Climate Change Risk and the Cost of Mortgage Credit

Climate Change Risk and the Cost of Mortgage Credit
Duc Duy Nguyen, Steven Ongena, Shusen Qi, Vathunyoo Sila
Review of Finance, Volume 26, Issue 6, November 2022, Pages 1509–1549, https://doi.org/10.1093/rof/rfac013

Does the residential property market incorporate risks related to sea level rise (SLR)? Several recent studies examine prices of US coastal homes. Evidence so far is mixed and suggests that there are barriers that prevent homebuyers, who are mainly retail investors, from incorporating SLR risks into house prices.

We tackle this question by examining mortgages on residential properties. While both residential mortgages and residential properties are exposed to similar risks (e.g. the uncertainty of home values and future cash flows due to SLR), financial institutions should be more sophisticated than average investors. While an average investor may purchase a house only a few times in their life, banks process a large volume of mortgage applications every day. Further, financial institutions are likely to have sophisticated risk systems in place that can appropriately identify, measure, and incorporate climate change risk.

Our results suggest that even for sophisticated investors such as banks, their ability to price SLR risk in residential mortgages is limited. We document a modest “SLR premium” in the residential mortgage market: lenders charge higher interest rate spreads on mortgage for properties exposed to greater SLR risk. For a $506,712 mortgage (our sample average), this SLR premium translates to about $9,000 increase in financing cost. We further evaluate the increase in implied probability of default associated with the SLR premium and find that the implied increase in default probability associated with the SLR premium is small compared to benchmarks in recent studies. These results suggest that financial institutions may not yet incorporate the full extent of SLR risk into their pricing of residential mortgages.

Moreover, we find that that lenders’ attention and attitudes towards climate change risk could be the mechanisms that prevent them from incorporating SLR risk into mortgage pricing. The SLR premium is less salient in the 1990s, when climate change was less recognized. Further, we find that the SLR premium is more salient following a hurricane or periods of heightened media attention to climate change. However, these effects quickly disappear, suggesting that lenders’ attention to climate change is short-lived. The SLR premium is also smaller in areas where fewer local residents (including local loan officers) believe that climate change is happening. Experience of lenders also matter, as we find that SLR premium is larger among small/local banks, banks that engage more in traditional banking activities, and banks that handle more mortgage applications for properties exposed to SLR risk.

Our paper adds to the understanding of how SLR risk is incorporated in residential properties by showing that banks are aware and attempt to price this risk in residential mortgages. However, the modest economic magnitude of the SLR premium, together with its sensitivity to factors such as local beliefs, attention, and lenders’ experience, highlight the challenges lenders face in incorporating and managing risks related to SLR. Our findings are especially important from a regulatory perspective because it demonstrates that a more standardized approach to measure and incorporate climate-related risk may be needed.

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