Impacts of extreme weather events on mortgage risks and their evolution under climate change:A case study on Florida

International audienceWe develop an additive Cox proportional hazard model with time-varying covariates, including spatio-temporal characteristics of weather events, to study the impact of weather extremes (heavy rains and tropical cyclones) on the probability of mortgage default and prepayment. We compare the survival model with a flexible logistic model and an extreme gradient boosting algorithm. We estimate the models on a portfolio of mortgages in Florida, consisting of 69,046 loans and 3,707,831 loan-month observations with localization data at the five-digit ZIP code level. We find a statistically significant and non-linear impact of tropical cyclone intensity on default as well as a significant impact of heavy rains in areas with large exposure to flood risks. These findings confirm existing results in the literature and also provide estimates of the impact of the extreme event characteristics on mortgage risk, e.g. the impact of tropical cyclones on default more than doubles in magnitude when moving from a hurricane of category two to a hurricane of category three or more. We build on the identified effect of exposure to flood risk (in interaction with heavy rainfall) on mortgage default to perform a scenario analysis of the future impacts of climate change using the First Street flood model, which provides projections of exposure to floods in 2050 under RCP 4.5. We find a systematic increase in risk under climate change that can vary based on the scenario of extreme events considered. Climate-adjusted credit risk allows risk managers to better evaluate the impact of climate-related risks on mortgage portfolios

Consumer finance: challenges for operational research

Consumer finance has become one of the most important areas of banking, both because of the amount of money being lent and the impact of such credit on global economy and the realisation that the credit crunch of 2008 was partly due to incorrect modelling of the risks in such lending. This paper reviews the development of credit scoring—the way of assessing risk in consumer finance—and what is meant by a credit score. It then outlines 10 challenges for Operational Research to support modelling in consumer finance. Some of these involve developing more robust risk assessment systems, whereas others are to expand the use of such modelling to deal with the current objectives of lenders and the new decisions they have to make in consumer finance. <br/

Mortgage Default Risk and Real Estate Prices: The Use of Index-Based Futures and Options in Real Estate

Evidence is shown, using US foreclosure data by state 1975-93, that periods of high default rates on home mortgages strongly tend to follow real estate price declines or interruptions in real estate price increase. The relation between price decline and foreclosure rates is modelled using a distributed lag. Using this model, holders of residential mortgage portfolios could hedge some of the risk of default by taking positions in futures or options markets for residential real estate prices, were such markets to be established.

Operations research in consumer finance: challenges for operational research

Consumer finance has become one of the most important areas of banking both because of the amount of money being lent and the impact of such credit on the global economy and the realisation that the credit crunch of 2008 was partly due to incorrect modelling of the risks in such lending. This paper reviews the development of credit scoring,-the way of assessing risk in consumer finance- and what is meant by a credit score. It then outlines ten challenges for Operational Research to support modelling in consumer finance. Some of these are to developing more robust risk assessment systems while others are to expand the use of such modelling to deal with the current objectives of lenders and the new decisions they have to make in consumer financ

Exposure to Real Estate in Bank Portfolios

We implement a three-step procedure to assess the extent of exposure to real estate in commercial banks. First, we investigate the determinants of delinquency on real estate loans. We find the changes in interest rates and income to be the major determinants of aggregate delinquency rate. In the second step, we adopt a stress testing approach to calculate the potential impact on banks’ position of any adverse changes in these determinants. These calculations suggest that a 1.3 percentage point increase in mortgage interest rate leads to a 20% decrease in a typical bank’s distance to default. Finally, we look at the cross-sectional differences to identify the most vulnerable banks. Banks with rapid loan growth along with high cost-income ratio appear to be the most likely to experience a deterioration in their soundness.

A Risk Management Model for MBS Issuers

Most previous studies that developed Mortgage-backed Securities (MBS) models focused on investors, but the model that is presented here is specifically for MBS issuers. I developed a risk management tool for issuers and guarantors to monitor their MBS portfolios. The model projects the cash inflow of mortgages and the cash outflow to MBS; alters the traditional model by introducing decision trees; combines the prepayment, delinquency, default, and recovery of delinquency into a single model; and uses a simulation program with multiple path generation to develop a model for issuers to manage their MBS portfolios. According to the results of the model, issuers can manage the risk level of their portfolios by determining the Collection Account Balance, the Overcollateralization Ratio, the Net Residual Value, and the Liquidity Advance. The final part of this paper provides suggestions on risk management for MBS issuers.Mortgage-backed securities, risk management, MBS issuers, cash flow projection, Korea Mortgage Corporation

Can banks circumvent minimum capital requirements? The case of mortgage portfolios under Basel II

The recent mortgage crisis has resulted in several bank failures as the number of mortgage defaults increased. The current Basel I capital framework does not require banks to hold sufficient amounts of capital to support their mortgage lending activities. The new Basel II capital rules are intended to correct this problem. However, Basel II models could become too complex and too costly to implement, often resulting in a trade-off between complexity and model accuracy. In addition, the variation of the model, particularly how mortgage portfolios are segmented, could have a significant impact on the default and loss estimated and, thus, could affect the amount of capital that banks are required to hold. This paper finds that the calculated Basel II capital varies considerably across the default prediction model and segmentation schemes, thus providing banks with an incentive to choose an approach that results in the least required capital for them. The authors also find that a more granular segmentation model produces smaller required capital, regardless of the economic environment. In addition, while borrowers' credit risk factors are consistently superior, economic factors have also played a role in mortgage default during the financial crisis.Capital ; Banks and banking ; Basel capital accord

Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer

The Fannie Mae-Freddie Mac crisis may have been the most avoidable financial crisis in history. Economists have long complained that the risks posed by the government-sponsored enterprises were large relative to any social benefits. We now realize that the overall policy of promoting home ownership was carried to excess. Even taking as given the goal of expanding home ownership, the public policy case for subsidizing mortgage finance was weak. The case for using the GSEs as a vehicle to subsidize mortgage finance was weaker still. The GSE structure serves to privatize profits and socialize losses. And even if one thought that home ownership was worth encouraging, mortgage debt was worth subsidizing, and the GSE structure was viable, allowing the GSEs to assume a dominant role in mortgage finance was a mistake. The larger they grew, the more precarious our financial markets became. Regulators should contemplate freezing the mortgage purchase activities of the GSEs while at the same time loosening the capital requirements for banks to hold low-risk mortgages. The result would almost surely be an industry much less concentrated than the current duopoly. A housing finance system that does not rely so heavily on Freddie Mac and Fannie Mae will be more robust. We have to assume that sooner or later some of the institutions involved in mortgage finance will fail. The policy should be to promote a housing finance system where mortgage risk is spread among dozens of institutions. That way, the failure of some firms can be resolved through mergers and orderly restructuring, without exposing the financial system to the sort of catastrophic risk that is represented by Fannie Mae and Freddie Mac

The future of securitization

Securitization is a financial innovation that experiences a boom-bust cycle, as many other innovations before. This paper analyzes possible reasons for the breakdown of primary and secondary securitization markets, and argues that misaligned incentives along the value chain are the primary cause of the problems. The illiquidity of asset and interbank markets, in this view, is a market failure derived from ill-designed mechanisms of coordinating financial intermediaries and investors. Thus, illiquidity is closely related to the design of the financial chains. Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements