Fitch Ratings, one of the big three rating services (the other two are Moody’s and Standard and Poors) announced big changes to their pricing models that rates mortgage securities. What is changing? Why is this change so impactful? Why will commercial and residential mortgage rates increase? How will this impact property values?
Background on Mortgage Security rating
Before getting into the changes Fitch is making it is important to understand at a very high level how the mortgage market works. As mortgages are made by banks or other lenders many times they are bundled into securities. Banks do this to “turn their cash”. If a bank or other lender held all of their loans, they would likely exceed their capital very quickly if they are operating on a large scale.
After a security is created, the three rating agencies “grade” the security from AAA to D. With AAA being the safest, best quality, and least likely to default and D being the opposite as most risky. Buyers of securities use this rating to price in risk. A buyer would pay more for a AAA security as opposed to a D rated security.
It is important to note that bonds and yields work in inverse. The higher the price of security, the lower the yield. Someone buying a D rated security will demand a much higher return than someone buying an AAA security due to the risk. This means that the rates on lower rated securities will be considerably higher than AAA securities
How is Fitch changing their ratings?
Fitch Ratings will factor natural disaster and catastrophic risk into their ratings of residential mortgage-backed securities (RMBS), the firm announced Tuesday, the first of the three major U.S. credit ratings agencies to consider environmental risk explicitly for this asset class.
The adjustment would add a new penalty to existing risk metrics. It is expected to better distinguish mortgage pools with high exposure to natural disaster risk, namely those with high concentrations in Florida and California, said Bailey.
Why change the ratings now?
Last year Hurricanes Florence and Michael cost an estimated 49 billion with California wildfires adding another 24 billion in losses. “Over the last couple years, RMBS investors are increasingly focused on natural disaster risk. And we felt it would be helpful to try to quantify that for them,” said Grant Bailey, an analyst at Fitch who co-authored the report.
Natural disasters are becoming more expensive and prevalent in many areas and this risk needs to be factored into the rating. Not only is non-payment an issue but natural disasters are also a large risk to the performance of a security. For example if a house is wiped out by a hurricane, that would increase the risk of non-payment as the borrower is paying on a house they cannot use. Theoretically insurance would cover this cost, but let’s assume a hurricane displaces a resident for a 12-24 months as the house needs to be totally rebuilt. The risk of default (or strategic default) is greatly amplified.
Why is this change so important?
This is the first time that a security has tried to quantify the environmental risk and include this risk in the rating of mortgage pools. High risk areas will get dinged on their ratings due to environmental risk. These reductions in ratings will lead to a demand for higher yields from investors and ultimately higher rates.
How will this impact mortgage rates?
The required yield due to the riskiness of where a property is located will flow through the mortgage market. For example, let’s say a pool of loans in Colorado is rated AAA a similar pool of loans has a large concentration in California that has increased wildfire exposure. As a result of the increased risk of “natural disaster” this pool might have a AA rating. Investors who buy the pool with a high natural disaster concentration will demand a higher rate than the AAA pool. These costs will be factored into rates. Mortgage rates on a commercial building in a high risk area in California will be higher than a similar building in Colorado and Georgia without the risk.
Others will likely follow suit
Fitch is on the cusp of big changes in the mortgage securities market. Moody’s and S&P will likely follow suit as losses from environmental risk will continue to rise due to the growth in populations in high risk areas like Coastal areas and Western states.
How will this impact real estate values
We are already seeing this today where environmental risk is impacting values. Properties that are in flood areas many times are selling for less than properties in non-flood areas. A study on science daily found that properties in a flood zone sold for 7.3% less than non-flood zone properties. Currently flooding is the only environmental risk highlighted in mortgage securities. As Fitch and others quantify other environmental risks from hurricanes and fires look for property values to be impacted in these areas as well similar to the risk in flood zones.
Fitch is beginning a historic market shift to quantify environmental risk for security buyers. As others follow suit, the market will demand a premium for the increased risks associated with these mortgages. Although these changes will not happen overnight, eventually this will flow through the real estate market with higher costs for property owners in the higher risk areas and ultimately a decline in prices.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).