Adaptation Using Financial Markets: Climate Risk Diversification through Securitization

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 have a small impact on performance metrics such as deal losses, yield-to-maturity, and total returns, depending on the degree of spatial correlation and concentration. This paper builds a data set of the securitization chain from mortgage-level to MBS deal-level cash flows. 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 a mean-variance framework that trades off return and risk. Extrapolating wildfire risk using a wildfire probability model and temperature projections in 2050, the paper provides and implements a portfolio diversification algorithm that builds climate-resilient MBSs whose returns are minimally impacted by wildfire risk even as they supply mortgage credit to wildfire prone areas.