Extreme weather and high insurance costs pose foreclosure risk

The rising cost of homeowners’ insurance coupled with the rising regularity of weather-related natural disasters is serving to erode the longstanding barrier between mortgage lenders and loan losses, according to a new report published by First Street. As the frequency of disasters has risen — destabilizing the insurance market, limiting coverage and raising consumers’ costs — that barrier is beginning to show signs of stress.

If that barrier breaks down completely, it could lead to a spike in foreclosures, since “the financial stability of borrowers and the performance of their mortgages are increasingly at risk,” says First Street, an organization that previously declared it is “on a mission to connect climate change to financial risk.”

The report is First Street’s 13th National Risk Assessment and illustrates “that flooding events emerge as the primary driver of post-disaster foreclosures among perils, particularly when they occur outside [the Federal Emergency Management Agency (FEMA)]’s Special Flood Hazard Areas (SFHAs), where flood insurance is not mandatory.”

Indirect economic pressures also pose serious risks. Home prices in the areas impacted by 2012’s Hurricane Sandy show that they had fallen 14% annually over the five years preceding the disaster, eroding equity and options once the hurricane made landfall and devastated the Mid-Atlantic region.

“The combination of depressed home prices, lower equity, and flooding impacts led to a spike in foreclosures among damaged and flood-affected properties following Sandy,” the report explained.

“These factors produced ‘hidden’ credit losses to banks, with Sandy resulting in $68 million in unanticipated unpaid principal and interest—equivalent to $34 million in credit losses under a 50% loss-given-default assumption—that conventional credit-risk models failed to capture, highlighting the need to include Climate Risk as the 6th ‘C’ of a standard credit risk modeling framework.”

Indirect economic pressure could lead to as much as $1.2 billion in credit losses this year, with those losses estimated to rise to $5.4 billion by 2035.

“This growing share of foreclosure losses is largely driven by the escalating insurance crisis and the increasing frequency and severity of flooding anticipated in the coming decade,” the report stated. As a result, climate change is becoming a “critical factor to be evaluated alongside traditional metrics such as character, capacity, capital, collateral, and conditions.”