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25 June 2024

Housing in a hothouse world: could it be the next financial crash?

In the coming decades, housing could become the largest stranded asset in the financial system. As the last financial crisis has shown, ignoring housing has great consequences and ignoring housing risks stemming from worsening climate change will have consequences that are likely to be even worse.

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This op-ed was originally published in Green Central Banking, on 24 June 2024.

Homes are being washed away by floods and burned down by wildfires, damage is caused by hailstones the size of golf balls, entire towns swept away by hurricanes and homes drift into the sea as a result of coastal erosion. These are all becoming far too common a sight with the worsening effects of climate change. Housing worldwide constitutes 60% of all mainstream investments and often the largest wealth we as individuals possess or are in the process of building up.

As the impact of climate change intensifies, there is potentially a systemic financial crisis building up on the horizon. Exacerbating the impact of climate change on housing wealth could potentially trigger large losses for the banks and the wider financial system as housing is key to financial (in)stability, creating a strong sense of déja vu.

As a guardian of financial stability, the European Central Bank (ECB) needs to take proactive measures to minimise and map both transition and physical risks in the real estate sector.

In the coming decades, housing could become the largest stranded asset in the financial system. In the real estate sector, stranding – defined as collapsing expectations of the future profit leading to wealth loss – could arise from losses in banks’ mortgage portfolios and borrowers defaulting on their loans. This would be caused by rising insurance and energy costs, coupled with the potential costs from physical destruction and rebuilding as a result of extreme weather events.

A study in Nature reveals that properties exposed to higher flood risk in the US are overvalued by US$121–$237bn, while the severity and frequency of flooding will increase by 11% as climate change intensifies. As a result, these assets could potentially become “bad apples” within the financial system.

Houses exposed to physical risks would become prohibitively expensive to insure or completely uninsurable. Already in the US, insurance companies have restricted the coverage they offer or pulled out of states such as Florida and California entirely. In the meantime, transition risk means that low energy performance buildings could see their values drop sharply. This could be systemically relevant for the financial sector, since residential mortgages constitute €4.1tn and commercial real estate another €1.4tn for the European banks.

Data gaps obscure risks on the ECB’s balance sheet

Housing related finance also has a global dimension.

Imagine a large climate-induced physical disaster in one part of the world, say in the US. There, the value of these assets would plummet and banks and insurers would incur losses on their books. Real estate is the most securitised asset in the world and the amount packaged, sold and traded somewhere else, albeit having significantly decreased since the global financial crisis, still remains notable.

As long as real estate is used in financial transactions across the world, climate risks in housing could also assume a global dimension.

The ECB is not immune as the matter concerns its balance sheet and its role in fulfilling its financial stability mandate.

Almost all of the covered bonds and half of asset-backed securities accepted by the ECB as collateral are backed by mortgages, which is around a third of all the collateral accepted by the ECB. Covered bonds are treated as ultra-safe assets rated triple and double A. The ECB has had three separate asset purchase programmes for covered bonds.

However, there is little information on the properties of this underlying asset class and its risks, such as its energy performance as well as physical risks. Not having enough information is a problem as it masks the full extent of climate risks on the ECB’s balance sheet and sends further signals of real estate as ultra-safe assets to be used in financial transactions.

We need to rebuild climate-proof housing to mitigate these risks. A useful starting point could be green lending operations directed at energy efficiency renovations. While it is not a panacea, it would help address some of the transition risks building up in the system.

Moreover, it would be prudent for the ECB to expand on physical risks in its stress tests and study their impact on banks’ liquidity, credit and operations. The ECB could develop this stress test together with the European Systemic Risk Board and the European Insurance and Occupational Pensions Authority as it has already done for transition risks in the retirement pensions sector in 2022.

As the last financial crisis has shown, ignoring housing has great consequences and ignoring housing risks stemming from worsening climate change will have consequences that are likely to be even worse.

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