Financial Risks This Hurricane Season

SMITH BRAIN TRUST – The 2020 Atlantic hurricane season is forecast to be among the worst. And that has Maryland Smith’s Clifford Rossi taking a close look at the potential financial risks.

Rossi, professor of the practice in finance at the University of Maryland’s Robert H. Smith School of Business, recently completed an empirical study on the impact of hurricane frequency and intensity on mortgage default risk.

In his research, which included a sample of 100,000 Freddie Mac mortgages along with FEMA data, he finds that with an increasing frequency of major hurricanes there will also be a sizable increase in borrower defaults. The results, he writes, carry “significant implications” for borrowers and investors in mortgage credit risk.

First, he writes, if long-term hurricane trends bear out, and the frequency and intensity for major Atlantic hurricanes continues to rise, mortgage default risk along the East Coast will likely rise in tandem.

Second, investors in mortgage credit risk from hurricane-prone locations will face higher default losses. Unless Fannie Mae, Freddie Mac and the Federal Housing Administration factor that risk into their pricing of credit risk, these government-sponsored enterprises would be underpricing hurricane risk effects on default. “This could also affect risk-based capital requirements and loan loss reserve estimates for Fannie Mae and Freddie Mac,” Rossi notes.

And third, he says, private investors of GSE credit-risk transfer (CRT) securities could experience higher credit losses associated with pools of loans from hurricane-prone areas. Those investors in lower-rated tranches would be particularly impacted given the nature of their exposure to losses that happen earlier, compared to the more highly rated tranches.

Further use of so-called catastrophe bonds could be one vehicle to diversify hurricane risks, Rossi says. Such bonds could be set up as part of a CRT transaction that would transfer hurricane default risk to another investor such as a reinsurer.

For prospective homeowners, he says it will become increasingly important to become informed on where a property is located in terms of flood and hurricane risk.