Property damage from physical climate risk has become increasingly common. According to the US National Oceanic and Atmospheric Administration, 119 weather and climate disasters that each entailed more than US$1 billion in property damage have occurred in the United States since 2010—roughly twice the number of such events that occurred in the previous decade. Globally, economic losses from natural disasters reached US$133 billion in 2019, only around US$56 billion of which were insured, according to the Swiss Re Foundation.

The frequency and magnitude of these disasters are projected to intensify in the coming decade, with the southern United States particularly exposed to heightened hurricane and flood risks. The rising risk of property value loss related to catastrophic events increases the importance of distinguishing projected mortgage pool losses between pools, based on exposure to natural disaster risk. Geographical characteristics (concentration, insurance coverage) can heavily influence probability of default (PD) emerging from natural disasters, but it is important to understand the extent to which these risks are managed. Figure 1 shows the average cost of damages from severe weather in the United States.

Figure 1. Average Cost of Severe Weather Events in the USA, 1980–2019 (US$ billions)

At Fitch, we use a two-layer approach to integrating climate risk into US residential mortgage-backed security (RMBS) loan loss expectations:

1.       Implicit adjustment: The methodology implicitly considers natural disaster and catastrophe risk based on past natural disasters in the historical dataset used to develop the loan loss model; geographic concentration penalties (e.g., RMBSs with greater concentrations in California and Florida will be affected more than those concentrated in other states); and rating scenarios that assume severe housing and economic stresses.

2.       Explicit adjustment: Further adjustment is made through an additional penalty (or credit) layered on to rating stress assumptions detailed in the aforementioned implicit adjustments. The additional adjustment includes projected property losses from storm surge, inland flooding, and earthquakes, but it does not explicitly consider the risk of disasters that are typically covered by standard homeowners insurance (e.g., fire damage or wind damage from tornadoes). The adjustment is intended to better distinguish among RMBSs with different levels of estimated natural disaster risk.

Fitch uses the estimated property losses from future catastrophic events to reduce each borrower’s current property value when projecting credit losses. The reduction in the current property value negatively affects the borrower’s loan-to-value ratio and, consequently, influences both projected probability of default and projected loan losses on those defaults.

Fitch’s approach to sustainable finance and climate risk is to provide better transparency on ESG-related credit risks that influence credit ratings. We have achieved this goal through our ESG Relevance Scores, which have been fully integrated into our existing research process.

Our analysts systematically evaluate ESG credit considerations that are incorporated into ratings methodologies. When assessing credit transactions, analysts will refer to the asset class and sector ESG templates to allocate overall and individual E, S, and G Relevance Scores. One such element in the case of catastrophe risk is “Exposure to Environmental Impacts.” Figure 2 shows the ESG template for RMBS transactions.

Figure 2. ESG Template for RMBS Transactions

Source: Fitch Ratings

Fitch Ratings’ ESG Relevance Scores, illustrated in Figure 3, reveal how our analysts integrate ESG credit considerations into their credit analysis and ratings. A score of 5 represents ESG issues that currently have a direct impact on the rating all by themselves, and a score of 1 represents ESG issues that have no credit impact or are irrelevant to both the entity and the sector from a credit perspective.

Figure 3. ESG Relevance Scoring Definitions

Source: Fitch Ratings, “Introducing ESG Relevance Scores for Structured Finance and Covered Bonds” (15 October 2019).

Investors use Fitch’s ESG Relevance Scores to understand the level of credit-specific ESG risk being captured in the credit ratings of entities or transactions in their portfolios. ESG Relevance Scores also assist investors in assessing whether they need to consider and/or incorporate additional downside risk or upside potential related to ESG credit considerations into their credit analysis and models.

This rated transaction consists of 7,026 prime quality seasoned residential mortgage loans with a total balance of US$425.9 million as of the cutoff date. The pool has an unusually low average loan-to-value ratio of 49.6%, with 94% of fixed-rate mortgages under 30 years duration, and 90% of payments made on time in the past 2 years. Despite these metrics, a number of negative factors are driving the overall elevated ESG Relevance Score of 5, indicating a direct impact on the ratings driven by Exposure to Environmental Impacts (see Figure 4).

Figure 4. ESG Navigator for BRAVO Residential Funding Trust 2019-2 T

Because of this pool’s large concentration in the Gulf Coast region, natural disaster and catastrophe risk are far higher compared with most transactions. Approximately 43% of the pool is concentrated in Louisiana and an additional 33% in Texas, resulting in a 1.16´ PD adjustment for the geographic concentration and increasing expected loss (EL) by 104 basis points (bps). This is one of the largest adjustments Fitch has made for geographic concentration.

Nearly a quarter of the pool is located in an area recently listed by federal agencies as a natural disaster area in response to Hurricane Barry in 2019. Fitch haircut property values for homes located in these areas by 10% to reflect the potential risk of property damage. Multiple studies of US Federal Emergency Management Agency natural disaster areas find a significant detrimental effect on local property values, accounting for other factors, driven by higher insurance premiums and anticipation of future damage.

To account for potential future risk of natural disaster, the catastrophe risk adjustment added 28 bps to expected loss levels. Given the highly concentrated profile of the pool, however, we doubled the catastrophe risk adjustment to 56 bps.

This mortgage pool consists of very high-quality 30- and 25-year, fixed-rate, fully amortizing loans to borrowers with strong credit profiles, relatively low leverage, and large liquid reserves. It has a combined loan-to-value (CLTV) ratio of 68%. Approximately 44% of the pool is concentrated in California, with relatively low municipal concentration. The largest municipal concentration is Los Angeles (20.4%), followed by Miami (11.7%) and New York (7.2%). These areas account for nearly 40% of the pool. As a result, Fitch applied a 1.03´ PD adjustment for geographic concentration.

An ESG Relevance Score of 3 for Exposure to Environmental Impacts reflects the fact that this transaction has cash flow exposure to extreme weather events, such as flooding, hurricanes, tornados, and earthquakes, but this factor has minimal impact on the rating because of the characteristics already outlined (see Figure 5). We note some evidence of insurers withdrawing from high wildfire risk areas, such as parts of California, but in most cases, these properties would be covered by standard insurance policies.

Figure 5. ESG Navigator for Sequoia Mortgage Trust 2020-3

These examples highlight the key role of asset location and geographical concentration, together with underlying fundamentals, as key drivers of credit risk. Mortgage pools with a high geographical concentration and a concentration in areas of heightened natural disaster risk are likely to face a double penalty in terms of expected loss/PD because of the likelihood of multiple insurance claims from multiple disasters within the area (driving up premiums and lowering property values), as well as anticipation of increased magnitude and frequency of such disasters in the future.

Nonetheless, rated transactions with high geographical concentration but strong underlying credit profiles and shorter average loan maturities will be better placed to manage these risks, as highlighted in our second example. This underlines the importance of integrating ESG factors in credit ratings research in a consistent and transparent way, while providing reasonable forward-looking assessments of these risks.

More information on Fitch’s ESG Research is available at: https://www.fitchratings.com/topics/esg.

© 2020 Fitch Ratings Ltd. All rights reserved.

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