Thursday, November 28, 2019

Global Climate Change and its Potential Impact on the Banking Industry and Borrowers

As has become apparent, the very concept of global climate change has become one of the most divisive issues of our times.  Those on the denying side of the debate insist that changes in global temperatures are transitory and are most definitely not connected to the increased and cumulative emissions of greenhouse gases while those on the pro-climate change side of the equation sound regular alerts that climate change is about to have an irreversible and negative impact on our future survival as a species.  While all of this debate is interesting, a recent publication shows us that the debate itself is immaterial since all that really matters is how corporations, particularly those in the banking industry view the issue.

The Federal Reserve Bank of San Francisco recently published an extensive series of articles under its Community Development Innovation Review entitled "Strategies to Address Climate Change Risk in Low- and Moderate-income Communities".  One article in this publication by Michael D. Berman is of particular interest because it shows us how climate change (or the perception of climate change) could ultimately impact all of us, particularly those Americans who are living in flood-prone regions.

Let's open this posting by looking at data regarding both fluvial (river) and ocean/sea level flooding for the United States.  A 2018 paper "Estimates of present and future flood risk in the conterminous United States" published in Environmental Research Letters indicates that about 40.8 million Americans or 13.3 percent of the entire population of the study area are at risk of one in 100 year floods from flooding along rivers.  This is significantly higher than the estimates from FEMA which significantly understate the population impact of flooding as you can see on this graphic from the paper with SSP2 representing a medium population growth scenario and SSP5 representing a higher population growth scenario:

From the author's calculations, he author also calculates that this will have a $2.9 trillion impact on GDP and will impact $1.2 trillion worth of assets that are vulnerable to flood damage. 

In retrospect, let's look at fluvial flooding predictions for the main flooding season in 2019.  Here is a map from the National Oceanic and Atmospheric Administration (NOAA) showing the flooding outlook for the spring of 2019:

Now, let's look at ocean-related flooding.  According to NOAA, in 2018, the United States, the frequency of high tide flooding days reached five days, tying the record of 2015 as shown on this graphic:

Here is a map from Global Flood Map showing the regions of the United States that will be prone to flooding if sea level rises by 18 inches:

A sea level increase will result in the displacement of just over 14 million people.
Now, let's look at the paper entailed "Flood Risk and Structural Adaptation of Markets: An Outline for Action" by Michael Berman.  In his paper, Mr. Berman states that current tools are incapable of quantifying the risk of floods as the severity and frequency of floods increases across the United States.  While financial institutions and property owners have relied on historical flood data supply by FEMA, it is increasingly apparent that these maps are outdated and highly inaccurate and that new tools to accurately assess the likelihood of flooding need to be developed.  He states that financial institutions need to do four things:

1.) work together to create standardized metrics and tools, scoring systems and risk assessment tools to be utilized at the time of mortgage origination.

2.) oversee the creation and updating of these metrics and tools.

3.) utilize these new tools to better understand the risk of flooding at the time of mortgage origination.

4.) design and implement mortgage loan products that encourage prudent behaviour by borrowers. 

Here is a quote showing the results of these actions:

"The result of these actions will catalyze a series of additional steps as municipalities, engineers, architects, and building materials manufacturers “follow the money” to promote behaviors and capture new markets to reduce flood risk, as public awareness is increased. The new initiatives will in turn reduce losses to property owners, lenders, insurers, munici­palities as well as all of those who share in the direct and indirect losses from floods. The total positive impact on the social welfare of communities is truly beyond quantification."

Now, let's look a key and very important quote from this paper:

"From December 2017 to July 2018, the author of this article conducted a series of unstruc­tured interviews with over 20 national and regional participants in the mortgage and real estate industry. No lender, asset or portfolio manager, or buyer of commercial mortgage-backed securities (CMBS) first loss B-Pieces interviewed accounts for flood risk at the transac­tion date or over the life of the asset, other than determining whether a property requires flood insurance solely because it is in the 100-year floodplain at the initial transaction date. When specifically asked, no participant takes into account any of the following potential life of investment risk factors: (i) increases in flood insurance premiums, which may be substan­tial in light of the new FEMA risk rating system expected in 2020; (ii) adverse impacts on asset values and business interruption due to projected or actual increased flooding;15 or (iii) increases in local real estate taxes, as municipalities and counties increase spending on infrastructure to mitigate flood risk and/or sea level rise. For instance, no respondent had taken into account substantial new and/or projected infrastructure costs such as the $500 million of bonds for flood mitigation in Miami Beach or the estimated multi-billion dollar cost of converting from septic to sewerage systems in Miami-Dade County.

There is a real possibility that real estate values in some communities will be decreasing due to increased flood risk just as the real estate tax base is being relied on for funding of new flood mitigation infrastructure. Furthermore, if and when a 30-year mortgage is no longer available in a particular neighborhood due to flood risk (or the prohibitive price or lack of availability of flood insurance), property values will undoubtedly be substantially adversely impacted. This can be disastrous for a homeowner whose house is their largest asset and a substantial portion of their net worth. This will have a disproportionate adverse impact on low- and moderate-income (LMI) households. Obviously, this can result in a downward spiral of property values for such communities. While this is unlikely to be a substantial issue in the near term, the adverse impact on real estate portfolios of the GSEs, banks and other financial institutions may be substantial in the long run." (my bold)

I hope that you read that carefully.  What the author (a representative of the world's most influential central bank) is telling us is that, in the future, we can expect one of two things:

1.) financial institutions may decide to stop issuing mortgages to potential home purchasers in regions where there is increased risk of flooding.

2.) this will have a negative impact on the value of homes in these flood-prone areas which could wipe out the value of the real estate asset.

Let's close with this thought.  As I noted at the beginning of this posting, the concept of global climate change is one of the most divisive issues of our time.  While we are being distracted by this division, behind the scenes, changes that will impact millions of American households (not to mention households around the world) are in play.  Whether or not we believe that global climate change is to blame for the rise in flooding is immaterial.  It is the viewpoint of the world's financial institutions that matter.  If they believe that global climate change is negatively impacting the value of their enterprise, we can be assured that they will do everything possible to protect themselves and their profitability and will show absolutely no regard for our viewpoint on the cause of rising waters in our neighbourhoods.  As the 2007 - 2008 collapse in the banking sector proved, we matter little to the bankers among us. 

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