Federal Housing Finance Agency
Office of Inspector General
Disaster Risk for Enterprise
Single-Family Mortgages
White Paper
•
WPR-2021-004
•
March 23, 2021
WPR-2021-004
March 23, 2021
Executive Summary
Fannie Mae and Freddie Mac (the Enterprises) recognize that they may be
exposed to the risk of losses on mortgages they own or guarantee from
disasters such as floods, earthquakes, and wildfires. According to the
Enterprises, natural disasters have not resulted historically in significant losses
for them. However, they recognize that a number of factors, such as the
growing risk of floods or fires in many parts of the country, and climate
change may cause disaster risk to increase.
Other market participants bear some of the disaster risk associated with
Enterprise mortgages. For mortgages to be eligible for purchase by the
Enterprises, both Enterprises require the borrowers to have property insurance
that protects against certain natural perils, such as wind and fire, and flood
insurance is required for homes in certain high-risk areas. In addition, the
Enterprises transfer part of the credit risk for a portion of their mortgages to
investors in credit-risk transfer (CRT) transactions.
We prepared this white paper to provide information about how the Federal
Housing Finance Agency (FHFA or Agency) and the Enterprises view disaster
risk for Enterprise single-family mortgages and to describe the ways in which
other market participants bear some of this risk.
OIG • WPR-2021-004 • March 23, 2021 3
TABLE OF CONTENTS ................................................................
EXECUTIVE SUMMARY .............................................................................................................2
ABBREVIATIONS .........................................................................................................................4
BACKGROUND .............................................................................................................................5
DEFINITION OF DISASTER RISK ..............................................................................................5
THE ENTERPRISES PROJECT DISASTER RISK MAY INCREASE ........................................6
WHO BEARS DISASTER RISK ON ENTERPRISE MORTGAGES ..........................................6
Mortgage Insurance ..................................................................................................................6
Property Insurance ....................................................................................................................7
Flood Insurance ................................................................................................................7
Earthquake Insurance ........................................................................................................8
Credit-Risk Transfer .................................................................................................................8
CONCLUSION ................................................................................................................................9
OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................10
ADDITIONAL INFORMATION AND COPIES .........................................................................11
OIG • WPR-2021-004 • March 23, 2021 4
ABBREVIATIONS .......................................................................
CRT Credit-Risk Transfer
Enterprises Fannie Mae and Freddie Mac
FEMA Federal Emergency Management Agency
FHFA or Agency Federal Housing Finance Agency
OIG Federal Housing Finance Agency Office of Inspector General
OIG • WPR-2021-004 • March 23, 2021 5
BACKGROUND ..........................................................................
Fannie Mae and Freddie Mac recognize that they may be exposed to the risk of losses on
mortgages they own or guarantee from disasters such as floods, earthquakes, and wildfires.
1
In its 2020 10-K, Fannie Mae reported that a single natural disaster of significant scope or
intensity could have a material impact on its financial condition. Similarly, Freddie Mac, in its
2020 10-K, noted its possible exposure to increased credit losses in the event of a major
natural disaster or significant climate change effects.
FHFA also has recognized risks that disasters pose to the Enterprises. FHFA has called risks
relating to uninsured or underinsured losses from flooding, earthquakes, and other natural
disasters “material” risks to the Enterprises. The Agency is seeking public input on the
potential risks to the housing finance system from natural disasters.
DEFINITION OF DISASTER RISK ..................................................
Neither FHFA nor Fannie Mae have adopted formal definitions of natural disaster risk.
Freddie Mac defines natural disaster risk as the credit loss to Freddie Mac that can occur
due to natural perils that cause a borrower to default. It observes that these perils are typically
low probability events that are difficult to predict and measure.
Fannie Mae and Freddie Mac refer to disasters in their guides for mortgage servicers, such as
to specify assistance that must be provided to borrowers in the event of a disaster. Both
Enterprises list earthquakes, floods, and hurricanes as examples of natural disasters.
According to FHFA, the loss mitigation options offered to borrowers in disaster-impacted
areas help borrowers recover from disasters, thereby reducing potential losses to the
Enterprises.
1
The Enterprises also face the risk that natural disasters may pose to their employees, facilities, systems, and
counterparties. For more information about Enterprise business resiliency and disaster recovery, see OIG,
Enterprise Business Resiliency: Risk Mitigation and Plan Development (March 22, 2021) (WPR-2021-003)
(online at www.fhfaoig.gov/sites/default/files/WPR-2021-003.pdf
) and OIG, For Nine Years, FHFA Has
Failed to Take Timely and Decisive Supervisory Action to Bring Fannie Mae into Compliance with its
Prudential Standard to Ensure Business Resiliency (March 22, 2021) (EVL-2021-002) (online at
www.fhfaoig.gov/sites/default/files/EVL-2021-002_(Redacted).pdf).
OIG • WPR-2021-004 • March 23, 2021 6
THE ENTERPRISES PROJECT DISASTER RISK MAY INCREASE .......
According to the Enterprises, natural disasters have not resulted historically in significant
losses for them. They view their loss exposure as reduced by geographic diversity, insurance
coverage, and CRT transactions, among other factors. According to Fannie Mae, natural
disasters do not directly result in credit losses; various steps determine whether a credit loss
will be incurred. Freddie Mac has noted that the ultimate loss impact from natural disasters
can often take years to realize.
According to Fannie Mae, flooding currently poses the most pertinent disaster risk to its
portfolio, and the risk is growing. Fannie Mae reported in its 2020 10-K that there are
concerns that the frequency and intensity of major weather-related events indicate the impact
of climate change and that this change will persist. The Enterprise added that more people are
living in high-risk areas, such as coastal areas that are vulnerable to severe storms and
flooding. Fannie Mae noted that the risk of significant flooding is expected to increase in
places outside of areas where flood insurance is currently required. In October 2020, Fannie
Mae’s CEO said, during an earnings call, that tackling the growing risk of floods and fires in
many parts of the country was part of the “new normal” for the Enterprise’s business. Freddie
Mac has noted that climate change could create additional risk due to significant long-term
changes to the environment, such as increased frequency and severity of adverse weather
events and rising sea levels.
WHO BEARS DISASTER RISK ON ENTERPRISE MORTGAGES .......
Mortgage Insurance
Under their charters, the Enterprises may only purchase conventional single-family mortgages
with loan-to-value ratios greater than 80% if the mortgages are supported by one of three
types of credit enhancements. Mortgage insurance is the credit enhancement used for the vast
majority of these Enterprise purchases. Mortgage insurance transfers a portion of the risk
arising from default of a mortgage to an insurer.
2
However, according to FHFA, mortgage
insurance does not cover defaults where the principal cause of default is physical damage due
to natural disasters (unless the property is restored to its original condition).
2
For more information about mortgage insurance for Enterprise loans, see OIG, Update on Mortgage Insurers
as Enterprise Counterparties (March 8, 2021) (WPR-2021-001) (online at
www.fhfaoig.gov/sites/default/files/WPR-2021-001.pdf
).
OIG • WPR-2021-004 • March 23, 2021 7
Property Insurance
For mortgages to be eligible for purchase, both
Enterprises require the borrowers to have property
insurance that protects against certain natural
perils, such as wind and fire.
3
FHFA told us that
property insurance covers most causes of damage
except for flood and earthquake risk. Figure 1
provides examples of Enterprise insurance
requirements by type of disaster.
Flood Insurance
In keeping with federal law, both Enterprises require homes located in special flood hazard
areas, as designated by the Federal Emergency Management Agency (FEMA), to be covered
by flood insurance in order for the mortgages on those homes to be eligible for purchase by
the Enterprises. The Enterprises could expand their requirements beyond the FEMA-
designated flood zones to include more geographic area, but have not as of this writing.
Borrowers typically obtain flood insurance through the National Flood Insurance Program
managed by FEMA but can also obtain such coverage from a private insurer (if certain
conditions are met). Fannie Mae reported that, as of December 31, 2020, 3.4% of its single-
family mortgages were located in special flood hazard areas. Approximately 4% of Freddie
Mac’s portfolio had flood insurance at origination as of December 2020, according to the
Enterprise.
According to Fannie Mae, many homeowners may be uninsured or underinsured for flood
risk. Fannie Mae notes that inadequate insurance coverage contributes to defaults after
flooding and to credit expenses for the Enterprises. As Fannie Mae reported to FHFA, flood
events frequently occur outside of special flood hazard areas, potentially causing significant
losses for homeowners. Similarly, Freddie Mac told FHFA that FEMA’s flood maps
frequently vary from areas that are actually inundated. According to Freddie Mac,
approximately 83% of homes affected by 2017 hurricanes were not required to have flood
insurance. First Street Foundation, which models flood risk, reported in February 2021 that
2.7 million properties at risk of structural damage were located in areas having substantial
flood risk but were outside of designated special flood hazard areas.
4
Even homes with flood
insurance can be underinsured because coverage through the National Flood Insurance
3
Often the Enterprises’ disaster losses come from their real-estate owned (foreclosed properties), which the
Enterprises self-insure according to FHFA.
4
See First Street Foundation, The Cost of Climate: America’s Growing Flood Risk (February 2021) (online at
https://assets.firststreet.org/uploads/2021/02/The_Cost_of_Climate_FSF20210219-1.pdf
).
Type of
Disaster
Requirement
Wind
Fire
Flood
flood hazard areas
Earthquake
FIGURE 1. EXAMPLES OF ENTERPRISE
INSURANCE REQUIREMENTS
OIG • WPR-2021-004 • March 23, 2021 8
Program has a $250,000 limit for the structure. FHFA explained that borrowers generally do
not purchase additional coverage outside of the National Flood Insurance Program.
Fannie Mae reported in its 2020 10-K that the Enterprise was exploring the role that it, along
with FHFA and others, could play in helping to address some of the risks associated with
natural disasters. In particular, Fannie Mae said that it was examining flood risk and insurance
beyond its current requirements. Fannie Mae added that developing solutions was
complicated by factors such as the range of affected stakeholders, the possible need for
legislative or regulatory action, industry insurance capacity, and affordability.
Earthquake Insurance
According to the Enterprises, they do not currently require homes to have earthquake
insurance in order for the mortgages to be eligible for purchase, including homes in
earthquake-prone areas.
5
FHFA reports that damage caused by earthquakes is not covered in
the vast majority of single-family homeowner insurance policies in vulnerable areas, and very
few homeowners carry separate earthquake insurance. It explained, in 2018, to Congress that
the cost of earthquake insurance was prohibitive and, in its view, a viable market for
earthquake insurance did not exist for the single-family mortgage market. FHFA further
reported that, for those homeowners who obtained earthquake coverage, that coverage
generally was not sufficient to cover the damage to the property.
According to Fannie Mae’s 10-K, earthquakes are one of the two most likely scenarios where
property damage may result in default not covered by property insurance (with the other being
flooding outside of special flood hazard areas). Analysis conducted for Freddie Mac projected
that a single earthquake could result in large potential losses.
Credit-Risk Transfer
Fannie Mae and Freddie Mac have CRT programs that transfer part of the risk of default for a
portion of their single-family mortgages to investors. The Enterprises use transactions
including security issuances and reinsurance transactions to transfer the risk. FHFA has noted
that CRT is intended to cover losses to the Enterprises above what is covered by property,
flood, or earthquake insurance. According to Fannie Mae, for loans covered by CRT, CRT
would cover all weather and disaster-related losses except the amount of loss exposure
retained by the Enterprise. Freddie Mac has explained that there are no “carve-outs” in issued
5
Fannie Mae had required earthquake insurance for mortgages for properties in Puerto Rico and Guam but has
dropped those requirements. California historically has been at risk for earthquakes. However, Fannie Mae
indicates that, under California law, if the Enterprises were to require earthquake insurance for detached single-
family homes in the state, then the state-established earthquake insurer (which is unique to California) would
have to suspend insuring additional homes.
OIG • WPR-2021-004 • March 23, 2021 9
CRT transactions for natural disaster risk. However, FHFA has reported that some Enterprise
mortgages might not be covered by CRT, including those that experience a disaster prior to
being included in a CRT transaction. An industry observer recently noted that natural
disasters remain a risk for CRT.
According to the Enterprises, their single-family CRT issuances were disrupted as a result of
the pandemic. Fannie Mae reported that it did not enter into new transactions in the second
quarter of 2020, and it remained out of the market after market conditions improved.
6
Freddie
Mac reported that its single-family CRT issuances declined significantly during the second
quarter of 2020, with no issues of its standard CRT transactions.
7
The Enterprise executed
new transactions beginning in the third quarter, but cautioned that the pandemic could
continue to adversely affect its CRT transactions.
CONCLUSION ............................................................................
Fannie Mae and Freddie Mac recognize that they may be exposed to the risk of losses on
mortgages they own or guarantee from disasters such as floods, earthquakes, and wildfires.
According to the Enterprises, natural disasters have not resulted historically in significant
losses for them. However, they recognize that a number of factors, such as the growing risk of
floods or fires in many parts of the country, and climate change may cause disaster risk to
increase.
Other market participants bear some of the disaster risk associated with Enterprise mortgages.
The homeowner’s property insurance covers some risks, for example, and flood insurance is
required for homes in certain high-risk areas. Fannie Mae has reported that the two most
likely scenarios where property damage may result in default not covered by property
insurance are flooding outside of special flood hazard areas and earthquakes. The Enterprises
transfer part of the credit risk for a portion of their mortgages to investors in their CRT
transactions. According to the Enterprises, their single-family CRT issuances were disrupted
as a result of the pandemic.
6
The Enterprise said that it was evaluating the costs and benefits of CRT, including the capital relief provided
under FHFA’s regulatory capital framework. Fannie Mae reported that, as a result of not resuming CRT, the
portion of its single-family business protected by credit enhancement fell from 53% in 2019 to 42% at year-end
2020.
7
Freddie Mac reported that, driven by lower CRT issuance, credit enhancement coverage of its single-family
portfolio fell to 54% in the second quarter of 2020 from 58% in the first quarter.
OIG • WPR-2021-004 • March 23, 2021 10
OBJECTIVE, SCOPE, AND METHODOLOGY .................................
The objective of this white paper was to provide information about how FHFA and the
Enterprises view disaster risk for Enterprise single-family mortgages and about who bears
this risk. The focus was credit losses from physical disasters such as floods, earthquakes, and
wildfires. To achieve this objective, we reviewed FHFA and Enterprise documents as well as
publicly available documents. We also interviewed FHFA and Enterprise officials.
We provided FHFA with the opportunity to respond to a draft of this white paper. We
appreciate the cooperation of FHFA staff, as well as the assistance of all those who
contributed to the preparation of this white paper.
OIG • WPR-2021-004 • March 23, 2021 11
ADDITIONAL INFORMATION AND COPIES .................................
For additional copies of this report:
• Call: 202-730-0880
• Fax: 202-318-0239
• Visit: www.fhfaoig.gov
To report potential fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:
• Call: 1-800-793-7724
• Fax: 202-318-0358
• Visit: www.fhfaoig.gov/ReportFraud
• Write:
FHFA Office of Inspector General
Attn: Office of Investigations – Hotline
400 Seventh Street SW
Washington, DC 20219