Climate change and sea level rise threaten to increase the default risk of mortgages on homes in coastal areas. Faced with this reality, small coastal lenders have begun selling more climate-sensitive mortgages to Fannie Mae and Freddie Mac, thereby transferring the risk of climate-induced default off the lenders’ books. Fannie Mae and Freddie Mac play a crucial role in supporting America’s mortgage finance system by purchasing qualifying private home loans, packaging them into investable security pools, and guaranteeing timely payment of principal and interest to outside investors. Through selling mortgages to Fannie Mae and Freddie Mac, lenders can use their increased liquidity to fund additional mortgages. The effectiveness of this process, however, is dependent on Fannie Mae and Freddie Mac accepting high-quality loans that carry minimal risks of default.

This Note argues that absent some form of intervention, small coastal lenders will likely continue offloading their climate-induced default risk until Fannie Mae and Freddie Mac become so overleveraged that they can no longer ensure a functioning secondary mortgage market and taxpayers are forced to bail them out—akin to the 2008 financial crisis. Further, this Note seeks to frame such harmful lending behavior as a general market failure, and, more specifically, as a variation of the Lemons Problem. Using familiar solutions to the Lemons Problem as guideposts, this Note attempts to curtail the asymmetrical offloading of climate-sensitive loans through a mixture of public and private mechanisms aimed at improving the ability of Fannie Mae and Freddie Mac to incorporate climate risks into loan purchasing decisions.

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AUTHOR: 

Peyton J. Klein