investors — who have zero knowledge of or interest in your particular home or city — who can be paid to accept financial exposure of a defined nature for a fixed period of time in the event that one of the named events occurs.
This means we have a situation where whoever is buying or selling the risk is multiple steps away from the actual property. Sound familiar? It’s hard to gauge how far these instruments have spread into the financial system.
This sounds a lot like the financial weapons of mass destruction, such as the securitized instruments that were traded before the 2008 crash. What about rating agencies? Are they doing a better job of independently assessing risk?
In this instance, the entities which evaluate insurance-linked securities (and most of the reinsurance companies that trade them) all have proprietary systems for assessing various risks and exposure in the broader insurance market. Some like RMS and AIR have been modeling not only flood, earthquake, and tornado risk for years, but also perils like terrorist attacks and pandemics. Others like Jupiter and 427 focus on potential weather incidents, like wildfire, flood, sea rise, and drought.
One problem is that the inputs are not agreed. There is not consensus, at least in the United States, about existing flood risk even independent of sea-level rise, never mind about potential future rise. A second concern is that there also is not consensus about how to model what might happen. The third concern, and in my view most unnerving, is that these firms’ projections are proprietary. Modelers and the financiers that they service know more about the prospects for my property than I do. I find this information asymmetry to be worrying. Who is going to come out on the short end of the stick here?
The well-known credit rating agencies, like Moody’s, S&P, and Fitch, are behind the curve right now because they tend to focus on financial ratios, like debt service coverage and loan to value. For decades the natural disaster exposures of homes, municipal buildings, and power plants was static, and history of past loss was a very good guide to future loss. That guide is no longer reliable. That adjusted thought process will need to propagate through the industry as well, and that could change a lot of AAA bonds to BB+ and once more percolate down into collateral and swaps, as it did a decade ago — again touching many people who don’t live anywhere near the problem geographies and don’t even invest beyond their 401(k).
You’ve been warning for years that America’s housing market has been ignoring the risk of perils associated with climate change. Do you believe we are approaching a correction?
Yes. Damage from climate change has accelerated faster than many people anticipated. In USA in 2020, there were 16 weather/climate disaster events with losses exceeding $1 billion each (some much larger). The average from 2015 to 2019 was 13.8 such events. The average for the 40 years prior to 2020 was 6.6. What’s more, we are seeing risks we didn’t foresee just a few years ago. We’ve been rightly worried about coastal flooding from sea-level rise but in the last several years there’s also been an increase in river flooding from rain and huge damage from wildfires.
Among other issues, we haven’t faced the tough question of whether people should be restricted from building or rebuilding in these places that are, in the example of California, natural fire corridors that have been recognized for centuries. Instead, in California we’ve required utilities to bring power to homes in these dangerous areas, and now the state is mandating that insurance companies renew fire policies at below-market rates. Similarly, in parts of the east coast, private insurers have long since exited the homeowner flood risk market and instead the coverage is provided with deeply subsidized premiums by state agencies relying on the National Flood Insurance Program.
This is a classic market distortion.
Indeed. It encourages people to make or maintain housing investments that are exposed to more danger than they realize. For now, governmental entities absorb the extra cost of these risks when they repair or rebuild these homes (using the tax receipts from other property owners, by the way).
Insuring, repairing, and rebuilding properties that really are uninsurable has artificially inflated home prices by papering over this risk pricing gap. In the short run many parties benefit from propping up housing prices, but with increased exposure to peril and further tightening of government budgets this cash-hemorrhaging system cannot endure. The question is whether it’s going to settle out slowly or settle out fast. My concern is that all of a sudden it just snaps and there’s this giant reset that leads to a real disruption in housing prices.
Take us through that scenario.
The optimistic scenario is that a gradual sea level rise or a slight increase in fires will lead to gradual declines (or relatively slower appreciation) in house prices. The broader system has time to adjust.
The greater worry is that insurance premium support will suddenly dry up, and at the same time mortgage underwriters will start to factor in the substantial danger of these exposures. The result will be a dramatic consequent rise in insurance premiums, coupled with a reduction in mortgage loan-to-value ratios (and at worst the complete inability to buy fire and flood insurance at all, or to refinance a mortgage). Housing prices will plummet in these areas. For many homeowners the equity in their property is their biggest asset. It’s a real problem if that asset declines in value or even goes negative (if you owe more on your house than its risk-adjusted value).
This scenario will result in a second circle of trouble. Most American municipalities get the bulk of their revenue from property taxes. Property taxes are tied to the value of homes and commercial real estate. If home values fall, then property tax receipts fall without a simultaneous reduction in a city or town’s expenses, so their ability to service their municipal bonds becomes imperiled. That could lead to the ratings of the bonds being downgraded. That puts cities and towns under cost-cutting pressure, which then leads to other stresses on government services. It also increases their cost of borrowing, with both factors leading to a downward spiral.
A knock-on effect will be a potential decline in the ratings and value of certain bonds. Tax-advantaged fixed-income instruments, such as municipal bonds, are a big part of many people’s retirement portfolios (and many insurance companies’ reserves). I argue, then, that this aspect of climate risk touches everyone’s pocketbook.
The 2008 correction in housing prices spread throughout the financial system. Is there concern this could happen again?
Yes. You won’t be surprised to hear that the really dangerous amplification is from algorithms and risk transfer in sophisticated financial products. Homeowners buy their property/casualty and fire/flood insurance policies through brand-name companies, such as Allstate or Progressive. But these companies often don’t retain all of the exposure to pay for loss events. In particular, they don’t mind being exposed if say one house burns down – the other premiums collected cover that cost.
But if an entire county or part of a state gets hit hard by a hurricane, they can’t cover losses to all of those homes on their own. They often contract, in bulk, with another tier of insurers called reinsurance companies. These firms include giant but lesser-known companies like Swiss Re, Munich Re, and General Re. Those international firms attempt to spread their exposure across the globe and across many categories of peril like tornado, hurricane, earthquake, wind, and flood.
In addition to diversifying the risks, the reinsurers also can slice off some of the risk into insurance-linked securities — including weather derivatives sometimes known as “catastrophe bonds.” The probability of an event happening and the likely cost of the event are rated by several specialty companies then bought and sold by financial investors — who have zero knowledge of or interest in your particular home or city — who can be paid to accept financial exposure of a defined nature for a fixed period of time in the event that one of the named events occurs.
This means we have a situation where whoever is buying or selling the risk is multiple steps away from the actual property. Sound familiar? It’s hard to gauge how far these instruments have spread into the financial system.
This sounds a lot like the financial weapons of mass destruction, such as the securitized instruments that were traded before the 2008 crash. What about rating agencies? Are they doing a better job of independently assessing risk?
In this instance, the entities which evaluate insurance-linked securities (and most of the reinsurance companies that trade them) all have proprietary systems for assessing various risks and exposure in the broader insurance market. Some like RMS and AIR have been modeling not only flood, earthquake, and tornado risk for years, but also perils like terrorist attacks and pandemics. Others like Jupiter and 427 focus on potential weather incidents, like wildfire, flood, sea rise, and drought.
One problem is that the inputs are not agreed. There is not consensus, at least in the United States, about existing flood risk even independent of sea-level rise, never mind about potential future rise. A second concern is that there also is not consensus about how to model what might happen. The third concern, and in my view most unnerving, is that these firms’ projections are proprietary. Modelers and the financiers that they service know more about the prospects for my property than I do. I find this information asymmetry to be worrying. Who is going to come out on the short end of the stick here?
The well-known credit rating agencies, like Moody’s, S&P, and Fitch, are behind the curve right now because they tend to focus on financial ratios, like debt service coverage and loan to value. For decades the natural disaster exposures of homes, municipal buildings, and power plants was static, and history of past loss was a very good guide to future loss. That guide is no longer reliable. That adjusted thought process will need to propagate through the industry as well, and that could change a lot of AAA bonds to BB+ and once more percolate down into collateral and swaps, as it did a decade ago — again touching many people who don’t live anywhere near the problem geographies and don’t even invest beyond their 401(k).
