A Theoretical Analysis of the Implications of Rising Climate Risk and Adaptive Investments on House Prices, Mortgage Credit Volumes and Financial Stability

This research studies what the implications are of rising climate risk on house prices, mortgage credit volumes and default rates, thereby establishing a relationship between rising climate risk and financial stability. In a theoretical framework, climate risk is introduced by modeling a flooding event which potentially damages the house of agents. As climate risk rises over time, the expected damages as caused by this flooding event increase over time, which leads to a rise in house value risk in the long run and causes houses to trade at a discount in the market - a result which is consistent with the empirical literature. Despite the fall in house prices, mortgage credit volumes continue to rise until redistributive growth reaches its saturation point. As the decline in house prices and simultaneous rise in mortgage credit volumes causes loan-to-value ratio’s to increase, the increase in climate risk is associated with a rise in default rates. Once investments in adaptation are introduced, the expected damages fall at first which causes house prices to increase slightly. However, once climate risk becomes sufficiently pressing, the expected damages continue to rise and house prices fall sharply, reaching levels which are only marginally higher than in the model with climate risk. As the investments in adaptation need to be financed, mortgage lending volumes now reach higher level than in the model with climate risk and, once redistributive growth has reached its saturation point, mortgage lending volumes decline at a much slower pace. This causes loan-to-value ratios and, as a consequence, default rates to become higher than in the model with climate risk, which indicates that there exists a trade-off between preventing damages from climate change and safeguarding financial stability