Exploring Climate Risk, Risk Retention, and CMBS: Understanding their Interplay

Abstract

This paper investigates how climate risks influence the CMBS market and examines the role of the Dodd-Frank Act's risk retention rule in shaping the behavior of CMBS issuers and loan originators. Using a dataset of over 40,000 loans from 556 CMBS deals issued between 2011 and 2018, we identify significant moral hazard within the "originate-to-distribute" model, particularly related to climate risks. Our findings indicate that following the implementation of the risk retention rule, CMBS issuers reduce their exposure to high-risk geographic areas. In contrast, in the absence of this rule, loan originators expedite the securitization of climateaffected loans, while underwriters avoid including such loans in their portfolios. Although climate risk is reflected in loan pricing, we find evidence of mispricing at the deal level. These results highlight the need for strong regulations to align the interests of market participants and mitigate moral hazard, with important implications for investors, policymakers, and financial stability.