Adaptation Using Financial Markets: Climate Risk Diversification through Securitization

83 Pages Posted: 4 Apr 2024

See all articles by Matthew E. Kahn

Matthew E. Kahn

University of Southern California; National Bureau of Economic Research (NBER)

Amine Charles-Louis Ouazad

HEC Montréal

Erkan Yönder

John Molson School of Business, Concordia University

Multiple version iconThere are 2 versions of this paper

Date Written: March 7, 2024

Abstract

In the face of rising climate risk, financial institutions may adapt by transferring such risk to securitizers that have the skill and expertise to build diversified pools, such as Mortgage-Backed Securities. In diversified pools, exposure to climate risk may be a drop in the ocean of cash flows. This paper builds a data set of the entire securitization chain from mortgage-level to MBS deal-level cash flows, and observes the prices of the tranches at monthly frequency. Wildfires lead to higher rates of prepayment and foreclosure at the mortgage level, and larger losses during foreclosure sales. At the MBS deal level, a lower spatial concentration of dollar balances (lower spatial dollar Herfindahl), a lower spatial correlation in wildfire events (within-deal correlation), leads to a lower exposure to wildfire events. These quantifiable metrics of diversification identify those existing deals whose design makes them resilient to climate change. This paper builds optimal deals by finding the portfolio weights in an asset demand system that targets return and risk. Extrapolating wildfire risk using a granular wildfire probability model and temperature projections in 2050, we build climate resilient MBSs whose returns are minimally impacted by wildfire risk even as they supply mortgage credit to wildfire prone areas. Finally, we test whether the market prices the sensitivity of each deal's cash flow to wildfire risk.

Keywords: finance, mortgage-backed securities, climate risk, asset pricing, environmental economics

JEL Classification: G1,G10,G11,G12,G17,G21,G5,Q5,Q54,R3

Suggested Citation

Kahn, Matthew E. and Ouazad, Amine Charles-Louis and Yönder, Erkan, Adaptation Using Financial Markets: Climate Risk Diversification through Securitization (March 7, 2024). Available at SSRN: https://ssrn.com/abstract=4751898 or http://dx.doi.org/10.2139/ssrn.4751898

Matthew E. Kahn

University of Southern California ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Amine Charles-Louis Ouazad (Contact Author)

HEC Montréal ( email )

3000, ch. de la Côte-Ste-Catherine
Montréal, Quebec H3T 2A7
Canada

Erkan Yönder

John Molson School of Business, Concordia University ( email )

Montreal
Canada

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