Incorporating Climate Risk into Credit Risk Modeling: An Application in Housing Finance

Alexandra Lefevre and Agnes Tourin ()
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Alexandra Lefevre: Department of Mathematics for Engineering, Courant Institute of Mathematical Sciences, New York University Tandon School of Engineering, 2 MetroTech Center, Room 865, Brooklyn, NY 11201, USA
Agnes Tourin: Department of Finance and Risk Engineering, New York University Tandon School of Engineering, 6 MetroTech Center, Brooklyn, NY 11201, USA

FinTech, 2023, vol. 2, issue 3, 1-27

Abstract: This paper examines the integration of climate risks into structural credit risk models. We focus on applications in housing finance and argue that mortgage defaults due to climate disasters have different statistical features than default due to household-specific reasons. We propose two models incorporating climate risk based on two separate default definitions. The first focuses on default as a response to a decrease in home value, and the second defines default as a consequence of missed mortgage payments. Using mortgage performance data during Hurricane Harvey, we conduct an empirical study whose results suggest that climate events are potentially another source of undiversifiable credit risk affecting homeowners’ ability to make contractual monthly payments. We also show that incorporating this climate-specific default process may capture additional uncertainty in default probability assessments.

Keywords: climate risk; credit risk; mortgage default; Merton model; compound Poisson process (search for similar items in EconPapers)
JEL-codes: C6 F3 G O3 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:gam:jfinte:v:2:y:2023:i:3:p:34-640:d:1234941

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