During the mortgage bubble in the early 2000s, when investors were feverishly trading faulty subprime bonds, a few savvy skeptics recognized the bonds were doomed, so they bet against them. They shorted the bonds and made billions.
Now one of those players is doing the same thing, but not on subprime. He’s doing it based on the risks to the housing market from climate change and the coronavirus pandemic.
Dave Burt is a financial analyst who looks at risk in real estate derivatives markets. That’s what he was doing back in 2005, analyzing vast pools of subprime mortgage bonds that Wall Street was creating and trading. He examined the homes and borrowers who owned them.
“I had a strong suspicion that they would go bad,” said Burt.
Burt sold his findings to the few investors who wanted to short those pools of mortgages. They were right and made billions. He was featured in Michael Lewis’ best-selling book “The Big Short.”
“Burt had the most sensational information and models to analyze the information,” Lewis wrote. “He could tell you, for example, what would happen to mortgage loans zip code by zip code in various house price scenarios.”
Floods, fires and wind
Burt now says he can do the same thing when it comes to climate risk.
Burt says that as the risks of floods, fires and wind increase, the cost of owning a home will go up — costs from higher insurance rates, higher taxes and uninsured losses. As the cost goes up, the value of the home goes down, and, consequently, the mortgage on the home is at higher risk of default.
It is just like during the subprime storm, when borrowers who couldn’t really afford the homes they were buying were offered loans that were cheap up front but then quickly turned expensive. They then defaulted on those loans, and home values crashed, bringing the broader economy down with them.
“This is going to be much more broadly impactful than just a mortgage story,” said Burt, who is using data from Boston-based risQ, a data analytics firm specializing in climate risk. He’s looking at specific areas where home values are likely to fall from climate impacts, causing homeowners to walk away from their mortgage.
In order to profit off that information, he’s going to short a specific type of mortgage bond.
“These bonds are issued by Fannie Mae and Freddie Mac to essentially protect them against the first X number of losses,” he explained.
Burt thinks those bonds are overvalued because, by his calculations, close to a third of U.S. homeowners are vulnerable to big losses in the value of their homes from climate change.
“I think it’s quite viable and indeed as an economic proposition but also as a political proposition,” said Jesse Keenan, associate professor of real estate at Tulane University and a climate expert.
Keenan said he believes that in a Biden administration, more focused on climate overall, and with the potential for Fannie Mae and Freddie Mac to come out of government conservatorship, investors will be looking even more closely at these credit risk transfers.
“It shows now there is a market for credit risk transfers. You have a market, a buyer, a seller, an underwriter. I think it’s all there,” said Keenan.
Burt is essentially profiting off of people’s peril. He admits that, with one caveat.
“Honestly, I’m doing this in large part less for the profits and more to make a difference. The subprime mortgage problem, if people had become aware, through realization of market losses, of the problems being created by subprime risk in 2005, 2 million households wouldn’t have had to go through foreclosure,” he said.
Burt says he will take half the profits generated by his investments and put them into a nonprofit that will, in turn, invest in clean energy technology, carbon capture technology and social response efforts to the effects of climate change. More importantly, he claims he is educating the financial market about climate risk, even as he takes a risk himself.
“The biggest risk to this approach is timing. How long can I pay for those shorts before this theme gets realized?”
In other words, before the the devastating impacts of climate change create massive dislocation.
Burt recently launched his own investment firm, Delta Terra Capita, which bills itself as “climate risk intelligence for institutional investors.” Its platform offers tools to measure the physical risk of real estate losses and then translate that into the financial impacts on real estate investments, mortgage securities and related derivatives.
Now Burt is adding the coronavirus to the mix because he believes climate and Covid together make the bet even bigger.
“Covid has created a lot of problems fundamentally for the systems that support the housing market and have potentially been contributing to the mispricing of these climate risks and asset values. Namely, that insurance premiums are too low,” said Burt.
About 3 million mortgages are now in government or private sector Covid bailout programs, and there is no guarantee that those borrowers will ever get current on their loans again, so the homes are at risk of foreclosure.
“You’re talking about very high delinquency rates of mortgages that we all thought were much higher quality than, for instance, you saw before the crisis,” explained Burt.
Rising foreclosures cause surrounding home values to fall. Home prices right now are inflating fast because of huge demand from Covid’s stay-at-home culture.
“It’s really the conflated impact of climate risks being rationalized in valuations and the current state of the economy, as a result of the Covid impacts, that will create these substantial value declines,” he added.